Man, Economy, and State with Power and Market






5 Man, Economy, and State with Power and Market : © Copyright 2004 by Ludwig von Mises Institute, Scholar’s Edition Copyright © 2009 by Ludwig von Mises Institute, Scholar’s Edition, second edition Man, Economy, and State : Copyright © 1962 by William Volker Fund and D. Van Nostrand Copyright © 1970 by Murray N. Rothbard Copyright © 1993 by Murray N. Rothbard, revised edition Copyright 2001 by Ludwig von Mises Institute © Power and Market : Copyright © 1970 by Institute for Humane Studies Copyright © 1977 by Institute for Humane Studies, second edition All rights reserved. Written permission must be secured from the publisher to use or reproduce any part of this book, except for brief quotations in critical reviews or articles. Published by the Ludwig von Mises Institute, 518 West Magnolia Avenue, Auburn, Alabama 36832-4501 ISBN: 978-1-933550-27-5

6 O T Ludwig von Mises (Man, Economy, and State) AND TO Libertarians of the Past, who Blazed the Trail and to Libertarians of the Future, who Shall Overcome (Power and Market)

7 The Ludwig von Mises Institute dedicates this volume to all of its generous donors and wishes to thank these Patrons, in particular: George W. Connell Andreas Acavalos, Mr. and Mrs. David Baumgardner, Richard Bleiberg, John Hamilton Bolstad, Louis Carabini (Monex International), Christopher P. Condon, Anthony Deden (Sage Capital Zurich AG), Mrs. Floy Johnson, Neil Kaethler, Mr. and Mrs. R. Nelson Nash Mr. and Mrs. J.R. Bost, Dr. John Brätland, William H. Conn, Carl Creager, Dr. and Mrs. George G. Eddy, Douglas E. French, John R. Harper, Roland Manarin, Ronald Mandle, Mr. and Mrs. William W. Massey, Jr., Hall McAdams, E.H. Morse, Edward W. Rehak, Donald Mosby Rembert, Thomas S. Ross, Dr. Tito Tettamanti, Jan Tucker, Joe Vierra, Dr. Jim Walker Anonymous, Toby Baxendale, Robert Blumen, Tobin Campbell, Dr. John P. Cochran, John Cooke, Kerry E. Cutter, D. Allen and Sandra Dalton, Rosemary D’Augusta (Perna Travel), James V. De Santo (DTL Inc.), Capt. and Mrs. Maino des Granges, Frank Van Dun, Eric Englund, Charles Ezell, Martin Garfinkel, Mr. and Mrs. Thomas E. Gee, Frank W. Heemstra, Jule R. Herbert, Jr., L. Charles Hilton, Jr., Mr. and Mrs. Max Hocutt, Keith A. Homan, Julia Irons, George D. Jacobs, M.D., Dr. Preston W. Keith, Robert N. Kennedy, Richard J. Kossmann, M.D., David Kramer, Steven R. Krause, John Leger, Arthur L. Loeb, Björn Lundahl, Samuel Medrano, M.D., Frederick L. Maier, Dr. Douglas Mailly, Steven R. McConnell, Joseph Edward Paul Melville, Roy G. Michell, Jr., Dr. Dorothy Donnelley Moller, Reed W. Mower, Ron N. Neff, Christopher P. O’Hagan, Mr. and Mrs. Stanley E. Porter, Thomas H. Reed, James A. Reichert, Michael Robb, Conrad Schneiker, Alvin See, Mr. and Mrs. Thomas W. Singleton (Nehemi ah Foundation), Carlton M. Smith, Kent Snyder, Geb Sommer, William V. Stephens, Charles Strong, Michael F. Thomas, Mr. and Mrs. James Tusty, Mr. and Mrs. Quinten E. Ward, Thomas Winar, Dr. Steven Lee Yamshon, Mr. and Mrs. Leland L. Young, Robert S. Young



10 C ONTENTS AN NTRODUCTION TO THE E DITION OF M ECOND , E CONOMY , I S M TATE WITH ARKET OWER AND P S AND by Joseph T. Salerno . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xix P REFACE TO EVISED E DITION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . li R C HAPTER 1—F UNDAMENTALS OF H UMAN A CTION . . . . . . . . . . . . 1 1. The Concept of Action. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2. First Implications of the Concept . . . . . . . . . . . . . . . . . . . . 2 3. Further Implications: The Means . . . . . . . . . . . . . . . . . . . . 8 4. Further Implications: Time . . . . . . . . . . . . . . . . . . . . . . . . 13 5. Further Implications. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 A. Ends and Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 B. The Law of Marginal Utility. . . . . . . . . . . . . . . . . . . . . 21 6. Factors of Production: The Law of Returns . . . . . . . . . . . 33 7. Factors of Production: Convertibility and Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 8. Factors of Production: Labor versus Leisure . . . . . . . . . . 42 9. The Formation of Capital . . . . . . . . . . . . . . . . . . . . . . . . . 47 10. Action as an Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 Appendix A: Praxeology and Economics . . . . . . . . . . . . . . . . . 72 Appendix B: On Means and Ends . . . . . . . . . . . . . . . . . . . . . . . 76 C HAPTER 2—D IRECT E XCHANGE . . . . . . . . . . . . . . . . . . . . . . . . . 79 1. Types of Interpersonal Action: Violence . . . . . . . . . . . . . . 79 2. Types of Interpersonal Action: Voluntary Exchange and the Contractual Society . . . . . . . . . . . . . . . . . . . . . . . 84 vii

11 Power and Market with viii Man, Economy, and State 3. Exchange and the Division of Labor . . . . . . . . . . . . . . . . . 95 4. Terms of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 5. Determination of Price: Equilibrium Price. . . . . . . . . . . 106 6. Elasticity of Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 7. Speculation and Supply and Demand Schedules . . . . . . 130 8. Stock and the Total Demand to Hold . . . . . . . . . . . . . . . 137 9. Continuing Markets and Changes in Price . . . . . . . . . . . 142 10. Specialization and Production of Stock. . . . . . . . . . . . . . 153 11. Types of Exchangeable Goods . . . . . . . . . . . . . . . . . . . . . 162 12. Property: The Appropriation of Raw Land . . . . . . . . . . 169 13. Enforcement Against Invasion of Property. . . . . . . . . . . 176 NDIRECT C HE P ATTERN OF I 3—T E XCHANGE . . . . . . . 187 HAPTER 1. The Limitations of Direct Exchange . . . . . . . . . . . . . . . 187 2. The Emergence of Indirect Exchange . . . . . . . . . . . . . . 189 3. Some Implications of the Emergence of Money . . . . . . 193 4. The Monetary Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196 5. Money Income and Money Expenditures . . . . . . . . . . . . 198 6. Producers’ Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . 206 7. Maximizing Income and Allocating Resources . . . . . . . . 213 . . . . . . . . . . . . . . . . . . 233 C ONSUMPTION 4—P HAPTER RICES AND C 1. Money Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233 2. Determination of Money Prices . . . . . . . . . . . . . . . . . . . 238 3. Determination of Supply and Demand Schedules . . . . . 249 4. The Gains of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . 257 5. The Marginal Utility of Money . . . . . . . . . . . . . . . . . . . 261 A. The Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261 B. The Money Regression. . . . . . . . . . . . . . . . . . . . . . . . 268 C. Utility and Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276 D. Planning and the Range of Choice . . . . . . . . . . . . . . 279 6. Interrelations among the Prices of Consumers’ Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280 7. The Prices of Durable Goods and Their Services . . . . . 288 8. Welfare Comparisons and the Ultimate Satisfactions of the Consumer. . . . . . . . . . . . . . . . . . . . . 298

12 Contents ix 9. Some Fallacies Relating to Utility . . . . . . . . . . . . . . . . . . 302 Appendix A: The Diminishing Marginal Utility of Money . 311 Appendix B: On Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316 5—P RODUCTION : T HE . . . . . . . . . . . . . . 319 TRUCTURE S C HAPTER 1. Some Fundamental Principles of Action . . . . . . . . . . . . . 319 2. The Evenly Rotating Economy . . . . . . . . . . . . . . . . . . . . 320 3. The Structure of Production: A World of Specific Factors . . . . . . . . . . . . . . . . . . . . . . . 329 4. Joint Ownership of the Product by the Owners of the Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . 333 5. Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340 6. Ownership of the Product by Capitalists: Amalgamated Stages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345 7. Present and Future Goods: The Pure Rate of Interest . 348 8. Money Costs, Prices, and Alfred Marshall . . . . . . . . . . . 353 9. Pricing and the Theory of Bargaining . . . . . . . . . . . . . . 362 I : T HE R AT E O F NTEREST RODUCTION HAPTER 6—P C . . . . . . . . . . . . . . . . . . . 367 TS D ETERMINATION I AND 1. Many Stages: The Pure Rate of Interest . . . . . . . . . . . . . 367 2. The Determination of the Pure Rate of Interest: The Time Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375 3. Time Preference and Individual Value Scales . . . . . . . . . 379 4. The Time Market and the Production Structure . . . . . . 390 5. Time Preference, Capitalists, and Individual Money Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410 6. The Post-Income Demanders . . . . . . . . . . . . . . . . . . . . . 416 7. The Myth of the Importance of the Producers’ Loan Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420 8. The Joint-Stock Company. . . . . . . . . . . . . . . . . . . . . . . . 426 9. Joint-Stock Companies and the Producers’ Loan Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435 10. Forces Affecting Time Preferences . . . . . . . . . . . . . . . . . 443 11. The Time Structure of Interest Rates . . . . . . . . . . . . . . . 445 Appendix: Schumpeter and the Zero Rate of Interest . . . . . 450

13 Power and Market with x Man, Economy, and State HAPTER RODUCTION : G ENERAL P RICING C 7—P OF THE ACTORS . . . . . . . . . . . . . . . . . . . . . . . . . . . 453 F 1. Imputation of the Discounted Marginal Value Product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453 2. Determination of the Discounted Marginal Value Product. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465 A. Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465 B. The Marginal Physical Product. . . . . . . . . . . . . . . . . 466 (1) The Law of Returns . . . . . . . . . . . . . . . . . . . . . . 468 (2) Marginal Physical Product and Average Physical Product . . . . . . . . . . . . . . . . . . . . . . . . . 468 C. Marginal Value Product . . . . . . . . . . . . . . . . . . . . . . 475 3. The Source of Factor Incomes . . . . . . . . . . . . . . . . . . . . 478 4. Land and Capital Goods . . . . . . . . . . . . . . . . . . . . . . . . . 479 5. Capitalization and Rent . . . . . . . . . . . . . . . . . . . . . . . . . . 488 6. The Depletion of Natural Resources . . . . . . . . . . . . . . . 496 Appendix A: Marginal Physical and Marginal Value Product . 500 Appendix B: Professor Rolph and the Discounted Marginal Productivity Theory. . . . . . . . . . . . . . . . . . . . . 504 HAPTER 8—P RODUCTION : E C NTREPRENEURSHIP C HANGE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509 AND 1. Entrepreneurial Profit and Loss . . . . . . . . . . . . . . . . . . . 509 2. The Effect of Net Investment . . . . . . . . . . . . . . . . . . . . . 517 3. Capital Values and Aggregate Profits in a Changing Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527 4. Capital Accumulation and the Length of the Structure of Production. . . . . . . . . . . . . . . . . . . . . . . . . . 537 5. The Adoption of a New Technique. . . . . . . . . . . . . . . . . 544 The Entrepreneur and Innovation . . . . . . . . . . . . . . . . . 546 6. The Beneficiaries of Saving-Investment . . . . . . . . . . . . . 547 7. The Progressing Economy and the Pure Rate of Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549 8. The Entrepreneurial Component in the Market Interest Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550 9. Risk, Uncertainty, and Insurance. . . . . . . . . . . . . . . . . . . 552

14 Contents xi HAPTER RODUCTION : P ARTICULAR F ACTOR 9—P C I . . . . . . . . . . . 557 RODUCTIVE NCOMES P P RICES AND 1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557 2. Land, Labor, and Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . 557 A. Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557 B. The Nature of Labor . . . . . . . . . . . . . . . . . . . . . . . . . 564 C. Supply of Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566 D. Supply of Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 572 E. Productivity and Marginal Productivity . . . . . . . . . . 578 F. A Note on Overt and Total Wage Rates . . . . . . . . . . 580 G. The “Problem” of Unemployment . . . . . . . . . . . . . . 581 3. Entrepreneurship and Income . . . . . . . . . . . . . . . . . . . . . 588 A. Costs to the Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . 588 B. Business Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601 C. Personal Consumer Service . . . . . . . . . . . . . . . . . . . . 605 D. Market Calculation and Implicit Earnings . . . . . . . . 606 E. Vertical Integration and the Size of the Firm . . . . . . 609 4. The Economics of Location and Spatial Relations. . . . . 617 5. A Note on the Fallacy of “Distribution” . . . . . . . . . . . . . 622 6. A Summary of the Market . . . . . . . . . . . . . . . . . . . . . . . . 624 C HAPTER 10—M ONOPOLY AND C OMPETITION . . . . . . . . . . . . . 629 1. The Concept of Consumers’ Sovereignty . . . . . . . . . . . . 629 A. Consumers’ Sovereignty versus Individual Sovereignty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629 B. Professor Hutt and Consumers’ Sovereignty . . . . . . 631 2. Cartels and Their Consequences. . . . . . . . . . . . . . . . . . . 636 A. Cartels and “Monopoly Price”. . . . . . . . . . . . . . . . . . 636 B. Cartels, Mergers, and Corporations . . . . . . . . . . . . . 643 C. Economics, Technology, and the Size of the Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645 D. The Instability of the Cartel . . . . . . . . . . . . . . . . . . . 651 E. Free Competition and Cartels . . . . . . . . . . . . . . . . . . 653 F. The Problem of One Big Cartel. . . . . . . . . . . . . . . . . 659

15 Power and Market with xii Man, Economy, and State 3. The Illusion of Monopoly Price . . . . . . . . . . . . . . . . . . . 661 A. Definitions of Monopoly . . . . . . . . . . . . . . . . . . . . . . 661 B. The Neoclassical Theory of Monopoly Price . . . . . . 672 C. Consequences of Monopoly-Price Theory . . . . . . . . 675 (1) The Competitive Environment. . . . . . . . . . . . . . 675 (2) Monopoly Profit versus Monopoly Gain to a Factor. . . . . . . . . . . . . . . . . 677 (3) A World of Monopoly Prices?. . . . . . . . . . . . . . . 680 (4) “Cutthroat” Competition . . . . . . . . . . . . . . . . . . 681 D. The Illusion of Monopoly Price on the Unhampered Market . . . . . . . . . . . . . . . . . . . . . . . . . 687 E. Some Problems in the Theory of the Illusion of Monopoly Price . . . . . . . . . . . . . . . . . . . . . . . . . . . 698 (1) Location Monopoly . . . . . . . . . . . . . . . . . . . . . . . 698 (2) Natural Monopoly . . . . . . . . . . . . . . . . . . . . . . . . 702 4. Labor Unions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 704 A. Restrictionist Pricing of Labor . . . . . . . . . . . . . . . . . 704 B. Some Arguments for Unions: A Critique . . . . . . . . . 716 (1) Indeterminacy . . . . . . . . . . . . . . . . . . . . . . . . . . . 716 (2) Monopsony and Oligopsony . . . . . . . . . . . . . . . . 717 (3) Greater Efficiency and the “Ricardo Effect” . . . 718 5. The Theory of Monopolistic or Imperfect Competition . . . . . . . . . . . . . . . . . . . . . . . . . . 720 A. Monopolistic Competitive Price . . . . . . . . . . . . . . . . 720 B. The Paradox of Excess Capacity . . . . . . . . . . . . . . . . 726 C. Chamberlin and Selling Cost. . . . . . . . . . . . . . . . . . . 736 6. Multiform Prices and Monopoly . . . . . . . . . . . . . . . . . . . 739 7. Patents and Copyrights . . . . . . . . . . . . . . . . . . . . . . . . . . 745 C HAPTER 11—M ONEY AND I TS P URCHASING P OWER . . . . . . . . 755 1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 755 2. The Money Relation: The Demand for and the Supply of Money . . . . . . . . . . . . . . . . . . . . . . . . 756 3. Changes in the Money Relation . . . . . . . . . . . . . . . . . . . 762 4. Utility of the Stock of Money . . . . . . . . . . . . . . . . . . . . . 764

16 Contents xiii 5. The Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . 767 A. Money in the ERE and in the Market. . . . . . . . . . . . 767 B. Speculative Demand . . . . . . . . . . . . . . . . . . . . . . . . . . 768 C. Secular Influences on the Demand for Money . . . . . 771 D. Demand for Money Unlimited? . . . . . . . . . . . . . . . . 772 E. T he PPM and the Rate of Interest . . . . . . . . . . . . . . 773 F. Hoarding and the Keynesian System . . . . . . . . . . . . 776 (1) Social Income, Expenditures, and Unemployment . . . . . . . . . . . . . . . . . . . . . . . . 776 (2) “Liquidity Preference”. . . . . . . . . . . . . . . . . . . . . 785 G. The Purchasing-Power and Terms-of-Trade Components in the Rate of Interest . . . . . . . . . . . . . 792 6. The Supply of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . 798 A. The Stock of the Money Commodity . . . . . . . . . . . . 798 B. Claims to Money: The Money Warehouse . . . . . . . . 800 C. Money-Substitutes and the Supply of Money. . . . . . 805 D. A Note on Some Criticisms of 100-Percent Reserve . 810 7. Gains and Losses During a Change in the Money Relation. 811 8. The Determination of Prices: The Goods Side and the Money Side . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 815 9. Interlocal Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 818 A. Uniformity of the Geographic Purchasing Power of Money . . . . . . . . . . . . . . . . . . . 818 B. Clearing in Interlocal Exchange . . . . . . . . . . . . . . . . 821 10. Balances of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 822 11. Monetary Attributes of Goods. . . . . . . . . . . . . . . . . . . . . 826 A. Quasi Money. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 826 B. Bills of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . 827 12. Exchange Rates of Coexisting Moneys . . . . . . . . . . . . . . 828 13. The Fallacy of the Equation of Exchange. . . . . . . . . . . . 831 14. The Fallacy of Measuring and Stabilizing the PPM . . . 843 A. Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 843 B. Stabilization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 847 15. Business Fluctuations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 851 16. Schumpeter’s Theory of Business Cycles . . . . . . . . . . . . 854

17 Power and Market with xiv Man, Economy, and State 17. Further Fallacies of the Keynesian System . . . . . . . . . . . 859 A. Interest and Investment . . . . . . . . . . . . . . . . . . . . . . . 859 B. The “Consumption Function” . . . . . . . . . . . . . . . . . . 860 C. The Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 866 18. The Fallacy of the Acceleration Principle. . . . . . . . . . . . 868 E CONOMICS OF IOLENT V HE HAPTER C 12—T ARKET . . . . . . . . . . . . 875 M NTERVENTION IN THE I 1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 875 2. A Typology of Intervention . . . . . . . . . . . . . . . . . . . . . . . 877 3. Direct Effects of Intervention on Utility . . . . . . . . . . . . 878 4. Utility Ex Post : Free Market and Government . . . . . . . . 885 5. Triangular Intervention: Price Control . . . . . . . . . . . . . . 892 6. Triangular Intervention: Product Control . . . . . . . . . . . 900 7. Binary Intervention: The Government Budget . . . . . . . 907 8. Binary Intervention: Taxation . . . . . . . . . . . . . . . . . . . . . 914 A. Income Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 914 B. Attempts at Neutral Taxation. . . . . . . . . . . . . . . . . . . 919 C. Shifting and Incidence: A Tax on an Industry. . . . . . 927 D. Shifting and Incidence: A General Sales Tax . . . . . . 930 E. A Tax on Land Values. . . . . . . . . . . . . . . . . . . . . . . . . 934 F. Taxing “Excess Purchasing Power” . . . . . . . . . . . . . . 937 9. Binary Intervention: Government Expenditures . . . . . . 938 A. The “Productive Contribution” of Government Spending . . . . . . . . . . . . . . . . . . . . . . . . 938 B. Subsidies and Transfer Payments . . . . . . . . . . . . . . . . 942 C. Resource-Using Activities . . . . . . . . . . . . . . . . . . . . . 944 D. The Fallacy of Government on a “Business Basis” . . . . . . . . . . . . . . . . . . . . . . . . . 946 E. Centers of Calculational Chaos . . . . . . . . . . . . . . . . . 952 F. Conflict and the Command Posts . . . . . . . . . . . . . . . 953 G. The Fallacies of “Public” Ownership . . . . . . . . . . . . 955 H. Social Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 957 I. Socialism and Central Planning . . . . . . . . . . . . . . . . . 958

18 xv Contents 10. Growth, Affluence, and Government . . . . . . . . . . . . . . . 962 A. The Problem of Growth . . . . . . . . . . . . . . . . . . . . . . 962 B. Professor Galbraith and the Sin of Affluence . . . . . . 973 11. Binary Intervention: Inflation and Business Cycles . . . . . 989 A. Inflation and Credit Expansion . . . . . . . . . . . . . . . . . 989 B. Credit Expansion and the Business Cycle . . . . . . . . . 994 C. Secondary Developments of the Business Cycle . . 1004 D. The Limits of Credit Expansion . . . . . . . . . . . . . . . 1008 E. The Government as Promoter of Credit Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . 1014 F. The Ultimate Limit: The Runaway Boom . . . . . . . 1018 G. Inflation and Compensatory Fiscal Policy . . . . . . . 1021 12. Conclusion: The Free Market and Coercion . . . . . . . . 1024 Appendix A: Government Borrowing. . . . . . . . . . . . . . . . . . 1025 Appendix B: “Collective Goods” and “External Benefits”: Two Arguments for Government Activity. . . . . . . . . . . 1029 OWER AND M ARKET P 1—D EFENSE S ERVICES ON THE F REE M ARKET . . . . C HAPTER 1047 HAPTER UNDAMENTALS OF I NTERVENTION . . . . . . . . . . 1057 2—F C 1. Types of Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . 1057 2. Direct Effects of Intervention on Utility . . . . . . . . . . . 1061 A. Intervention and Conflict. . . . . . . . . . . . . . . . . . . . . 1061 B. Democracy and the Voluntary . . . . . . . . . . . . . . . . . 1065 C. Utility and Resistance to Invasion . . . . . . . . . . . . . . 1067 D. The Argument from Envy . . . . . . . . . . . . . . . . . . . . 1068 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1069 E. Utility Ex Post 3—T RIANGULAR I NTERVENTION . . . . . . . . . . . . . . . 1075 C HAPTER 1. Price Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1075 2. Product Control: Prohibition . . . . . . . . . . . . . . . . . . . . 1086

19 Power and Market with Man, Economy, and State xvi 3. Product Control: Grant of Monopolistic Privilege . . . 1089 A. Compulsory Cartels . . . . . . . . . . . . . . . . . . . . . . . . . 1094 B. Licenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1094 C. Standards of Quality and Safety . . . . . . . . . . . . . . . 1096 D. Tariffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1101 E. Immigration Restrictions . . . . . . . . . . . . . . . . . . . . . 1107 F. Child Labor Laws . . . . . . . . . . . . . . . . . . . . . . . . . . 1111 G. Conscription. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1113 H. Minimum Wage Laws and Compulsory Unionism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1114 I. Subsidies to Unemployment . . . . . . . . . . . . . . . . . . 1115 J. Penalties on Market Forms . . . . . . . . . . . . . . . . . . . 1115 K. Antitrust Laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1117 L. Outlawing Basing-Point Pricing . . . . . . . . . . . . . . . 1121 M. Conservation Laws. . . . . . . . . . . . . . . . . . . . . . . . . . 1122 N. Patents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1133 O. Franchises and “Public Utilities” . . . . . . . . . . . . . . 1138 P. The Right of Eminent Domain . . . . . . . . . . . . . . . . 1139 Q. Bribery of Government Officials . . . . . . . . . . . . . . 1141 R. Policy Toward Monopoly. . . . . . . . . . . . . . . . . . . . . 1143 Appendix A: On Private Coinage . . . . . . . . . . . . . . . . . . . . 1144 . . . . . . . . . . . . . . . . 1146 Lebensraum Appendix B: Coercion and C NTERVENTION : T AXATION . . . . . . . . . . . 1149 HAPTER 4—B INARY I 1. Introduction: Government Revenues and Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1149 2. The Burdens and Benefits of Taxation and Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1151 3. The Incidence and Effects of Taxation . . . . . . . . . . . . . 1156 Part I: Taxes on Incomes . . . . . . . . . . . . . . . . . . . . . . . 1156 A. The General Sales Tax and the Laws of Incidence . . . . . . . . . . . . . . . . . . . . . . . . . . . 1156 B. Partial Excise Taxes; Other Production Taxes. . . . . 1162 C. General Effects of Income Taxation . . . . . . . . . . . . 1164 D. Particular Forms of Income Taxation . . . . . . . . . . . 1171 (1) Taxes on Wages . . . . . . . . . . . . . . . . . . . . . . . . . 1171 (2) Corporate Income Taxation . . . . . . . . . . . . . . . 1171 (3) “Excess”Profit Taxation . . . . . . . . . . . . . . . . . . . 1173

20 xvii Contents (4) The Capital Gains Problem . . . . . . . . . . . . . . . . 1174 (5) Is a Tax on Consumption Possible? . . . . . . . . . . 1180 4. The Incidence and Effects of Taxation . . . . . . . . . . . . . 1183 Part II: Taxation on Accumulated Capital . . . . . . . . . . 1183 A. Taxatuin on Gratuitous Transfers: Bequests and Gifts. . . . . . . . . . . . . . . . . . . . . . . . . . . 1185 B. Property Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . 1185 C. A Tax on Individual Wealth . . . . . . . . . . . . . . . . . . .1190 5. The Incidence and Effects of Taxation . . . . . . . . . . . . . 1191 Part III: The Progressive Tax . . . . . . . . . . . . . . . . . . . 1191 6. The Incidence and Effects of Taxation . . . . . . . . . . . . . 1196 Part IV: The “Single Tax” on Ground Rent . . . . . . . . 1196 7. Canons of “Justice” in Taxation . . . . . . . . . . . . . . . . . . . 1214 A. The Just Tax and the Just Price . . . . . . . . . . . . . . . . 1214 B. Costs of Collection, Convenience, and Certainty. . 1216 C. Distribution of the Tax Burden . . . . . . . . . . . . . . . . 1218 (1) Uniformity of Treatment. . . . . . . . . . . . . . . . . . 1218 a. Equality Before the Law: Tax Exemption . . 1218 b. The Impossibility of Uniformity . . . . . . . . . 1221 (2) The “Ability-to-Pay” Principle . . . . . . . . . . . . . 1224 a. The Ambiguity of the Concept . . . . . . . . . . 1224 b. The Justice of the Standard . . . . . . . . . . . . . 1227 (3) Sacrifice Theory. . . . . . . . . . . . . . . . . . . . . . . . . 1231 (4) The Benefit Principle . . . . . . . . . . . . . . . . . . . . 1236 (5) The Equal Tax and the Cost Principle . . . . . . . 1240 (6) Taxation “For Revenue Only” . . . . . . . . . . . . . . 1244 (7) The Neutral Tax: A Summary. . . . . . . . . . . . . . 1244 D. Voluntary Contributions to Government . . . . . . . . 1245 5—B I NTERVENTION : G OVERNMENT INARY HAPTER C . . . . . . . . . . . . . . . . . . . . . . . . . . . 1253 E XPENDITURES 1. Government Subsidies: Transfer Payments . . . . . . . . . 1254 2. Resource-Using Activities: Government Ownership versus Private Ownership . . . . . . . . . . . . . . 1259 3. Resource-Using Activities: Socialism . . . . . . . . . . . . . . 1272 4. The Myth of “Public” Ownership . . . . . . . . . . . . . . . . . 1276 5. Democracy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1279 Appendix: The Role of Government Expenditures in National Product Statistics . . . . . . . . . . . . . . . . . . . . 1292

21 Power and Market with Man, Economy, and State xviii NTIMARKET E THICS : A P RAXEOLOGICAL C 6—A HAPTER . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1297 RITIQUE C 1. Introduction: Praxeological Criticism of Ethics . . . . . . 1297 2. Knowledge of Self-Interest: An Alleged Critical Assumption . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1300 3. The Problem of Immoral Choices . . . . . . . . . . . . . . . . 1303 4. The Morality of Human Nature . . . . . . . . . . . . . . . . . . 1306 5. The Impossibility of Equality . . . . . . . . . . . . . . . . . . . . 1308 6. The Problem of Security . . . . . . . . . . . . . . . . . . . . . . . . 1313 7. Alleged Joys of the Society of Status . . . . . . . . . . . . . . . 1315 8. Charity and Poverty . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1318 9. The Charge of “Selfish Materialism” . . . . . . . . . . . . . . 1321 10. Back to the Jungle?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1324 11. Power and Coercion. . . . . . . . . . . . . . . . . . . . . . . . . . . . 1326 A. “Other Forms of Coercion”: Economic Power . . . 1326 B. Power Over Nature and Power Over Man . . . . . . . 1329 12. The Problem of Luck . . . . . . . . . . . . . . . . . . . . . . . . . . 1333 13. The Traffic-Manager Analogy . . . . . . . . . . . . . . . . . . . . 1334 14. Over- and Underdevelopment . . . . . . . . . . . . . . . . . . . . 1334 15. The State and the Nature of Man . . . . . . . . . . . . . . . . . 1335 16. Human Rights and Property Rights . . . . . . . . . . . . . . . 1337 Appendix: Professor Oliver on Socioeconomic Goals . . . . . 1340 A. The Attack on Natural Liberty . . . . . . . . . . . . . . . . 1341 B. The Attack on Freedom of Contract . . . . . . . . . . . 1344 C. The Attack on Income According to Earnings . . . 1347 : E CONOMICS C HAPTER 7—C ONCLUSION AND OLICY UBLIC P P . . . . . . . . . . . . . . . . . . . . . . . 1357 1. Economics: Its Nature and Its Uses . . . . . . . . . . . . . . . 1357 2. Implicit Moralizing: The Failures of Welfare Economics . . . . . . . . . . . . . . . . . . . . . . . . . . 1360 3. Economics and Social Ethics . . . . . . . . . . . . . . . . . . . . . 1363 4. The Market Principle and the Hegemonic Principle . . . 1365 B IBLIOGRAPHY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1371 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I NDEX OF N AMES 1395 UBJECTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1405 S NDEX OF I

22 NTRODUCTION TO I DITION OF E ECOND S THE TAT E AND , CONOMY S AN , E M P OWER AND M ARKET WITH URRAY R OTHBARD BEGAN WORK ON this magnum opus on Jan- M 1 uary 1, 1952. On May 5, 1959 Rothbard wrote to his mentor, 2 Ludwig von Mises, informing him, “È finito!” The more than Man, Economy, seven years that it took Rothbard to complete elapsed during, what was up to that time, one of the and State most sterile and retrogressive decades in the history of scientific economics, dating back to the birth of the science in the sys- 3 tematic treatise of Richard Cantillon published in 1755. In The Introduction draws substantially on the information and resources found in the Murray N. Rothbard Papers. The Rothbard Papers are currently held at the Ludwig von Mises Institute, Auburn, Alabama, and include, among other materials, Murray Rothbard’s letters and correspondence (1940–1994), memos and unpublished essays (1945–1994), and drafts of published works. 1 Rothbard to H. Cornuelle, June 28, 1952; Rothbard Papers. 2 Rothbard to Mises, May 5, 1959; Rothbard Papers. In English, “It is finished.” 3 Richard Cantillon, Essai sur la Nature du commerce en Général , ed. and trans. Henry Higgs (New York: Augustus M. Kelley, 1964). xix

23 with Power and Market Man, Economy, and State xx view of the progressive degeneration of economic thought throughout the 1950s, the eventual publication of Rothbard’s treatise in 1962 was a milestone in the development of sound economic theory and an event that rescued the science from self-destruction. The era of modern economics emerged with the publication of Carl Menger’s seminal work, , in 1871. Principles of Economics In this slim book, Menger set forth the correct approach to the- oretical research in economics and elaborated some of its imme- diate implications. In particular, Menger sought to identify the causal laws determining the prices that he observed being paid 4 daily in actual markets. His stated goal was to formulate a real- istic price theory that would provide an integrated explanation of the formation of market phenomena valid for all times and 5 places. Menger’s investigations led him to the discovery that all market prices, wage rates, rents, and interest rates could ulti- mately be traced back to the choices and actions of consumers striving to satisfy their most important wants by “economizing” scarce means or “economic goods.” Thus, for Menger, all 4 Carl Menger, Principles of Economics , trans. James Dingwall and Bert E. Hoselitz (New York: New York University Press, 1981). Menger had worked as an economic journalist and market analyst for daily newspapers on and off for over a decade. For an overview of Menger’s life and thought see Joseph T. Salerno, “Carl Menger: The Founding of the Aus- trian School,” in Randall G. Holcombe, ed., 15 Great Austrian Economists (Auburn, Ala.: Ludwig von Mises Institute, 1999), pp. 71–100 and the sources cited therein. 5 Thus in his Preface to the book, Menger ( Principles , p. 49) wrote, I have devoted special attention to the investigation of the causal connections between economic phenomena involving products and the corresponding agents of production . . . for the purpose of establishing a price theory based upon reality and placing all price phenomena (including inter- est, wages, ground rent, etc.) under one unified point of view. . . . (Emphasis added)

24 Introduction to the Second Edition xxi prices, rents, wage, and interest rates were the outcome of the value judgments of individual consumers who chose between concrete units of different goods according to their subjective values or “marginal utilities” to use the term coined by his stu- dent Friedrich Wieser. With this insight was born modern eco- nomics. Menger’s causal-realist approach to economic theorizing quickly began to attract outstanding followers both in Austria and, later, throughout Continental Europe and the Anglophone countries. What came to be called the “Austrian School” grew rapidly in prestige and numbers and by World War I theoreti- cal research based on the causal-realist approach was considered the cutting edge of economic science. For various reasons, the school suffered an amazingly rapid decline, especially in Great Britain and the United States but also in Austria, after the war. By the 1920s, the causal-realist approach had been overshad- owed by the partial equilibrium approach of Alfred Marshall in Great Britain, the U.S., and even parts of Continental Europe. Its star fell further with the importation of the mathematical general equilibrium approach of Léon Walras into the English- speaking world in the early 1930s. A little later Menger’s approach was nearly buried by the Keynesian Revolution. Hence, by the advent of World War Two there ceased to be a self-conscious, institutionally-embedded network of economists actively engaged in teaching and research in the Mengerian tra- 6 dition. After World War II, a new and stifling orthodoxy known as the “neoclassical synthesis” had descended upon economics, especially in the United States. This so-called “synthesis” was actually a hodgepodge of the three disparate approaches that 6 For the factors underlying the rise and decline of the early Austrian School, see Joseph T. Salerno, “The Place of Mises’s Human Action in the Development of Modern Economic Thought,” Quarterly Journal of Aus- trian Economics 2, no. 1 (Spring 1999): 35–65.

25 with Power and Market xxii Man, Economy, and State had overwhelmed the Mengerian causal-realist approach in the interwar period. It jumbled together the Marshallian and Wal- rasian approaches to price determination with Keynesian macroeconomics. The first two approaches focused narrowly on analyzing the determination of unreal, equilibrium prices either in single markets (partial equilibrium) or in all markets simultaneously (general equilibrium). Keynesian macroeco- nomics denied the efficacy of the price system altogether in coordinating the various sectors of an economy confronted with the “failure of aggregate demand.” This latter condition was supposed to have caused the Great Depression and was further alleged by Keynes and his followers to be an endemic feature of the market economy. The neoclassical synthesis thus pro- claimed that the price system worked efficiently to allocate scarce resources only if the government deftly employed fiscal and monetary policies to maintain a level of aggregate demand or total spending in the economy that was sufficient to absorb a full employment level of output. This new orthodoxy also promoted hyper-specialization and a corresponding disintegration of economic science into a clutter of compartmentalized sub-disciplines. Even the theoret- ical core of economics was now split into “microeconomics” and “macroeconomics,” which had seemingly very little connection to each another. Specialized journals proliferated and resulted in a radical change in the research culture, with a premium on the writing and reading of the latest journal articles. The few books that were published were technical monographs or dumbed-down textbooks; the era of the great systematic treatise 7 on economic theory was at a close. 7 Indeed, in the Preface to this treatise, Rothbard laments the demise of “the old-fashioned treatise on economic ‘principles’ ” after World War One and the ensuing progressive disintegration of economics, including economic theory, into compartmentalized sub-disciplines. On the factors

26 xxiii Introduction to the Second Edition Almost the sole holdout against this intellectual revolution was Ludwig von Mises. With the publication in 1940 of Nation- , , the German-language forerunner of alökonomie Human Action Mises single-handedly recovered and greatly advanced the sys- 8 tem of causal-realistic economic theory. In particular, he inte- grated Mengerian value and price theory with his own earlier restatement of monetary theory. In addition, he provided a rig- orous foundation for the entire system of economic theory in a broader science of human action that he himself had expounded in earlier works and now further elaborated. This science of human action he now dubbed, “praxeology.” Unfortunately, Mises’s great treatise was almost completely ignored by the 9 postwar economics profession. However, while it failed to inspire an immediate renewal of the Mengerian scientific move- ment, did lay the foundations for its later revival. Human Action This revival was to be ignited by the publication of Man, Econ- 10 in 1962. omy, and State that exacerbated this fragmentation of economics after World War Two, see Joseph T. Salerno, “Economics: Vocation or Profession,” Ludwig von Mises Institute Daily Article (November 17, 2004), available at 8 Ludwig von Mises, , Scholar’s Human Action: A Treatise on Economics Edition (Auburn, Ala.: Ludwig von Mises Institute, 1998). 9 Human On the reasons for this, see Salerno “The Place of Mises’s ,” pp. 59–761. The books that molded postwar economics were cut Action from a completely different cloth than Mises’s treatise and dealt primarily with the formal techniques, rather than the substance, of economic the- ory. These included, especially: J.R. Hicks, Value and Capital: An Inquiry into Some Fundamental Principles of Economics Theory , 2nd ed. (New York: Oxford University Press, 1946); Paul A. Samuelson, Foundations of Eco- nomic Analysis (Cambridge, Mass.: Harvard University Press, 1947); and George J. Stigler, The Theory of Price (New York: Macmillan, 1947). 10 Rothbard’s central role in the modern revival of Austrian econom- ics is detailed in Joseph T. Salerno, “The Rebirth of Austrian Econom- ics—In Light of Austrian Economics,” Quarterly Journal of Austrian Eco- nomics 5, no. 4 (Winter 2002): 111–28.

27 with Power and Market xxiv Man, Economy, and State When Rothbard initiated work on what would turn out to be a full-blown treatise, he conceived of the project as a book suitable both for lay readers and for college instruction that would bring “to the surface and [clarify] the step-by-step nature of the edifice which Mises had constructed but more or less had taken for granted that his readers would under- 11 stand.” This was necessary because was Human Action addressed to a scholarly audience, and Mises had accordingly iarity among his readers with many assumed a great deal of famil of the concepts and theorems of what he called “modern sub- jectivist economics.” Thus Rothbard intended “to do for Mises, what McCulloch did for Ricardo,” that is, to make his work 12 comprehensible to an intelligent lay readership. But Rothbard quickly realized that his original plan was flawed and had to be abandoned for three reasons. First the tra- ditional textbook format was too disorganized in its arrange- ment and treatment of various topics to accommodate the development of economic theory in the logical step-by-step manner that Rothbard had envisioned. As such, it was inade- quate to convey a “sense of the grand sweep, of the coherent system integrating and pervading all aspects of sound economic 13 doctrine.” Second, Rothbard discovered that there existed “a lot of gaps” in Mises’s “economic organon” that he had to “fill 14 in” himself. In addition, Rothbard’s step-by-step deductions led him to the conclusion that Mises’s theory of monopoly, which was held by most economists in the Mengerian tradition, was irreparably flawed and had to be completely revised. The book was thus turning out “to involve a good deal of original 11 Rothbard to H. Cornuelle, June 28, 1952; Rothbard Papers. 12 Rothbard to H. Cornuelle, March 14, 1951; Rothbard Papers. “What McCulloch did for Ricardo” refers to John Ramsay McCulloch’s Principles of Political Economy (New York: Augustus M. Kelley, [1864] 1965). 13 Ibid . 14 Rothbard to R. Cornuelle, August 9, 1954; Rothbard Papers.

28 Introduction to the Second Edition xxv contribution” on Rothbard’s part. Third, as he proceeded in writing the book, Rothbard was concurrently researching the literature and reading widely, and he began to realize that Human Action had emerged from a very broad tradition that included many more economists than just Mises and his famous predecessors and direct protégés (e.g., Friedrich A. Hayek) in the native Austrian School. Moreover, as Rothbard read and wrote it became increasingly clear to him that the various strands of this theoretical tradition, which included many important American and British contributions in addition to the great Austrian works, had not yet been completely integrated and their principles fully delineated in a systematic treatise. Accordingly, Rothbard concluded, “many essential points must be deduced originally or with the help of other works” and therefore “the book cannot simply be a paraphrase of Human 15 .” Action Rothbard’s proposed book was thus transformed, in the very process of its writing, from a straightforward exposi- tion of the principles of received doctrine of the Austrian School narrowly conceived to a treatise elaborating a complete system of economic theory and featuring many original, and even radically new, deductions and theorems. Mises himself immediately recognized the profound origi- nality and significance of Rothbard’s contribution. In his review of Man, Economy, and State , Mises wrote that Rothbard joins the ranks of eminent economists by publishing a voluminous work, a systematic treatise on econom- ics. . . . In every chapter of his treatise, Rothbard . . . adopt[s] the best teachings of his predecessors . . . and 16 add[s] to them highly important observations. . . . 15 Rothbard to H. Cornuelle, June 28, 1952; Rothbard Papers. 16 Ludwig von Mises, “ Man, Economy and State: A New Treatise on Eco- nomics ,” in idem, Economic Freedom and Interventionism: An Anthology of Articles and Essays , ed. Bettina Bien Greaves (Irvington-on-Hudson, N.Y.: The Foundation for Economic Education, 1990), pp. 155–56.

29 with Power and Market xxvi Man, Economy, and State Mises went on to characterize Rothbard’s work as . . . an epochal contribution to the general science of human action, praxeology, and its practically most important and up-to-now best elaborated part, eco- nomics. Henceforth, all essential studies in these branches of knowledge will have to take full account of the theories and criticisms expounded by Dr. 17 Rothbard. Given Mises’s exacting scholarly standards and his well- known parsimony in paying compliments for scientific contri- butions, this is high praise indeed for a book published by a 18 thirty-six year old economist. More importantly, Mises evi- dently viewed Rothbard’s work as opening a new epoch in mod- ern economic science. Rothbard himself was not reluctant to indicate the respects in which he considered his treatise to have been a departure from or an advance upon Mises’s work. Foremost, among Roth- bard’s theoretical innovations was his formulation of a complete and integrated theory of production. Previously, production theory in causal-realist analysis was in disarray and had con- sisted of a number of independent and conflicting strands of thought that treated capital and interest, marginal productivity theory, rent theory, entrepreneurship and so on in isolation. Somewhat surprised by this yawning gap in production theory, Rothbard commented: Mises has very little detail on production theory, and as a consequence it took me many false starts, and lots of what turned out to be wasted effort, before I 17 Ibid ., pp. 156–57. 18 The following statement is indicative of Mises’s attitude in this respect: “There never lived at the same time more than a score of men whose work contributed anything essential to economics” (Mises, Human Action , p. 869).

30 Introduction to the Second Edition xxvii arrived at what satisfied me as a good Production Theory. (It’s involved emancipation from 90 percent 19 of current textbook material.) Man, Economy, and State In , Rothbard elaborates a unified and systematic treatment of the structure of production, the theory of capital and interest, factor pricing, rent theory, and the role of entrepreneurship in production. Furthermore, pro- duction theory is presented as part of the core of economic analysis and covers five of the book’s twelve chapters and approximately 30 percent of its text. One of Rothbard’s greatest accomplishments in production theory was the development of a capital and interest theory that integrated the temporal pro- duction-structure analysis of Knut Wicksell and Hayek with the pure-time-preference theory expounded by Frank A. Fetter and Ludwig von Mises. Although the roots of both of these strands of thought can be traced back to Böhm-Bawerk’s work, his exposition was confused and raised seemingly insoluble contra- 20 dictions between the two. They were subsequently developed separately until Rothbard revealed their inherent logical con- nection. Despite Mises’s lavish praise for the book as an epochal leap forward in economic science as well as general recognition among many adherents, observers, and critics of the contem- porary Austrian movement that is Man, Economy, and State indeed a foundational work in the renaissance of modern Aus- trian economics, there are two crucial questions regarding the book that, surprisingly, have never even been addressed, let 19 Rothbard to R. Cornuelle, memo: “Textbook or Treatise?”; Roth- bard Papers. 20 In Human Action , Mises avoided a deep analysis of the time-span- ning structure of production, perhaps because he associated it with the concept of the backward-looking “average period of production” in Böhm-Bawerk’s work which he criticized (Mises, Human Action , pp. 485–86).

31 with Power and Market xxviii Man, Economy, and State alone resolved. The first question relates to the precise sense in eatise can be described as a work in “Aus- which Rothbard’s tr trian economics” and how Rothbard himself conceived the con- nection between his treatise and this body of received doctrine. The second question concerns Rothbard’s perception of the relationship of the theoretical system expounded in his treatise and the neoclassical synthesis of the 1950s. As we shall see, the answers to these questions are not only surprising but are preg- nant with implications for interpreting recent developments in Austrian economics and evaluating its future possibilities and prospects. Before addressing the question of the doctrinal filiation and Austrian economics, it is between Man, Economy, and State instructive to examine Mises’s attitude toward the Austrian School because it is not as straightforward as is generally sup- posed and it clearly influenced Rothbard’s view. As early as 1932, Mises had argued that all the essential ideas of the Aus- trian School of economics had been absorbed into the main- 21 stream of what he called “modern subjectivist economics.” According to Mises, the Austrian and the Anglo-American Schools and the School of Lausanne . . . differ only in their mode of expressing the same fundamental idea and . . . are divided more by their terminology and by peculiari- ties of presentation than by the substance of their 22 teachings. Now admittedly this opinion was delivered at an economics conference in Germany that was heavily attended by the still influential remnants of the German Historical School who were 21 Mises, Human Action , p. 3. 22 Ludwig von Mises, Epistemological Problems of Economics , 3rd ed. (Auburn, Ala.: Ludwig von Mises Institute, 2003), p. 228.

32 Introduction to the Second Edition xxix antagonistic to economic theory of all kinds. It certainly can be reasonably argued that, given this venue, Mises’s remarks were intended as a generic defense of theoretical research in eco- nomics. In fact, a year earlier Mises had written, Within the field of modern economics the Austrian School has shown its superiority to the School of Lausanne and the schools related to the latter, which favor mathematical formulations, by clarifying the causal relationship between value and cost, while at the same time eschewing the concept of function, 23 which in our science is misleading. In spite of the foregoing caveat, Mises continued to maintain that the label “Austrian School” was an anachronism, arguing in the last publication of his career in 1969, that the Austrian School constituted a closed chapter in the history of economic thought from about the time of Menger’s death in 1921. By that time, according to Mises, all the essential ideas of the Austrian School were by and large accepted as an integral part of economic theory . . . [and] one no longer distinguished between an Austrian School and other economics. The appel- lation “Austrian School” became the name given to an important chapter of the history of economic thought; it was no longer the name of the specific sect with doctrines different from those held by other 24 economists. As noted, Mises used the term “modern subjectivist eco- nomics” to describe the new synthesis of theoretical approaches that he believed had begun to emerge in the 1920s. There are 23 Ibid ., p. 175. 24 Ludwig von Mises, The Historical Setting of the Austrian School of Eco- nomics , 2nd ed. (Auburn, Ala.: Ludwig von Mises Institute, 1984), p. 41.

33 with Power and Market Man, Economy, and State xxx two problems with this label, which may explain Mises’s ambivalent attitude toward the inclusion of the Marshallian and Lausanne Schools under its head. First, by World War I most theoretical economists at least paid lip service to some version of subjective-value theory, so that subjectivism was no longer a distinguishing characteristic of a unique approach to theoretical research. Second, as we have seen in our own time, the term subjectivism is a notoriously elastic term that can be stretched to denote even the nihilistic approach to economic theory famously propounded by George Shackle, the later Ludwig Lachmann, and a number of post-modernist and hermeneutical 25 economists. Rothbard evidently followed Mises in construing the term “Austrian School” as the designation for an important move- Man, ment in the history of economic thought. In the text of Economy, and State , Rothbard uses the terms “Austrian” or “Aus- trian School” at least ten times enclosed in quotation marks, as he naturally would if he were referring to a movement that had only historical significance to the contemporary reader. The few times he uses these terms without quotation marks, they clearly refer to historical doctrines or controversies such as “the Austrian-Wicksteedian theory of price” or the Austrian School versus Alfred Marshall on the relationship between prices and costs. The single time that Rothbard mentions “Austrian” in his 25 For an overview and critique of this nihilist turn in economics, see David Gordon, Hermeneutics Versus Austrian Economics (Auburn, Ala.: Ludwig von Mises Institute, 1986), available at etexts/hermeneutics.asp; Hans-Hermann Hoppe, “In Defense of Extreme Rationalism: Thoughts on Donald McCloskey’s The Rhetoric of Economics ,” Review of Austrian Economics 3 (1989): 179–214, available at; and Murray N. Roth- bard, “The Hermeneutical Invasion of Philosophy and Economics,” in idem, The Logic of Action Two: Applications and Criticism from the Austrian School (Lyme, N.H.: Edward Elgar, 1997), pp. 275–93.

34 xxxi Introduction to the Second Edition Preface to the first edition, he does so in the phrase “the ‘Aus- trian’ economists,” placing the word in quotation marks and 26 using it in a sentence featuring verbs in the past tense. This textual exegesis is not meant to imply that Rothbard did not consider his work as continuing the great tradition origi- nated by the early Austrian economists. Indeed Rothbard wrote of the myth among economists that the Austrian School is effectively dead and has no more to contribute and that everything of lasting worth that it had to offer was effectively stated and integrated in Alfred Mar- 27 . shall’s Principles Rather, the point is that Rothbard’s goal was to recover and advance a much broader doctrinal tradition, for which Menger’s and Böhm-Bawerk’s works were indisputably the taproot. Thus in his Preface, Rothbard stated, “This book, then, is an attempt 28 to fill part of the enormous gap of 40 year’s time.” The “gap” Man, Rothbard is here referring to separates the publication of Economy, and State and that of the last three systematic econom- ics treatises to appear in English, by Philip Wicksteed (1910), 29 Frank Fetter (1910), and Frank Taussig (1911). The treatises 26 Rothbard, , p. xcii. Man, Economy, and State 27 Ibid ., p. 357. 28 Ibid ., p. xciii. 29 Philip H. Wicksteed, The Common Sense of Political Economy and Selected Papers and Reviews on Economic Theory , ed. Lionel Robbins, 2 vols. (New York: Augustus M. Kelley, 1967); Frank A. Fetter, The Principles of Economics with Applications to Practical Problems (New York: The Century Co., 1910); F.W. Taussig, Principles of Economics , 2 vols. (New York: The Macmillan Company, 1911). Rothbard did not consider Human Action an “old-style Principles” because “it assumes considerable previous eco- nomic knowledge and includes within its spacious confines numerous

35 with Power and Market xxxii Man, Economy, and State of Wicksteed and Fetter in particular were in what Rothbard called “the praxeological tradition.” Their procedure, like his own, was “slowly and logically to build on the basic axioms an 30 integrated and coherent edifice of economic truth.” The main reason that his treatise contains numerous references to the his- torical Austrian school was because Rothbard judged the mem- bers of this school to have “best perceived this method and used it most fully and cogently. They were the classic employers, in 31 short, of the ‘praxeologic’ method.” In contrast to Mises’s “modern subjectivist economics,” Rothbard’s reference to the “praxeologic method” drew a bright line between those who employed Menger’s procedure in logically deducing economic laws from a few basic facts of reality and those who did not. “Praxeology” was Mises’s explicit and self-conscious elaboration of this venerable procedure for discovering the causal laws governing market phenomena. The early Austrian School and their followers, and even some of the better classical economists, had used this research method without being fully aware of it. The praxeological method begins with the self-evident reality of human action and its immediate implications. It then introduces other empirical postulates that reflect the concrete conditions of action from which emerge the historically specific market phenomena that the economist seeks to analyze. It is, therefore, necessarily about real things. It is for this reason that it has no use for fic- tions and figments like the “representative firm,” “the perfectly competitive market,” or “the social welfare function”; nor does it concern itself with the existence, uniqueness, and stability of general equilibrium. philosophic and historical insights” (Rothbard, Man, Economy, and State , p. xciii). 30 Rothbard, Man, Economy, and State , p. xciii. 31 Ibid ., p. xcii.

36 Introduction to the Second Edition xxxiii The highly selective use that the praxeological method makes of imaginary constructs has a single aim: the systematic elaboration of a unified body of theory comprising meaningful propositions about the causes of economic phenomena in the world as it is, has been, or is likely to be. As Mises put it, the praxeological method, . . . studies acting under unrealized and unrealizable conditions only from two points of view. It deals with states of affairs which, although not real in the pres- ent and past world, could possibly become real at some future date. And it examines unreal and unreal- izable conditions if such an inquiry is needed for a satisfactory grasp of what is going on under the con- 32 ditions present in reality. Mises concluded, “The specific method of economics is the method of imaginary constructions. . . . [I]t is the only method 33 of praxeological and economic inquiry.” Rothbard took Mises’s dictum seriously and for seven years immersed himself in employing and perfecting this method in elaborating an integrated system of economic theory. This explains why Rothbard identified the use of the praxeological method, rather than a loose subjectivist orientation, as the hall- mark and acid test of scientific economics. During the long period of sustained effort in writing the present volume, Roth- bard thus became a master practitioner of the praxeological research method. He not only skillfully used the various imagi- nary constructs whose nature and specific use Mises had explic- itly formulated in , but also devised new ones as Human Action needed to assist in the deduction of new theorems to elucidate 34 unexplained features of economic reality. 32 Mises, Human Action , p. 65. 33 Ibid ., pp. 237–38. 34 Ibid ., pp. 237–57.

37 Power and Market with Man, Economy, and State xxxiv Let us take a detailed example to illustrate Rothbard’s proce- dure. In confronting the daunting task of untangling and sys- tematizing causal-realist production theory, Rothbard postu- lates an imaginary world of specific factors, in which each and every individual laborer, parcel of land, and capital good is irrevocably committed to the production of a single product and cannot be converted to use in any other production 35 process. Rothbard also imagines two variations of this world. In the first, the cooperating factors in each stage of a given pro- duction process jointly own the product (i.e., capital good) of that stage and, since the services of all capital goods are embod- ied in the final product, therefore all factors jointly own the final good that is sold to consumers in exchange for money. The money receipts are then distributed according to the terms of a voluntary contract among all joint factor owners. In the second variation, a single capitalist or consortium of capitalists pay the various factors participating in the amalgamated process in advance of the sale of the final product on the market and in exchange receive ownership of the capital goods from every 35 While this construct is highly unrealistic, it is not unrealizable like the evenly rotating economy (ERE), which abstracts completely from change and uncertainty and is used to analytically isolate interest income and the capitalist function which earns it from entrepreneurial profit. Thus a world in which every factor is suited for one and only one task is not inconceivable or logically contradictory. In contrast, the ERE is indeed an unrealizable and self-contradictory construct. It describes a world in which, for example, the future is known with perfect certainty but action, which is always aimed at changing the future, occurs; and agents hold money balances despite the absence of uncertainty regarding the temporal pattern of their future receipts and expenditures. This is not to imply that proximity to reality makes one imaginary construct better or more useful than another; the sole test of a construct’s usefulness is the aid it gives to thought in deducing the causal laws operating in real mar- kets.

38 Introduction to the Second Edition xxxv stage as well as the stock of final consumer goods and the 36 money revenue obtained from its sale to consumers. In both variations of the construct, an evenly rotating economy is assumed in order to abstract from the problems of entrepre- neurship. With the assistance of this construct, Rothbard deduces a number of important theorems and principles of production. First, in the case of joint ownership of the product by the col- laborating land and labor factors, there are no independent, pri- mordial owners of capital goods, which are intermediate goods in the production process and therefore resolvable into the labor and land inputs that cooperated in producing them. Sec- ond, and consequently, all income in production consists of wages and land rents—capital goods, which are merely way sta- tions on the path to the final product, do not earn any net rents for their owners. Third, all cooperating laborers and land own- ers must wait for their income from the inception of the pro- ductive process to its termination and the subsequent sale of the final product to consumers. Therefore, fourth, the size of the aggregate income of the cooperating factor owners depends solely and completely on the demand of consumers for their product. A relative shift in relative consumer demand between final goods will fall solely and completely on the specific factors that are involved in the production of the affected products. Once the capitalist is introduced into this fictitious world, a fifth principle becomes immediately evident: the function of the capitalist is to relieve the factor owners of the burden of waiting for income, as he advances them present money payments from his accumulated savings for the joint product of their labor and land services. In exchange for these present wages and rents, the 36 For the explanation of this construct and its variations and the elab- oration of its implications, see Rothbard, Man, Economy, and State , pp. 329–66.

39 with Power and Market xxxvi Man, Economy, and State capitalist receives an interest return on his invested funds, which is based on time preference and reflects the value dis- monetary revenues he will be future count of the anticipated present receiving relative to the money payments he expends on the factor services. Conversely, the factor owners agree to this deduction from the full-sale proceeds of their product that is embodied in their discounted wage and rent payments from the capitalist, because these present payments unshackle them from the temporal dimension of the production process. A sixth prin- ciple is that, even in a world of capitalist ownership of the entire production process, capital goods still do not generate a net monetary income for their owners, because the net interest return obtained by the capitalist-owners is fully derived from the discount incorporated into the present wages and rents paid to owners of labor and land factors, who are the only net recip- ients of incomes in a world without capitalists. Thus wage, rent, and interest incomes logically exhaust the entire proceeds from the sale of the final product, leaving no remainder for net pay- 37 ments to capital goods. This analysis of Rothbard’s hypothetical world of purely spe- cific factors also is pregnant with implications for the role of subjective costs in production and pricing. Given that specific 37 This conclusion of the exhaustion of the income from production among wages, rents, and interest receipts hold true only under the assumption that future market conditions are known with certainty. Once this assumption is dropped and the possibility is admitted of over- valuation or undervaluation of the complements of specific factors by capitalist investors, entrepreneurial profits and losses enter the picture. However, in a world of purely specific factors such profits and losses would not have an allocative function because, by definition, factors can- not shift between production processes. More importantly, it becomes clear that such incomes accrue to the capitalists alone and that, therefore, in the real world of uncertainty, the functions of capitalist and entrepre- neur are integrated in the same agent.

40 xxxvii Introduction to the Second Edition land factors and capital goods have no alternative uses in this imagined world, an immediate inference is that their use in pro- duction is “costless” and their respective supply curves perfectly inelastic. Labor, specific to a particular production process though it may be, in contrast, is costly to use because it has an alternative use in the production of “leisure,” which is an instantaneously producible consumers’ good. Thus, in a world without capitalists, labor involves the disutility of foregoing both leisure and present goods. The arrival of capitalists on the scene reduces, but does not eradicate, the disutility of labor. These inferences starkly demonstrate the principle that all pro- duction costs are ultimately and essentially subjective. Leisure preferences and time preferences thus determine the ultimate costs of production and these costs are purely subjective and consist of the valuation of the forgone utilities of the producers against the anticipated monetary revenues from consumers. Once these (subjective) producers’ costs have all been incurred, the stocks of the various kinds of consumers’ goods emerge from the production process ready for sale to consumers. Unless their producers have a direct use for the goods, their sale to consumers is completely costless and their relative prices are determined solely by the structure of value scale of consumers. Hence, barring speculation on future price variations, the sup- ply curves for the various stocks of consumer goods are also per- fectly inelastic. In sum, “production costs”—that is, the disutil- ities of labor and waiting that have already been incurred, or the utilities of leisure and immediate enjoyment that have already been forgone, by producers—have no role whatever in deter- 37 mining the prices of the existing stocks of consumers goods. Rothbard also wields the fictive construction he formulated to demolish Marshallian price theory, according to which prices were determined by two blades of a scissors: the subjective val- ues of consumers composing one blade while the objective or real costs of production compose the other blade. While Mar- shall and his contemporary followers concede that, in the tran- sient immediate run the subjective-value blade predominates in

41 with Power and Market xxxviii Man, Economy, and State determining prices, they maintain that in the long-run equilib- rium, where the permanent tendencies of the economy reveal themselves, the cost of production blade governs because the price of every product conforms to its average cost of produc- tion. Thus Marshallians superficially conclude that costs must therefore determine prices. However, Rothbard easily demon- strates that this conformity between price and average cost in long-run equilibrium or the ERE, which itself is not real but a useful imaginary construction, is the result of the same princi- ples governing the determination of the actual prices that momentarily prevail and at which exchanges take place in real- world markets. In a world where all factors are purely specific to a single production process, Rothbard shows that in the long run, where entrepreneurial errors are absent and profits and losses have been totally eliminated, the aggregate payments to all factors cooperating in a given production process are rigidly governed by and must perfectly correspond to the aggregate revenues spent on the final product by consumers minus the interest return to capitalists. Accepting this deduction and dividing both aggregate revenues and aggregate factor pay- ments by the quantity of product implies that the direction of causation of the equality between price and average cost, espe- in the long run, runs from the former to the latter. cially Rothbard’s formulation and deployment of this imaginary world of purely specific factors epitomizes the application of the praxeological method in theoretical research. As Mises pointed out, The main formula for designing of imaginary con- structions is to abstract from the operation of some conditions present in actual action. Then we are in a position to grasp the hypothetical consequences of the absence of these conditions and to conceive the 38 effects of their existence. 38 Mises, Human Action , p. 238.

42 xxxix Introduction to the Second Edition Thus Rothbard first imagines that in this world all production processes are owned by the cooperating factors themselves, who must endure without income until the final product has emerged and is sold to consumers. By first analyzing the state of affairs in abstraction from the existence of the capitalist, we are able to grasp his function of advancing his accumulated savings to the factors before the sale of the final product and to com- prehend the nature of his income as a return to time preference, which has been previously established much earlier in the chain of praxeological deductions as an immediate inference from the Action Axiom. In assuming away the capitalist we have also assumed away monetary costs of production, since the only money payments are directly from consumers to the joint factor owners of the final product. This enables us to see that total monetary costs are essentially determined by and equal to these total money expenditures by consumers as mediated through capitalists who have previously advanced present wages and rents to the factor owners. In later chapters, Rothbard proceeds to drop the assumption of purely specific factors and admits varying degrees of speci- ficity among factors into his analysis. The effects of relatively nonspecific factors in the production process can now be iden- tified by investigating how their presence modifies the out- comes of a hypothetical world of purely specific factors. Since nonspecific factors can be converted to use in a wide range of production processes, a relative shift in consumer demand, , will alter their allocation while only temporarily ceteris paribus affecting their prices. But the principles already deduced regarding specific factors still hold sway in this more complex world and so we are able to conclude that prices of the relatively specific factors in any process will bear the brunt of the change in aggregate consumer expenditures on a given final product. Thus, for instance, in the case of a relative decline of the demand for diamonds, all other things equal, the capital values of diamond mines and the wages of highly skilled jewelers will also decline while the wages of diamond miners and rents of

43 with Power and Market xl Man, Economy, and State electric generators will undergo little change as these nonspe- cific factors shift to other employments. Furthermore, intro- duction of nonspecific factors into the analysis will make a large part of the monetary costs of production appear to be given to the capitalist-employer of factors independently of the demand for his particular good. As a result, the capitalist will react to a change in his costs by adjusting his level of production, just as he would in the case of a change in the demand for his product. Hence, in the absence of a long chain of deductive reasoning Rothbard and earlier Austri- à la utilizing imaginary constructs, ans, a superficial view of the matter will render Marshall’s metaphor of the two blades of the scissors as a plausible repre- sentation of reality. Without sedulous employment of the prax- eological method, it would be impossible to conceive that it is the demands of consumers for the outputs of a wide range of production processes, as mediated through the bids of capital- ist-entrepreneurs, as ultimately and exclusively determinative of the prices of all factors, relatively nonspecific as well as purely specific. This praxeological method so masterfully deployed by Roth- bard had been used, even if implicitly and crudely, as the pri- mary tool of theoretical research in economics up through the 1930s. However, as Rothbard points out, it was precisely “Mar- shall’s distrust of ‘long chains of deduction,’” in addition to “the whole Cambridge impetus toward” making short-cut assump- tions designed to make their theory more testable was one of the factors that led to the gradual breakdown of the praxeolog- 39 ical method and its replacement by positivism. By the early 39 Rothbard, Man, Economy, and State , p. xcii. While Marshall utilized the method of imaginary constructions, his aversion to lengthy step-by- step deduction runs afoul of Mises’s warning: that it is “a method very dif- ficult to handle because it can easily result in fallacious syllogisms. It leads along a sharp edge; on both sides yawns the chasm of absurdity and non- sense” (Mises, Human Action , p. 238).

44 Introduction to the Second Edition xli 1950s the praxeological method and verbal logic had been eclipsed by positivism and mathematical models. For example, the leading economist of the postwar era, Paul Samuelson now maintained that the task of economic theory was to “organize the facts into useful and meaningful” patterns and in so doing to 40 provide economical descriptions of complex reality. Economic theorems, then, had to be framed in a manner that was “opera- tionally meaningful.” According to Samuelson, a meaningful theorem was “simply a hypothesis about empirical data that could conceivably be refuted, if only under ideal conditions.” Whether such a theorem was “false,” or “of trivial importance,” or even of “indeterminate” validity was not as important to in princi- Samuelson as it being framed as a proposition capable 41 of empirical refutation. ple For Samuelson, theorems would thus be embodied and expressed in highly simplified mathemat- be subjected to empirical tests could ical models that if the data were available . Since, admittedly, the requisite data were rarely accessible the most that could be expected from such abstract models was that they “often point the way to an element of truth present in a complex situation” and that they “afford tol- 42 erably accurate extrapolations and interpolations.” However, in a retrospective, Samuelson lamented the lack of success of the crude positive method in economics, writing: 40 Paul Samuelson, “My Life Philosophy: Policy Credos and Working Ways,” in Michael Szenberg, ed., Eminent Economists: Their Life Philoso- phies (New York: Cambridge University Press, 1993), p. 241. 41 Foundations of Economic Analysis , 2nd ed. (New Paul Samuelson, York: Atheneum, 1976), p. 4. 42 Paul Samuelson, “International Factor Price Equalisation Once Again,” in The American Economics Association, Readings in International Economics (Homewood, Ill.: Richard D. Irwin, 1968), pp. 58; and idem, “My Life Philosophy,” p. 241.

45 with Power and Market xlii Man, Economy, and State When I was 20 . . . I expected that the new econo- metrics would enable us to narrow down the uncer- tainties of our economic theories. We would be able to test and reject false theories. We would be able to infer new good theories. . . [I]t has turned out not to be possible to arrive at a close approximation to indis- putable truth [and] it seems objectively to be the case that there does not accumulate a convergent body of econometric findings, convergent on a testable 43 truth. Of course this does not mean that Samuelson’s faith in the positivist method was shaken. Rather, it confirmed his prior belief that truth was multifaceted and therefore “Precision in deterministic facts or in probability laws can at best be only par- 44 tial and approximate.” If Samuelson downplayed the attainment of truth as a goal of theoretical research in favor of the formulation of operationally meaningful theorems, the other avatar of positivism in postwar economics, Milton Friedman, jettisoned all references to truth and realism in assessing the validity of economic theorems. Rejecting Samuelson’s crude logical positivism, Friedman rev- eled in the falsity or “unrealism” of a theorem’s assumptions and offered the seemingly more sophisticated alternative of “falsifi- cationism,” which was allegedly based on Karl Popper’s philoso- 45 phy of science. Friedman’s position was concisely summed up 43 Samuelson, “My Life Philosophy,” p. 243. 44 Ibid ., p. 244 45 Milton Friedman, “The Methodology of Positive Economics,” in idem, Essays in Positive Economics (Chicago: University of Chicago Press, 1970), pp. 1–43. Some methodologists have argued that Friedmanite- positivist methodology shares little more than vocabulary with Popper’s philosophy of science. For example, see Lawrence A. Boland, The Foun- dations of Economic Method (Boston: Allen & Unwin, 1982), pp. 155–96.

46 Introduction to the Second Edition xliii in Mark Blaug’s statement, “No assumptions about economic behavior are absolutely true and no theoretical conclusions are 46 valid for all times and places. . . .” Despite the formal adherence by most of the profession to positivist methods during the 1950s, Rothbard’s quest to recover and reconstruct the edifice of sound economic theory drove him to scour the contemporary literature for new ideas and insights as carefully as he had scrutinized the writings of his predecessors in the causal-realist tradition. Rothbard’s treatise contains citations from over 150 books, journal articles, confer- ence proceedings, government documents, dissertations, and policy and research institute monographs published between Man, Economy, and the appearance of Human Action in 1949 and 47 Rothbard’s deep engagement with the contem- in 1962. State porary literature paid off as he discovered that many of these works contained research that clarified, refined or advanced causal-realist theory and he eagerly integrated these contribu- tions into his own work. For example in his notable development of an explanation of the firm’s costs and return on investment that sharply deviates from the Marshallian theory of the firm, Rothbard was heavily influenced by two neglected articles coauthored by André Gabor 48 and I.F. Pierce on “the Austro-Wicksellian” theory of the firm. 46 Mark Blaug, , 4th ed. (New York: Cam- Economic Theory in Retrospect bridge University Press, 1986), p. 3. 47 Actually some of the references in the present edition are to works published after 1962, because this volume includes Power and Market which was originally written as the third volume of Man, Economy, and State , but was published separately eight years later. For the story behind the editorial decision to truncate and publish it Man, Economy, and State as two volumes and Rothbard’s reaction to it, see Stromberg, pp. lxv–lxxi. 48 André Gabor and I.F. Pearce, “A New Approach to the Theory of the Firm,” Oxford Economic Papers 54 (October 1952): 252–65; idem, “The Place of Money Capital in the Theory of Production,” Quarterly Journal of Economics 72 (November 1958): 537–57.

47 with Power and Market xliv Man, Economy, and State Rothbard cites a discussion by the Cambridge econ omist Roy Harrod, in addition to a discussion by Böhm-Bawerk, as a source for his own path-breaking identification of a fourth com- ponent in the gross business income of the capitalist-entrepre- neur. This “ownership” or “decision-making” rent is distinct from and in addition to implicit wages of management, interest 49 In his thorough- return on invested capital, and pure profit. going critique of the theories of perfect and monopolistic com- petition doctrines and his original formulation of a positive the- ory of competition as a dynamic process, Rothbard favorably cites the contributions of a number of his mainstream contem- poraries including: G. Warren Nutter; Wayne Leeman; Mar- shall I. Goldman; and Reuben Kessel. Rothbard singles out a Quality and book by Lawrence Abbott published in 1952 titled Competition for special praise, characterizing it as “one of the 50,51 Indeed, the outstanding theoretical works of recent years.” theory of rivalrous competition that Rothbard expounds is clearly influenced by Abbott’s arguments on the central impor- tance of the qualitative dimensions of competition. The fact that theoretical research employing verbal logic and the praxeological method still remained relatively pervasive among academic economists even as late as the 1950s highlights the deep and hardy roots of the causal-realist tradition. It is also accounts for the reason why Rothbard did not yet perceive any 49 Roy Harrod, “Theory of Profit,” in idem, Economic Essays (New York, Harcourt and Brace & Co., 1952), pp. 190–95. For a detailed dis- cussion of Rothbard’s concept of decision-making rent and its signifi- cance for the theories of entrepreneurship and the firm, see Joseph T. Salerno, “The Entrepreneur: Real and Imagined,” Quarterly Journal of Austrian Economics 11 (3). 50 Lawrence Abbott, Quality and Competition: An Essay on Economic Theory (Westport, Conn.: Greenwood Press, 1973). 51 Rothbard, Man, Economy and State , p. 666, fn. 28.

48 Introduction to the Second Edition xlv advantage in appropriating the label “Austrian” to differentiate his treatise from contemporary economics. In fact, in private correspondence dated February 1954, Rothbard expressed con- fidence that mainstream economic theorists could still be drawn back toward the causal-realist research program and that his work in progress will, I believe, command the attention of the profes- sion as a treatise because of its considerable elabora- tions in those areas not developed by Mises, its dif- ferences from Mises in such areas as monopoly, bank- ing ethics, and government . . . and its refutations of 52 current economic theory. While in retrospect we may be tempted to dismiss Rothbard’s bold prediction as a burst of youthful optimism, it hardly reflects the attitude of someone intent on completely breaking with the prevailing doctrine and founding a heterodox school of thought. By the advent of the 1970s, however, mainstream economic theory had sunk to almost unfathomable depths, degenerating into a series of loosely related mathematical models which had little contact with reality. Following the prevailing Friedmanite- positivist methodology, the tentative “validity”—never the truth—of these models was putatively established by empiri- cally testing their ability to predict or, more accurately, “retro- dict” using the methods of econometrics. The last vestiges of the Mengerian approach thus disappeared from the curricula of graduate economics programs and causal-realist theoretical research was now completely banished from academic journals, which had become the main, if not the only, research outlet for mainstream economics. 52 Rothbard to R. Cornuelle, memo: “Textbook or Treatise?”; Roth- bard Papers.

49 Power and Market with Man, Economy, and State xlvi Around the same time as this sea change in economic theory and method, there began to coalesce outside the formal institu- tion of academic economics a new intellectual movement that was directly inspired by Rothbard’s reconstruction of the causal- Man, Economy, and State. This realist theoretical organon in movement comprised mainly graduate students and younger faculty members associated with U.S. academic institutions who were disaffected with the orthodox neoclassical synthesis, which had begun to break down with the failure of the Kennedy-John- son “New Economic” policies to rein in the Vietnam War infla- tion and the subsequent emergence of stagflation in the early 1970s. By the mid-1970s the new movement had grown to such an extent that the opportunity presented itself to institutionalize and promote its existence by means of a formal academic con- ference on Austrian economics, which was held at South Royal- ton, Vermont, in June 1974. The appellation “Austrian” was chosen for this new intellectual tendency mainly for strategic reasons. Since the Rothbardian movement embraced a method and body of doctrine that now shared very little common ground with the entrenched positivist orthodoxy, the label at least provided the movement with a recognizable affiliation with one of the great streams of early marginalist thought that had fed into this modern mainstream. The name also instantly endowed the movement with the great cachet associated with the well-known names of the founding members of the Austrian School, such as Carl Menger, Eugen von Böhm-Bawerk, and Friedrich von Wieser and its later representatives Ludwig von Mises and Friedrich A. Hayek. The prestige of the “Austrian” brand name was further enhanced when Hayek became a co- recipient of the Nobel Prize in economics later in the year. The term had the additional virtue of identifying the movement’s general theoretical orientation. Rothbard and his followers eagerly embraced the new desig- nation and began to refer to themselves as members or followers

50 xlvii Introduction to the Second Edition of the modern Austrian School, which was now positioned as a heterodox challenger to “mainstream economics.” Despite its significant short-run strategic virtues, however, branding the school of thought that coalesced at the South Royalton confer- ence as “Austrian” has engendered a number of serious prob- lems in the long run. First, it has come to obscure the extent to which the modern Austrian School was directly inspired by Rothbard. Indeed it is no exaggeration to say that a large major- ity of the thirty or so participants in the South Royalton con- ference adhered to the body of causal-realist theory elaborated in Man, Economy, and State . Second, it conceals the fact, noted above, that in writing this treatise, Rothbard drew from a much broader range of literature than that emanating from the origi- nal Austrian School and its direct intellectual descendents. Third, the label diverts attention from Rothbard’s primary mis- sion in writing his treatise, which has to purge modern eco- nomic science of its alien positivist and mathematical formalist elements and to reconstruct it along consistently causal-realist lines. It cannot be stated too often or too emphatically that engineering a radical break from standard economic theory and establishing a heterodox school of thought that rejected all forms of equilibrium analysis and the use of imaginary con- Man, Economic, structs was not Rothbard’s purpose in writing and State . Indeed, as we have seen, one of Rothbard’s most important contributions in his treatise is his painstaking expli- cation of the content and the proper use of fictitious constructs and imaginary states of the world in deriving meaningful propo- sitions about the causal determinants of observable economic phenomena. The last and perhaps most significant disadvantage of apply- ing the unqualified term “Austrian” to the post-South Royalton economics movement is the fact that it fosters a conflation of the very different and conflicting research programs that have grown up under this opaque semantic veil. Rothbard recognized and lamented this state of affairs in the Preface to the revised edition of Man, Economy, and State published in 1993:

51 Power and Market with Man, Economy, and State xlviii In fact, the number of Austrians has grown so large, and the discussion so broad, that differences of opinion and branches of thought have arisen, in some cases developing into genuine clashes of thought. Yet they have all been conflated and jammed together by non- Austrians and even by some within the school, giving rise to a great deal of intellectual confusion, lack of clarity, and outright error. The good side of these developing disputes is that each side has clarified and sharpened its underlying premises and world-view. It has indeed become evident in recent years that there are three clashing paradigms within Austrian eco- nomics: the original Misesian or praxeological para- digm, to which the present author adheres; the Hayekian paradigm, stressing “knowledge” and “dis- covery” rather than praxeological “action” and “choice,” and whose leading exponent now is Profes- sor Israel Kirzner; and the nihilistic view of the late Ludwig Lachmann, an institutionalist anti-theory approach taken from the English “subjectivist” Key- nesian G.L.S Shackle. (p. xiv) While this accurately describes the state of Austrian econom- ics in the early 1990s, the situation has become even more con- tentious and muddled since then. While the Lachmannian branch has waned somewhat in influence, a new, wildly eclectic tendency has developed which proposes to agglomerate indis- criminately selected elements of Menger, Mises, Hayek, Lach- mann, Kirzner, and Rothbard with random insights from Adam Smith’s economics, Public Choice Theory, New Institutional Economics, transaction costs economics, game theoretic model- ing, hermeneutical economics, and ethnographic and historical case studies, all under the rubric of Austrian economics or “good economics.” Needless to say, the situation is even less satisfac- tory now than it was when Rothbard penned the passage above. Those interested in pursuing theoretical research in the Men- gerian causal-realist tradition are now viewed by the profession, thanks to the Austrian label, as part of a splintered and feuding

52 xlix Introduction to the Second Edition heterodox movement more interested in discoursing on meta- economic esoterica or devising “spontaneous-order” explana- cal episodes than in analyzing the “mun- tions for obscure histori dane” issues at the heart of mainstream economics—value the- ory, price theory, capital theory, monetary theory, and business cycles. Fortunately, points the way out of Man, Economy, and State this morass of confusion, which threatens permanent and wholesale marginalization of all branches of Austrian econom- ics. Every page of Rothbard’s treatise is imbued with a profound awareness that the causal-realist theoretical system that he was expounding was in the mainstream of an international eco- nomic tradition that originated in the Marginalist Revolution. His treatise thus was not intended as the program for a new het- erodox movement or the revival of an old one; rather it repre- sented an endeavor to reconstruct orthodox economics on the unshakeable foundation of the praxeological method and to use this method to substantively advance the theory. In a crucial sense, economic science had temporarily lost its bearings and was beginning to stray from its rich heritage and Rothbard aimed at setting it back on course. Consequently, he never con- ceded the mainstream of economic science to the disciples of mathematical modeling and the positivist method, whom he regarded as an irrationalist cult that had hijacked economics and whose silly doctrines would sooner or later wind up in the dust- bin of intellectual history. Rothbard has been proven correct. Mathematical modeling has revealed itself to be a vain and formalistic exercise incapable of explaining the international currency crises, stock-market and real-estate bubbles, and the global financial crises that have wracked our world in the past two decades. It is increasingly evident even to professional economists that the tortuous posi- tivist detour has led to an intellectual dead end. Hence, bizarre heterodox sects such as behavioral economics, experimental economics, the “happiness” literature, neuro-economics, etc.,

53 Power and Market with Man, Economy, and State l now abound. Some market-oriented economists have even abandoned modern economic theory altogether for the less rig- orous rhetoric and metaphors of Adam Smith’s “invisible hand” 53 and Hayek’s “spontaneous order.” The death knell is now tolling for the mathematical and pos- itivist pretenders to the mainstream of economics. The time is now ripe for Austrians to recover their rightful position as the true representatives of the central tendency of modern eco- nomic theory by affirming the praxeological method as the research method of economics. The prodigious fruits of this method stand before us in the integrated theoretical structure expounded in . Man, Economy, and State 53 Of course the concept of the “spontaneous order” was only one of Hayek’s many contributions. Most of these contributions were squarely in the Mengerian causal-realist tradition and dealt with themes of mun- dane economics such as capital theory, business-cycle theory, interna- tional monetary theory, and comparative monetary institutions. For a col- lection of Hayek’s most important works in these areas, see Prices and Pro- duction and Other Works: F.A. Hayek on Money, the Business Cycle, and the Gold Standard , ed. Joseph T. Salerno (Auburn, Ala.: Ludwig von Mises Institute, 2008). Also see Peter G. Klein, “The Mundane Economics of the Austrian School,” Quarterly Journal of Austrian Economics 11, no. 3 (Fall 2008), for the argument that the notion of spontaneous order, rightly understood, has roots in Menger’s causal-realist economics.

54 REFACE TO P R EVISED E DITION of World War I, it seems, NE OF THE UNHAPPY CASUALTIES O was the old-fashioned treatise on economic “principles.” Before World War I, the standard method, both of presenting and advancing economic thought, was to write a disquisition setting forth one’s vision of the corpus of economic science. A work of this kind had many virtues wholly missing from the modern world. On the one hand, the intelligent layman, with little or no previous acquaintance with economics, could read it. On the other hand, the author did not limit himself, textbook-fashion, to choppy and oversimplified compilations of currently fashion- able doctrine. For better or worse, he carved out of economic theory an architectonic—an edifice. Sometimes the edifice was an original and noble one, sometimes it was faulty; but at least was an edifice, for beginners to see, for colleagues to adopt there or criticize. Hyperrefinements of detail were generally omitted as impediments to viewing economic science as a whole, and they were consigned to the journals. The university student, too, learned his economics from the treatise on its “principles;” it was not assumed that special works were needed with chapter lengths fitting course requirements and devoid of original doc- trine. These works, then, were read by students, intelligent lay- men, and leading economists, all of whom profited from them. [P UBLISHER ’ S N OTE : This “Preface to Revised Edition” is from the 1993 edition of Man, Economy, and State , published by the Mises Insti- tute.] li

55 with Power and Market lii Man, Economy, and State Their spirit is best illustrated by a prefatory passage from one of the last of the species: I have tried in this book to state the principles of eco- nomics in such form that they shall be comprehensible to an educated and intelligent person who has not before made any systematic study of the subject. Though designed in this sense for beginners, the book does not gloss over difficulties or avoid severe reasoning. No one can understand economic phenomena or pre- pare himself to deal with economic problems who is unwilling to follow trains of reasoning which call for sustained attention. I have done my best to be clear, and to state with care the grounds on which my conclusions rest, as well as the conclusions themselves, but have 1 made no vain pretense of simplifying all things. Since the brilliant burst that gave us the works of Wicksteed (1910), Taussig (1911), and Fetter (1915), this type of treatise has disappeared from economic thought, and economics has become appallingly fragmented, dissociated to such a degree that there any more; instead, we find myriad bits and hardly is an economics pieces of uncoordinated analysis. Economics has, first, been frag- mented into “applied” fields—“urban land economics,” “agricul- tural economics,” “labor economics,” “public finance economics,” etc., each division largely heedless of the others. More grievous still has been the disintegration of what has been confined to the cate- tility theory, monopoly theory, gory of “economic theory.” U international trade theory, etc., down to linear programming and games theory—each moves in its sharply isolated compartment, with its own hyperrefined literature. Recently, growing awareness of this fragmentation has led to vague “interdisciplinary” admix- tures with all the other “social sciences.” Confusion has been worse confounded, with resulting invasive forays of numerous other disciplines into economics, rather than the diffusion of eco- nomics elsewhere. At any rate, it is somewhat foolhardy to 1 Frank W. Taussig, Principles of Economics (New York: Macmillan, 1911), p. vii.

56 liii Preface attempt to integrate economics with everything else before eco- been made whole. Only then will the proper itself nomics has place of economics among the other disciplines become manifest. I think it fair to say that, with only a single exception (Lud- ), general treatise on eco- not one wig von Mises’ Human Action nomic principles has appeared since World War I. Perhaps the closest approach was Frank H. Knight’s Risk, Uncertainty, and was published far back in 1921. Since then, there Profit , and that has been no book of remotely as broad a scope. The only place where we can find economics treated with any degree of breadth is in the elementary textbooks. These textbooks, however, are sorry substitutes for a genuine Princi- ples. Since they must, by their nature, present only currently received doctrine, their work is uninteresting to the established economist. Furthermore, since they may only boil down the existing literature, they must of necessity present to the student a hodgepodge of fragmented chapters, each with little or no relation to the other. Many economists see no loss in all this; in fact, they herald these developments as signs of the enormous progress the sci- ence has made on all fronts. Knowledge has grown so vast that no man can encompass it all. Yet economists should at least be economics responsible for knowing —the essentials of the body of their discipline. Certainly, then, these essentials could have been presented by this time. The plain fact is that economics is fragmented precisely it is no longer regarded as an edi- because fice; since it is considered a congeries of isolated splinters, it is treated as such. Perhaps the key to this change is that formerly economics was regarded as a logical structure. Fundamentally, whatever the dif- ferences of degree, or even of proclaimed methodology, eco- nomics was considered a deductive science using verbal logic. Grounded on a few axioms, the edifice of economic thought was deduced step by step. Even when the analysis was primitive or the announced methodology far more inductive, this was the

57 Power and Market with Man, Economy, and State liv essence of economics during the nineteenth century. Hence, the treatise on economic “principles”—for if economics proceeds by deductive logic grounded on a few simple and evident axioms, then the corpus of economics can be presented as an interrelated whole to the intelligent layman with no loss of ulti- mate rigor. The layman is taken step by step from simple and evident truths to more complex and less evident ones. The “Austrian” economists best perceived this method and used it most fully and cogently. They were the classic employ- ers, in short, of the “praxeologic” method. In the present day, however, the prevailing epistemology has thrown over praxeol- ogy for methods at once too empirical and too “theoretical.” Empiricism has disintegrated economics to such an extent that no one thinks to look for a complete edifice; and, paradoxically, it has falsified economics by making economists eager to intro- duce admittedly false and short-cut assumptions in order to make their theories more readily “testable.” Alfred Marshall’s distrust of “long chains of deduction,” as well as the whole Cambridge impetus toward such short cuts, has contributed a great deal to this breakdown. On the other hand, verbal logic in economic theory has been replaced by mathematics, seemingly more precise and basking in the reflected glory of the physical sciences. The dominant econometric wing of mathematical economists also looks for empirical verifications and thereby compounds the errors of both methods. Even on the level of pure theoretical integration, mathematics is completely inap- propriate for any sciences of human action. Mathematics has, in fact, contributed to the compartmentalization of economics— to specialized monographs featuring a hyperrefined maze of matrices, equations, and geometric diagrams. But the really important thing is that nonmathematicians cannot un- not derstand them; the crucial point is that mathematics cannot contribute to economic knowledge. In fact, the recent conquest of mathematical economics by econometrics is a sign of recog- nition that pure mathematical theory in economics is sterile.

58 lv Preface This book, then, is an attempt to fill part of the enormous gap of 40 years’ time. Since the last treatise on economic “prin- ciples,” economics has proceeded a long way in many areas, and its methodology has been immeasurably improved and strengthened by those continuing to work in the praxeological tradition. Furthermore, there are still great gaps in the praxeo- logical corpus, since so few economists have worked at shaping it. Hence, the attempt in this book to develop the edifice of eco- nomic science in the manner of the old-fashioned works on its “principles”—slowly and logically to build on the basic axioms an integrated and coherent edifice of economic truth. Hyper- refinements have been shunned as much as possible. In short, Professor Taussig’s quoted statement of intention has been mine also, with the addition that I have felt it necessary to include, at pertinent points, refutation of some of the main opposing doc- trines. This was especially needed because economic fallacy prevails far more widely than in Taussig’s time. one general trea- I have indicated briefly that there has been tise since World War I. Professor Paul Samuelson has written rhapsodically of the joy of being under thirty at the time of pub- lication of Keynes’ General Theory . I can say the same for the Human Action publication of Ludwig von Mises’ in 1949. For once more, once again an edi- whole here at last was economics fice. Not only that—here was a structure of economics with many of the components newly contributed by Professor Mises himself. There is no space here to present or expound Mises’ great contributions to economic science. That will have to be done elsewhere. Suffice it to say that from now on, little con- structive work can be done in economics unless it starts from Human Action . Human Action is a general treatise, but not an old-style Prin- ciples. Instead, it assumes considerable previous economic knowledge and includes within its spacious confines numerous philosophic and historical insights. In one sense, the present

59 Power and Market with Man, Economy, and State lvi work attempts to isolate the economic, fill in the interstices, and spell out the detailed implications, as I see them, of the Misesian structure. It must not be thought, however, that Professor Mises is in any way responsible for these pages. Indeed, he may well differ strongly with many sections of this volume. Yet it is my hope that this work may succeed in adding a few bricks to the noble structure of economic science that has reached its most modern and developed form in the pages of Human Action . The present work deduces the entire corpus of economics from a few simple and apodictically true axioms: the Funda- action —that men employ means to achieve mental Axiom of of ends, and two subsidiary postulates: that there is a variety human and natural resources, and that leisure is a consumers’ good. Chapter 1 begins with the action axiom and deduces its immediate implications; and these conclusions are applied to “Crusoe economics”—that much maligned but highly useful analysis that sets individual man starkly against Nature and ana- lyzes his resulting actions. Chapter 2 introduces other men and, consequently, social relations. Various types of interpersonal direct exchange relations are analyzed, and the economics of (barter) is set forth. Exchange cannot be adequately analyzed until property rights are fully defined—so chapter 2 analyzes property in a free society. Chapter 2, in fact, marks the begin- ning of the body of the book—an analysis of the economics of voluntary exchange. Chapter 2 discusses the free market of barter, and the subsequent chapters treat the economics of indi- rect —or monetary—exchange. Thus, analytically, the book deals fully with the economics of the free market, from its prop- erty relations to the economics of money. Chapter 3 introduces money and traces the patterns of indi- rect exchange on the market. Chapter 4 treats the economics of consumption and the pricing of consumers’ goods. Chapters 5– 9 analyze production on the free market. One of the features of this consumption and production theory is the resurrection of Professor Frank A. Fetter’s brilliant and completely neglected

60 lvii Preface —i.e., the concept of rent as the hire price of a theory of rent then becomes the process of deter- unit service. Capitalization mining the present values of the expected future rents of a good. The Fetter-Mises pure time-preference theory of interest is synthesized with the Fetter rent theory, with the Austrian the- origi- ory of the structure of production, and with separation of from produced factors of production. One “radical” feature of nal our analysis of production is a complete break with the cur- rently fashionable “short-run” theory of the firm, substituting for this a general theory of marginal value productivity and cap- italization. It is a “general equilibrium” analysis in the dynamic Austrian sense, and not in the static, currently popular Wal- rasian sense. Chapter 10 expounds a completely new theory of monop- oly—that monopoly can be meaningfully defined only as a grant of privilege by the State, and that a monopoly price can be attained only from such a grant. In short, there can be no monopoly or monopoly price on the free market. The theory of monopolistic competition is also discussed. And chapter 11 sets forth the theory of money on the free market, along with an extensive discussion of the Keynesian theories. Having completed the theory of the purely free market, I then turn, in the final chapter, to applying praxeological analy- sis to a systematic discussion of various forms and degrees of coercive intervention and their consequences. The effects of coercive intervention can be studied only after fully analyzing the construct of a purely free market. Chapter 12 presents a typology of intervention, discusses its direct and indirect con- sequences and the effects on utility, and sets forth a necessarily brief analysis of the various major types of intervention, includ- ing price control, monopoly grants, taxation, inflation, and government enterprise and expenditures. The chapter and the book conclude with a brief summary assessment of the free market, as contrasted to interventionist and other coercive sys- tems.

61 Power and Market with Man, Economy, and State lviii For this revised edition, I have decided to keep the original text and footnotes intact, and to confine any changes to this revised preface. Professor Mises died in 1973, and the following year, as luck would have it, the Austrian School of economics that Mises had kept alive in an almost underground existence burst forward into a spectacular revival. It is no accident that this revival coincided with the virtual collapse of the previously dominant Keynesian paradigm. Keynesians had promised to steer the economy easily away from the recurring pitfalls of inflationary boom, and recession and unemployment; instead, they would insure permanent and stable prosperity, bringing us full employment without inflation. And yet, after three decades of Keynesian planning, we faced a new phenomenon that can- not even exist, much less be explained, in the Keynesian para- recession and high unemploy- digm: inflation combined with ment. This unwelcome specter first appeared in the inflationary recession of 1973–74, and has been repeated since, the last time being the recession of 1990—? The Austrian revival of 1974 was also spurred by F.A. Hayek’s receiving the Nobel Prize for economics that year, the first free-market and nonmathematical economist to be accorded that honor. The economics profession’s obsession with the Nobel reawakened interest in Hayek and in the Aus- trian School. But this award to Hayek itself can be no coinci- dence, since it reflects disillusion by economists in Keynesian macro-models. Since 1974, the number of Austrians, books and articles by Austrians, and interest in the school, has greatly multiplied. It is a reflection of the difference in the quality of academia in the two countries that, even though there are proportionately fewer Austrian School economists in Britain than in the United States, Austrian economics is accorded a great deal more respect in Britain. In British textbooks and surveys of thought, Austrian eated economics, while not often winning agreement, is tr

62 Preface lix objectively and fairly as a respectable wing of economic thought. In the United States, on the contrary, while there are a large number of sympathizers as well as adherents in the profession, Austri ans are still marginalized, unheeded, and unread by the bulk of economists. Intellectual curiosity has a habit of breaking through, how- ever, especially among college and graduate students. As a result, the Austrian School has flourished over the last two decades, despite severe institutional obstacles. In fact, the number of Austrians has grown so large, and the discussion so broad, that differences of opinion and branches of thought have arisen, in some cases developing into genuine clashes of thought. Yet they have all been conflated and jammed together by non-Austrians and even by some within the school, giving rise to a great deal of intellectual confusion, lack of clar- ity, and outright error. The good side of these developing dis- putes is that each side has clarified and sharpened its underlying premises and world-view. It has indeed become evident in recent years that there are three very different and clashing par- adigms within Austrian economics: the original Misesian or praxeological paradigm, to which the present author adheres; the Hayekian paradigm, stressing “knowledge” and “discovery” rather than the praxeological “action” and “choice,” and whose leading exponent now is Professor Israel Kirzner; and the nihilistic view of the late Ludwig Lachmann, an institutionalist anti-theory approach taken from the English “subjectivist”- Keynesian G.L.S. Shackle. Fortunately, there is now a scholarly * journal, The Review of Austrian Economics , where the reader can keep apprised of ongoing developments in Austrian economics, as well as other publications, conferences, and instructional courses of the Ludwig von Mises Institute. The Mises Institute, founded on the centenary of his birth, keeps alive the spirit of * [P UBLISHER ’ S N OTE : In addition, The Quarterly Journal of Austrian Economics began publishing in 1998.]

63 with Power and Market lx Man, Economy, and State Mises as well as the paradigm that he has bequeathed to schol- arship and to the world. For the latest on the three Austrian paradigms, the reader is referred to the Mises Institute Work- ing Paper by the present author, “The Present State of Austrian ** Economics” (November, 1992). My overriding intellectual debt, of course, is to Ludwig von Mises. But apart from that, I can never fully express my personal debt. His wisdom, kindness, enthusiasm, good humor, and unflagging encouragement of even the slightest signs of productivity among his students were a lifelong inspiration to those who knew him. He was one of the great teachers of eco- nomics, as well as one of the great economists, and I am grate- ful to have had the opportunity of studying for many years at his Seminar in Advanced Economic Theory at New York Univer- sity. I can also never fully express my gratitude to Llewellyn H. Rockwell, Jr., who, at a low point in Misesian economics, with no endowment, no large pledges of support, and armed only with an idea, founded and dedicated his life to the Ludwig von Mises Institute. Lew has done a remarkable job of building and expanding the Institute, and of devoting himself to the Misesian paradigm. In addition, Lew has been a close and valued friend and intellectual colleague for many years. It is obvious that, without his efforts, this new edition would never have seen the light of day. Finally, I must at least try to convey how grateful I am to another long-time colleague, Burton S. Blumert, of the Mises Institute and head of the Center for Libertarian Studies, Burlin- game, California. Self-effacing and indispensable, Burt is always there—with wit, wisdom, kindness, and friendship. ** [P UBLISHER ’ S N OTE : This essay was reprinted as chapter 7 in Murray N. Rothbard, The Logic of Action I: Method, Money, and the Austrian School (Cheltenham, U.K.: Edward Elgar, 1997).]

64 lxi Preface It is impossible to list all the friends and acquaintances who, over the many years, have taught and inspired me in the area of Austrian economics, or in the wider arena of political economy, and in the nature of coercion of freedom. I am grateful to them all. None of them, of course, are responsible for any errors herein. M OTHBARD URRAY N. R Las Vegas, Nevada May, 1993


66 1 UNDAMENTALS F 1 1 CTION A UMAN H OF 1. The Concept of Action in the study of man HE DISTINCTIVE AND CRUCIAL FEATURE T Human action is defined simply as pur- . action is the concept of It is therefore sharply distinguishable from poseful behavior. those observed movements which, from the point of view of man, are not purposeful. These include all the observed movements of inorganic matter and those types of human behavior that are purely reflex, that are simply involuntary responses to certain stimuli. Human action, on the other hand, can be meaningfully interpreted by other men, for it is 2 purpose governed by a certain that the actor has in view. The end purpose of a man’s act is his ; the desire to achieve this for instituting the action. motive end is the man’s S N OTE : Page numbers cited in parentheses within the [P UBLISHER ’ text refer to the present edition.] 1 For further reading on this topic, the best source is the epochal work of Ludwig von Mises, Human Action (New Haven, Conn.: Yale University Press, 1949), pp. 1–143, and passim . 2 ., p. 11; F.A. Hayek, “The Facts of the Social Sciences,” in Cf. ibid (Chicago: University of Chicago Press, Individualism and Economic Order (Glencoe, Ill.: The Counter-Revolution of Science 1948), pp. 57–76; Hayek, The Free Press, 1952), pp. 25–35; and Edith T. Penrose, “Biological American Economic Review, Analogies in the Theory of the Firm,” Decem- ber, 1952, pp. 804–19, especially 818–19. 1

67 Power and Market with Man, Economy, and State 2 All human beings act by virtue of their existence and their 3 nature as human beings. We could not conceive of human beings who do not act purposefully, who have no ends in view , act that they desire and attempt to attain. Things that did not that did not behave purposefully, would no longer be classified as human. It is this fundamental truth—this axiom of human action— that forms the key to our study. The entire realm of praxeology and its best developed subdivision, economics, is based on an 4 analysis of the necessary logical implications of this concept. The fact that men act by virtue of their being human is indis- putable and incontrovertible. To assume the contrary would be an absurdity. The contrary—the absence of motivated behav- 5 ior—would apply only to plants and inorganic matter. 2. First Implications of the Concept it The first truth to be discovered about human action is that Only individuals have can be undertaken only by individual “actors.” ends and can act to attain them. There are no such things as ends of or actions by “groups,” “collectives,” or “States,” which do not take place as actions by various specific individu als. “Societies” or 3 Cf. Aristotle, , Bk. I, especially ch. vii. Ethica Nicomachea 4 This chapter consists solely of a development of the logical implica- tions of the existence of human action. Future chapters—the further parts of the structure—are developed with the help of a very small number of subsidiary assumptions. Cf. Appendix below and Murray N. Rothbard, “Praxeology: Reply to Mr. Schuller,” American Economic Review, December, 1951, pp. 943–46; and “In Defense of ‘Extreme Apriorism,’” Southern Eco- nomic Journal, January, 1957, pp. 314–20. 5 There is no need to enter here into the difficult problem of animal behavior, from the lower organisms to the higher primates, which might be considered as on a borderline between purely reflexive and motivated behavior. At any rate, men can understand (as distinguished from merely observe) such behavior only in so far as they can impute to the animals motives that they can understand.

68 Fundamentals of Human Action 3 “groups” have no independent existence aside from the actions of their individual members. Thus, to say that “governments” act is merely a metaphor; actually, certain individuals are in a certain relationship with other individuals and act in a way that 6 they and the other individuals recognize as “governmental.” The metaphor must not be taken to mean that the collective institution itself has any reality apart from the acts of various individuals. Similarly, an individual may contract to act as an agent in representing another individual or on behalf of his family. Still, only individuals can desire and act. The existence of an institution such as government becomes meaningful only through influencing the actions of those individuals who are 7 and those who are not considered as members. In order to institute action, it is not sufficient that the indi- He vidual man have unachieved ends that he would like to fulfill. must also expect that certain modes of behavior will enable him to attain his ends. A man may have a desire for sunshine, but if he realizes that he can do nothing to achieve it, he does not act on this desire. He must have certain ideas about how to achieve his ends. Action thus consists of the behavior of individuals directed towards ends in ways that they believe will accomplish their purpose. Action requires an image of a desired end and “technological ideas” or plans on how to arrive at this end. Men find themselves in a certain . It environment situation , or is this situation that the individual decides to change in some way in order to achieve his ends. But man can work only with the numerous elements that he finds in his environment, by rearranging them in order to bring about the satisfaction of his 6 To say that only individuals act is not to deny that they are influenced in their desires and actions by the acts of other individuals, who might be fellow members of various societies or groups. We do not at all assume, as some critics of economics have charged, that individuals are “atoms” iso- lated from one another. 7 Cf. Hayek, Counter-Revolution of Science , p. 34. Also cf. Mises, Human Action , p. 42.

69 with Power and Market 4 Man, Economy, and State ends. With reference to any given act, the environment external to the individual may be divided into two parts: those elements which he believes he cannot control and must leave unchanged, and those which he can alter (or rather, thinks he can alter) to general condi- arrive at his ends. The former may be termed the of the action; the latter, the tions means used. Thus, the individ- ual actor is faced with an environment that he would like to change in order to attain his ends. To act, he must have techno- logical ideas about how to use some of the elements of the envi- , as pathways, to arrive at his ends. Every act ronment as means must therefore involve the employment of means by individual actors to attempt to arrive at certain desired ends. In the exter- nal environment, the general conditions cannot be the objects of any human action; only the means can be employed in 8 action. All human life must take place in time . Human reason can- not even conceive of an existence or of action that does not take place through time. At a time when a human being decides to act in order to attain an end, his goal, or end, can be finally and completely attained only at some point in the future. If the desired ends could all be attained instantaneously in the present, then man’s ends would all be attained and there would be no reason for him to act; and we have seen that action is necessary to the nature of man. Therefore, an actor chooses means from his environment, in accordance with his ideas, to arrive at an expected end, completely attainable only at some point in the future. For any given action, we can distinguish among three periods of time involved: the period before the action, the time absorbed by the action, and the period after the action has been completed. All action aims at rendering conditions at some time in the future more satisfactory for the actor than they would have been without the intervention of the action. 8 Cf. Talcott Parsons, The Structure of Social Action (Glencoe, Ill.: The Free Press, 1949), pp. 44 ff.

70 5 Fundamentals of Human Action is always scarce. He is not immortal; his time A man’s time on earth is limited. Each day of his life has only 24 hours in which he can attain his ends. Furthermore, all actions must take means place through time. Therefore time is a that man must use to arrive at his ends. It is a means that is omnipresent in all human action. which ends shall be satisfied choosing Action takes place by by the employment of means. Time is for man only scarce because whichever ends he chooses to satisfy, there are others that must remain unsatisfied. When we must use a means so choice that some ends remain unsatisfied, the necessity for a arises. For example, Jones is engaged in watching a among ends baseball game on television. He is faced with the choice of ) continuing to watch the baseball a spending the next hour in: ( game, ( b ) playing bridge, or ( c ) going for a drive. He would like to do all three of these things, but his means (time) is insuffi- ; one end can be satisfied, but cient. As a result, he must choose the others must go unfulfilled. Suppose that he decides on ranked course A. This is a clear indication that he has the satis- faction of end A higher than the satisfaction of ends B or C . From this example of action, many implications can be deduced. In the first place, i.e., limited with all means are scarce, respect to the ends that they could possibly serve. If the means are in unlimited abundance, then they need not serve as the object of attention of any human action. For example, air in most situations is in unlimited abundance. It is therefore not a means and is not employed as a means to the fulfillment of ends. It need not be allocated, as time is, to the satisfaction of the more important ends, since it is sufficiently abundant for all human requirements. Air, then, though indispensable, is not a general condition means, but a of human action and human wel- fare. Secondly, these scarce means must be allocated by the actor to serve certain ends and leave other ends unsatisfied. This act of may be called economizing the means to serve the most choice

71 Power and Market with Man, Economy, and State 6 desired ends. Time, for example, must be economized by the actor to serve the most desired ends. The actor may be inter- preted as ranking his alternative ends in accordance with their to him. This scaling of ends may be described as assigning value value valua- ranks of to the ends by the actor, or as a process of tion . Thus, suppose that Jones ranked his alternative ends for the use of an hour of time as follows: 1. Continuing to watch the baseball (First) game 2. Going for a drive (Second) (Third) 3. Playing bridge scale of values or scale of preferences This was his . The supply of means (time) available was sufficient for the attainment of only one of these ends, and the fact that he chose the baseball game shows that he ranked that highest (or first). Suppose now that he is allocating two hours of his time and can spend an hour on each pursuit. If he spends one hour on the game and then a sec- ond hour on the drive, this indicates that his ranking of prefer- ences is as above. The lowest-ranking end—playing bridge— goes unfulfilled. Thus, the larger the supply of means available, the more ends can be satisfied and the lower the rank of the ends that must remain unsatisfied. Another lesson to be derived is that action does not necessar- ily mean that the individual is “active” as opposed to “passive,” in the colloquial sense. Action does not necessarily mean that an individual must stop doing what he has been doing and do something else. He also acts, as in the above case, who chooses to continue in his previous course, even though the opportunity to change was open to him. Continuing to watch the game is just as much action as going for a drive. Furthermore, action does not at all mean that the individual must take a great deal of time in deliberating on a decision to act. The individual may make a decision to act hastily, or after great deliberation, according to his desired choice. He may

72 Fundamentals of Human Action 7 decide on an action coolly or heatedly; none of these courses 9 affects the fact that action is being taken. Another fundamental implication derived from the exis- tence of human action is the uncertainty of the future. This must be true because the contrary would completely negate the pos- sibility of action. If man knew future events completely, he would never act, since no act of his could change the situation. Thus, the fact of action signifies that the future is uncertain to the actors. This uncertainty about future events stems from two basic sources: the unpredictability of human acts of choice, and insufficient knowledge about natural phenomena. Man does not know enough about natural phenomena to predict all their future developments, and he cannot know the content of future human choices. All human choices are continually changing as a result of changing valuations and changing ideas about the most appropriate means of arriving at ends. This does not mean, of course, that people do not try their best to estimate future developments. Indeed, any actor, when employing means, estimates that he will thus arrive at his desired goal. But he never has certain knowledge of the future. All his actions are based on his judgment of the course of of necessity speculations future events. The omnipresence of uncertainty introduces the error in human action. The actor may ever-present possibility of find, after he has completed his action, that the means have been inappropriate to the attainment of his end. To sum up what we have learned thus far about human action: The distinguishing characteristic of human beings is . Action is purposeful behavior directed that all humans act toward the attainment of ends in some future period which will involve the fulfillment of wants otherwise remaining unsatis- fied. Action involves the expectation of a less imperfectly satis- fied state as a result of the action. The individual actor chooses 9 Some writers have unfoundedly believed that praxeology and econom- ics assume that all action is cool, calculating, and deliberate.

73 with Power and Market 8 Man, Economy, and State to employ elements in his environment as means to the expected achievement of his ends, them by direct- economizing ing them toward his most valued ends (leaving his least valued ones unsatisfied), and in the ways that his reason tells him are most appropriate to attain these ends. His method—his chosen means—may or may not turn out to be inappropriate. 3. Further Implications: The Means . These goods to satisfy man’s wants are called means The 10 goods are all the objects of economizing action. Such goods ) they are may all be classified in either of two categories: ( a directly serviceable immediately and in the satisfaction of the ) they may be transformable into directly actor’s wants, or ( b serviceable goods only at some point in the future—i.e., are indi- means. The former are called rectly serviceable consumption goods The latter are called or consumers’ goods or goods of the first order. goods of higher order. or factors of production or producers’ goods Let us trace the relations among these goods by consider- ing a typical human end: the eating of a ham sandwich. Having a desire for a ham sandwich, a man decides that this is a want that should be satisfied and proceeds to act upon his judgment of the methods by which a ham sandwich can be assembled. The consumers’ good is the ham sandwich at the point of being eaten. It is obvious that there is a scarcity of this consumers’ good as there is for all direct means; otherwise it would always be available, like air, and would not be the object of action. But if the consumers’ good is scarce and not obviously available, how can it be made available? The answer is that man must rearrange various elements of his environment in order to pro- the ham sandwich at the desired place—the consumers’ duce means as indirect good. In other words, man must use various 10 The common distinction between “economic goods” and “free goods” (such as air) is erroneous. As explained above, air is not a means, but a general condition of human welfare, and is not the object of action.

74 9 Fundamentals of Human Action co-operat ing factors of production to arrive at the direct means. ; This necessary process involved in all action is called production it is the use by man of available elements of his environment as indirect means—as co-operating factors—to arrive eventually at a consumers’ good that he can use directly to arrive at his end. Let us consider the pattern of some of the numerous co- operating factors that are involved in a modern developed econ- omy to produce one ham sandwich as a consumers’ good for the use of one consumer. Typically, in order to produce a ham sand- wich for Jones in his armchair, it is necessary for his wife to expend energy in unwrapping the bread, slicing the ham, plac- ing the ham between bread slices, and carrying it to Jones. All this work may be called the of the housewife. The co-oper- labor ating factors that are directly necessary to arrive at the con- sumers’ good are, then: the housewife’s labor, bread in the kitchen, ham in the kitchen, and a knife to slice the ham. Also needed is the land on which to have room to live and carry on these activities. Furthermore, this process must, of course, take time , which is another indispensable co-operating factor. The above factors may be called first-order producers’ goods , since, in this case, these co-operate in the production of the consumers’ good. Many of the first-order producers’ goods, however, are produced also unavailable in nature and must be themselves, with the help of other producers’ goods. Thus, bread in the kitchen must be produced with the co-operation of the following fac- tors: in carrying it (plus bread-in-retail-shop and housewife’s labor the ever-present land-as-standing-room, and time). In this pro- cedure, these factors are second-order producers’ goods, since they co-operate in producing first-order goods. Higher-order factors are those co-operating in the production of factors of lower order. ) of production may be ana- Thus, any process (or structure lyzed as occurring in different stages . In the earlier or “higher” stages, producers’ goods must be produced that will later co- operate in producing other producers’ goods that will finally

75 with Power and Market 10 Man, Economy, and State co-operate in pr oducing the desired consumers’ good. Hence, in a developed economy, the structure of production of a given consumers’ good might be a very complex one and involve numerous stages. Important general conclusions can, however, be drawn that apply to all processes of production. In the first place, each stage time of production takes . Secondly, the factors of production those that are themselves pro- may all be divided into two classes: those that are found already available in nature—in man’s and duced, . The latter may be used as indirect means without environment having been previously produced; the former must first be pro- (or duced with the aid of factors in order to aid in the later produced fac- “lower”) stages of production. The former are the ; the latter are the original factors of production . tors of production The original factors may, in turn, be divided into two classes: the , and the use of nonhuman elements pro- expenditure of human energy ; the latter is Nature or Labor . The first is called vided by nature 11 Land. Thus, the classes of factors of production are Labor, Land, and the produced factors, which are termed Capital Goods. Labor and Land, in one form or another, enter into each stage of production. Labor helps to transform seeds into wheat, wheat into flour, pigs into ham, flour into bread, etc. Not only is Labor present at every stage of production, but so also is Nature. Land must be available to provide room at every stage of the process, and time, as has been stated above, is required for each stage. Furthermore, if we wish to trace each stage of production far enough back to original sources, we must arrive at a point where only labor and nature existed and there were no capital goods. This must be true by logical implication, since all capital goods must have been produced at earlier stages with the aid of labor. If we could trace each production process far 11 The term “land” is likely to be misleading in this connection because it is not used in the popular sense of the word. It includes such natural resources as water, oil, and minerals.

76 Fundamentals of Human Action 11 enough back in time, we must be able to arrive at the point— the earliest stage—where man combined his forces with nature unaided by produced factors of production. Fortunately, it is not necessary for human actors to perform this task, since action uses materials available in the present to arrive at desired future , and there is no need to be concerned with goals in the past . development in the There is another unique type of factor of production that is indispensable in every stage of every production process. This is the “technological idea” of how to proceed from one stage to another and finally to arrive at the desired consumers’ good. This is but an application of the analysis above, namely, that for any action, there must be some or idea of the actor about plan how to use things as means, as definite pathways, to desired ends. Without such plans or ideas, there would be no action. These plans may be called recipes ; they are ideas of recipes that the actor uses to arrive at his goal. A recipe must be present at each stage of each production process from which the actor pro- ceeds to a later stage. The actor must have a recipe for trans- forming iron into steel, wheat into flour, bread and ham into sandwiches, etc. The distinguishing feature of a recipe is that, once learned , it generally does not have to be learned again. It can be noted and remembered. Remembered, it no longer has to be produced; it unlimited factor of production that remains with the actor as an never wears out or needs to be economized by human action. It becomes a general condition of human welfare in the same way 12 as air. It should be clear that the end of the production process— the consumers’ good—is valued because it is a direct means of , and consumed satisfying man’s ends. The consumers’ good is this act of consumption constitutes the satisfying of human wants. 12 We shall not deal at this point with the complications involved in the original learning of any recipe by the actor, which is the object of human action.

77 with Power and Market 12 Man, Economy, and State This consumers’ good may be a material object like bread or an immaterial one like friendship. Its important quality is not whether it is material or not, but whether it is valued by man as a means of satisfying his wants. This function of a consumers’ good is called its in ministering to human wants. Thus, service the material bread is valued not for itself, but for its service in satisfying wants; just as an immaterial thing, such as music or medical care, is obviously valued for such service. All these serv- ices are “consumed” to satisfy wants. “Economic” is by no means equivalent to “material.” It is also clear that the factors of production—the various higher-order producers’ goods— are valued solely because of their anticipated usefulness in helping to produce future consumers’ goods or to produce lower-order producers’ goods that will help to bring about The valuation of factors of production is consumers’ goods. derived from actors’ evaluation of their products (lower stages), all of which eventually derive their valuation from the end 13 result—the consumers’ good. Furthermore, the omnipresent fact of the scarcity of con- sumers’ goods must be reflected back in the sphere of the fac- tors of production. The scarcity of consumers’ goods must imply a scarcity of their factors. If the factors were unlimited, then the consumers’ goods would also be unlimited, which can- some not be the case. This does not exclude the possibility that factors, such as recipes, may be unlimited and therefore general conditions of welfare rather than scarce indirect means. But other factors at each stage of production must be in scarce sup- ply, and this must account for the scarcity of the end product. Man’s endless search for ways to satisfy his wants—i.e., to increase his production of consumers’ goods —takes two forms: increasing his available supply of factors of production and improving his recipes. 13 Cf. Carl Menger, Principles of Economics (Glencoe, Ill.: The Free Press, 1950), pp. 51–67.

78 Fundamentals of Human Action 13 Although it has seemed evident that there are several co- operating factors at each stage of production, it is important to there must always be more realize that for each consumers’ good This is implied in the very exis- than one scarce factor of production. tence of human action. It is impossible to conceive of a situation where only one factor of production produces a consumers’ good or even advances a consumers’ good from its previous stage of production. Thus, if the sandwich in the armchair did not require the co-operating factors at the previous stage (labor of preparation, carrying, bread, ham, time, etc.), then it would always be in the status of a consumers’ good—sandwich-in-the- armchair. To simplify the example, let us suppose the sandwich already is prepared and in the kitchen. Then, to produce a con- sumers’ good from this stage forward requires the following fac- tors: (1) the sandwich; (2) carrying it to the armchair; (3) time; (4) the land available. If we assume that it required only one fac- tor—the sandwich—then we would have to assume that the sandwich was magically and instantaneously moved from kitchen to armchair without effort. But in this case, the consumers’ good would not have to be produced at all, and we would be in the impossible assumption of Paradise. Similarly, at each stage of the productive process, the good must have been produced by at more than one (higher-order) scarce co-operating factor; least otherwise this stage of production could not exist at all. 4. Further Implications: Time Time is omnipresent in human action as a means that must be economized. Every action is related to time as follows: . . . A is the period before the beginning of the action; A is the point in time at which the action begins; AB is the period during

79 Power and Market with Man, Economy, and State 14 is the point at which the action ends; which the action occurs; B is the period after the end of the action. B . . . and is defined as the period of production AB —the period from the beginning of the action to the time when the consumers’ good is available. This period may be divided into various stages, each itself taking a period of time. The time expended during the period of production consists of the time during which labor energy is expended ( or working time ) and maturing time , i.e., time required without the necessity of concurrent expenditure of labor. An obvious example is the case of agriculture. There might be six months between the time the soil is tilled and the time the harvest is reaped. The total time during which labor must be expended may be three weeks, while the remaining time of over five months consists of the time during which the crop must mature and ripen by the processes of nature. Another example of a lengthy maturing time is the aging of wine to improve its quality. Clearly, each consumers’ good has its own period of pro- duction. The differences between the time involved in the periods of production of the various goods may be, and are, innumerable. One important point that must be emphasized when considering action and the period of production is that acting trace back past production processes to their orig- man does not inal sources. In the previous section, we traced back consumers’ goods and producers’ goods to their original sources, demon- produced solely by originally strating that all capital goods were labor and nature. Acting man, however, is not interested in past presently available means processes, but only in using to achieve anticipated future ends. At any point in time, when he begins ), he has available to him: labor, nature-given A the action (say elements, and . He begins the previously produced capital goods For him , the period A action at B. expecting to reach his end at , since he is not concerned with the amount AB of production is of time spent in past production of his capital goods or in the

80 Fundamentals of Human Action 15 14 methods by which they were produced. Thus, the farmer about to use his soil to grow crops for the coming season does not worry about whether or to what extent his soil is an origi- nal, nature-given factor or is the result of the improvements of previous land-clearers and farmers. He is not concerned about the previous time spent by these past improvers. He is con- cerned only with the capital (and other) goods in the present and the future. This is the necessary result of the fact that action occurs in the present and is aimed at the future. Thus, acting man considers and values the factors of production available in the present in accordance with their anticipated services in the future production of consumers’ goods, and never in accor- dance with what has happened to the factors in the past. A fundamental and constant truth about human action is that Given man prefers his end to be achieved in the shortest possible time. the specific satisfaction, the sooner it arrives, the better. This results from the fact that time is always scarce, and a means to be economized. The sooner any end is attained, the better. Thus, with any to be attained, the shorter the period given end of action, i.e., production, the more preferable for the actor. This is the universal fact of time preference. At any point of time, and for any action, the actor most prefers to have his end attained in the immediate present. Next best for him is the immediate future, and the further in the future the attainment The less waiting of the end appears to be, the less preferable it is. 15 time, the more preferable it is for him. 14 For each actor, then, the period of production is equivalent to his waiting time —the time that he must expect to wait for his end after the commencement of his action. 15 Time preference may be called the preference for present satisfaction , provided it is over or present good over future good future satisfaction remembered that it is the same satisfaction (or “good”) that is being com- pared over the periods of time. Thus, a common type of objection to the assertion of universal time preference is that, in the wintertime, a man will prefer the delivery of ice the next summer (future) to delivery of ice

81 Power and Market with Man, Economy, and State 16 Time enters into human action not only in relation to the the length of time in which waiting time in production, but also in the consumers’ good will satisfy the wants of the consumer. Some con- sumers’ goods will satisfy his wants, i.e., attain his ends, for a short period of time, others for a longer period. They can be consumed for shorter or longer periods. This may be included in the diagram of any action, as shown in Figure 2. This length BC of the consumers’ , is the of time, duration of serviceableness good. It is the length of the time the end served by the con- sumers’ good continues to be attained. This duration of ser- viceableness differs for each consumers’ good. It may be four hours for the ham sandwich, after which period of time the actor desires other food or another sandwich. The builder of a house may expect to use it to serve his wants for 10 years. Obvi- ously, the expected durative power of the consumers’ good to 16 serve his end will enter into the actor’s plans. Clearly, all other things being equal, the actor will prefer a consumers’ good of greater durability to one of lesser, since the former will render more total service. On the other hand, if the in the present. This, however, confuses the concept “good” with the material properties of a thing, whereas it actually refers to subjective sat- isfactions. Since ice-in-the-summer provides different (and greater) satis- different goods. factions than ice-in-the-winter, they are the same, but not In this case, it is different satisfactions that are being compared, despite property of the thing may be the same. physical the fact that the 16 It has become the custom to designate consumer goods with a longer , and those of shorter duration as durable goods duration of serviceableness as . Obviously, however, there are innumerable degrees of nondurable goods durability, and such a separation can only be unscientific and arbitrary.

82 17 Fundamentals of Human Action actor values the total service rendered by two consumers’ goods equally, he will, because of time preference, choose the less durable good since he will acquire its total services sooner than the other. He will have to wait less for the total services of the less durable good. The concepts of period of production and duration of serviceableness are present in all human action. There is also a third time-period that enters into action. Each person has a general time-horizon, stretching from the present into the future, for which he plans various types of action. Whereas period of production and duration of serviceableness refer to specific consumers’ goods and differ with each consumers’ good, the period of provision (the time-horizon) is the length of future time for which each actor plans to satisfy his wants. The period of provision, therefore, includes planned action for a considerable variety of consumers’ goods, each with its own period of production and duration. This period of provision dif- fers from actor to actor in accordance with his choice. Some people live from day to day, taking no heed of later periods of time; others plan not only for the duration of their own lives, but for their children as well. 5. Further Implications NDS AND ALUES A. E V All action involves the employment of scarce means to attain the most valued ends. Man has the choice of using the scarce means for various alternative ends, and the ends that he chooses are the ones he values most highly. The less urgent wants are those that remain unsatisfied. Actors can be interpreted as rank- ing their ends along a scale of values, or scale of preferences. These scales differ for each person, both in their content and in their orders of preference. Furthermore, they differ for the same individual at different times. Thus, at some other point in time, the actor mentioned in section 2 above might choose to go for a drive, or to go for a drive and then to play bridge,

83 Power and Market with Man, Economy, and State 18 rather than to continue watching the game. In that case, the ranking on his preference scale shifts to this order: 1. Going for a drive (First) 2. Playing bridge (Second) (Third) 3. Continuing to watch baseball game Moreover, a new end might have been introduced in the mean- time, so that the actor might enjoy going to a concert, and this may change his value scale to the following: (First) 1. Going for a drive (Second) 2. Going to a concert 3. Playing bridge (Third) (Fourth) 4. Continuing to watch baseball game The choice of which ends to include in the actor’s value scale and the assignment of rank to the various ends constitute the Each time the actor ranks and process of value judgment. chooses between various ends, he is making a judgment of their value to him. to this value scale held by name It is highly useful to assign a all human actors. We are not at all concerned with the specific content of men’s ends, but only with the fact that various ends are ranked in the order of their importance. These scales of prefer- or happiness or satisfaction or ence may be called or welfare utility contentment. Which name we choose for value scales is not important. At any rate, it permits us to say, whenever an actor increased has attained a certain end, that he has his state of satis- faction, or his contentment, happiness, etc. Conversely, when someone considers himself worse off, and fewer of his ends are being attained, his satisfaction, happiness, welfare, etc., have . decreased It is important to realize that there is never any possibility measuring increases or decreases in happiness or satisfaction. of Not only is it impossible to measure or compare changes in the

84 Fundamentals of Human Action 19 satisfaction of different people; it is not possible to measure changes in the happiness of any given person. In order for any measurement to be possible, there must be an eternally fixed and objectively given unit with which other units may be com- pared. There is no such objective unit in the field of human val- uation. The individual must determine subjectively for himself whether he is better or worse off as a result of any change. His preference can only be expressed in terms of simple choice, or . Thus, he can say, “I am better off ” or “I am happier” rank because he went to a concert instead of playing bridge (or “I will be better off” for going to the concert), but it would be com- pletely meaningless for him to try to assign units to his prefer- ence and say, “I am two and a half times happier because of this choice than I would have been playing bridge.” Two and a half ? There is no possible unit of happiness that can be what times used for purposes of comparison and, hence, of addition or mul- tiplication. Thus, values cannot be measured; values or utilities cannot be added, subtracted, or multiplied. They can only be ranked as better or worse. A man may know that he is or will be happier or less happy, but not by “how much,” not by a meas- 17 urable quantity. All action is an attempt to exchange a less satisfactory state of The actor finds himself (or ex- affairs for a more satisfactory one. pects to find himself) in a nonperfect state, and, by attempting to attain his most urgently desired ends, expects to be in a bet- ter state. He cannot measure the gain in satisfaction, but he does know which of his wants are more urgent than others, and 17 Accordingly, the numbers by which ends are ranked on value scales are ordinal , not cardinal , numbers. Ordinal numbers are only ranked; they cannot be subject to the processes of measurement. Thus, in the above example, all we can say is that going to a concert is valued more than play- ing bridge, and either of these is valued more than watching the game. We cannot say that going to a concert is valued “twice as much” as watch- ing the game; the numbers two and four cannot be subject to processes of addition, multiplication, etc.

85 with Power and Market 20 Man, Economy, and State all he does know when his condition has improved. Therefore, , X —an exchange of one state of affairs, action involves exchange Y , which the actor anticipates will be a more satisfactory one for (and therefore higher on his value scale). If his expectation turns on his preference scale will be Y out to be correct, the value of , and he has made a in his X higher than the value of net gain state of satisfaction or utility. If he has been in error, and the —is higher than the value of the state that he has given up— X profit ) , he has suffered a net loss Y value of . This psychic gain (or and loss cannot be measured in terms of units, but the actor always knows whether he has experienced psychic profit or psy- 18 chic loss as a result of an action-exchange. means strictly in accordance with their Human actors value valuation of the ends that they believe the means can serve. Obvi- ously, consumers’ goods are graded in value in accordance with the ends that men expect them to satisfy. Thus, the value placed on the enjoyment contributed by a ham sandwich or a house will determine the value a man will place on the ham sandwich or the house themselves. Similarly, producers’ goods are valued in accordance with their expected contribution in producing con- sumers’ goods. Higher-order producers’ goods are valued in accordance with their anticipated service in forming lower-order producers’ goods. Hence, those consumers’ goods serving to attain more highly valued ends will be valued more highly than those serving less highly valued ends, and those producers’ goods serving to produce more highly valued consumers’ goods will themselves be valued more highly than other producers’ goods. process of imputing values to goods takes place in the Thus, the opposite direction to that of the process of production. Value proceeds from the ends to the consumers’ good to the various 18 An example of suffering a loss as a result of an erroneous action would be going to the concert and finding that it was not at all enjoyable. The actor then realizes that he would have been much happier continu- ing to watch the game or playing bridge.

86 Fundamentals of Human Action 21 first-order producers’ goods, to the second-or der producers’ 19 goods, etc. The original source of value is the ranking of ends by human actors, who then impute value to consumers’ goods, and so on to the orders of producers’ goods, in accordance with their expected ability to contribute toward serving the various 20 ends. AW OF M ARGINAL U B. T HE L TILITY It is evident that things are valued as means in accordance with their ability to attain ends valued as more or less urgent. Each physical unit of a means (direct or indirect) that enters into human action is valued separately. Thus, the actor is interested in evaluating only those units of means that enter, or that he considers will enter, into his concrete action. Actors choose between, and evaluate, not “coal” or “butter” in general, but specific units of coal or butter. In choosing between acquiring cows or horses, the actor does not choose between the class of cows and the class of horses, but between specific units of them—e.g., two cows versus three horses. Each unit that enters into concrete action is graded and evaluated separately. Only when several units together enter into human action are all of them evaluated together. The processes that enter into valuation of specific units of dif- 21 An individual ferent goods may be illustrated in this example: possessing two cows and three horses might have to choose between giving up one cow or one horse. He may decide in this case to keep the horse, indicating that in this state of his stock, 19 A large part of this book is occupied with the problem of how this process of value imputation can be accomplished in a modern, complex economy. 20 This is the solution of a problem that plagued writers in the economic field for many years: the source of the value of goods. 21 Cf. Ludwig von Mises, The Theory of Money and Credit (New Haven: Yale University Press, 1953), p. 46.

87 with Power and Market 22 Man, Economy, and State a horse is more valuable to him than a cow. On the other hand, he might be presented with the choice of keeping either his entire stock of cows or his stock of horses. Thus, his stable and cowshed might catch fire, and he is presented with the choice of saving the inhabitants of one or of the other building. In this case, two cows might be more valuable to him than three horses, so that he will prefer to save the cows. When deciding between units of his stock, the actor may therefore prefer good X Y , while he may choose good Y to good if he must act upon . his whole stock of each good This process of valuation according to the specific units involved provides the solution for the famous “value paradox” which puzzled writers for centuries. The question was: How can men value bread less than platinum, when “bread” is obvi- ously more useful than “platinum”? The answer is that acting man does not evaluate the goods open to him by abstract classes, but in terms of the specific units available. He does not wonder whether “bread-in-general” is more or less valuable to him than “platinum-in-general,” but whether, given the present available stock of bread and platinum, a “loaf of bread” is more or less valuable to him than “an ounce of platinum.” That, in 22 most cases, men prefer the latter is no longer surprising. As has been explained above, value, or utility, cannot be measured, and therefore cannot be added, subtracted, or mul- tiplied. This holds for specific units of the same good in the same way as it holds for all other comparisons of value. Thus, if butter is an object serving human ends, we know that two pounds of butter will be valued more highly than one pound. This will be true until a point is reached when the butter is available in unlimited quantities to satisfy human wants and 22 Also cf. T.N. Carver, The Distribution of Wealth (New York: Macmil- lan & Co., 1904), pp. 4–12. See below for a further discussion of the influ- ences on man’s valuation of specific units resulting from the size of the available stock.

88 23 Fundamentals of Human Action will then be transferred from the status of a means to that of a say cannot general condition of human welfare. However, we that two pounds of butter are “twice as useful or valuable” as one pound. What has been involved in this key concept of “specific units of a good”? In these examples, the units of the good have interchangeable from the point of view of the actor . Thus, any been concrete pound of butter was evaluated in this case perfectly equally with any other pound of butter. Cow A and cow B were valued equally by the individual, and it made no difference to him which cow he was faced with the choice of saving. Similarly, horse A was valued equally with horse B and with horse C, and the actor was not concerned which particular horse he had to choose. When a commodity is in such a way available in specific homogeneous units equally capable of rendering the same service to the supply . A supply of a good actor , this available stock is called a is available in specific units each perfectly substitutable for every other. The individual above had an available supply of two cows and three horses, and a supply of pounds of butter. What if one pound of butter was considered by the actor as of better quality than another pound of butter? In that case, the different goods from the point of view of two “butters” are really the actor and will be evaluated differently. The two pounds of butter are now two different goods and are no longer two units of a supply of one good. Similarly, the actor must have valued each horse or each cow identically. If he preferred one horse to each of the others, or one cow to the other, then they are no longer units of the supply of the same good. No longer are his horses interchangeable for one another. If he grades horse A above the others and regards horses B and C indifferently, then he has supplies of two different goods (omitting the cows): say, “Grade A horses—one unit”; and “Grade B horses—two units.” If a specific unit is differently evaluated from all other units, then the supply of that good is only one unit.

89 Power and Market with Man, Economy, and State 24 Here again, it is very important to recognize that what is the physical property of a not significant for human action is good, but the evaluation of the good by the actor. Thus, physi- cally there may be no discernible difference between one pound of butter and another, or one cow and another. But if the actor chooses to evaluate them differently, they are no longer part of the supply of the same good. The interchangeability of units in the supply of a good does not mean that the concrete units are actually valued equally. position They may and will be valued differently whenever their in the supply is different. Thus, suppose that the isolated individ- ual successively finds one horse, then a second, then a third. Each horse may be identical and interchangeable with the oth- ers. The first horse will fulfill the most urgent wants that a horse can serve; this follows from the universal fact that action uses scarce means to satisfy the most urgent of the not yet satisfied wants. When the second horse is found, he will be put to work satisfying the most urgent of the wants remaining. These wants, however, must be ranked lower than the wants that the previous horse has satisfied. Similarly, the third horse acquired might be capable of performing the same service as the others, but he will be put to work fulfilling the highest of the remaining wants— which, however, will yet be lower in value than the others. The important consideration is the relation between the unit to be acquired or given up and the quantity of supply (stock) already available to the actor. Thus, if no units of a good (whatever the good may be) are available, the first unit will satisfy the most urgent wants that such a good is capable of satisfying. If to this supply of one unit is added a second unit, the latter will fulfill the most urgent wants remaining, but these will be less urgent than the ones the first fulfilled. Therefore, the value of the sec- ond unit to the actor will be less than the value of the first unit. Similarly, the value of the third unit of the supply (added to a stock of two units) will be less than the value of the second unit. which horse is chosen first It may not matter to the individual pounds of butter he consumes, but which and which second, or

90 Fundamentals of Human Action 25 those units which he does use first will be the ones that he val- ues more highly. Thus, for all human actions, as the quantity of the supply (stock) of a good increases, the utility (value) of each additional unit decreases. Let us now consider a supply from the point of view of a possible , rather than an increase. Assume that a man has decrease a supply of six (interchangeable) horses. They are engaged in fulfilling his wants. Suppose that he is now faced with the neces- sity of giving up one horse. It now follows that this smaller stock of means is not capable of rendering as much service to him as the larger supply. This stems from the very existence of the 23 good as a means. the utility of X units of a good is Therefore, Because of the always greater than the utility of X – 1 units. impossibility of measurement, it is impossible to determine by how much greater one value is than the other. Now, the question arises: Which utility, which end, does the actor give up because he is deprived of one unit? Obviously, he gives up the least Thus, urgent of the wants which the larger stock would have satisfied. if the individual was using one horse for pleasure riding, and he considers this the least important of his wants that were fulfilled by the six horses, the loss of a horse will cause him to give up pleasure riding. The principles involved in the utility of a supply may be il- lustrated in the following value-scale diagram (Figure 3). We are considering any given means, which is divisible into homo- geneous units of a supply, each interchangeable and capable of giving service equal to that of the other units. The supply must be scarce in relation to the ends that it is capable of fulfilling; otherwise it would not be a good, but a condition of human welfare. We assume for simplicity that there are 10 ends which 23 This would not be true only if the “good” were not a means, but a general condition of human welfare, in which case one less unit of supply would make no difference for human action. But in that case it would not be a good , subject to the economizing of human action.

91 Power and Market with Man, Economy, and State 26 the means could fulfill, and that each unit of means is capable of serving one of the ends. If the supply of the good is 6 units, then the first six ends, ranked in order of importance by the valuing individual, are the ones that are being satisfied. Ends ranked 7–10 remain unsatisfied. If we assume that the stock arrived in successive units, then the first unit went to satisfy end 1, the second unit was used to serve end 2, etc. The sixth unit was used to serve end 6. The dots indicate how the units were used for the different ends, and the arrow indicates the direc- tion the process took, i.e., that the most important ends were served first; the next, second, etc. The diagram illustrates the aforementioned laws that the utility (value) of more units is greater than the utility of fewer units and that the utility of each successive unit is less as the quantity of the supply increases. Now, suppose the actor is faced with the necessity of giving up one unit of his stock. His total will be 5 instead of 6 units. Obviously, he gives up satisfying the end ranked sixth, and con- tinues to satisfy the more important ends 1–5. As a result of the interchangeability of units, it does not matter to him which of

92 27 Fundamentals of Human Action the six units he must lose; the point is that he will give up serv- ing this sixth end. Since action considers only the present and which units he the future not the past, it does not matter to him acquired first in the past. He deals only with his presently avail- able stock. In other words, suppose that the sixth horse that he had previously acquired (named “Seabiscuit”) he had placed in the service of pleasure riding. Suppose that he now must lose another horse (“Man o’ War”) which had arrived earlier, and which was engaged in the more important duty (to him) of lead- ing a wagon. He will still give up end 6 by simply transferring Seabiscuit from this function to the wagon-leading end. This consequence follows from the defined interchangeability of units and from disregard of past events which are of no conse- quence for the present and the future. Thus, the actor gives up the lowest-ranking want that the original stock (in this case, six units) was capable of satisfying. the mar- This one unit that he must consider giving up is called ginal unit . It is the unit “at the margin.” This least important end fulfilled by the stock is known as the satisfaction provided by utility of the marginal unit —in short: the the marginal unit, or the . If the marginal unit is marginal satisfaction, or marginal utility is the end that one unit, then the marginal utility of the supply must be given up as the result of a loss of the unit. In Figure 3, the marginal utility is ranked sixth among the ends. If the sup- ply consisted of four units, and the actor were faced with the necessity of giving up one unit, then the value of the marginal unit, or the marginal utility , would have a rank of four. If the stock consisted of one unit, and this had to be given up, the value of the marginal unit would be one—the value of the high- est-ranked end. We are now in a position to complete an important law in- dicated above, but with different phraseology: The greater the supply of a good, the lower the marginal utility; the smaller the sup- ply, the higher the marginal utility. This fundamental law of eco- nomics has been derived from the fundamental axiom of human

93 Power and Market with Man, Economy, and State 28 sometimes known as the action; it is the law of marginal utility, . Here again, it must be law of diminishing marginal utility emphasized that “utility” is not a cardinal quantity subject to the processes of measurement, such as addition, multiplication, etc. It is a ranked number expressible only in terms of higher or lower order in the preferences of men. This law of marginal utility holds for all goods, regardless of the size of the unit considered. The size of the unit will be the one that enters into concrete human action, but whatever it is, the same principle applies. Thus, if in certain situations, the actor must consider only as the units to add or sub- pairs of horses tract from his stock, instead of the individual horses, he will construct a new and shorter scale of ends with fewer units of supply to consider. He will then go through a similar process of assigning means to serve ends and will give up the least valued end should he lose a unit of supply. The ends will simply be ranked in terms of the alternative uses of pairs of horses, instead of single horses. What if a good cannot be divided into homogeneous units for purposes of action? There are cases where the good must be treated as a whole in human action. Does the law of marginal utility apply in such a case? The law does apply, since we then . In this case, the mar- treat the supply as consisting of one unit ginal unit is equal in size to the total supply possessed or desired by the actor. The value of the marginal unit is equal to the first rank of the ends which the total good could serve. Thus, if an indi- vidual must dispose of his whole stock of six horses, or acquire a stock of six horses together, the six horses are treated as one unit. The marginal utility of his supply would then be equal to the first-ranking end that the unit of six horses could supply. additions instead of de- If, as above, we consider the case of creases to stock, we recall that the law derived for this situation was that as the quantity of supply increases, the utility of each additional unit decreases. Yet this additional unit is precisely the . Thus, if instead of decreasing the supply from six marginal unit

94 29 Fundamentals of Human Action it from five to six, the value of the ad- to five horses, we increase ditional horse is equal to the value of the sixth-ranking end— say, pleasure riding. This is the same marginal unit, with the same utility, as in the case of decreasing the stock from six to five. Thus, the law derived previously was simply another form of the law of marginal utility. The greater the supply of a good, the lower the marginal utility; the smaller the supply, the higher the marginal utility. This is true whether or not the marginal unit is the unit of decrease of stock or the unit of addition to stock, when these are considered by the actor. If a man’s supply units, and he is considering the addition of of a good equals X X one unit, this is the marginal unit. If his supply is + 1 units, and he is considering the loss of one unit, this too is his mar- ginal unit, and its value is identical with the former (provided that his ends and their ranking are the same in both cases). We have dealt with the laws of utility as they apply to each good treated in human action. Now we must indicate the relationship among various goods. It is obvious that more than one good exists in human action. This has already been defi- nitely proven, since it was demonstrated that more than one fac- tor of production, hence more than one good, must exist. Fig- ure 4 below demonstrates the relationship between the various value scales of two goods are goods in human action. Here the considered— X and . For each good, the law of marginal util- Y ity holds, and the relation between supply and value is revealed in the diagram for each good. For simplicity, let us assume that Y cows, and that the value scales representing X is horses and those held by the individual are as follows (horizontal lines are drawn through each end to demonstrate the relationship in the -1 is ranked high- ranking of the ends of the two goods): End Y -1, -2, and X -3 (horses one, X X est (say, cow one); then ends -2; Y -3; X -4; Y -4; X two, and three); Y -5; X -6; X -7; Y -6; Y - Y -5; 7. Now, the man’s value scales will reveal his choices involv- ing alternatives of action in regard to these two goods. Suppose

95 Power and Market with Man, Economy, and State 30 (horses). He is faced with the that his stock is: 3 (cows) and 4 X Y He will either one cow or one horse. alternative of giving up choose the alternative that will deprive him of the least valued end possible. Since the marginal utility of each good is equal to the value of the least important end of which he would be deprived, he compares the marginal utility of X with the marginal has a rank of - X utility of Y . In this case, the marginal unit of X Y 4, and the marginal unit of Y has a rank of Y -3. But the end - -4. Hence, the mar- X 3 is ranked higher on his value scale than Y is in this case higher than (or greater than) the ginal utility of marginal utility of X . Since he will give up the lowest possible utility, he will give up one unit of X. Thus, presented with a choice of units of goods to give up, he will give up the good with units of low- est marginal utility on his value scale. Suppose another example: that his stock is three horses and two cows. He has the alterna- tive of giving up 1 or 1 Y . In this case, the marginal utility of Y X is ranked at is ranked at -3. But X -3 occu- Y -2, and that of X X -2, and therefore Y pies a higher position on his value scale than

96 31 Fundamentals of Human Action is at this point lower than the marginal the marginal utility of Y . He gives up a unit of utility of Y X . The converse occurs if the man must choose between the his stock by either one unit of alternative of X increasing or one and X . Thus, suppose that his stock is four units of Y unit of Y . He must choose between adding one horse or four units of one cow. He then compares the marginal utility of increase, i.e., the value of the most important of the not yet satisfied wants. -5; of Y at Y -5. But X is then ranked at The marginal utility of X -5 on his value scale, and he will there- -5 ranks higher than X Y fore choose the former. Thus, faced with the choice of adding units of goods, he will choose the unit of highest marginal utility on his value scale. Another example: Previously, we saw that the man in a posi- X Y ) would, if faced with the choice of giving up one , 3 tion of (4 Y unit of either X , with a lower mar- X or , give up the unit of , X ginal utility. In other words, he would prefer a position of (3 ) to (4 X , 2 Y 3 X , 3 Y ) and Y ). Now suppose he is in a position of (3 X Y . faced with the choice of adding one unit of or one unit of is greater than that Since the marginal utility of the increased X X Y and to arrive at a posi- of , he will choose to add the unit of Y ) rather than (3 X tion of (4 Y ). The reader can work out X , 3 , 4 the hypothetical choices for all the possible combinations of the actor’s stock. It is evident that in the act of choosing between giving up or or Y , the actor must have, in effect, adding units of either X Unless he placed both goods on a single, unitary value scale. and could place Y X on one value scale for comparison, he could not have determined that the marginal utility of the fourth unit was higher than that of the fourth unit of of . The very fact X Y of action in choosing between more than one good implies that the units of these goods must have been ranked for comparison on one value scale of the actor. The actor may not and cannot measure differences in utility, but he must be engaged in rank- ing all the goods considered on one value scale. Thus, we

97 Power and Market with Man, Economy, and State 32 should actually consider the ends served by the two means as ranked on one value scale as follows: Ends (Ranked) 1 Y- 1 — 2 — -1 X -2 X 3 — X 4 — -3 -2 Y 5 — 6 — -3 Y -4 7 — X -4 Y 8 — -5 X 9 — 10 — Y -5 X -6 11 — 12 — X -7 Y 13 — -6 -7 Y 14 — These principles permit of being extended from two to any number of goods. Regardless of the number of goods, any man will always have a certain combination of units of them in his stock. He may be faced with the choice of giving up one unit of any good that he might choose. By ranking the various goods and the ends served by the relevant units, the actor will give up the unit of that good of which the marginal utility to him is the lowest. Similarly, with any given combination of goods in his stock, and faced with the choice of adding one unit of any of the goods available, the actor will choose that good whose marginal utility of increase will be highest. In other words, all the goods are ranked on one value scale in accordance with the ends they serve. If the actor has no units of some goods in his possession, this does not affect the principle. Thus, if he has no units of X or Y in his possession, and he must choose between adding a unit of

98 Fundamentals of Human Action 33 , he will choose the marginal unit of greatest X or one unit of Y . The principle is easily extended to the utility, in this case, Y case of goods. n It must be reiterated here that value scales do not exist in a void apart from the concrete choices of action. Thus, if the Y , 2 Z , etc.), his choices for adding and actor has a stock of (3 X , 4 subtracting from stock take place in this region, and there is no need for him to formulate hypothetical value scales to deter- X mine what his choices would have been if his stock were (6 , , 5 , etc.). No one can predict with certainty the course of his Y 8 Z choices except that they will follow the law of marginal utility, which was deduced from the axiom of action. The solution of the value paradox mentioned above is now fully clear. If a man prefers one ounce of platinum to five loaves of bread, he is choosing between units of the two goods based on the supply available. On the basis of the available supply of platinum and of bread, the marginal utility of a unit of platinum 24 is greater than the marginal utility of a unit of bread. 6. Factors of Production: The Law of Returns We have concluded that the value of each unit of any good is equal to its marginal utility at any point in time, and that this value is determined by the relation between the actor’s scale of wants and the stock of goods available. We know that there are two types of goods: consumers’ goods, which directly serve human wants, and producers’ goods, which aid in the process of production eventually to produce consumers’ goods. It is clear that the utility of a consumers’ good is the end directly served. The utility of a producers’ good is its contribution in producing consumers’ goods. With value imputed backward from ends to consumers’ goods through the various orders of producers’ 24 On the whole subject of marginal utility, see Eugen von Böhm-Baw- erk, The Positive Theory of Capital (New York: G.E. Stechert, 1930), pp. 138–65, especially pp. 146–55.

99 Power and Market with Man, Economy, and State 34 goods, the utility of any producers’ good is its contribution to its product—the lower-stage producers’ good or the consumers’ good. As has been discussed above, the very fact of the necessity of producing consumers’ goods implies a scarcity of factors of pro- duction. If factors of production at each stage were not scarce, then there would be unlimited quantities available of factors of the next lower stage. Similarly, it was concluded that at each more than stage of production, the product must be produced by scarce higher-order factor of production. If only one factor one were necessary for the process, then the process itself would not be necessary, and consumers’ goods would be available in un- limited abundance. Thus, at each stage of production, the pro- duced goods must have been produced with the aid of more co-operate than one factor. These factors in the production complementary factors. process and are termed Factors of production are available as units of a homoge- neous supply, just as are consumers’ goods. On what principles will an actor evaluate a unit of a factor of production? He will evaluate a unit of supply on the basis of the least importantly valued product which he would have to forgo were he deprived of the unit factor. In other words, he will evaluate each unit of a factor as equal to the satisfactions provided by ginal unit—in this case, its mar the utility of its marginal product. The marginal product is the product forgone by a loss of the marginal marginal unit, and its value is determined either by its product in the next stage of production, or, if it is a consumers’ good, by the utility of the end it satisfies. Thus, the value value assigned to a unit of a factor of production is equal to the of its marginal product marginal productivity . , or its Since man wishes to satisfy as many of his ends as possible, and in the shortest possible time (see above), it follows that he will strive for the maximum product from given units of factors at As long as the goods are composed of each stage of production. homogeneous units, their quantity can be measured in terms of

100 35 Fundamentals of Human Action these units, and the actor can know when they are in greater or lesser supply. Thus, whereas value and utility cannot be meas- ured or subject to addition, subtraction, etc., quantities of homogeneous units of a supply can be measured. A man knows how many horses or cows he has, and he knows that four horses are twice the quantity of two horses. P (which can be a producers’ good or Assume that a product a consumers’ good) is produced by three complementary fac- Y Z . These are all higher-order producers’ goods. tors, , and X , Since supplies of goods are quantitatively definable, and since in nature quantitative causes lead to quantitatively observable , X quantities of effects, we are always in a position to say that: a combined with , and c quantities of Z , lead to p b quantities of Y quantities of the product P. Now let us assume that we hold the quantitative amounts b a unchanged. The amounts p are free to c and and therefore yielding the maximum p vary. The value of a, i.e., the maxi- a / opti- mum average return of product to the facto, is called the X amount of . The mum law of returns states that with the quantity of complementary factors held constant, there always exists some opti- As the amount of the varying mum amount of the varying factor. factor decreases or increases from the optimum, , the average / p a unit product declines. The quantitative extent of that decline depends on the concrete conditions of each case. As the supply of the varying factor increases, just below this optimum, the average return of product to the varying factor is increasing; after the optimum it is decreasing. These may be called states of decreasing returns to the factor, with the increasing returns and maximum return at the optimum point. The law that such an optimum must exist can be proved by contemplating the implications of the contrary. If there were no optimum, the average product would increase indefinitely as the quantity of the factor increased. (It could not increase indef- X , since the product will be zero initely as the quantity decreases / a can always be p when the quantity of the factor is zero.) But if

101 Power and Market with 36 Man, Economy, and State a , this means that any desired increased merely by increasing could be secured by merely increasing the supply quantity of P X . This would mean that the proportionate supply of factors of Z can be ever so small; any decrease in their supply can Y and always be compensated to increase production by increasing the X . This would signify that factor X supply of is perfectly sub- stitutable for factors and Z and that the scarcity of the latter Y factors would not be a matter of concern to the actor so long as factor X was available in abundance. But a lack of concern for their scarcity means that Y and Z would no longer be scarce factors. Only one scarce factor, X , would remain. But we have seen that there must be more than one factor at each stage of production. Accordingly, the very existence of various factors of production implies that the average return of product to each factor must have some maximum, or optimum, value. In some cases, the optimum amount of a factor may be the only amount that can effectively co-operate in the production process. Thus, by a known chemical formula, it may require precisely two parts of hydrogen and one part of oxygen to pro- duce one unit of water. If the supply of oxygen is fixed at one unit, then any supply of hydrogen under two parts will produce no product at all, and all parts beyond two of hydrogen will be quite useless. Not only will the combination of two hydrogen and one oxygen be the optimum combination, but it will be the only amount of hydrogen that will be at all useful in the pro- duction process. The relationship between average product and marginal prod- uct to a varying factor may be seen in the hypothetical example illustrated in Table 1. Here is a hypothetical picture of the returns to a varying factor, with other factors fixed. The average unit product increases until it reaches a peak of eight at five units of X . This is the optimum point for the varying factor. The mar- ginal product is the increase in total product provided by the marginal unit. At any given supply of units of factor X , a loss of one unit will entail a loss of total product equal to the marginal product.

102 37 Fundamentals of Human Action T ABLE 1 VERAGE A ARGINAL M NIT U T ACTOR OTAL ACTOR F F RODUCT RODUCT P RODUCT P P YX a Δ p/ Δ p/a UNITS p UNITS a UNITS b 3 0 0 0 ... 31 44 4 32105 6 33186 8 3 12 30 4 7.5 3540810 5 7.5 45 6 3 37497 4 X Thus, if the supply of is increased from three units to four units, total product is increased from 18 to 30 units, and this increase is the marginal product of X with a supply of four units. Similarly, if the supply is cut from four units to three units, the total product must be cut from 30 to 18 units, and thus the mar- ginal product is 12. that will yield the opti- X It is evident that the amount of mum of average product is not necessarily the amount that max- imizes the marginal product of the factor. Often the marginal product reaches its peak before the average product. The rela- tionship that always holds mathematically between the average and the marginal product of a factor is that as the average prod- uct increases (increasing returns), the marginal product is greater than the average product. Conversely, as the average product declines (diminishing returns), the marginal product is less than the average 25 product. 25 For algebraic proof, see George J. Stigler, The Theory of Price (New York: Macmillan & Co., 1946), pp. 44–45.

103 Power and Market with Man, Economy, and State 38 It follows that when the average product is at a maximum, it equals the marginal product. It is clear that, with one varying factor, it is easy for the actor to set the proportion of factors to yield the optimum return for the factor. But how can the actor set an optimum combination of factors if all of them can be varied in their supply? If one combi- X Z Y , yields an optimum return for nation of quantities of , and X , Y , and another combination yields an optimum return for etc., how is the actor to determine which combination to with choose? Since he cannot quantitatively compare units of X , how can he determine the optimum proportion Z or units of Y of factors? This is a fundamental problem for human action, and its methods of solution will be treated in subsequent chapters. 7. Factors of Production: Convertibility and Valuation Factors of production are valued in accordance with their anticipated contribution in the eventual production of con- sumers’ goods. Factors, however, differ in the degree of their specifity , i.e., the variety of consumers’ goods in the production of which they can be of service. Certain goods are completely spe- —are useful in producing only one consumers’ good. Thus, cific when, in past ages, extracts from the mandrake weed were con- sidered useful in healing ills, the mandrake weed was a com- pletely specific factor of production—it was useful purely for this purpose. When the ideas of people changed, and the man- drake was considered worthless, the weed lost its value com- pletely. Other producers’ goods may be relatively nonspecific and capable of being used in a wide variety of employments. They could never be perfectly nonspecific—equally useful in all production of consumers’ goods—for in that case they would be general conditions of welfare available in unlimited abun- dance for all purposes. There would be no need to economize them. Scarce factors, however, including the relatively nonspe- cific ones, must be employed in their most urgent uses. Just as a supply of consumers’ goods will go first toward satisfying the

104 39 Fundamentals of Human Action most urgent wants, then to the next most urgent wants, etc., so a supply of factors will be allocated by actors first to the most urgent uses in producing consumers’ goods, then to the next most urgent uses, etc. The loss of a unit of a supply of a factor will entail the loss of the least urgent of the presently satisfied uses. it is from one The less specific a factor is, the more convertible use to another. The mandrake weed lost its value because it could not be converted to other uses. Factors such as iron or wood, however, are convertible into a wide variety of uses. If one type of consumers’ good falls into disuse, iron output can be shifted from that to another line of production. On the other hand, once the iron ore has been transformed into a machine, it becomes less easily convertible and often completely specific to the product. When factors lose a large part of their value as a result of a decline in the value of the consumers’ good, they will, if possible, be converted to another use of greater value. If, despite the decline in the value of the product, there is no bet- ter use to which the factor can be converted, it will stay in that line of product or cease being used altogether if the consumers’ good no longer has value. For example, suppose that cigars suddenly lose their value as consumers’ goods; they are no longer desired. Those cigar ma- chines which are not usable in any other capacity will become, valueless. Tobacco leaves, however, will lose some of their value, but may be convertible to uses such as cigarette production with little loss of value. (A loss of all desire for tobacco, however, will result in a far wider loss in the value of the factors, although part of the land may be salvaged by shifting from tobacco to the pro- duction of cotton.) Suppose, on the other hand, that some time after cigars lose their value this commodity returns to public favor and regains its former value. The cigar machines, which had been rendered valueless, now recoup their great loss in value. On the other hand, the tobacco leaves, land, etc., which had shifted from

105 Power and Market with Man, Economy, and State 40 cigars to other uses will reshift into the production of cigars. These factors will gain in value, but their gain, as was their pre- vious loss, will be less than the gain of the completely specific a change in the factor. These are examples of a general law that value of the product causes a greater change in the value of the specific factors than in that of the relatively nonspecific factors. To further illustrate the relation between convertibility and Y X valuation, let us assume that complementary factors 10 , , 5 and 8 . First, suppose that each of these P produce a supply of 20 Z factors is completely specific and that none of the supply of the factors can be replaced by other units. Then, if the supply of one ), the entire product is lost, and the of the factors is lost (say 10 X other factors become valueless. In that case, the supply of that factor which must be given up or lost equals in value the value of , while the other factors have a zero P the entire product—20 value. An example of production with purely specific factors is a pair of shoes; the prospect of a loss of one shoe is valued at the value of the entire pair, while the other shoe becomes valueless , 5 Y , and 8 Z in case of a loss. Thus, jointly , factors 10 X produce a product that is valued, say, as rank 11 on the actor’s value scale. Lose the supply of one of the factors, and the other comple- mentary factors become completely valueless. Now, let us assume, secondly, that each of the factors is non- can be used in another line of production that X specific: that 10 Y will yield a product, say, ranked 21st on the value scale; that 5 in another use will yield a product ranked 15th on the actor’s value scale; and that 8 can be used to yield a product ranked Z X 30th. In that case, the loss of 10 would mean that instead of would be satisfying a want of rank 11, the units of Y and Z shifted to their next most valuable use, and wants ranked 15th and 30th would be satisfied instead. We know that the actor preferred the satisfaction of a want ranked 11th to the satisfac- tion of wants ranked 15th and 30th; otherwise the factors would not have been engaged in producing P in the first place. But now the loss of value is far from total, since the other factors can still yield a return in other uses.

106 41 Fundamentals of Human Action Convertible factors will be allocated among different lines of production according to the same principles as consumers’ goods are allocated among the ends they can serve. Each unit of supply will be allocated to satisfy the most urgent of the not yet satisfied wants, i.e., where the value of its marginal product is the highest. A loss of a unit of the factor will deprive the actor of only the least important of the presently satisfied uses, i.e., that use in which the value of the marginal product is the low- est. This choice is analogous to that involved in previous exam- ples comparing the marginal utility of one good with the mar- ginal utility of another. This lowest-ranked marginal product may be considered the value of the marginal product of any unit of the factor, with all uses taken into account. Thus, in the X is a convertible factor in a myriad of above case, suppose that , X different uses. If one unit of P has a marginal product of say, 3 a marginal product in another use of 2 , etc., the actor Q , 5 R on his value ranks the values of these marginal products of X P , 2 scale. Suppose that he ranks them in this order: 4 , 5 R . , 3 S Q In that case, suppose he is faced with the loss of one unit of X . X R , where He will give up the use of a unit of in production of the marginal product is ranked lowest. Even if the loss takes P , but shift a , he will not give up 3 place in the production of P from the less valuable use and give up 5 R . Thus, just X unit of R as the actor gave up the use of a horse in pleasure riding and not in wagon-pulling by shifting from the former to the latter use, so the actor who (for example) loses a cord of wood intended for building a house will give up a cord intended for a service less valuable to him—say, building a sled. Thus, the value of the marginal product of a unit of a factor will be equal to its value in its marginal use, i.e., that use served by the stock of the fac- tor whose marginal product is ranked lowest on his value scale. We now can see further why, in cases where products are convertible factors, the general law made with specific and holds that the value of convertible factors changes less than P that of specific factors in response to a change in the value of or in the conditions of its production. The value of a unit of a

107 with Power and Market 42 Man, Economy, and State convertible factor is set, not by the conditions of its employ- ment in type of product, but by the value of its marginal one product when its uses are taken into consideration. Since a all specific factor is usable in only one line of production, its unit value is set as equal to the value of the marginal product in that line of production alone. Hence, in the process of valuation, the any specific factors are far more responsive to conditions in 26 than are the nonspecific factors. given process of production As with the problem of optimum proportions, the process of value imputation from consumers’ good to factors raises a great many problems which will be discussed in later chapters. Since one product cannot be measured against other products, and units of different factors cannot be compared with one another, how can value be imputed when, as in a modern economy, the structure of production is very complex, with myriads of prod- ucts and with convertible and inconvertible factors? It will be seen that value imputation is easy for isolated Crusoe-type actors, but that special conditions are needed to enable the value-imputing process, as well as the factor-allocating process, to take place in a complex economy. In particular, the various not the values, of course) must be units of products and factors ( made commensurable and comparable. 8. Factors of Production: Labor versus Leisure Setting aside the problem of allocating production along the most desired lines and of measuring one product against an- to maximize his pro- other, it is evident that every man desires He tries to satisfy as duction of consumers’ goods per unit of time. many of his important ends as possible, and at the earliest pos- sible time. But in order to increase the production of his con- sumers’ goods, he must relieve the scarcity of the scarce factors of production; he must increase the available supply of these 26 For further reading on this subject, see Böhm-Bawerk, Positive The- ory of Capital , pp. 170–88; and Hayek, Counter-Revolution of Science , pp. 32–33.

108 Fundamentals of Human Action 43 scarce factors. The nature-given factors are limited by his envi- ronment and therefore cannot be increased. This leaves him or of capital goods with the choice of increasing his supply of expenditure of labor. increasing his It might be asserted that another way of increasing his pro- duction is to improve his technical knowledge of how to pro- duce the desired goods—to improve his recipes. A recipe, how- ever, can only set outer limits on his increases in production; the actual increases can be accomplished solely by an increase in the supply of productive factors. Thus, suppose that Robinson Cru- soe lands, without equipment, on a desert island. He may be a competent engineer and have full knowledge of the necessary processes involved in constructing a mansion for himself. But without the necessary supply of factors available, this knowl- edge could not suffice to construct the mansion. One method, then, by which man may increase his produc- tion per unit of time is by increasing his expenditure of labor. In the first place, however, the possibilities for this expansion are strictly limited—by the number of people in existence at any time and by the number of hours in the day. Secondly, it is lim- ited by the ability of each laborer, and this ability tends to vary. And, finally, there is a third limitation on the supply of labor: whether or not the work is directly satisfying in itself, labor 27 leisure , a desirable good. always involves the forgoing of We can conceive of a world in which leisure is not desired and labor is merely a useful scarce factor to be economized. In such a world, the total supply of available labor would be equal to the total quantity of labor that men would be capable of expending. 27 This is the first proposition in this chapter that has not been deduced from the axiom of action. It is a subsidiary assumption, based on empirical observation of actual human behavior. It is not deducible from human action because its contrary is conceivable, although not generally existing. On the other hand, the assumptions above of quantitative relations of cause and effect were logically implicit in the action axiom, since knowledge of definite cause-and-effect relations is necessary to any decision to act.

109 with Power and Market 44 Man, Economy, and State Everyone would be eager to work to the maximum of capacity, since increased work would lead to increased production of desired consumers’ goods. All time not required for main- taining and preserving the capacity to work would be spent in 28 labor. Such a situation could conceivably exist, and an eco- nomic analysis could be worked out on that basis. We know from empirical observation, however, that such a situation is leisure is a con- very rare for human action. For almost all actors, , to be weighed in the balance against the prospect sumers’ good of acquiring other consumers’ goods, including possible satis- faction from the effort itself. The more a man labors, the less leisure he can enjoy. Increased labor therefore reduces the avail- able supply of leisure and the utility that it affords. Conse- quently, “people work only when they value the return of labor higher than the decrease in satisfaction brought about by the 29 curtailment of leisure.” It is possible that included in this “return” of satisfaction yielded by labor may be satisfaction in the labor itself, in the voluntary expenditure of energy on a pro- ductive task. When such satisfactions from labor do not exist, then simply the expected value of the product yielded by the effort will be weighed against the disutility involved in giving up leisure—the utility of the leisure forgone. Where labor does provide intrinsic satisfactions, the utility of the product yielded will include the utility provided by the effort itself. As the quan- tity of effort increases, however, the utility of the satisfactions provided by labor itself declines, and the utility of the successive units of the final product declines as well. Both the marginal utility of the final product and the marginal utility of labor-sat- isfaction decline with an increase in their quantity, because both goods follow the universal law of marginal utility. In considering an expenditure of his labor, man not only takes into account which are the most valuable ends it can serve 28 Cf. Mises, Human Action , p. 131. 29 Ibid ., p. 132.

110 45 Fundamentals of Human Action (as he does with all other factors), these ends possibly including also the satisfaction derived from productive labor itself, but he weighs the prospect of abstaining from the expenditure of labor in order to obtain the consumers’ good, leisure. Leisure, like any other good, is subject to the law of marginal utility. The first unit of leisure satisfies a most urgently felt desire; the next unit serves a less highly valued end; the third unit a still less highly valued end, etc. The marginal utility of leisure decreases as the supply increases, and this utility is equal to the value of the end that would have to be forgone with the loss of the unit of lei- sure. But in that case, the marginal disutility of work (in terms of leisure forgone) increases with every increase in the amount of labor performed. In some cases, labor itself may be positively disagreeable, not only because of the leisure forgone, but also because of specific conditions attached to the particular labor that the actor finds disagreeable. In these cases, the marginal disutility of labor in- cludes both the disutility due to these conditions and the dis- utility due to leisure forgone. The painful aspects of labor, like the forgoing of leisure, are endured for the sake of the yield of the final product. The addition of the element of disagreeable- ness in certain types of labor may reinforce and certainly does not counteract the increasing marginal disutility imposed by the cumulation of leisure forgone as the time spent in labor increases. Thus, for each person and type of labor performed, the bal- ancing of the marginal utility of the product of prospective units of effort as against the marginal disutility of effort will include the satisfaction or dissatisfaction with the work itself, in addition to the evaluation of the final product and of the leisure forgone. The labor itself may provide positive satisfaction, pos- itive pain or dissatisfaction, or it may be neutral. In cases where the labor itself provides positive satisfactions, however, these are intertwined with and cannot be separated from the prospect of ob- taining the final product. Deprived of the final product, man will

111 with Power and Market 46 Man, Economy, and State consider his labor senseless and useless, and the labor itself will no longer bring positive satisfactions. Those activities which are for their own sake are not labor but are pure purely engaged in play , consumers’ goods in themselves. Play, as a consumers’ good, is subject to the law of marginal utility as are all goods, and the time spent in play will be balanced against the utility to 30 be derived from other obtainable goods. In the expenditure of any hour of labor, therefore, man weighs the disutility of the labor involved (including the leisure forgone plus any dissatisfaction stemming from the work itself) against the utility of the contribution he will make in that hour to the production of desired goods (including future goods and any pleasure in the work itself), i.e., with the In each hour he will expend his value of his marginal product. good whose marginal product is that effort toward producing highest on his value scale. If he must give up an hour of labor, he will give up a unit of that good whose marginal utility is lowest on his value scale. At each point he will balance the util- ity of the product on his value scale against the disutility of fur- ther work. We know that a man’s marginal utility of goods pro- vided by effort will decline as his expenditure of effort increases. On the other hand, with each new expenditure of effort, the marginal disutility of the effort continues to increase. Therefore, a man will expend his labor as long as the marginal utility of the return exceeds the marginal disutility of the labor effort. A man will stop work when the marginal disu- tility of labor is greater than the marginal utility of the 31 increased goods provided by the effort. 30 Leisure is the amount of time not spent in labor, and play may be con- sidered as one of the forms that leisure may take in yielding satisfaction. On labor and play, cf. Frank A. Fetter, Economic Principles (New York: The Cen- tury Co., 1915), pp. 171–77, 191, 197–206. 31 Cf. L. Albert Hahn, Common Sense Economics (New York: Abelard- Schuman, 1956), pp. 1 ff.

112 47 Fundamentals of Human Action Then, as his consumption of leisure increases, the marginal utility of leisure will decline, while the marginal utility of the goods forgone increases, until finally the utility of the marginal products forgone becomes greater than the marginal utility of leisure, and the actor will resume labor again. This analysis of the laws of labor effort has been deduced from the implications of the action axiom and the assumption of leisure as a consumers’ good. 9. The Formation of Capital With the nature-given elements limited by his environment, and his labor restricted both by its available supply and its dis- utility, there is only one way by which man can increase his pro- duction of consumers’ goods per unit of time—by increasing the quantity of capital goods. Beginning with unaided labor and nature, he must, to increase his productivity, mix his labor energy with the elements of nature to form capital goods. These goods are not immediately serviceable in satisfying his wants, but must be transformed by further labor into lower-order cap- ital goods, and finally into the desired consumers’ goods. In order to illuminate clearly the nature of capital formation and the position of capital in production, let us start with the hypothetical example of Robinson Crusoe stranded on a desert island. Robinson, on landing, we assume, finds himself without the aid of capital goods of any kind. All that is available is his own labor and the elements given him by nature. It is obvious that without capital he will be able to satisfy only a few wants, of which he will choose the most urgent. Let us say that the only goods available without the aid of capital are berries and leisure. Say that he finds that he can pick 20 edible berries an hour, and, on this basis, works 10 hours in berry-picking and enjoys 14 hours a day of leisure. It is evident that, without the aid of cap- ital, the only goods open to him for consumption are goods shortest period of production. Leisure is the one good that with the is produced almost instantaneously, while berries have a very

113 Power and Market with Man, Economy, and State 48 short production period. Twenty berries have a production period of one hour. Goods with longer periods of production are not available to him unless he acquires capital goods. There are two ways in which longer processes of production through the use of capital may increase productivity: (1) they same may provide a greater production of the good per unit of time; or (2) they may allow the actor to consume goods that are with shorter processes of production. not available at all As an example of the first type of increase in productivity, Robinson may decide that if he had the use of a long stick, he could shake many berries off the trees instead of picking them by hand. In that way he might be able to step up his production to 50 berries an hour. How might he go about acquiring the stick? Obviously, he must expend labor in getting the materials, transporting them, shaping them into a stick, etc. Let us say that 10 hours would be necessary for this task. This means that to 10 hours’ production of con- obtain the stick, Crusoe must forgo sumers’ goods. He must either sacrifice 10 hours of leisure or 10 hours of berries at 20 per hour (200 berries), or some combina- tion of the two. He must sacrifice, for 10 hours, the enjoyment cap- of consumers’ goods, and expend his labor on producing a ital good —the stick—which will be of no immediate use to him. He will be able to begin using the capital good as an indirect aid to future production only after the 10 hours are up. In the meantime, he must forgo the satisfaction of his wants. He must for 10 hours and for that restrict his consumption transfer his labor period from producing immediately satisfying consumers’ goods into the production of capital goods, which will prove . The restriction of con- in the future their usefulness only saving , and the transfer of labor and land to sumption is called investment . the formation of capital goods is called We see now what is involved in the process of capital forma- tion. The actor must decide whether or not to restrict his con- sumption and invest in the production of capital goods, by weighing the following factors: Does the utility yielded by the

114 49 Fundamentals of Human Action increased productivity of the longer process of production out- goods to acquire present weigh the sacrifice that I must make of ? We have already seen above the consumers’ goods in the future time preference universal fact of —that a man will always prefer obtaining a given satisfaction earlier than later. Here, the actor more satisfactions per unit of must balance his desire to acquire as against the fact that, to do so, he must give up satisfac- time future tions in the present to increase his production in the . His disutil- time preference for present over future accounts for his ity of waiting, which must be balanced against the utility that will be eventually provided by the capital good and the longer process of production. How he chooses depends on his scale of values. It is possible, for example, that if he thought the stick would provide him with only 30 berries an hour and would take 20 hours to make, he would not make the saving-investment decision. On the other hand, if the stick took five hours to make and could provide him with 100 berries an hour, he might make the decision readily. If he decides to invest 10 hours in adding to his capital goods, there are many ways in which he might restrict his con- sumption. As mentioned above, he can restrict any combination of berries or leisure. Setting aside leisure for purposes of sim- plification, he may decide to take a whole day off at once and produce no berries at all, completing the stick in one day. Or, he may decide to pick berries for eight hours instead of 10, and devote the other two hours a day to making the stick, in which case the completion of the stick will take five days. Which method he will choose depends on the nature of his value scale. In any case, he must restrict his consumption by 10 hours’ worth of labor—200 berries. The rate of his restriction will depend on how urgently he wants the increased production, as compared with the urgency with which he desires to maintain his present supply of berries. Analytically, there is little difference between working on consumers’ goods, accumulating a stock of them, and then work- ing full time on the capital good, and working on the capital

115 with Power and Market 50 Man, Economy, and State good and consumer goods simultaneously. Other things being equal, however, it is possible that one of the methods will prove more productive; thus, it may be that the actor can complete the task in less time if he works on it continuously. In that case, he will tend to choose the former method. On the other hand, the berries might tend to spoil if accumulated, and this would lead him to choose the latter route. A balance of the various factors on his value scale will result in his decision. Let us assume that Robinson has made his decision, and, after five days, begins to use the stick. On the sixth day and thereafter, then, 500 berries a day will begin to pour forth, and he will harvest the fruits of his investment in capital goods. Crusoe can use his increased productivity to increase his as well as to increase his output of berries. Thus, hours of leisure he might decide to cut his daily labor from 10 hours to eight. His output of berries will then be increased, because of the stick, from 200 to 400 berries per day, while Crusoe is able to increase his hours of leisure from 14 to 16 per day. Obviously, Crusoe can choose to take his increased productivity in various combinations of increased output of the good itself and of 32 increased leisure. Even more important than its use in increasing output per unit of time is the function of capital in enabling man to acquire at all goods which he could not obtain otherwise. A very short period of production enables Crusoe to produce leisure and at least some berries, but without the aid of capital he cannot of his other wants at all. To acquire meat he must have any attain a bow and arrows, to acquire fish he must have a pole or net, to acquire shelter he must have logs of wood, or canvas, and an axe to cut the wood. To satisfy any such wants, he must restrict his 32 In this sense, the stick might be called a “labor-saving device,” although the terminology is misleading. It is “labor-saving” only to the extent that the actor chooses to take the increased productivity in the form of leisure.

116 51 Fundamentals of Human Action consumption and invest his labor in the production of capital goods. In other words, he must embark on lengthier processes of production than had been involved in culling berries; he must take time out to produce the capital goods themselves before he can use them to enjoy consumers’ goods. In each case, the deci- sions that he makes in embarking on capital formation will be a result of weighing on his value scale the utility of the expected increased productivity as against the disutility of his time pref- erence for present as compared to future satisfactions. It is obvious that the factor which holds every man back from investing more and more of his land and labor in capital goods is his time preference for present goods. If man, other things being equal, did not prefer satisfaction in the present to satisfaction in the future, he would never consume; he would invest all his time and labor in increasing the production of future goods. But “never consuming” is an absurdity, since con- suming is the end of all production. Therefore, at any given shorter peri- point in time, all men will have invested in all the ods of production to satisfy the most urgently felt wants that their knowledge of recipes allows; any further formation of capital will go into longer processes of production . Other things being equal (i.e., the relative urgency of wants to be satisfied, and the actor’s knowledge of recipes), any further investment will be in a longer process of production than is now under way. Here it is important to realize that “a period of production” does not involve only the amount of time spent on making the actual capital good, but refers to the amount of waiting-time from the start of producing the capital good until the consumers’ good is produced. In the case of the stick and the berries, the two times are identical, but this was so only because the stick was a first-order capital good, i.e., it was but one stage removed from the output of consumers’ goods. Let us take, for example, a more complex case—the building by Crusoe of an axe in order to chop wood to produce a house for himself. Crusoe must de- cide whether or not the house he will gain will be worth the

117 Power and Market with Man, Economy, and State 52 consumers’ goods forgone in the meantime. Let us say it will take Crusoe 50 hours to produce the axe, and then a further 200 hours, with the help of the axe, to chop and transport wood in order to build a house. The longer process of production which Crusoe must decide upon is now a three-stage one, totaling 250 hours. First, labor and nature produce the axe, a second-order capital good; second, labor, plus the axe, plus nature-given ele- ments, produces logs-of-wood, a first-order capital good; finally, labor and the logs of wood combine to yield the desired consumers’ good—a house. The length of the process of pro- duction is the entire length of time from the point at which an actor must begin his labor to the point at which the consumers’ good is yielded. Again, it must be observed that, in considering the length of a process of production, the actor is not interested in past history as such. The length of a process of production for an actor is the Thus, if Cru- waiting-time from the point at which his action begins. soe were lucky enough to find an axe in good condition left by some previous inhabitant, he would reckon his period of pro- duction at 200 hours instead of 250. The axe would be given to him by his environment. This example illustrates a fundamental truth about capital goods: Capital is a way station along the road to the enjoyment fur- of consumers’ goods. He who possesses capital is that much on the road to the desired consumers’ good. ther advanced in time Crusoe without the axe is 250 hours away from his desired house; Crusoe with the axe is only 200 hours away. If the logs of wood had been piled up ready-made on his arrival, he would be that much closer to his objective; and if the house were there to begin with, he would achieve his desire immediately. He would be further advanced toward his goal without the necessity of fur- ther restriction of consumption. Thus, the role of capital is to advance men in time toward their objective in producing con- sumers’ goods. This is true for both the case where new con- more old sumers’ goods are being produced and the case where

118 53 Fundamentals of Human Action goods are being produced. Thus, in the previous case, without the stick, Crusoe was 25 hours away from an output of 500 berries; with the stick, he is only 10 hours away. In those cases where capital enables the acquisition of new goods—of goods which could not be obtained otherwise—it is an absolutely indis- pensable , as well as convenient, way station toward the desired consumers’ good. It is evident that, for any formation of capital, there must saving —a restriction of the enjoyment of consumers’ goods be in the present—and the investment of the equivalent resources in the production of capital goods. This enjoyment of con- consump- sumers’ goods—the satisfaction of wants—is called tion . The saving might come about as a result of an increase in the available supply of consumers’ goods, which the actor decides to save in part rather than consume fully. At any rate, consumption must always be less than the amount that could be secured. Thus, if the harvest on the desert island improves, and Crusoe finds that he can pick 240 berries in 10 hours with- out the aid of a stick, he may now save 40 berries a day for five days, enabling him to invest his labor in a stick, without cutting back his berry consumption from the original 200 berries. Sav- ing involves the restriction of consumption compared to the be consumed; it does not always involve an amount that could actual reduction in the amount consumed over the previous level of consumption. All capital goods are perishable. Those few products that are not perishable but permanent become, to all intents and pur- . Otherwise, all capital goods are perish- poses, part of the land able, used up during the processes of production. We can there- transformed fore say that capital goods, during production, are into their products. With some capital goods, this is physically quite evident. Thus, it is obvious, for example, that when 100 pounds of bread-at-wholesale are combined with other factors to produce 100 pounds of bread at retail, the former factor is immediately and completely transformed into the latter factor.

119 Power and Market with Man, Economy, and State 54 The using up of capital goods is dramatically clear. The whole of the capital good is used up in each production-event. The other capital goods, however, are also used up, but not as sud- denly. A truck transporting bread may have a life of 15 years, amounting to, say, 3,000 of such conversions of bread from the 1 wholesale to the retail stage. In this case, we may say that /3,000 of the truck is used up each time the production process occurs. Similarly, a mill converting wheat into flour may have a useful l life of 20 years, in which case we could say that /20 of the mill was used up in each year’s production of flour. Each particular capital good has a different useful life and therefore a different . Capital rate of being used up, or, as it is called, of depreciation goods vary in the duration of their serviceableness. Let us now return to Crusoe and the stick. Let us assume that the stick will have a useful life of 10 days, and is so esti- mated by Crusoe, after which it wears out, and Crusoe’s output reverts to its previous level of 20 berries per hour. He is back where he started. Crusoe is therefore faced with a choice, after his stick comes into use. His “standard of living” (now, say, at 500 berries a day plus 14 hours of leisure) has improved, and he will not like the prospect of a reduction to 200 when the stick gives out. If he wishes to maintain his standard of living intact, therefore, he must, during the 10 days, work on building another stick, which can be used to replace the old one when it wears out. This act In order of building another stick involves a further act of saving. to invest in a replacement for the stick, he must again save— restrict his co nsumption as compared to the production that might be available. Thus, he will again have to save 10 hours’ worth of labor in berries (or leisure) and devote them to invest- ing in a good that is only indirectly serviceable for future pro- duction. Suppose that he does this by shifting one hour a day from his berry production to the labor of producing another stick. By doing so, he restricts his berry consumption, for 10 days, to 450 a day. He has restricted consumption from his

120 Fundamentals of Human Action 55 maximum, although he is still much better off than in his orig- inal, unaided state. is renewed at the end of the 10 capital structure Thus, the days, by saving and investing in a replacement. After that, Cru- soe is faced with the choice of taking his maximum again production of 500 berries per day and finding himself back to a 200-per-day level at the end of 10 more days, or of making a third act of saving in order to provide for replacement of the 33 second stick when it wears out. If Crusoe decides not to replace the first or the second stick, and accepts a later drop in output to avoid undergoing present In other words, he is electing to saving, he is consuming capital. consume instead of to save and maintain his capital structure and future rate of output. Consuming his capital enables Cru- now soe to increase his consumption from 450 to 500 berries per day, but at some point in the future (here in 10 days), he will be forced to cut his consumption back to 200 berries. It is clear that what has led Crusoe to consume capital is his time prefer- , which in this case has led him to prefer more present con- ence sumption to greater losses in future consumption. (a Thus, any actor, at any point in time, has the choice of: ) adding to his capital structure, ( ) maintaining his capital intact, b or ( ) and ( b ) involve acts of c) consuming his capital. Choices ( a saving. The course adopted will depend on the actor’s weighing his disutility of waiting, as determined by his time preference, against the utility to be provided in the future by the increase in his intake of consumers’ goods. At this point in the discussion of the wearing out and replacement of capital goods we may observe that a capital good rarely retains its full “powers” to aid in production and then 33 It is necessary to emphasize that independent acts of saving are nec- essary for replacement of goods, since many writers (e.g., J.B. Clark, Frank H. Knight) tend to assume that, once produced, capital, in some mystical way, reproduces itself without further need for acts of saving.

121 with Power and Market 56 Man, Economy, and State suddenly lose all its serviceability. In the words of Professor Benham, “capital goods do not usually remain in perfect tech- nical condition and then suddenly collapse, like the wonderful 34 ‘one-hoss shay.’ ” Crusoe’s berry output, instead of remaining 500 for 10 days and then falling back to 200 on the 11th day, is likely to decline at some rate before the stick becomes com- pletely useless. Another method of maintaining capital may now prove available. Thus, Crusoe may find that, by spending a little time repairing the stick, breaking off weaker parts, etc., he may be able to prolong its life and maintain his output of berries longer. In short, he may be able to add to his capital structure via . repairs Here again he will balance the added increase in future out- loss in consumers’ present put of consumers’ goods against the goods which he must endure by expending his labor on repairs. Making repairs therefore requires an independent act of saving and a choice to save. It is entirely possible, for example, that Crusoe will decide to replace the stick, and spend his labor on that purpose, but will not consider it worthwhile to repair it. Which course he decides to take depends on his valuation of the various alternative outputs and his rate of time preference. An actor’s decision on what objects to invest in will depend on the expected utility of the forthcoming consumers’ good, its durability, and the length of his waiting-time. Thus, he may first invest in a stick and then decide it would not be worthwhile to invest in a second stick; instead, it would be better to begin building the axe in order to obtain a house. Or he may first make a bow and arrows with which to hunt game, and after that begin working on a house. Since the marginal utility of the stock of a good declines as the stock increases, the more he has one consumers’ good, the more likely he will be of the stock of 34 Cf. Frederic Benham, Economics (New York: Pitman Publishing, 1941), p. 162.

122 57 Fundamentals of Human Action to expend his new savings on a different consumers’ good, since the second good will now have a higher marginal utility of product to his invested labor and waiting, and the marginal util- ity of the first will be lower. If two consumers’ goods have the same expected marginal utility in daily serviceability and have the same period of wait- ing time, but one is more durable than the other, then the actor will choose to invest in production of the former. On the other hand, if the total serviceableness of two expected consumers’ goods is the same, and their length of period of production is the same, the less durable good will be invested in, since its total satisfactions arrive earlier than the other. Also, in choos- ing between investing in one or the other of two consumers’ goods, the actor will, other things being equal, choose that good with the shorter period of production, as has been dis- cussed above. Any actor will continue to save and invest his resources in various expected future consumers’ goods as long as the utility, considered in the present, of the marginal product of each unit saved and invested is greater than the utility of present con- sumers’ goods which he could obtain by not performing that saving. The latter utility—of present consumers’ goods for- gone—is the “disutility of waiting.” Once the latter becomes greater than the utility of obtaining more goods in the future through saving, the actor will cease to save. Allowing for the relative urgency of wants, man, as has been demonstrated above, tends to invest first in those con- sumers’ goods with the shortest processes of production. Therefore, any given saving will be invested either in main- taining the present capital structure or in adding to it capital in more and more remote stages of production, i.e., in longer processes of production. Thus, any new saving (beyond main- taining the structure) will tend to lengthen production processes and invest in higher and higher orders of capital goods. In a modern economy, the capital structure contains goods of almost infinite remoteness from the eventual consumers’

123 Power and Market with Man, Economy, and State 58 goods. We saw above some of the stages involved in the produc- tion of a comparatively very simple good like a ham sandwich. The laborer in an iron mine is far removed indeed from the ham sandwich in Jones’ armchair. It is evident that the problems of measurement that arose in previous sections would be likely to pose a grave difficulty in saving and investing. How do actors know when their capital structure is being added to or consumed, when the types of cap- ital goods and consumers’ goods are numerous? Obviously, Crusoe knows when he has more or fewer berries, but how can a modern complex economy, with innumerable capital goods and consumers’ goods, make such decisions? The answer to this problem, which also rests on the commensurability of different goods, will be discussed in later chapters. In observing the increased output made possible by the use of capital goods, one may very easily come to attribute some sort of independent productive power to capital and to say that three types of productive forces enter into the production of consumers’ goods: labor, nature, and capital. It would be easy to draw this conclusion, but completely fallacious. Capital goods have no independent productive power of their own; in the last analysis they are completely reducible to labor and land, which produced them, and time. Capital goods are “stored-up” labor, land, and time; they are intermediate way stations on the road to the eventual attainment of the consumers’ goods into which they are transformed. At every step of the way, they must be worked on by labor, in conjunction with nature, in order to con- tinue the process of production. Capital is not an independent productive factor like the other two. An excellent illustration of this truth has been provided by Böhm-Bawerk: The following analogy will make it perfectly clear. A man throws a stone at another man and kills him. Has the stone killed the man? If the question is put without laying any special emphasis it may be answered without hesitation in the affirmative. But how if the murderer, on his trial, were to defend

124 59 Fundamentals of Human Action himself by saying that it was not he but the stone that had killed the man? Taking the words in this sense, should we still say that the stone had killed the man, and acquit the murderer? Now it is with an empha- sis like this that economists inquire as to the inde- pendent productivity of capital. . . . We are not ask- ing about dependent intermediate causes, but about ultimate independent elements. The question is not whether capital plays a part in the bringing about of a productive result—such as the stone does in the killing of the man—but whether, granted the pro- ductive result, some part of it is due to capital so entirely and peculiarly that it simply cannot be put to the credit of the two other recognized elementary factors, nature and labor. Böhm-Bawerk replies in the negative, pointing out that capital goods are purely way stations in the process of production, worked on at every possible stage by the forces of labor and land: If, today, by allying my labor with natural powers, I make bricks out of clay, and tomorrow, by allying my labor with natural gifts, I obtain lime, and the day after that make mortar and so construct a wall, can it be said of any part of the wall that I and the natural made it? Again, before a lengthy powers have not piece of work, such as the building of a house, is quite finished, it naturally must be at one time a fourth fin- ished, then a half finished, then three-quarters fin- ished. What now would be said if one were to describe these inevitable stages of the work as inde- pendent requisites of house-building, and maintain that, for the building of a house, we require, besides building materials and labor, a quarter-finished house, a half-finished house, a three-quarters fin- ished house? In form perhaps it is less striking, but in effect it is not a whit more correct, to elevate those intermediate steps in the progress of the work, which

125 with Power and Market 60 Man, Economy, and State outwardly take the shape of capital, into an inde- pendent agent of production by the side of nature and 35 labor. And this holds true regardless of how many stages are involved or how remote the capital good is from the ultimate consumers’ good. Since investment in capital goods involves looking toward the future, one of the risks that an actor must always cope with of future conditions. Producing consumers’ uncertainty is the goods directly involves a very short period of production, so that the uncertainty incurred is not nearly as great as the uncer- tainty of longer processes of production, an uncertainty that becomes more and more important as the period of production 36 lengthens. Suppose that Crusoe, while deciding on his investment in the stick, believes that there is a good possibility of his finding a grove where berries are in abundance, giving him an output of 50 or more berries per hour without the aid of a stick, and also where the berries would be so close as to render the stick use- less. In that case, the more likely he thinks are the chances of finding the grove, the less likely he is to make the decision to invest in the stick, which would then be of no help to him. The greater the doubt about the usefulness the stick will have after it is ready, the less likelihood of investing in it, and the more likelihood of either investing in another good or of consuming instead of saving. We can consider that there is a sort of “un- certainty discount” on the expected future utility of the invest- ment that may be so large as to induce the actor not to make the 35 Böhm-Bawerk, Positive Theory of Capital , pp. 95–96. Also see Mises, Human Action , pp. 480–90, and pp. 476–514. 36 This uncertainty is a subjective feeling (“hunch” or estimate) and can- not be measured in any way. The efforts of many popular writers to apply mathematical “probability theory” to the uncertainty of future historical events are completely vain. Cf. Mises, Human Action , pp. 105–18.

126 Fundamentals of Human Action 61 investment. The uncertainty factor in this case works with the time-preference factor to the disadvantage of the investment, against which the actor balances the expected utility of future output. On the other hand, uncertainty may work as an added spur to making the investment. Thus, suppose that Crusoe believes that a blight may strike the berries very shortly and that if this happens, his unaided berry-output would dangerously decline. If the blight struck, Crusoe would be in great need of the stick to even maintain his output at the present low level. Thus, the possibility that the stick may be of even greater use to him than he anticipates will add to the expected utility of his investment, and the greater the chance of this possibility in Crusoe’s view, the more likely he will be to invest in the stick. Thus, the un- certainty factor may work in either direction, depending on the specific situation involved. We may explain the entire act of deciding whether or not to perform an act of capital formation as the balancing of relative utilities, “discounted” by the actor’s rate of time preference and also by the uncertainty factor. Thus, first let us assume, for pur- poses of simplification, that Crusoe, in making the stick, forgoes 10 hours’ worth of present goods, i.e., 200 berries, and has ac- quired 1,500 berries three days later as a result of the investment decision. If the 1,500 berries had been immediately available, there would be no doubt that he would have given up 200 berries to acquire 1,500. Thus, 1,500 berries in the present might have a rank of four on his value scale, while 200 berries have a rank of 11: 1,500 berries in the present 4 200 berries in the present 11 Now, how will Crusoe decide between 200 berries in the present and 1,500 berries thr ee days from now? Since all choices

127 with Power and Market Man, Economy, and State 62 have to be made on one value scale, Crusoe must grade the util- ity of 1,500 berries three days from now as against the utility of 200 berries now. If the former is greater (higher on his value scale) he will make the decision to save and invest in the stick. If the latter is greater, and his 200 berries forgone have a greater value than the expectation of 1,500 berries three days from now, then his time preference has conquered the increased utility of stock, and he will not make the saving-investment decision. Thus, the actor’s value scale may be: a ) 4 1,500 berries in the present ( 11 200 berries now 12 1,500 berries three days from now or it may be: ( b ) 4 1,500 berries in the present 9 1,500 berries three days from now 11 200 berries now In case ( b ) he will make the decision to invest; in case ( a ) he will not. We can say that the value of 1,500 berries three days from now is the present value of the future good. The expected future good is discounted by the actor according to his rate of time preference. The present value of his expected future good is compared to the present value of the present good on the actor’s value scale, and the decision to save and invest is made accord- ingly. It is clear that the higher the rate of discount, the lower the present value of the future good will be, and the greater the likelihood of abstaining from the investment. On the other hand, the lower the rate of discount, the higher the present

128 Fundamentals of Human Action 63 value of future goods will be on the actor’s value scale, and the greater the likelihood of its being greater than the value of pres- ent goods forgone, and hence of his making the investment. Thus, the investment decision will be determined by which is greater: the present value of the future good or the present value of present goods forgone. The present value of the future good, in turn, is determined by the value that the future good would have if immediately present (say, the “expected future value of the future good”); and by the rate of time preference. The greater the former, the greater will be the present value of the future good; the greater the latter (the rate of discount of future compared to present goods), the lower the present value. At any point in time, an actor has a range of investment de- cisions open to him of varying potential utilities for the prod- 37 ucts that will be provided. He also has a certain rate of time preference by which he will discount these expected future util- ities to their present value. How much he will save and invest in any period will be determined by comparing these present val- ues with the value of the consumers’ goods forgone in making the investment decision. As he makes one investment decision after another, he will choose to allocate his resources first to investments of highest present value, then to those of next high- est, etc. As he continues investing (at any given time), the pres- ent value of the future utilities will decline. On the other hand, since he is giving up a larger and larger supply of consumers’ goods in the present, the utility of the consumers’ goods that he forgoes (leisure and others) will increase—on the basis of the law of marginal utility. He will cease saving and investing at the 37 That such a range of investment decisions enabling him to achieve greater future output must always be open to him is a fundamental truth derived from the assumption of human action. If they were not open to him, it would mean that man could not (or rather, believed that he could not) act to improve his lot, and therefore there would be no possibility of action. Since we cannot even conceive of human existence without action, it follows that “investment opportunities” are always available.

129 Power and Market with Man, Economy, and State 64 point at which the value of goods forgone exceeds the present value of the future utilities to be derived. This will determine an of saving and investing at any time. rate actor’s It is evident that the problem again arises: How can actors decide and compare time-preference rates for innumerable possible goods and in a complex, modern economy? And here too, the answer for a complex economy lies in establishing commensurability among all the various commodities, present and future, as will be discussed in later chapters. Now, the uncertainty factors enter into the actor’s decision in one way or the other. The delicate procedure of weighing all the various factors in the situation is a complex process that takes place in the mind of every actor according to his under- standing of the situation. It is a decision depending purely on the individual judgment, the subjective estimates, of each actor. The “best” decision cannot be exactly, or quantitatively, decided forecast- upon in advance by objective methods. This process of the future conditions that will occur during the course of his ing action is one that must be engaged in by every actor. This necessity of guessing the course of the relevant conditions and their possible change during the forthcoming action is called Thus, to some extent at least, every the act of entrepreneurship. man is an entrepreneur. Every actor makes his estimate of the uncertainty situation with regard to his forthcoming action. in entrepreneurship are The concepts of success or failure thus deducible from the existence of action. The relatively suc- cessful entrepreneur is the one who has guessed correctly the changes in conditions to take place during the action, and has invested accordingly. He is the Crusoe who has decided not to build the stick because his judgment tells him that he will soon find a new grove of berries, which he then finds. On the other hand, the relatively unsuccessful entrepreneur is the one who has been badly mistaken in his forecast of the relevant changes in conditions taking place during the course of his action. He is the Crusoe who has failed to provide himself with a stick against

130 65 Fundamentals of Human Action the blight. The successful actor, the successful entrepreneur, makes correct estimates; the unsuccessful entrepreneur is the one who makes erroneous estimates. Suppose now that an investment has already been made, and capital goods have already been built with a goal in view, when changing conditions reveal that an error has been made. The actor is then faced with the problem of determining what to do with the capital good. The answer depends on the convertibility of the capital good. If the good becomes worthless in the use for which it is intended, the actor, though having made an error in investing in it in the first place, now has it on his hands and has to make the best of it. If there is another use to which the actor can conveniently transfer the capital good, he will do so. Thus, if Crusoe finds that a new grove has rendered his stick useless for berry-picking, he may use it as a walking stick. He would not have invested in it originally if he had known it would be use- less for berry-picking, but now that he has it, he turns it to its most urgent available use. On the other hand, he may feel that it is hardly worthwhile to spend time replacing the stick, now that it is usable only for walking purposes. Or, after working 50 hours and building an axe, he may find a house left by some pre- vious inhabitant. The axe, however, may be convertible to use in something just a bit lower in value—say, building a bow and arrows for hunting or building a boat for fishing. The axe may be so valuable in these uses that Crusoe will still work to replace and maintain it in operation. It is clear that the accumulated stock of capital goods (or, for that matter, durable consumers’ goods) imposes a conservative force on present-day action. The actor in the present is influ- enced by his (or someone else’s) actions in the past, even if the latter were to some extent in error. Thus, Crusoe might find an axe already available, built by a previous inhabitant. It might not be the sort of axe that Crusoe would consider the best available. However, he may decide, if it is a serviceable axe, to use it as a capital good and to wait until it wears out before replacing it

131 Power and Market with Man, Economy, and State 66 with one of his choosing. On the other hand, he may feel that it is so blunt as to be of little use, and begin immediately to work on an axe of his own. The conservatism of the past exercises a similar influence location , another aspect of the same prob- on the question of lem. Thus, Crusoe may already have built his house, cleared a field, etc., in one portion of the island. Then, one day, in walk- ing around the island, he might find a section at the other end with far greater advantages in fishing, fruits, etc. If he had not invested in any capital goods or durable consumers’ goods, he would immediately shift his location to this more abundant area. However, he has already invested in certain capital goods: some, such as the axe, are easily convertible to the new location; others, such as the cleared field and the house, cannot be con- verted in their location. Therefore, he has to decide on his value scale between the advantages and disadvantages of moving: the more abundant fish and fruits versus the necessity of working to build a new house, make a new clearing, etc. He might decide, for example, to stay in the house and clearing until they have worn down to a certain point, without working on a replace- ment, and then shift to the new location. If an actor decides to abandon nonconvertible capital, such as the stick or the cleared field, in favor of producing other cap- , as some may think, wasting ital and consumers’ goods, he is not his resources by allowing the emergence of “unused capacity” of his resources. When Crusoe abandons his clearing or stick or house (which may be considered in this connection as equiva- lent to capital), he is abandoning nonconvertible capital for the sake of using his labor in combination with natural elements or capital goods that he believe s will yield him a greater utility. Similarly, if he refuses to go deep into a jungle for berries, he is not “wasting” his nonconvertible supply of land-and-berries, for he judges doing so of far less utility than other uses that he could make of his labor and time. The existence of a capital good not in use reveals an error made by this or by some previous

132 Fundamentals of Human Action 67 actor in the past , but indicates that the actor expects to acquire a greater utility from other uses of his labor than he could obtain by continuing the capital good in its originally intended use or 38 by converting it to some other use. This discussion provides the clue to an analysis of how actors will employ the original nature-given factors of produc- tion. In many cases, actors have their choice among the varying elements provided by nature. Thus, suppose that Crusoe, in his explorations of the island, finds that among the possible loca- tions where he can settle, some are abundant in their output of berries (setting aside their production of other consumers’ goods), some less so, and some useless and barren. Clearly, other considerations being equal, he will settle on the most fer- tile—the “best” land—and employ this factor as far as is deter- mined by the utility of its product, the possibility of investing in useful capital goods on the land, the value he places on leisure, etc. The poorer areas of land will remain unused. As stated above, this development is to be expected; there is no reason to be surprised at such evidence of “unused resources.” On the other hand, if the better areas are used up, then Crusoe will go on to utilize some of the next best areas, until the utility of the supply produced fails to exceed the utility of his leisure forgone. (“Next best” includes all the relevant factors, such as productiv- ity, convenient access to the best land, etc.) not Areas of potential use, but which the actor chooses to bring into use because it would not “pay” in terms of utilities forgone, are called submarginal areas. They are not objects of action at the moment, but the actor has them in mind for possi- ble future use. On the other hand, Crusoe’s island may be so small or so barren that all his available useful land or water areas must be pressed into use. Thus, Crusoe might have to explore the whole island for his daily output of 200 berries. In that case, if his 38 On the “unused capacity” bogey, see Benham, Economics , pp. 147–49.

133 Power and Market with Man, Economy, and State 68 resources are such that he must always employ all the possibly useful nature-given factors, it is obvious that the actor is pretty close to the bare survival level. In those cases where nature-given factors are worked on, “improved,” and maintained by human labor, these are, in effect, thereby changed into capital goods. Thus, land that has been cleared, tilled, plowed, etc., by human labor has become a capital good. This land is a produced good, and not an origi- nally given good. Decisions concerning whether and how much to improve the soil, or whether to maintain it or extract the maximum present consumers’ goods at the expense of future losses (“erosion”), are on exactly the same footing as all capital- formation decisions. They depend on a comparison of the expected utility of future production as against the utility of present consumers’ goods forgone. It is clear that capital formation and the concomitant period of lengthening of the period of production prolong the provision of the actor. Capital formation lengthens the period in the future for which he is providing for the satisfaction of wants. involves the anticipation of wants that will be felt in the Action future, an estimate of their relative urgency, and the setting about to satisfy them. The more capital men invest, the longer their period of provision will tend to be. Goods being directly is the . A and presently consumed are present goods future good present expectation of enjoying a consumers’ good at some point in the future. A future good may be a claim on future con- sumers’ goods, or it may be a capital good, which will be trans- formed into a consumers’ good in the future. Since a capital good is a way station (and nature-given factors are original sta- tions) on the route to consumers’ goods, capital goods and nature-given factors are both future goods. Similarly, the period of provision can be prolonged by lengthening the duration of serviceableness of the consumers’ goods being produced. A house has a longer durability than a crop of berries, for example, and Crusoe’s investment in a house

134 Fundamentals of Human Action 69 considerably lengthens his period of provision. A durable con- sumers’ good is consumed only partially from day to day, so that each day’s consumption is that of a present good, while the stock of the remainder is a future good. Thus, if a house is built and 1 will last 3,000 days, one day’s use will consume /3,000 of it, while the remainder will be consumed in the future. One three-thou- sandth of the house is a present good, while the remaining part 39 is a future good. It may be added that another method of lengthening the period of production is the simple accumulation of stocks of con- sumers’ goods to be consumed in the future instead of the pres- ent. For example, Crusoe might save a stock of 100 berries to be plain consumed a few days or a week later. This is often called , in which saving capitalist saving , as distinguished from saving 40 enters into the process of capital formation. We shall see, how- ever, that there is no essential difference between the two types of saving and that plain saving is also capitalist saving in that it too results in capital formation. We must keep in mind the vital fact that the concept of a “good” refers to a thing the units of which the actor believes afford equal serviceability. It does not refer to the physical or chemical characteristics of the good. We remember our critique of the popular fallacious objection to the universal fact of time preference—that, in any given winter, ice 41 the next summer is preferred to ice now. This was not a case of same good in the future to its preferring the consumption of the consumption in the present. If Crusoe has a stock of ice in the winter and decides to “save” some until next summer, this means different that “ice-in-the-summer” is a good, with a different intensity of satisfaction, from “ice-in-the-winter,” despite their 39 Cf. Böhm-Bawerk, Positive Theory of Capital , pp. 238–44. 40 Plain saving is not to be confused with an earlier example, when Cru- soe saved stocks of consumers’ goods to be consumed while devoting his labor to the production of capital. 41 See note 15 above.

135 with Power and Market 70 Man, Economy, and State physical similarities. The case of berries or of any other good is similar. If Crusoe decides to postpone consuming a portion of his stock of berries, this must mean that this portion will have a greater intensity of satisfaction if consumed later than now— enough greater, in fact, to overcome his time preference for the present. The reasons for such difference may be numerous, involving anticipated tastes and conditions of supply on that future date. At any rate, “berries-eaten-a-week-from-now” become a more highly valued good than “berries-eaten-now,” and the number of berries that will be shifted from today’s to next week’s consumption will be determined by the behavior of the diminishing marginal utility of next week’s berries (as the supply increases), the increasing marginal utility of today’s berries (as the supply decreases), and the rate of time preference. Suppose that as a resultant of these factors, Crusoe decides to shift 100 berries for this purpose. In that case, these 100 berries are removed from the category of consumers’ goods and shifted to that of capital goods. These are the sort of capital goods, how- maturing time to be transferred ever, which, like wine, need only into consumers’ goods, without the expenditure of labor (except the possible extra labor of storing and unstoring the berries). It is clear, therefore, that the accumulation of a stock of con- 42 sumers’ goods is also saving that goes into capital formation. The saved goods immediately become capital goods, which later mature into more highly valued consumers’ goods. There is no essential difference between the two types of saving. 10. Action as an Exchange We have stated that all action involves an exchange—a giv- ing up of a state of affairs for what the actor expects will be a 42 The period of production will be equal to the time difference between the act of saving and the act of future consumption, as in all other cases of investment.

136 Fundamentals of Human Action 71 43 We may now elaborate on the implica- more satisfactory state. tions of this truth, in the light of the numerous examples that have been given in this chapter. Every aspect of action has involved a choice among alternatives—a giving up of some goods for the sake of acquiring others. Wherever the choice occurred—whether among uses of durable consumers’ goods, or of capital goods; saving versus consumption; labor versus leisure; etc.—such choices among alternatives, such renouncing of one thing in favor of another, were always present. In each case, the actor adopted the course that he believed would afford him the highest utility on his value scale; and in each case, the actor gave up what he believed would turn out to be a lesser utility. Before analyzing the range of alternative choices further, it is necessary to emphasize that man must always act . Since he is always in a position to improve his lot, even “doing nothing” is a form of acting. “Doing nothing”—or spending all of his time in leisure—is a choice that will affect his supply of consumers’ goods. Therefore, man must always be engaged in choosing and in action. Since man is always acting, he must always be engaged in trying to attain the greatest height on his value scale , whatever the always be room type of choice under consideration. There must for improvement in his value scale; otherwise all of man’s wants would be perfectly satisfied, and action would disappear. Since this cannot be the case, it means that there is always open to each actor the prospect of improving his lot, of attaining a value higher than he is giving up, i.e., of making a psychic profit. What he is giving up may be called his costs , i.e., the utilities that he is forgoing in order to attain a better position. Thus, an actor’s costs are his forgone opportunities to enjoy consumers’ goods. Similarly, the (greater) utility that he expects to acquire because of the action may be considered his psychic income , or psychic rev- enue , which in turn will be equal to the utility of the goods he 43 See page 19 above.

137 Power and Market with 72 Man, Economy, and State will consume as a result of the action. Hence, at the inaugura- tion of any action, the actor will believe that this course of maximize his psychic income or action will, among the alternatives, psychic revenue , i.e., attain the greatest height on his value scale. A A PPENDIX CONOMICS E RAXEOLOGY AND P praxeological This chapter has been an exposition of part of —the analysis that forms the body of economic theory. analysis This analysis takes as its fundamental premise the existence of human action. Once it is demonstrated that human action is a necessary attribute of the existence of human beings, the rest of praxeology (and its subdivision, economic theory) consists of the elaboration of the logical implications of the concept of action. Economic analysis is of the form: (1) Assert A—action axiom. (2) If A , then B ; if B , then C ; if C , then D , etc.—by rules of logic. Therefore, we assert (the truth of) B, C, D , etc. (3) It is important to realize that economics does not propound any laws about the content of man’s ends. The examples that we have given, such as ham sandwich, berries, etc., are simply illus- trative instances, and are not meant to assert anything about the content of a man’s goals at any given time. The concept of action involves the use of scarce means for satisfying the most urgent wants at some point in the future, and the truths of eco- nomic theory involve the formal relations between ends and means, and not their specific contents. A man’s ends may be “egoistic” or “altruistic,” “refined” or “vulgar.” They may emphasize the enjoyment of “material goods” and comforts, or they may stress the ascetic life. Economics is not concerned with their content, and its laws apply regardless of the nature of these ends.

138 Fundamentals of Human Action 73 psychology or from the Praxeology, therefore, differs from philosophy of ethics . Since all these disciplines deal with the sub- jective decisions of individual human minds, many observers have believed that they are fundamentally identical. This is not the case at all. Psychology and ethics deal with the content of human ends; they ask, why does the man choose such and such ends, or ends should men value? Praxeology and econom- what ics deal with any given ends and with the formal implications of the fact that men have ends and employ means to attain them. Praxeology and economics are therefore disciplines separate and distinct from the others. Thus, all explanations of the law of marginal utility on psychological or physiological grounds are erroneous. For example, many writers have based the law of marginal utility on an alleged “law of the satiation of wants,” according to which a man can eat so many scoops of ice cream at one time, etc., and then becomes satiated. Whether or not this is true in psychol- ogy is completely irrelevant to economics. These writers erro- neously concluded that, at the beginning of the supply, a second unit may be more enjoyable than the first, and therefore that marginal utility may increase at first before declining. This is completely fallacious. The law of marginal utility depends on no physiological or psychological assumptions but is based on the praxeological truth that the first unit of a good will be used to satisfy the most urgent want, the second unit the next most urgent want, etc. It must be remembered that these “units” must be of equal potential serviceability. For example, it is erroneous to argue as follows: Eggs are the good in question. It is possible that a man needs four eggs to bake a cake. In that case, the second egg may be used for a less urgent use than the first egg, and the third egg for a less urgent use than the second. However, since the fourth egg allows a cake to be produced that would not otherwise be available, the marginal utility of the fourth egg is greater than that of the third egg.

139 Power and Market with 74 Man, Economy, and State This argument neglects the fact that a “good” is not the physical material, but any material whatever of which the units will constitute an equally serviceable supply. Since the fourth egg is not equally serviceable and interchangeable with the first egg, the two eggs are not units of the same supply, and therefore the law of marginal utility does not apply to this case at all. To treat eggs in this case as homogeneous units of one each set of four eggs as a good, it would be necessary to consider unit. To sum up the relationship and the distinctions between praxeology and each of the other disciplines, we may describe them as follows: z Why man chooses various ends: . psychology z What men’s ends should be: philosophy of ethics. also: philosophy of aesthetics . z How to use means to arrive at ends: . technology What man’s ends are and have been, and how z man has used means in order to attain them: history . z The formal implications of the fact that men use means to attain various chosen ends: praxeology . What is the relationship between praxeology and eco- nomic analysis? Economics is a subdivision of praxeology—so far the only fully elaborated subdivision. With praxeology as the general, formal theory of human action, economics includes the analysis of the action of an isolated individual (Crusoe economics) and, especially elaborate, the analysis of interpersonal exchange (catallactics). The rest of praxeology is an unexplored area. Attempts have been made to formulate a logical theory of war and violent action, and violence in the form of government has been treated by political philosophy and by praxeology in tracing the effects of violent intervention in the free market. A theory of games has been elaborated, and interesting beginnings have been made in a logical analysis of voting.

140 Fundamentals of Human Action 75 The suggestion has been made that, since praxeology and economics are logical chains of reasoning based on a few uni- versally known premises, to be really scientific it should be elab- orated according to the symbolic notations of mathematical 44 logic. This represents a curious misconception of the role of mathematical logic, or “logistics.” In the first place, it is the each one is meaningful. great quality of verbal propositions that On the other hand, algebraic and logical symbols, as used in logistics, are not in themselves meaningful. Praxeology asserts the action axiom as true, and from this (together with a few empirical axioms—such as the existence of a variety of resources and individuals) are deduced, by the rules of logical inference, all the propositions of economics, each one of which is verbal and meaningful. If the logistic array of symbols were used, each proposition would not be meaningful. Logistics, therefore, is far more suited to the physical sciences, where, in contrast to the science of human action, the conclusions rather than the axioms are known. In the physical sciences, the premises are only hypo- thetical, and logical deductions are made from them. In these cases, there is no purpose in having meaningful propositions at each step of the way, and therefore symbolic and mathematical language is more useful. Simply to develop economics verbally, then to translate into logistic symbols, and finally to retranslate the propositions back into English, makes no sense and violates the fundamental sci- entific principle of Occam’s razor, which calls for the greatest 44 American Economic Review, March, Cf. G.J. Schuller, “Rejoinder,” see Murray N. Rothbard, “Toward a Recon- 1951, p. 188. For a reply, struction of Utility and Welfare Economics” in Mary Sennholz, ed. On Freedom and Free Enterprise: Essays in Honor of Ludwig von Mises (Prince- ton, N.J.: D. Van Nostrand, 1956), p. 227. Boris Ischboldin, “A Also see Critique of Econometrics,” Review of Social Economy, September, 1960, pp. 110–27; and Vladimir Niksa, “The Role of Quantitative Thinking in Modern Economic Theory,” Review of Social Economy, September, 1959, pp. 151–73.

141 with Power and Market 76 Man, Economy, and State possible simplicity in science and the avoidance of unnecessary multiplication of entities or processes. Contrary to what might be believed, the use of verbal logic is not inferior to logistics. On the contrary, the latter is merely an auxiliary device based on the former. For formal logic deals with the necessary and fundamental laws of thought, which must be verbally expressed, and logistics is only a symbolic sys- tem that uses this formal verbal logic as its foundation. There- fore, praxeology and economics need not be apologetic in the slightest for the use of verbal logic—the fundamental basis of 45 symbolic logic, and meaningful at each step of the route. PPENDIX A B NDS N M EANS AND E O It is often charged that any theory grounded on a logical ends separation of means is unrealistic because the two are and often amalgamated or fused into one. Yet if man acts purpo- ends sively, he therefore drives toward , and whatever route he to achieve them. The takes, he must, ipso facto , employ means distinction between means and ends is a necessary logical dis- tinction rooted in all human—indeed, all purposive—action. It is difficult to see the sense in any denial of this primordial truth. The only sense to the charge concerns those cases where certain , become ends in them- objects , or rather certain routes of action selves as well as means to other ends. This, of course, can often happen. There is no difficulty, however, in incorporating them above. into an analysis, as has been done Thus, a man may work at a certain job not only for the pay, but also because he enjoys the work or the location. Moreover, any desire for money is a desire for a means to other ends. The critics of praxeology 45 Cf. René Poirier, “Sur Logique” in André Lalande, Vocabulaire tech- nique et critique de la philosophie (Paris: Presses Universitaires de France, 1951), pp. 574–75.

142 Fundamentals of Human Action 77 confuse the necessary and eternal separation of ends and means as categories with their frequent coincidence in a particular con- crete resource or course of action.


144 2 XCHANGE E IRECT D 1. Types of Interpersonal Action: Violence based on the logical implica- WAS 1 HE ANALYSIS IN CHAPTER T tions of the assumption of action, and its results hold true for all application human action. The of these principles was confined, however, to “Crusoe economics,” where the actions of isolated individuals are considered by themselves. In these situations, there are no interactions between persons. Thus, the analysis could easily and directly be applied to number of isolated Cru- n soes on n islands or other isolated areas. The next task is to apply and extend the analysis to consider interactions between individual human beings. Let us suppose that Crusoe eventually finds that another individual, say Jackson, has also been living an isolated existence at the other end of the island. What types of interaction may . now take place between them? One type of action is violence Thus, Crusoe may entertain a vigorous hatred toward Jackson and decide to murder or otherwise injure him. In that case, Cru- soe would gain his end—murder of Jackson—by committing violence. Or Crusoe may decide that he would like to expropri- ate Jackson’s house and collection of furs and murder Jackson as a means to that end. In either case, the result is that Crusoe gains in satisfaction at the expense of Jackson, who, to say the least, suffers great psychic loss. Fundamentally similar is action 79

145 Power and Market with Man, Economy, and State 80 . Thus, Crusoe may based on a , or intimidation threat of violence hold up Jackson at the point of a knife and rob him of his accu- violent mulated furs and provisions. Both examples are cases of and involve gain for one at the expense of another. action The following factors, singly or in combination, might work to induce Crusoe (or Jackson) to refrain from any violent action against the other: (1) He may feel that the use of violence against any other hu- man being is i.e., that refraining from violence against immoral, another person is an end in itself, whose rank in his value scale is higher than that of any advantages in the form of capital or con- sumers’ goods that he might gain from such action. (2) He may decide that instituting violent action might well establish an unwelcome precedent, causing the other person to take up arms against him, so that he may end by being the vic- tim instead of the victor. If he begins a type of action where one must gain at the expense of another, then he must face the fact he might turn out to be the loser as a result of the action. that (3) Even if he feels that his violent action eventually will result in victory over the other, he may conclude that the “costs of the war” would exceed his net gain from the victory. Thus, the dis- fighting the war utility of time and labor-energy spent in (war may be defined as violent action used by two or more oppo- for the war (capital goods for war nents), in accumulating weapons uses), etc., might, in prospect, outweigh the spoils of conquest. (4) Even if Crusoe feels reasonably certain of victory and be- lieves that the costs of fighting will be far less than the utility of his spoils of victory, this short-run gain may well be outweighed in his decision by long-run losses. Thus, his conquest of Jack- son’s furs and house may add to his satisfaction for a while after + the “period of production” (= preparing for the war the length of time of the war itself), but, after a time, his house will decay and his furs will become worthless. He may then conclude that, by his murder of Jackson, he has lost permanently many serv- ices which Jackson’s continued existence might have furnished.

146 Direct Exchange 81 This might be companionship or other types of consumers’ or capital goods. Jackson might have served Crusoe without How resort to violence will be indicated below, but, at any rate, Cru- soe may be detained from using violence by estimating the disu- tility of the long-run consequences more highly than the utility of the expected short-run gains. On the other hand, his time preference may be so high as to cause his short-run gains to override the long-run losses in his decision. It is possible that Crusoe may institute violent action with- out taking into consideration the costs of the war or the long- run consequences, in which case his actions will turn out to be erroneous, i.e., the means he used were not the appropriate ones to maximize his psychic revenue. Instead of murdering his opponent, Crusoe might find it enslave more useful to him, and, under continual threat of vio- lence, to force Jackson to agree to expend his labor for the sat- 1 isfaction of Crusoe’s wants rather than his own. , Under slavery the master treats the slaves as he does his livestock, horses, and other animals, using them as factors of production to gratify his wants, and feeding, housing them, etc., just enough to enable them to continue in the master’s service. It is true that the slave agrees to this arrangement, but this agreement is the result of a choice between working for the master and injury through vio- lence. Labor under these conditions is qualitatively different from labor not under the threat of violence, and may be called or voluntary labor . If compulsory labor as compared to free labor Jackson agrees to continue working as a slave under Crusoe’s not dictates, it does mean that Jackson is an enthusiastic advo- cate of his own slavery. It simply means that Jackson does not believe that revolt against his master will better his condition, of the revolt in terms of possible violence because of the costs inflicted on him, the labor of preparing and fighting, etc. 1 For a discussion of the transformation from murder to slavery, cf. Franz Oppenheimer, The State (New York: Vanguard Press, 1914, reprinted 1928), pp. 55–70 and passim .

147 Power and Market with Man, Economy, and State 82 The argument that the slave might be an enthusiastic sup- porter of the system because of the food, etc., provided by his master ignores the fact that, in that case, violence and the threat of violence by the master would not be necessary. Jackson would simply voluntarily place himself in Crusoe’s service, and this arrangement would not be slavery, but another type considered 2,3 in the next section. It is clear that the slave is always worse off than he would be without the threat of violence by the master, and therefore, that the master always gains at the expense of the slave. hege- The interpersonal relation under slavery is known as 4 monic. The relationship is one of command and obedience, the commands being enforced by threats of violence. The master uses the slaves as instruments, as factors of production, for gratifying his wants. Thus, slavery, or hegemony, is defined as a system in which one must labor under the orders of another under the threat of violence. Under hegemony, the man who does the obeying—the “slave,” “serf,” “ward,” or “subject”— makes only one choice among two alternatives: (1) to subject himself to the master or “dictator”; or (2) to revolt against the regime of violence by use of his own violence or by refusing to obey orders. If he chooses the first course, he submits himself to 2 It is true that man, being what he is, cannot absolutely guarantee life- long service to another under a voluntary arrangement. Thus, Jackson, at present, might agree to labor under Crusoe’s direction for life, in return for food, clothing, etc., but he cannot guarantee that he will not change his mind at some point in the future and decide to leave. In this sense, a man’s own person and will is “inalienable,” i.e., cannot be given up to someone else for any future period. 3 Such an arrangement is not a guarantee of “security” of provisions, since no one can guarantee a steady supply of such goods. It simply means believes that B is better able to furnish a supply of these goods than that A he is himself. 4 Cf. Mises, Human Action , pp. 196–99, and, for a comparison of slaves and animals, ibid ., pp. 624–30.

148 Direct Exchange 83 the hegemonic ruler, and all the other decisions and actions are made by that ruler. The subject chooses in choosing to once obey the ruler; the other choices are made by the ruler. The subject acts as a passive factor of production for use by the mas- ter. After that one act of (continual) choice made by the slave, he engages in coerced or compulsory labor, and the dictator alone is free to choose and act. Violent action may result in the following developments: ( ) a inconclusive fighting, with neither opponent the victor, in which case the war may continue intermittently for a long be estab- period of time, or violent action may cease and peace b lished (the absence of war); ( ) the victor may kill the victim, in which case there is no further interpersonal action between the c two; ( ) the victor may simply rob the victim and leave, to return ) d to isolation, or perhaps with intermittent violent forays; or ( the victor may establish a continuing hegemonic tyranny over the victim by threats of violence. In course ( a ), the violent action has proved abortive and er- ), there is no further interpersonal interaction; in roneous; in ( b ), there is an alternation between robbery and isolation; and in c ( d ), a continuing hegemonic bond is established. ( Of these results, only in ( ) has a continuing pattern of inter- d personal relationship been constituted. These relations are compulsory, involving the following coerced “exchanges”: the slaves are treated as factors of production in exchange for food and other provisions; the masters acquire factors of production in exchange for supplying the provisions. Any continuing pat- , and it is clear tern of interpersonal exchanges is called a society 5 d that a society has been established only in case ( ). In the case of Crusoe’s enslavement of Jackson, the society established is a totally hegemonic one. 5 There is, of course, no judgment at this point concerning whether the establishment of a society or such a society is a good, bad, or indif- ferent development.

149 with Power and Market 84 Man, Economy, and State The term “society,” then, denotes a pattern of interpersonal exchanges among human beings. It is obviously absurd to treat “society” as “real,” with some independent force of its own. There is no reality to society apart from the individuals who compose it and whose actions determine the type of social pat- tern that will be established. We have seen in chapter 1 that all action is an exchange, and autis- we may now divide exchanges into two categories. One is Autistic exchange consists of any exchange that tic exchange. does not involve some form of interpersonal exchange of serv- ices. Thus, all of isolated Crusoe’s exchanges were autistic. On the other hand, the case of slavery did involve interpersonal in which each gives up some goods in order to acquire exchange, other goods from the other. In this form of compulsory exchange, however, only the ruler benefits from the exchange, since he is the only one who makes it of his own free choice. Since he must impose the threat of violence in order to induce the subject to make the exchange, it is clear that the latter loses by the exchange. The master uses the subject as a factor of pro- duction for his own profit at the latter’s expense, and this hege- monic relationship may be called . Under hegemonic exploitation 6 exchange, the ruler exploits the subject for the ruler’s benefit. 2. Types of Interpersonal Action: 7 Voluntary Exchange and the Contractual Society From this point on, we shall develop an analysis of the work- un- ings of a society based purely on voluntary action, entirely by violence or threats of violence. We shall examine hampered 6 This system has sometimes been called “compulsory co-operation,” but we prefer to limit the term “co-operation” to the result of voluntary choices. 7 For an analysis of exchange, see Menger, Principles of Economics , pp. 175–90. For a vivid discussion of exchange, see Frédéric Bastiat, Har- monies of Political Economy (Santa Ana, Calif.: The Register Publishing Co., 1944), I, 96–130.

150 85 Direct Exchange interpersonal actions that are purely voluntary, and have no trace of hegemonic relations. Then, after working out the laws of the we shall trace the nature and results of hege- unhampered market, monic relations—of actions based on violence or the threat of violence. We shall note the various effects of violent interference with voluntary actions and shall consider the consequences of approaches to a regime of total hegemony, of pure slavery or sub- jection. At present, we shall confine our discussion to an analysis of actions unhampered by the existence of violence of man against man. The major form of voluntary interaction is voluntary inter- personal exchange. A gives up a good to B in exchange for a good that B gives up to A. The essence of the exchange is that both people make it because they expect that it will benefit them; oth- erwise they would not have agreed to the exchange. A necessary con- two goods have dition for an exchange to take place is that the reverse valuations on the respective value scales of the two parties to Thus, suppose A and B are the two exchangers, and the exchange. A gives B good X in exchange for good Y . In order for this exchange to take place, the following must have been their value scales before making the exchange: A B ) 1—(Good X ) Y 1—(Good 2—Good X 2—Good Y (Parentheses around the good indicate that the party does not have it in his stock; absence of parentheses indicates that he , and B possesses good Y , and each eval- has.) A possesses good X uates the good of the other more highly than his own. After the exchange is made, both A and B have shifted to a higher posi- tion on their respective value scales. Thus, the conditions for an exchange to take place are that the goods are valued in reverse order by the two parties and that each of the parties knows of the existence of the other and the goods that he possesses. Without knowledge of the other per- son’s assets, no exchange of these assets could take place.

151 with Power and Market 86 Man, Economy, and State It is clear that the things that must be exchanged are goods , which will be useful to the receiving party. The goods may be present or future goods (or claims to future goods, which may be considered as equivalent to future goods), they may be capi- tal goods or consumers’ goods, labor or nature-given factors. At scarce means to any rate, the objects of an exchange must be human ends, since, if they were available in abundance for all, they would be general conditions of human welfare and not objects of human action. If something were a general condition of human welfare, there would be no need to give something up to acquire it, and it would not become the object of exchange. If the goods in question are unique goods with a supply of one unit, then the problem of when exchanges will or will not be made is a simple one. If A has a vase and B a typewriter, if each knows of the other’s asset, and if A values the typewriter more highly, and B values the vase more highly, there will be an A or B values whatever exchange. If, on the other hand, either he has more highly than what the other has, then an exchange will not take place. Similarly, an exchange will not take place if either party has no knowledge that the other party has a vase or a typewriter. supplies of On the other hand, if the goods are available in homogeneous units, the problem becomes more complex. Here, in determining how far exchanges of the two goods will 8 go, the law of marginal utility becomes the decisive factor. If Jones and Smith have certain quantities of units of goods X and Y of in their possession, then in order for Jones to trade one unit X Y , the following conditions have to be met: To for one unit of must be Y Jones, the marginal utility of the added unit of X greater than the marginal utility of the unit of given up; and 8 Strictly, the law of marginal utility is also applicable to the case where the supply is only one unit, and we can say that, in the example above, exchange will take place if, for A, the marginal utility of good Y is greater than the marginal utility of good X , and vice versa for B.

152 Direct Exchange 87 must be X to Smith, the marginal utility of the added unit of Y greater than the marginal utility of the unit of given up. Thus: (The marginal utilities of the goods to Jones and to Smith are, of course, not comparable, since they cannot be measured, and the two value scales cannot be reduced to one measure or scale.) However, as Jones continues to exchange with Smith units of Y X to Jones increases, , the marginal utility of for units of X because of the law of marginal utility. Furthermore, the mar- ginal utility of the added unit of Y continues to decrease as increases, because of the operation of this law. Y Jones’ stock of Eventually, therefore, Jones will reach a point where, in any fur- X ther exchange of for Y , the marginal utility of X will be greater , so that he will than the marginal utility of the added unit of Y make no further exchange. Furthermore, Smith is in a similar for X position. As he continues to exchange Y , for him the mar- ginal utility of Y increases, and the marginal utility of the added decreases, with the operation of the law of marginal unit of X utility. He too will eventually reach a point where a further exchange will lower rather than raise his position on his value scale, so that he will decline to make any further exchange. Since it takes two to make a bargain, Jones and Smith will exchange for units of reaches a point beyond Y until one of them X units of which further exchange will lead to loss rather than profit. Thus, suppose that Jones begins with a position where his consist of a supply of five horses and zero assets (stock of goods) cows, while Smith begins with assets of five cows and zero horses. How much, if any, exchanges of one cow for one horse

153 Power and Market with 88 Man, Economy, and State will be effected is reflected in the value scales of the two people. Thus, suppose that Jones’ value diagram is as shown in Figure 5. The dots represent the value of the marginal utility of each addi- tional cow, as Jones makes exchanges of one horse for one cow. The crosses represent the increasing marginal utility of each horse given up as Jones makes exchanges. Jones will stop trad- ing after the third exchange, when his assets consist of two horses and three cows, since a further such exchange will make him worse off. On the other hand, suppose that Smith’s value diagram appears as in Figure 6. The dots represent the marginal utility to Smith of each additional horse, while the crosses represent the marginal utility of each cow given up. Smith will stop trad- ing after two exchanges, and therefore Jones will have to stop after two exchanges also. They will end with Jones having a stock of three horses and two cows, and Smith with a stock of three cows and two horses. It is almost impossible to overestimate the importance of ex- change in a developed economic system. Interpersonal exchanges have an enormous influence on productive activities. Their exist- ence means that goods and units of goods have not only direct use-value for the producer, but also exchange-value. In other words, goods may now be exchanged for other goods of greater usefulness to the actor. A man will exchange a unit of a good so

154 Direct Exchange 89 long as the goods that it can command in exchange have greater value to him than the value it had in direct use, i.e., so long as its exchange-value is greater than its direct use-value. In the example above, the first two horses that Jones exchanged and the first two cows surrendered by Smith had a greater exchange value than direct use-value to their owners. On the other hand, from then on, their respective assets had greater use-value to 9 their owners than exchange-value. The existence and possibilities of exchange open up for pro- ducers the avenue of producing for a “market” rather than for themselves. Instead of attempting to maximize his product in isolation by producing goods solely for his own use, each per- son can now produce goods in anticipation of their exchange- value, and exchange these goods for others that are more valu- able to him. It is evident that since this opens a new avenue for the utility of goods, it becomes possible for each person to increase his productivity. Through praxeology, therefore, we know that only gains can come to every participant in exchange and that each must benefit by the transaction; otherwise he would not engage in it. Empirically we know that the exchange economy has made possible an enormous increase in productiv- ity and satisfactions for all the participants. Thus, any person can produce goods either for his own direct use or for purposes of exchange with others for goods is the he that he desires. In the former case, consumer of his own other product; in the latter case, he produces in the service of i.e., he “produces for a market.” In either case, it is consumers, clear that, on the unhampered “market,” it is the consumers who dictate the course of production. At any time, a good or a unit of a good may have for its pos- sessor either direct use-value or exchange-value or a mixture of both, and whichever is the greater is the determinant of his 9 On use-value and exchange-value, see Menger, Principles of Economics , pp. 226–35.

155 Power and Market with Man, Economy, and State 90 action. Examples of goods with only direct use-value to their owner are those in an isolated economy or such goods as eye- glasses ground to an individual prescription. On the other hand, producers of such eyeglasses or of surgical instruments find no direct use-value in these products, but only exchange-value. Many goods, as in the foregoing example of exchange, have both direct and exchange-value for their owners. For the latter goods, changing conditions may cause direct use-value to replace exchange-value in the actor’s hierarchy of values, or vice . Thus, if a person with a stock of wine happens to lose his versa taste for wine, the previous greater use-value that wine had for him will change, and the wine’s exchange-value will take prece- dence over its use-value, which has now become almost nil. Similarly, a grown person may exchange the toys that he had used as a child, now that their use-value has greatly declined. On the other hand, the exchange-value of goods may decline, causing their possessors to use them directly rather than exchange them. Thus, a milliner might make a hat for pur- poses of exchange, but some minor defect might cause its expected exchange value to dwindle, so that the milliner decides to wear the hat herself. One of the most important factors causing a change in the relationship between direct use-value and exchange-value is an increase in the number of units of a supply available. From the law of marginal utility we know that an increase in the supply of a good available decreases the marginal utility of the supply for direct use. Therefore, the more units of supply are available, the more likely will the exchange-value of the marginal unit be greater than its value in direct use, and the more likely will its owner be to exchange it. The more horses that Jones had in his stock, and the more cows Smith had, the more eager would they be to exchange them. Conversely, a decrease in supply will in- crease the likelihood that direct use-value will predominate. The network of voluntary interpersonal exchanges forms a society; it also forms a pattern of interrelations known as the unhampered . A society formed solely by the market has an market

156 91 Direct Exchange free market, a market not burdened by the interfer- market , or a ence of violent action. A society based on voluntary exchanges contractual society. In contrast to the hegemonic soci- is called a ety based on the rule of violence, the contractual type of society is based on freely entered contractual relations between indi- viduals. Agreements by individuals to make exchanges are called contracts , and a society based on voluntary contractual agree- ments is a contractual society. It is the society of the un- hampered market. In a contractual society, each individual benefits by the ex- change-contract that he makes. Each individual is an actor free to make his own decisions at every step of the way. Thus, the relations among people in an unhampered market are “symmet- rical”; there is equality in the sense that each person has equal power to make his own exchange-decisions. This is in contrast to a hegemonic relationship, where power is asymmetrical— where the dictator makes all the decisions for his subjects except the one decision to obey, as it were, at bayonet point. Thus, the distinguishing features of the contractual society, of the unhampered market, are self-responsibility, freedom from violence, full power to make one’s own decisions (except the decision to institute violence against another), and benefits for all participating individuals. The distinguishing features of a hegemonic society are the rule of violence, the surrender of the power to make one’s own decisions to a dictator, and exploita- tion of subjects for the benefit of the masters. It will be seen below that existing societies may be totally hegemonic, totally contractual, or various mixtures of different degrees of the two, and the nature and consequences of these various “mixed economies” and totally hegemonic societies will be analyzed. Before we examine the exchange process further, it must be considered that, in order for a person to exchange anything, he it. He gives up the ownership must first possess it, or own of good in order to obtain the ownership of good Y. Ownership by one X or more owners implies exclusive control and use of the goods

157 with Power and Market 92 Man, Economy, and State owned, and the goods owned are known as property . Freedom from violence implies that no one may seize the property of an- other by means of violence or the threat of violence and that each person’s property is safe, or “secure,” from such aggression. What goods become property? Obviously, only scarce means are property. General conditions of welfare, since they are abundant to all, are not the objects of any action, and therefore cannot be owned or become property. On the free market, it is nonsense to say that someone “owns” the air. Only if a good is scarce is it necessary for anyone to obtain it, or ownership of it, for his use. The only way that a man could assume ownership of the air is to use violence to enforce this claim. Such action could not occur on the unhampered market. On the free, unhampered market, a man can acquire prop- each man has erty in scarce goods as follows: (1) In the first place, ownership over his own self, over his will and actions, and the man- ner in which he will exert his own labor. (2) He acquires scarce nature-given factors either by appropriating hitherto unused factors for his own use or by receiving them as a gift from some- one else, who in the last analysis must have appropriated them 10 (3) He acquires capital goods or as hitherto unused factors. consumers’ goods either by mixing his own labor with nature- given factors to produce them or by receiving them as a gift from someone else. As in the previous case, gifts must eventu- ally resolve themselves into some actor’s production of the goods by the use of his own labor. Clearly, it will be nature- durable given factors, capital goods, and consumers’ goods that are likely to be handed down through gifts, since nondurable consumers’ goods will probably be quickly consumed. (4) He may any type of factor (labor service, nature-given fac- exchange tor, capital good, consumers’ good) for any type of factor. It is 10 Analytically, receiving a factor from someone as a gift simply pushes the problem back another stage. At some point, the actor must have appropriated it from the realm of unused factors, as Crusoe appropriated the unused land on the island.

158 93 Direct Exchange clear that gifts and exchanges as a source of property must even- tually be resolved into: self-ownership, appropriation of unused and nature-given factors, production of capital and consumers’ goods, as the ultimate sources of acquiring property in a free economic system. In order for the giving or exchanging of goods to take place, they must first be obtained by individual actors in one of these ways. The logical sequence of events is therefore: A man owns himself; he appropriates unused nature-given factors for his ownership; he uses these factors to produce capital goods and consumers’ goods which become his own; he uses up the consumers’ goods and/or gives them and the capital goods away to others; he exchanges some of these goods for other goods 11,12 that had come to be owned in the same way by others. These are the methods of acquiring goods that obtain on the free market, and they include all but the method of violent or 13 other invasive expropriation of the property of others. 11 On self-ownership and the acquisition of property, cf. the classic discussion of John Locke, “An Essay Concerning the True Original Extent and End of Civil Government, Second Treatise” in Ernest Barker, ed., (London: Oxford University Press, 1948), pp. 15–30. Social Contract 12 The problem of self-ownership is complicated by the question of children . Children cannot be considered self-owners, because they are not yet in possession of the powers of reason necessary to direct their actions. The fact that children are under the hegemonic authority of their parents until they are old enough to become self-owning beings is therefore not contrary to our assumption of a purely free market. Since children are not capable of self-ownership, authority over them will rest in some individ- uals; on an unhampered market, it would rest in their producers , the par- ents. On the other hand, the property of the parents in this unique case is not exclusive; the parents may not injure the children at will. Children, not long after birth, begin to acquire the powers of reasoning human beings and embody the potential development of full self-owners. There- fore the child will, on the free market, be defended from violent actions in the same way as an adult. On children, see ibid ., pp. 30–38. 13 For more on invasive and noninvasive acts in a free market, see sec- tion 13 below.

159 Power and Market with Man, Economy, and State 94 In contrast to general conditions of welfare, which on the free market cannot be subject to appropriation as property, some- scarce goods in use in production must always be under control, and therefore must always be one’s property . On the free market, the goods will be owned by those who either produced them, first put them to use, or received them in gifts. Similarly, under a system of violence and hegemonic bonds, someone or some people must superintend and direct the operations of these goods. Whoever performs these functions in effect owns these goods as property, regardless of the legal definition of ownership. This applies to persons and their services as well as to material goods. On the free market, each person is a com- plete owner of himself, whereas under a system of full hege- monic bonds, he is subject to the ownership of others, with the exception of the one decision not to revolt against the authority of the owner. Thus, violent or hegemonic regimes do not and property, which derives from the fundamentals of cannot abolish human action, but can only transfer it from one person or set of people (the producers or natural self-owners) to another set. We may now briefly sum up the various types of human action in the following table: A H UMAN CTION I. Isolation (Autistic Exchange) II. Interpersonal Action A. Invasive Action 1. War 2. Murder, Assault 3. Robbery 4. Slavery B. Noninvasive Action 1. Gifts 2. Voluntary Exchange This and subsequent chapters are devoted to an analysis of a noninvasive society, particularly that constituted by voluntary interpersonal exchange.

160 Direct Exchange 95 3. Exchange and the Division of Labor In describing the conditions that must obtain for interper- sonal exchange to take place (such as reverse valuations), we im- that are being plicitly assumed that it must be two different goods exchanged. If Crusoe at his end of the island produced only berries, and Jackson at his end produced only the same kind of berries, then no basis for exchange between them would occur. If Jackson produced 200 berries and Crusoe 150 berries, it would be nonsensical to assume that any exchange of berries would be 14 The only voluntary interpersonal action made between them. in relation to berries that could occur would be a gift from one to another. If exchangers must exchange two different goods, this implies that each party must have a different proportion of assets of goods in relation to his wants. He must have relatively in the acquisition of different goods from those the specialized other party produced. This specialization by each individual may have occurred for any one of three different reasons or any a ) differences in suitability and yield combination of the three: ( b ) differences in given capital and of the nature-given factors; ( ) differences in skill and in the durable consumers’ goods; and ( c 15 These factors, in addi- desirability of different types of labor. tion to the potential exchange-value and use-value of the goods, will determine the line of production that the actor will pursue. If the production is directed toward exchange, then the exchange-value will play a major role in his decision. Thus, Crusoe may have found abundant crops on his side of the island. These resources, added to his greater skill in farming and the lower disutility of this occupation for him because of a liking for 14 It is possible that Crusoe and Jackson, for the mutual fun of it, might pass 50 berries back and forth between them. This, however, would not be genuine exchange, but joint participation in an enjoyable con- sumers’ good—a game or play. 15 Basically, class ( b ) is resolvable into differences in classes ( a ) and ( c ) , which account for their production.

161 Power and Market with Man, Economy, and State 96 agriculture, might cause him to take up farming, while Jackson’s greater skill in hunting and more abundant game supply induce him to specialize in hunting and trapping. Exchange, a produc- tive process for both participants, implies specialization of pro- division of labor. duction, or The extent to which division of labor is carried on in a so- ciety depends on the extent of the market for the products. The lat- ter determines the exchange-value that the producer will be able to obtain for his goods. Thus, if Jackson knows that he will be able to exchange part of his catch of game for the grains and fruits of Crusoe, he may well expend all his labor on hunting. Then he will be able to devote all his labor-time to hunting, while Crusoe devotes his to farming, and their “surplus” stocks will be exchanged up to the limits analyzed in the previous sec- tion. On the other hand, if, for example, Crusoe has little use for meat, Jackson will not be able to exchange much meat, and he will be forced to be far more directly self-sufficient, produc- ing his own grains and fruits as well as meat. It is clear that, praxeologically, the very fact of exchange and the division of labor implies that it must be more productive for all concerned than isolated, autistic labor. Economic analysis alone, however, does not convey to us knowledge of the enor- mous increase in productivity that the division of labor brings to society. This is based on a further empirical insight, viz., the in human beings and in the world around enormous variety them. It is a fact that, superimposed on the basic unity of species and objects in nature, there is a great diversity. Particularly is there variety in the aforementioned factors that would give rise to specialization: in the locations and types of natural resources and in the ability, skills, and tastes of human beings. In the words of Professor von Mises: One may as well consider these two facts as one and the same fact, namely, the manifoldness of nature which makes the universe a complex of infinite vari- eties. If the earth’s surface were such that the physical conditions of production were the same at every

162 Direct Exchange 97 point and if one man were . . . equal to all other men . . . division of labor would not offer any advantages 16 for acting man. It is clear that conditions for exchange, and therefore where increased productivity for the participants, will occur each party has a superiority in productivity in regard to one of the —a superiority that may be due either to better goods exchanged nature-given factors or to the ability of the producer. If indi- viduals abandon attempts to satisfy their wants in isolation, and if each devotes his working time to that specialty in which he excels, it is clear that total productivity for each of the products is increased. If Crusoe can produce more berries per unit of time, and Jackson can kill more game, it is clear that productiv- ity in both lines is increased if Crusoe devotes himself wholly to the production of berries and Jackson to hunting game, after which they can exchange some of the berries for some of the game. In addition to this, full-time specialization in a line of production is likely to improve each person’s productivity in that line and intensify the relative superiority of each. More puzzling is the case in which one individual is superior to another in all lines of production. Suppose, for example, that Crusoe is superior to Jackson both in the production of berries and in the production of game. Are there any possibilities for exchange in this situation? Superficially, it might be answered that there are none, and that both will continue in isolation. Actually, it pays for Crusoe to specialize in that line of produc- tion in which he has the greatest superiority in produc- relative tion, and to exchange this product for the product in which Jackson specializes. It is clear that the inferior producer benefits by receiving some of the products of the superior one. The lat- ter benefits also, however, by being free to devote himself to 16 Mises, Human Action , pp. 157 ff. On the pervasiveness of variation, also cf. F.A. Harper, Liberty, A Path to Its Recovery (Irvington-on-Hud- son, N.Y.: Foundation for Economic Education, 1949), pp. 65–77, 139–41.

163 with Power and Market 98 Man, Economy, and State that product in which his productive superiority is the greatest. Thus, if Crusoe has a great superiority in berry production and a small one in game production, it will still benefit him to devote his full working time to berry production and then exchange some berries for Jackson’s game products. In an exam- ple mentioned by Professor Boulding: A doctor who is an excellent gardener may very well prefer to employ a hired man who as a gardener is inferior to himself, because thereby he can devote 17 more time to his medical practice. This important principle—that exchange may beneficially take place even when one party is superior in both lines of law of association , the law of compar- production—is known as the law of comparative advantage. or the ative costs, With all-pervasive variation offering possibilities for specialization, and favorable conditions of exchange occurring even when one party is superior in both pursuits, great oppor- tunities abound for widespread division of labor and extension of the market. As more and more people are linked together in the exchange network, the more “extended” is the market for each of the products, and the more will exchange-value pre- dominate, as compared to direct use-value, in the decisions of the producer. Thus, suppose that there are five people on the desert island, and each specializes in that line of product in which he has a comparative or absolute advantage. Suppose that each one concentrates on the following products: A . . . . . . . . . . . . . . . . . . berries B . . . . . . . . . . . . . . . . . . game C . . . . . . . . . . . . . . . . . . fish D . . . . . . . . . . . . . . . . . . eggs E . . . . . . . . . . . . . . . . . . milk 17 Kenneth E. Boulding, Economic Analysis (1st ed.; New York: Harper & Bros., 1941), p. 30; also ibid ., pp. 22–32.

164 99 Direct Exchange With more people participating in the market process, the opportunities for exchange for each actor are now greatly in- creased. This is true even though each particular act of exchange takes place between just two people and involves two goods. Thus, as shown in Figure 7, the following network of exchange may take place: Exchange-value now takes a far more dominant place in the decisions of the producers. Crusoe (if A is Crusoe) now knows that if he specializes in berries, he does not now have to rely solely on Jackson to accept them, but can exchange them for the products of several other people. A sud- den loss of taste for berries by Jackson will not impoverish Cru- soe and deprive him of all other necessities as it would have before. Furthermore, berries will now bring to Crusoe a wider variety of products, each in far greater abundance than before, some being available now that would not have been earlier. The greater productivity and the wider market and emphasis on exchange-value obtain for all participants in the market. It is evident, as will be explained further in later sections on indirect exchange, that the contractual society of the market is a genuinely co-operative society . Each person specializes in the task for which he is best fitted, and each serves his fellow men in order to serve himself in exchange. Each person, by produc- ing for exchange, co-operates with his fellow men voluntarily

165 with Power and Market 100 Man, Economy, and State and without coercion. In contrast to the hegemonic form of society, in which one person or one group of persons exploits the others, a contractual society leaves each person free to ben- efit himself in the market and as a consequence to benefit oth- ers as well. An interesting aspect of this praxeological truth is of that this benefit to others occurs regardless of the motives those involved in exchange. Thus, Jackson may specialize in hunting and exchange the game for other products even though he may be indifferent to, or even cordially detest, his fellow par- ticipants. Yet regardless of his motives, the other participants are benefitted by his actions as an indirect but necessary conse- quence of his own benefit. It is this almost marvelous process, whereby a man in pursuing his own benefit also benefits others, that caused Adam Smith to exclaim that it almost seemed that 18 an “invisible hand” was directing the proceedings. Thus, in explaining the origins of society, there is no need to conjure up any mystic communion or “sense of belonging” among individuals. Individuals recognize, through the use of reason, the advantages of exchange resulting from the higher productivity of the division of labor, and they proceed to follow this advantageous course. In fact, it is far more likely that feel- effects of a regime of ings of friendship and communion are the (contractual) social co-operation rather than the cause. Suppose, for example, that the division of labor were not productive, or that men had failed to recognize its productivity. In that case, there would be little or no opportunity for exchange, and each The independence. man would try to obtain his goods in autistic 18 Those critics of Adam Smith and other economists who accuse the latter of “assuming” that God or Nature directs the market process by an “invisible hand” for the benefit of all participants completely miss the mark. The fact that the market provides for the welfare of each individ- ual participating in it is a conclusion based on scientific analysis, not an assumption upon which the analysis is based. The “invisible hand” was simply a metaphor used in commenting on this process and its results. Cf. William D. Grampp, “Adam Smith and the Economic Man,” Journal of Political Economy, August, 1948, pp. 315–36, especially pp. 319–20.

166 101 Direct Exchange result would undoubtedly be a fierce struggle to gain possession of the scarce goods, since, in such a world, each man’s gain of useful goods would be some other man’s loss. It would be almost inevitable for such an autistic world to be strongly marked by violence and perpetual war. Since each man could gain from his fellows only at their expense, violence would be prevalent, and it seems highly likely that feelings of mutual hostility would be dominant. As in the case of animals quarreling over bones, such a warring world could cause only hatred and hostility between man and man. Life would be a bitter “struggle for survival.” On the other hand, in a world of voluntary social co-operation through mutually beneficial exchanges, where one man’s gain is another man’s gain , it is obvious that great scope is provided for the development of social sympathy and human friendships. It is the peaceful, co-operative society that creates favorable con- ditions for feelings of friendship among men. The mutual benefits yielded by exchange provide a major incentive (as in the case of Crusoe above) to would-be aggressors (initiators of violent action against others) to restrain their ag- gression and co-operate peacefully with their fellows. Individu- als then decide that the advantages of engaging in specialization and exchange outweigh the advantages that war might bring. Another feature of the market society formed by the division of labor is its permanence. The wants of men are renewed for each period of time, and so they must try to obtain for them- selves anew a supply of goods for each period. Crusoe wants to have a steady rate of supply of game, and Jackson would like to have a continuing supply of berries, etc. Therefore, the social relations formed by the division of labor tend to be permanent as individuals specialize in different tasks and continue to pro- duce in those fields. There is one, less important, type of exchange that does not same types involve the division of labor. This is an exchange of the of labor for certain tasks. Thus, suppose that Crusoe, Jackson, and Smith are trying to clear their fields of logs. If each one engaged solely in the work of clearing his own field, it would

167 with Power and Market 102 Man, Economy, and State take a long period of time. However, if each put in some time in a joint effort to roll the other fellow’s logs, the productivity of the log-rolling operations would be greatly increased. Each man could finish the task in a shorter period of time. This is particularly true for operations such as rolling heavy logs, which each man alone could not possibly accomplish at all and which they could perform only by agreed-upon joint action. In these cases, each man gives up his own labor in someone else’s field in exchange for receiving the labor of the others in his field, the latter being worth more to him. Such an exchange involves a of the same type of labor, rather than a division of combination labor into different types, to perform tasks beyond the ready capacity of an isolated individual. This type of co-operative “log-rolling,” however, would entail merely temporary alliances based on specific tasks, and, would not, as do specialization and division of labor, establish permanent exchange-ties and social 19 relations. The great scope of the division of labor is not restricted to situations in which each individual makes all of one particular product, as was the case above. Division of labor may entail the specializing by individuals in the different stages of production necessary to produce a particular consumers’ good. Thus, with a wider market permitting, different individuals specialize in the different stages, for example, involved in the production of the ham sandwich discussed in the previous chapter. General pro- ductivity is greatly increased as some people and some areas specialize in producing iron ore, some in producing different types of machines, some in baking bread, some in packaging meat, some in retailing, etc. The essence of developed market economies consists in the framework of co-operative exchange 20 emerging with such specialization. 19 See Mises, Human Action , pp. 157–58. 20 Such specialization of stages requires the adoption of indirect exchange, discussed in the following chapters.

168 Direct Exchange 103 4. Terms of Exchange Before analyzing the problem of the terms of exchange, it is well to recall the reason for exchange—the fact that each individual values more highly the good he gets than the good he gives up. This fact is enough to eliminate the fallacious notion that, if Crusoe and Jackson exchange 5,000 berries for one cow, there is some sort of “equality of value” between the cow and the 5,000 berries. Value exists in the valuing minds of individuals, and these individuals make the exchange precisely because for each of them there is an of values between the cow and inequality the berries. For Crusoe the cow is valued more than the 5,000 berries; for Jackson it is valued less. Otherwise, the exchange dou- could not be made. Therefore, for each exchange there is a rather than an equality, and hence there ble inequality of values, 21 are no “equal values” to be “measured” in any way. We have already seen what conditions are needed for exchange to occur and the extent to which exchange will take place on given terms. The question then arises: Are there any on which exchanges are made? terms principles that decide the Why does Crusoe exchange with Jackson at a rate of 5,000 berries for one cow, or 2,000 berries for one cow? Let us take the hypothetical exchange of 5,000 berries for (5,000 one cow. These are the terms, or the rate of exchange berries for one cow). If we express one commodity in terms of price of the commodity. Thus, the other, we obtain the the price of one good in terms of another is the amount of the other good divided . If two cows exchange by the amount of the first good in exchange for 1,000 berries, then the price of cows in terms of berries (“the berry-price of cows”) is 500 berries per cow. Conversely, the price of berries in terms of cows (“the cow-price of berries”) is 1 pric e is the rate of exchange between cow per berry. The /5 0 0 two commodities expressed in terms of one of the commodities. 21 Cf. Mises, Human Action , pp. 204–06; and Menger, Principles of Economics , pp. 192–94, 305–06.

169 Power and Market with Man, Economy, and State 104 Other useful concepts in the analysis of exchange are those of “selling” and “buying.” Thus, in the above exchange, we may bought sold two cows in say that Crusoe 1,000 berries and exchange. On the other hand, Jackson bought two cows and sold sale is the good given up in exchange, while 1,000 berries. The the is the good received. purchase Let us again focus attention on the object of exchange. We maxi- remember from chapter 1 that the object of all action is to , and to do this the actor tries to see to it that mize psychic revenue the psychic revenue from the action exceeds the psychic cost, so that he obtains a psychic profit. This is no less true of inter- personal exchange. The object in such an exchange for each party is to maximize revenue, to exchange so long as the expected psy- chic revenue exceeds the psychic cost. The psychic revenue from any exchange is the value of the goods received in the exchange. This is equal to the marginal utility to the purchaser of adding the goods to his stock. More complicated is the problem of the psy- include all that the actor chic costs of an exchange. Psychic costs gives up by making the exchange. This is equal to the next best use that he could have made of the resources that he has used. Suppose, for example, that Jackson possesses five cows and is considering whether or not to sell one cow in exchange. He de- cides on his value scale that the following is the rank in value of the possible uses of the cow: 1. 5,000 berries offered by Crusoe 2. 100 bbls. of fish offered by Smith 3. 4,000 berries offered by Jones 4. Marginal utility of the cow in direct use In this case, the top three alternatives involve the exchange- value of the cow, the fourth its value in direct use. Jackson will make the best use of his resource by making the exchange with Crusoe. The 5,000 berries of Crusoe will be his psychic rev- enue from the exchange, while the loss of the 100 barrels of fish constitutes his psychic cost. We saw above that, in order for

170 105 Direct Exchange exchange to take place, the marginal utility of the goods received must be greater than the marginal utility of the goods specific exchange to occur, the given up. We now see that for any marginal utility of the goods received must also be greater than the marginal utility forgone—that which could have been received in another type of exchange. It is evident that Jackson will always prefer an offer of more units of one type of good to an offer of fewer units of the same good. In other words, the seller will always prefer the highest pos- Jackson will prefer the price of 5,000 sible selling price for his good. berries per cow offered by Crusoe to the price of 4,000 berries per cow offered by Jones. It might be objected that this may not always be true and may be offset by other factors. Thus, the prospect of 4,000 berries from Jones may be evaluated higher ) the psychic than the prospect of 5,000 berries from Crusoe, if: ( a disutility of labor and time, etc., for delivery over a longer dis- tance to the latter renders the prospect of sale to Crusoe less attractive despite the higher price in berries; or ( b ) special feel- ings of friendship for Crusoe or hatred for Jones serve to change the utilities on Jackson’s value scale. On further analysis, how- ever, these turn out not to be vitiating factors at all. The rule that the actor will prefer the highest selling price for his good in terms of the other good always holds. It must be reiterated that is not defined by its physical characteristics, but by the good a equal serviceability of its units to the actor. Now, clearly, a berry from a longer distance, since it must call forth the disutility of the same good as the berry from a shorter not labor to move it, is distance, even though it is physically the same berry. The very fact that the first is further away means that it is not as servicea- ble as the other berry, and hence not the same good. For one “price” to be comparable with another, the good must be the 4,000 berries same. Thus, if Jackson prefers to sell his cow for from Jones as compared to 5,000 berries from Crusoe, it does not mean that he chooses a lower price for his product in terms of the same good (berries), but that he chooses a price in terms of one good (berries from Jones) over a price in terms of an

171 with Power and Market 106 Man, Economy, and State entirely different good (berries from Crusoe). Similarly, if, because of feelings of friendship or hostility, receiving berries from Crusoe takes on a different quality from that of receiving berries from Jones, the two packets of berries are no longer of equal serviceability to Jackson, and therefore they become for two different goods. If these feelings cause him to sell to Jones him for 4,000 berries rather than to Crusoe for 5,000 berries, this does not mean that he chooses a lower price for the same good; he chooses between two different goods—berries from Crusoe and berries from Jones. Thus, at all times, an actor will sell his prod- uct at the highest possible price in terms of the good received. Clearly, the converse is true for the buyer. The buyer will al- This truth can be ways purchase his good at the lowest possible price. traced in the example just discussed, since, at the point that Jackson was a seller of the cow, he was also a buyer of the berries. Where the good in question—berries—was comparable, he 1 bought at the lowest possible price—say cow per berry in /5,000 1 preference to cow per berry. In cases where Jackson /4,000 chooses the latter price, the two berries are no longer the same, but different, goods. If, to buy berries, the purchaser has to range further afield or buy from someone he dislikes, then this good becomes a different one in kind from the good closer by or sold by a friend. 22 5. Determination of Price: Equilibrium Price One of the most important problems in economic analysis is the question: What principles determine the formation of prices on the free market? What can be said by logical derivation from the fundamental assumption of human action in order to explain the determination of all prices in interpersonal exchanges, past, present, and future? 22 Cf. Böhm-Bawerk, Positive Theory of Capital , pp. 195–222. Also cf. Fetter, Economic Principles , pp. 42–72; and Menger, Principles of Economics , pp. 191–97.

172 107 Direct Exchange It is most convenient to begin with a case of isolated exchange, a case where only two isolated parties are involved in the ex- change of two goods. For example, Johnson and Smith are con- sidering a possible exchange of a horse of the former for some barrels of fish possessed by the latter. The question is: What can economic analysis say about the determinants of the exchange rate established between the two goods in the exchange? An individual will decide whether or not to make an exchange on the basis of the relative positions of the two goods on his value scale. Thus, suppose the value scale of Smith, the possessor of the fish, is as follows: (Any desired numbers of rank could be assigned to the various quantities, but these are not necessary here.) It is clear that Smith would be willing to acquire a horse from Johnson if he could give up 100 barrels of fish or less. One hundred barrels or less are less valuable to Smith than the horse. On the other hand, 101 or more barrels of fish are more valu- of the horse in able to him than the horse. Thus, if the price terms of the fish offered by Smith is , then 100 barrels or less Smith will make the exchange. If the price is 101 barrels or more, then the exchange will not be made.

173 with Power and Market 108 Man, Economy, and State Suppose Johnson’s value scale looks like this: Then, Johnson will not give up his horse for less than 102 barrels of fish. If the price offered for his horse is less than 102 barrels of fish, he will not make the exchange. Here, it is clear that no exchange will be made ; for at Johnson’s minimum selling price of 102 barrels of fish, it is more beneficial for Smith to keep the fish than to acquire the horse. In order for an exchange to be made, then, the minimum sell- ing price of the seller must be lower than the maximum buying price of the buyer for that good. In this case, it must be lower than the price of 100 barrels of fish per horse. Suppose that this condi- tion is met, and Johnson’s value scale is as follows:

174 Direct Exchange 109 Johnson will sell the horse for any amount of fish at or above 81 barrels. This, then, is his minimum selling price for the horse. With this as Johnson’s value scale, and Smith’s as pictured in Figure 8, what price will they agree upon for the horse (and, conversely, for the fish)? All analysis can say about this problem is that, since the exchange must be for the mutual benefit of both parties, the price of the good in isolated exchange will be established somewhere between the maximum buying price i.e., the price of the horse will be and the minimum selling price, somewhere between 100 barrels and 81 barrels of fish. (Simi- 1 /81 larly, the price of the fish will be set somewhere between 1 and of a horse per barrel.) We cannot say at which point /1 0 0 the price will be set. That depends on the data of each partic- ular case, on the specific conditions prevailing. In particular, it will depend upon the bargaining skill of the two individuals. Clearly, Johnson will try to set the price of the horse as high as possible, while Smith will try to set the price as low as pos- sible. This is based on the principle that the seller of the prod- uct tries to obtain the highest price, while the buyer tries to secure the lowest price. We cannot predict the point that the two will agree on, except that it will be somewhere in this 23 range set by the two points. Now, let us gradually remove our assumption of isolated ex- change. Let us first assume that Smith has a competitor, Brown, a rival in offering fish for the desired horse of Johnson’s. We assume that the fish offered by Brown is of identi cal service- ability to Johnson as the fish offered by Smith. Suppose that Smith’s value scale is the same as before, but that Brown’s value scale is such that the horse is worth more than 90 barrels of fish to him, but less than 91 barrels. The value scales of the three individuals will then appear as is shown in Figure 11. 23 Of course, given other value scales, the final prices might be deter- minate at our point, or within a narrow range. Thus, if Smith’s maximum buying price is 87, and Johnson’s minimum selling price is 87, the price will be uniquely determined at 87.

175 Power and Market with 110 Man, Economy, and State Brown and Smith are competing for the purchase of John- son’s horse. Clearly, only one of them can make the exchange for the horse, and since their goods are identical to Johnson, the lat- ter’s decision to exchange will be decided by the price offered for the horse. Obviously, Johnson will make the exchange with that potential buyer who will offer the highest price. Their value scales are such that Smith and Brown can continue to overbid each other as long as the price range is between 81 and 90 bar- rels of fish per horse. Thus, if Smith offers Johnson an exchange at 82 barrels per horse, Brown can compete by raising the bid to 84 barrels of fish per horse, etc. This can continue, however, only until Brown’s maximum buying price has been exceeded. If Smith offers 91 barrels for the horse, it no longer pays for Brown to make the exchange, and he drops out of the competition. Thus, the price in the exchange will be high enough to exclude the “less capable” or “less urgent” buyer—the one whose value scale does not permit him to offer as high a price as the other, “more capable,” buyer. We do not know exactly what the price will be, but we do know that it will be set by bargaining some- where at or below the maximum buying price of the most capable buyer and above the maximum buying price of the next most capable buyer. It will be somewhere between 100 barrels and 91 barrels, and the exchange will be made with Smith. We see that the addition of another competing buyer for the product considerably narrows the zone of bargaining in determining the price that will be set.

176 111 Direct Exchange This analysis can easily be extended to a case of one seller and n number of buyers (each offering the same commodity in ex- change). Thus, suppose that there are five potential buyers for the horse, all offering fish, whose value scales are as follows: With only one horse to be disposed of to one buyer, the buyers overbid each other until each must drop out of the competition. Finally, Smith can outbid A, his next most capable competitor, only with a price of 100. We see that in this case, the price in the exchange is uniquely determined—once the various value scales are given—at 100, since at a lower price A is still in the bidding, and, at a higher price, no buyer will be willing to conclude the exchange. At any rate, even if the value scales are not such as to determine the price uniquely, the addition of more competitors greatly narrows the bargaining zone. The general rule still holds: The price will be between the maximum buying price of the most capable and that of the next most capable competitor, 24 including the former and excluding the latter. It is also evident that the narrowing of the bargaining zone has taken place in an upward direction, and to the advantage of the seller of the product. The case of one-sided competition of many sellers with just one is the direct converse of the above and may be considered buyer by merely reversing the example and considering the price of ers of the the fish instead of the price of the horse. As more sell 24 Auction sales are examples of markets for one unit of a good with Economic Analysis one seller and many buyers. Cf. Boulding, , pp. 41–43.

177 Power and Market with Man, Economy, and State 112 fish competed to conclude the exchange with the one buyer, the zone of determination of the price of fish narrowed, although this time in a downward direction and to the further advantage of the buyer. As more sellers were added, each tried underbid his rival—to offer a lower price for the product to than his competitors. The sellers continued to underbid each other until all but the one seller were excluded from the mar- ket. In a case of many sellers and one buyer, the price will be set at a point between the minimum selling price of the second most capable and that of the most capable competitor —strictly, at a point below the former and down to or including the latter. In the final example above, the point was pushed down to be 1 uniquely determined at the latter point— horse per barrel. /100 We have so far considered the cases of one buyer and more than one seller, and of one seller and more than one buyer. We now come to the only case with great importance in a modern, complex economy based on an intricate network of exchanges: two-sided competition of buyers and sellers. Let us therefore con- sider a market with any number of competing buyers and sell- ers. Any product could be considered, but our hypothetical example will continue to be the sale of horses in exchange for fish (with the horses as well as the fish considered by all par- ties as homogeneous units of the same good). The following is a list of the maximum buying prices of the various buyers, based on the valuations on their respective value scales: Buyers of Horses Maximum Buying Price X1 . . . . . . . . . . . . . . . . . . . 100 barrels of fish X2 . . . . . . . . . . . . . . . . . . 98 X3 . . . . . . . . . . . . . . . . . . 95 X4 . . . . . . . . . . . . . . . . . . 91 X5 . . . . . . . . . . . . . . . . . . 89 X6 . . . . . . . . . . . . . . . . . . 88 X7 . . . . . . . . . . . . . . . . . . 86 X8 . . . . . . . . . . . . . . . . . . 85 X9 . . . . . . . . . . . . . . . . . . 83

178 113 Direct Exchange The following is a list of the minimum selling prices of the var- ious sellers on the market: Minimum Selling Prices Sellers of Horses Z1 . . . . . . . . . . . . . . . . . . . 81 barrels of fish Z2 . . . . . . . . . . . . . . . . . . 83 Z3 . . . . . . . . . . . . . . . . . . 85 Z4 . . . . . . . . . . . . . . . . . . 88 Z5 . . . . . . . . . . . . . . . . . . 89 Z6 . . . . . . . . . . . . . . . . . . 90 Z7 . . . . . . . . . . . . . . . . . . 92 Z8 . . . . . . . . . . . . . . . . . . 96 The “most capable buyer” of horses we recognize as Smith, with a buying price of 100 barrels. Johnson is the “most capable seller”— the seller with the lowest minimum selling price—at 81 barrels. The problem is to find the principle by which the price, or prices, of the exchanges of horses will be determined. Now, let us first take the case of X1—Smith. It is clear that it is to the advantage of Smith to make the exchange at a price of 100 barrels for the horse. Yet it is to Smith’s greater advan- tage to buy the good at the lowest possible price. He is not engaged in overbidding his competitors merely for the sake of overbidding. He will try to obtain the good for the lowest price that he can. Therefore, Smith will prefer to begin bidding for a horse at the lowest prices offered by his competitors, and only raise the offered price if it becomes necessary to do so in order to avoid being shut out of the market. Similarly, Johnson would make an advantageous sale at a price of 81 barrels. However, he is interested in selling his product at the highest possible price. He will underbid his competitor only if it becomes necessary to do so in order to avoid being shut out of the market without making a sale. It is evident that buyers will tend to start negotiations by offer- ing as low prices as possible, while sellers will tend to start by ask- ing for as high a price as they think they can obtain. Clearly, this

179 Power and Market with 114 Man, Economy, and State preliminary “testing of the market” will tend to be more pro- longed in a “new” market, where conditions are unfamiliar, while it will tend to be less prolonged in an “old” market, where the participants are relatively familiar with the results of the price- formation process in the past and can estimate more closely what the results will be. Let us suppose that buyers begin by offering the low price of 82 barrels for a horse. Here is a price at which each of the buy- ers would be glad to make a purchase, but only one seller, Z1, would be willing to sell at 82. It is possible that Z1, through ignorance, might conclude the exchange with some one of the buyers at 82, without realizing that he could have obtained a higher price. It is also possible that the other buyers will, through ignorance, permit the buyer to get away with this windfall without overbidding him for this cheap horse. But such a result is not very likely. It seems most likely that Z1 will not sell at such a low price, and that the buyers would immediately overbid any attempt by one of their number to conclude an exchange at that price. Even if, by some chance, one exchange was concluded at 82, it is obvious that such a price could not last. Since no other seller would make an exchange at that price, the price of further exchanges would have to rise further, as a result of upbidding by buyers. Let us assume at this point that no exchange will be made at this price because of the further upbidding of the buyers and the knowledge of this by the sellers. As the offering price rises, the least capable buyers, as in the previous case, begin to be ex- cluded from the market. A price of 84 will bring two sellers into the market, but will exclude X9 from the buyer’s side. As the offering price rises, the disproportion between the amount offered for sale and the amount demanded for purchase at the given price diminishes, but as long as the latter is greater than the for- mer, mutual overbidding of buyers will continue to raise the price. The amount offered for sale at each price is called the sup- ply ; the amount demanded for purchase at each price is called

180 Direct Exchange 115 demand . Evidently, at the first price of 82, the supply of the horses on the market is one; the demand for horses on the mar- ket is nine. Only one seller would be willing to sell at this price, while all nine buyers would be willing to make their purchase. On the basis of the above tabulations of maximum buying prices and minimum selling prices, we are able to present a list of the quantities of the good that will be demanded and supplied at each hypothetical price. T ABLE 2 RICE S UPPLIED D EMANDED P RICE EMANDED UPPLIED D S P 6 horses 4 horses 80 0 horses 9 horses 91 9 92 7 3 81 1 9 93 82 1 3 7 83 2 9 94 7 3 84 2 8 95 7 3 85 3 8 8 2 96 7 8 2 86 3 97 6 98 87 3 2 8 88 4 6 99 8 1 89 5 5 100 8 1 90 6 101 8 0 4 This table reflects the progressive entry into the market of the sellers as the price increases and the dropping out of the buyers as the price increases. As was seen above, as long as the demand exceeds the supply at any price, buyers will continue to overbid and the price will continue to rise. The converse occurs if the price begins near its highest point. Thus, if sellers first demand a price of 101 barrels for the horse, there will be eight eager sellers and no buyers. At a price of 99 the sellers may find one eager buyer, but chances are that a sale will not be made. The buyer will realize that there is no point in paying such a high price, and the other sellers will

181 with Power and Market 116 Man, Economy, and State who tries to make the sale at the price eagerly underbid the one supply exceeds the of 99. Thus, when the price is so high that the at that price, underbidding of suppliers will drive the demand price downward. As the tentative price falls, more sellers are excluded from the market, and more buyers enter it. If the overbidding of buyers will drive the price up whenever the quantity demanded is greater than the quantity supplied, and the underbidding of sellers drives the price down whenever sup- ply is greater than demand, it is evident that the price of the good will find a resting point where the quantity demanded is equal to the quantity supplied, i.e., where supply equals demand. i.e., there At this price and at this price only, the market is cleared, is no incentive for buyers to bid prices up further or for sellers to bid prices down. In our example, this final, or equilibrium price, is 89, and at this price, five horses will be sold to five buyers. This equilibrium price is the price at which the good will tend to be 25 set and sales to be made. Specifically, the sales will be made to the five most capable buyers at that price: X1, X2, X3, X4, and X5. The other less- capable (or less urgent) buyers are excluded from the market, because their value scales do not permit them to buy horses at 25 It is possible that the equilibrium point will not be uniquely deter- mined at one definite price. Thus, the pattern of supply and demand schedules might be as follows: D P S 89 5 6 5 6 90 The inequality is the narrowest possible, but there is no one point of equality. In that case, if the units are further divisible, then the price will be set to clear the market at a point in between, say 89.5 barrels of fish per horse. If both goods being exchanged are indivisible further, however, such as cows against horses, then the equilibrium price will be either 89 or 90, and this will be the closest approach to equilibrium rather than equilibrium itself.

182 Direct Exchange 117 that price. Similarly, sellers Z1–Z5 are the ones that make the sale at 89; the other sellers are excluded from the market, because their value scales do not permit them to be in the mar- ket at that price. In this horse-and-fish market, Z5 is the least capable of the sellers who have been able to stay in the market. Z5, whose minimum selling price is 89, is just able to make his sale at 89. marginal seller —the seller at the margin, the one who He is the would be excluded with a slight fall in price. On the other hand, X5 is the least capable of the buyers who have been able to stay marginal buyer —the one who would be in the market. He is the excluded by a slight rise in price. Since it would be foolish for the other buyers to pay more than they must to obtain their supply, they will also pay the same price as the marginal buyer, i.e., 89. Similarly, the other sellers will not sell for less than they could obtain; they will sell at the price permitting the marginal seller to stay in the market. Evidently, the more capable or “more urgent,” buyers (and sellers)—the supramarginal (which includes the marginal)— obtain a psychic surplus in this exchange, for they are better off than they would have been if the price had been higher (or lower). However, since goods can be ranked only on each indi- vidual’s value scale, and no measurement of psychic gain can be made either for one individual or between different individuals, little of value can be said about this psychic gain except that it exists. (We cannot even make the statement, for example, that the psychic gain in exchange obtained by X1 is greater than that of X5.) The excluded buyers and sellers are termed submarginal . The specific feature of the “clearing of the market” per- formed by the equilibrium price is that, at this price alone, all those buyers and sellers who are willing to make exchanges can do so. At this price five sellers with horses find five buyers for the horses; all who wish to buy and sell at this price can do so. At any other price, there are either frustrated buyers or frus- trated sellers. Thus, at a price of 84, eight people would like to buy at this price, but only two horses are available. At this price,

183 Power and Market with 118 Man, Economy, and State excess there is a great amount of “unsatisfied demand” or . Conversely, at a price of, say, 95, there are seven sellers demand eager to supply horses, but only three people willing to demand horses. Thus, at this price, there is “unsatisfied supply,” or excess Other terms for excess demand and excess supply are supply. “shortage” and “surplus” of the good. Aside from the universal fact of the scarcity of all goods, a price that is below the equi- librium price creates an additional shortage of supply for demanders, while a price above equilibrium creates a surplus of goods for sale as compared to demands for purchase. We see that the market process always tends to eliminate such shortages and surpluses and establish a price where demanders can find a supply, and suppliers a demand. It is important to realize that this process of overbidding of buyers and underbidding of sellers always takes place in the mar- ket, even if the surface aspects of the specific case make it appear that only the sellers (or buyers) are setting the price. Thus, a good might be sold in retail shops, with prices simply “quoted” by the individual seller. But the same process of bidding goes on in such a market as in any other. If the sellers set their prices below the equilibrium price, buyers will rush to make their pur- chases, and the sellers will find that shortages develop, accompa- nied by queues of buyers eager to purchase goods that are unavailable. Realizing that they could obtain higher prices for their goods, the sellers raise their quoted prices accordingly. On the other hand, if they set their prices above the equilibrium price, surpluses of unsold stocks will appear, and they will have to lower their prices in order to “move” their accumulation of unwanted stocks and to clear the market. The case where buyers quote prices and therefore appear to set them is similar. If the buyers quote prices below the equi- librium price, they will find that they cannot satisfy all their demands at that price. As a result, they will have to raise their quoted prices. On the other hand, if the buyers set the prices too high, they will find a stampede of sellers with unsalable

184 Direct Exchange 119 stocks and will take advantage of the opportunity to lower the price and clear the market. Thus, regardless of the of the form market, the result of the market process is always to tend toward the establishment of the equilibrium price via the mutual bid- ding of buyers and sellers. It is evident that, if we eliminate the assumption that no pre- liminary sales were made before the equilibrium price was established, this does not change the results of the analysis. Even if, through ignorance and error, a sale was made at a price of 81 or 99, these prices still will be ephemeral and temporary, and the final price for the good will tend to be the equilibrium price. Once the market price is established, it is clear that one price must rule over the entire market. This has already been implied by the fact that all buyers and sellers will tend to exchange at the same price as their marginal competitors. There will always be a tendency on the market to establish one and only one price at any time for a good. Thus, suppose that the market price has been established at 89, and that one crafty seller tries to induce a buyer to buy at 92. It is evident that no buyer will buy at 92 when he knows that he can buy on the regular market at 89. Similarly, no seller will be willing to sell at a price below the market if he knows that he can readily make his sale at 89. If for example, an ignorant seller sells a horse at 87, the buyer is likely to enter the market as a seller to sell the horse at 89. Such drives for arbitrage gains (buying and selling to take advantage of dis- crepancies in the price of a good) act quickly to establish one price for one good over the entire market. Such market prices will tend to change only when changing supply and demand conditions alter the equilibrium price and establish a condition of excess supply or excess demand where before the market had been cleared. A clearer picture of equilibrium prices as determined by sup- ply and demand conditions will be derived from the graphical representation in Figure 13.

185 with Power and Market 120 Man, Economy, and State It is evident that, as the price increases, new suppliers with higher minimum selling prices are brought into the market, while demanders with low maximum buying prices will begin to drop out. Therefore, as the price decreases, the quantity demanded must always either remain the same or increase, never decrease. Similarly, as the price decreases, the amount offered in supply must always decrease or remain the same, never increase. Therefore, the demand curve must always be vertical or rightward-sloping as the price decreases, while the supply curve must always be vertical or leftward-sloping as the price decreases. The curves will intersect at the equilibrium price, where supply and demand are equal. Clearly, once the zone of intersection of the supply and de- mand curves has been determined, it is the buyers and sellers at the margin—in the area of the equilibrium point—that deter- mine what the equilibrium price and the quantity exchanged will be.

186 Direct Exchange 121 The tabulation of supply offered at any given price is known as the while its graphical presentation, with the supply schedule, points connected here for the sake of clarity, is known as the Similarly, the tabulation of demand is the demand supply curve. and its graphical representation the demand curve, for schedule, each product and market. Given the point of intersection, the demand and supply curves above and below that point could take many conceivable shapes without affecting the equilibrium price. The direct determinants of the price are therefore the marginal buyers and sellers, while the valuations of the supra- marginal people are important in determining which buyers and sellers will be at the margin. The valuations of the excluded buy- ers and sellers far beyond the margin have no direct influence on the price and will become important only if a change in the mar- ket demand and supply schedules brings them near the inter- section point. Thus, given the intersection point, the pattern of supply and demand curves (represented by the solid and dotted lines) could be at least any one of the variants shown in Figure 14.

187 Power and Market with 122 Man, Economy, and State Up to this point we have assumed, for the sake of simplicity and clarity, that each demander, as well as each supplier, was limited to one unit of the good the price of which we have been concentrating on—the horse. Now we can remove this restric- tion and complete our analysis of the real world of exchange by permitting suppliers and demanders to exchange any number of horses that they may desire. It will be seen immediately that the removal of our implicit restriction makes no substantial change in the analysis. Thus, let us revert to the case of Johnson, whose minimum selling price for a horse was 81 barrels of fish. Let us now assume that Johnson has a stock of several horses. He is willing to sell one horse—the first—for a minimum price of 81 barrels, since on his value scale, he places the horse between 81 and 80 barrels of fish. What will be Johnson’s minimum selling price to part with his second horse? We have seen earlier in this chapter that, according to the law of marginal utility, as a man’s stock of goods declines, the value placed on each unit remain- ing increases; conversely, as a man’s stock of goods increases, the marginal utility of each unit declines. Therefore, the marginal utility of the second horse (or, strictly, of each horse after the first horse is gone), will be greater than the marginal utility of the first horse. This will be true even though each horse is capa- ble of the same service as every other. Similarly, the value of parting with a third horse will be still greater. On the other hand, while the marginal utility placed on each horse given up increases, the marginal utility of the additional fish acquired in exchange will decline. The result of these two factors is inevitably to raise the minimum selling price for each successive horse sold. Thus, suppose the minimum selling price for the first horse is 81 barrels of fish. When it comes to the second exchange, the value forgone of the second horse will be greater, and the value of the same barrels in exchange will decline. As a result, the minimum selling price below which Johnson will not sell the horse will increase, say, to 88. Thus, as the seller’s stock dwindles, his minimum selling price increases. Johnson’s value scale may appear as in Figure 15.

188 123 Direct Exchange On the basis of this value scale, Johnson’s own individual supply schedule can be constructed. He will supply zero horses up to a price of 80, one horse at a price between 81 and 87, two horses with the price between 88 and 94, three horses at a price of 95 to 98, and four horses at a price of 99 and above. The same can be done for each seller in the market. (Where the seller has only one horse to sell, the supply schedule is constructed as before.) It is clear that a market-supply schedule can be con- structed simply by adding the supplies that will be offered by the various individual sellers in the market at any given price. The essentials of the foregoing analysis of market supply re- main unchanged. Thus, the effect of constructing the market- supply schedule in this case is the same as if there were four sellers,

189 Power and Market with 124 Man, Economy, and State each supplying one horse, and each with minimum selling prices of 81, 88, 95, and 99. The fact that it is one man that is supplying the new units rather than different men does not change the results of the analysis. What it does is to reinforce the rule that the sup- ply curve must always be vertical or rightward-sloping as the price increases, i.e., that the supply must always remain unchanged For, in addition to the fact or increase with an increase in price. that new suppliers will be brought into the market with an increase in price, the same supplier will offer more units of the good. Thus, the operation of the law of marginal utility serves to reinforce the rule that the supply cannot decrease at higher prices, but must increase or remain the same. The exact converse occurs in the case of demand. Suppose that we allow buyers to purchase any desired number of horses. We remember that Smith’s maximum buying price for the first horse was 100 barrels of fish. If he considers buying a second horse, the marginal utility of the additional horse will be less than the utility of the first one, and the marginal utility of the same amount of fish that he would have to give up will increase. If the marginal utility of the purchases declines as more are made, and the marginal utility of the good given up increases, these factors result in lower maximum buying prices for each successive horse bought. Thus, Smith’s value scale might appear as in Figure 16. Such individual demand schedules can be made for each buyer on the market, and they can be added to form a resultant demand curve for all buyers on the market. It is evident that, here again, there is no change in the essence of the market-demand curve. Smith’s individual demand curve, with maximum buying prices as above, is analyt- ically equivalent to four buyers with maximum buying prices of 83, 89, 94, and 100, respectively. The effect of allowing more than one unit to be demanded by each buyer brings in the law of marginal utility to reinforce the aforementioned rule that the demand curve is rightward-sloping as the price decreases, i.e., that the demand must either increase or remain unchanged as the

190 Direct Exchange 125 price decreases. For, added to the fact that lower prices bring in previously excluded buyers, each individual will tend to demand more as the price declines, since the maximum buying prices will be lower with the purchase of more units, in accordance with the law of marginal utility. Let us now sum up the factors determining prices in interpersonal exchange. One price will tend to be established for each good on the market, and that price will tend to be the equilibrium price, determined by the intersection of the market supply and demand schedules. Those making the exchanges at this price will be the supramarginal and marginal buyers and sellers, while the less capable, or submarginal, will be excluded from the sale, because their value scales do not permit them to

191 Power and Market with 126 Man, Economy, and State make an exchange. Their maximum buying prices are too low, or their minimum selling prices too high. The market supply and demand schedules are themselves determined by the mini- mum selling prices and maximum buying prices of all the indi- viduals in the market. The latter, in turn, are determined by the placing of the units to be bought and sold on the individuals’ value scales, these rankings being influenced by the law of mar- ginal utility. In addition to the law of marginal utility, there is another factor influencing the rankings on each individual’s value scale. It is obvious that the amount that Johnson will supply at any price is limited by the stock of goods that he has available. Thus, Johnson may be willing to supply a fourth horse at a price of 99, but if this exhausts his available stock of horses, no higher price will be able to call forth a larger supply from Johnson. At least this is true as long as Johnson has no further stock available to sell. Thus, at any given time, the total stock of the good avail- able puts a maximum limit on the amount of the good that can be supplied in the market. Conversely, the total stock of the purchasing good will put a maximum limit on the total of the sale good that any one individual, or the market, can demand. At the same time that the market supply and demand sched- also clearly set- ules are setting the equilibrium price, they are ting the equilibrium of both goods that will be ex- quantity changed. In our previous example, the equilibrium quantities exchanged are five horses, and 5 x 89, or 445 barrels of fish, for the aggregate of the market. 26 6. Elasticity of Demand The demand schedule tells us how many units of the purchase good will be bought at each hypothetical price. From this sched- ule we may easily find the total number of units of the sale good that will be expended at each price. Thus, from Table 2, we find that at 26 Cf. Benham, Economics , pp. 60–63.

192 Direct Exchange 127 a price of 95, three horses will be demanded. If three horses are demanded at a price of 95 barrels of fish, then the total number of units of the sale good that will be offered in exchange will be 95, or 285 barrels of fish. This, then, is the of the x 3 total outlay sale good that will be offered on the market at that price. The total outlay of the sale good at each hypothetical price is shown in Table 3. 3 T ABLE B UYERS T OTAL O UTLAY RICE D EMANDED P ALE G OOD S 80 . . . . . . . 720 barrels of fish 9 horses 9 81 . . . . . . . 729 82 . . . . . . . 9 738 9 83 . . . . . . . 747 84 . . . . . . . 8 672 85 . . . . . . . 8 680 86. . . . . . . 7 602 87 . . . . . . . 6 522 6 88 . . . . . . . 528 89 . . . . . . . 5 445 4 360 90 . . . . . . . 91 . . . . . . . 364 4 92 . . . . . . . 3 276 93 . . . . . . . 3 279 94 . . . . . . . 3 282 95 . . . . . . . 285 3 96 . . . . . . . 2 192 97 . . . . . . . 2 194 98 . . . . . . . 2 196 99 . . . . . . . 1 99 100 . . . . . . . 1 100 101 . . . . . . . 0 0

193 Power and Market with 128 Man, Economy, and State Figure 17 is a graphic presentation of the total outlay curve. It is evident that this is a logical derivation from the demand curve and that therefore it too is a curve of outlay by buyers at each hypothetical price. A striking feature of the total outlay curve is that, in contrast to the other curves (such as the demand curve), it can slope in either direction as the price increases or decreases. The possi- bility of a slope in either direction stems from the operation of the two factors determining the position of the curve. Outlay = Price x Quantity Demanded (of purchase good). But we know that as the price decreases, the demand must either increase or remain the same. Therefore, a decrease in price tends to be counteracted by an increase in quantity, and, as a result, the total outlay of the sale good may either increase or decrease as the price changes. For any two prices, we may compare the total outlay of the sale good that will be expended by buyers. If the lower price yields a greater total outlay than the higher price, the total out- lay curve is defined as being elastic over that range. If the lower

194 Direct Exchange 129 price yields a lower total outlay than the higher price, then the curve is over that range. Alternatively, we may say that inelastic the former case is that of an elasticity greater than unity, the lat- ter of an elasticity less than unity , and the case where the total unit elasticity outlay is the same for the two prices is one of , or elasticity equal to one. Since numerical precision in the concept of elasticity is not important, we may simply use the terms “in- elastic,” “elastic,” and (for the last case) “neutral.” Some examples will clarify these concepts. Thus, suppose that we examine the total outlay schedule at prices of 96 and 95. At 96, the total outlay is 192 barrels; at 95, it is 285 barrels. The outlay is greater at the lower price, and hence the outlay sched- ule is elastic in this range. On the other hand, let us take the prices 95 and 94. At 94, the outlay is 282. Consequently, the schedule here is inelastic . It is evident that there is a simple geo- metrical device for deciding whether or not the demand curve is elastic or inelastic between two hypothetical prices: if the out- lay curve is further to the right at the lower price, the demand curve is elastic; if further to the left, the latter is inelastic. There is no reason why the concept of elasticity must be confined to two prices next to each other. Any two prices on the schedule may be compared. It is evident that an examination of the entire outlay curve demonstrates that the foregoing demand curve is basically elastic. It is elastic over most of its range, with the exception of a few small gaps. If we compare any two rather widely spaced prices, it is evident that the outlay is less at the higher price. If the price is high enough, the demand for any good will dwindle to zero, and therefore the outlay will dwindle to zero. Of particular interest is the elasticity of the demand curve at the equilibrium price. Going up a step to the price of 90, the curve is clearly elastic—total outlay is less at the higher price. Going down a step to 88, the curve is also elastic. This partic- ular demand curve is elastic in the neighborhood of the equi- librium price. Other demand curves, of course, could possibly be inelastic at their equilibrium price.

195 Power and Market with 130 Man, Economy, and State Contrary to what might be thought at first, the concept of “elasticity of supply” is not a meaningful one, as is “elasticity of demand.” If we multiply the quantity supplied at each price by the price, we obtain the number of barrels of fish (the sale good) which the sellers will demand in exchange. It will easily be seen, however, that this quantity always increases as the price increases, vice versa . At 82 it is 82, at 84 it is 168, at 88 it is 352, etc. and The reason is that its other determinant, quantity supplied, changes in the direction as the price, not in the inverse same direction as does quantity demanded. As a result, supply is 27 always “elastic,” and the concept is an uninteresting one. 7. Speculation and Supply and Demand Schedules We have seen that market price is, in the final analysis, de- termined by the intersection of the supply and demand sched- ules. It is now in order to consider further the determinants of these particular schedules. Can we establish any other conclu- sions concerning the causes of the shape and position of the supply and demand schedules themselves? 27 The attention of some writers to the elasticity of supply stems from an erroneous approach to the entire analysis of utility, supply, and demand. They assume that it is possible to treat human action in terms of “infinitely small” differences, and therefore to apply the mathematically elegant concepts of the calculus, etc., to economic problems. Such a treat- ment is fallacious and misleading, however, since human action must treat all matters only in terms of discrete steps. If, for example, the utility of X is so little smaller than the utility of Y that it can be regarded as identical or negligibly different, then human action will treat them as such, i.e., as the same good. Because it is conceptually impossible to measure utility, even the drawing of continuous utility curves is pernicious. In the supply and demand schedules, it is not harmful to draw continuous curves for the sake of clarity, but the mathematical concepts of continuity and the calcu- lus are not applicable. As a result, the seemingly precise concept of “elas- ticity at a point” (percentage increase in demand divided by a “negligibly small” percentage decrease in price) is completely out of order. It is this mistaken substitution of mathematical elegance for the realities of human action that lends a seeming importance to the concept of “elasticity of supply,” comparable to the concept of elasticity of demand.

196 Direct Exchange 131 We remember that, at any given price, the amount of a good that an individual will buy or sell is determined by the position of the sale good and the purchase good on his value scale. He will demand a good if the marginal utility of adding a unit of the purchase good is greater than the marginal utility of the sale good that he must give up. On the other hand, another indi- vidual will be a seller if his valuations of the units are in a reverse order. We have seen that, on this basis, and reinforced by the law of marginal utility, the market demand curve will never decrease when the price is lowered, and the supply curve will never increase when the price decreases. Let us further analyze the value scales of the buyers and sell- ers. We have seen above that the two sources of value that a good may have are direct use-value and exchange-value, and that the higher value is the determinant for the actor. An individual, therefore, can demand a horse in exchange for one of two rea- sons: its direct use-value to him or the value that he believes it will be able to command in exchange. If the former, then he will be a consumer of the horse’s services; if the latter, then he pur- chases in order to make a more advantageous exchange later. Thus, suppose in the foregoing example, that the existing market price has not reached equilibrium—that it is now at 85 barrels per horse. Many demanders may realize that this price is below the equilibrium and that therefore they can attain an arbitrage profit by buying at 85 and reselling at the final, higher price. We are now in a position to refine the analysis in the fore- going section, which did not probe the question whether or not sales took place before the equilibrium price was reached. We now assume explicitly that the demand schedule shown in Ta- ble 2 referred to demand for direct use by consumers. Smooth- ing out the steps in the demand curve represented in Figure 13, we may, for purposes of simplicity and exposition, portray it as in Figure 18. This, we may say, is the demand curve for direct use. For this demand curve, then, the approach to equilibrium takes place through actual purchases at the various prices, and then the shortages or the surpluses reveal the overbidding or

197 Power and Market with 132 Man, Economy, and State underbidding, until the equilibrium price is finally reached. To the extent that buyers foresee the final equilibrium price, how- ever, they will not buy at a higher price (even though they would that were the final price), but will wait for the have done so if price to fall. Similarly, if the price is below the equilibrium price, to the extent that the buyers foresee the final price, they will tend to buy some of the good (e.g., horses) in order to resell at a profit at the final price. Thus, if exchange-value enters the picture, and a good number of buyers act on their anticipations, the demand curve might change as shown in Figure 19. The old demand curve, based only on demand for use, is DD , and the new demand curve, including anticipatory forecasting of the equilib- . It is clear that such anticipations render the ′ ′ D D rium price, is

198 Direct Exchange 133 , since more will be bought at the elastic demand curve far more lower price and less at the higher. Thus, the introduction of exchange-value can restrict demand above the anticipated equilibrium price and increase it below that price, although the final demand—to consume—at the equilibrium price will remain the same. Now, let us consider the situation of the seller of the com- modity. The supply curve in Figure 13 treats the amount sup- plied at any price without considering possible equilibrium price. Thus, we may say that, with such a supply curve, sales will be made en route to the equilibrium price, and shortages or sur- pluses will finally reveal the path to the final price. On the other hand, suppose that many sellers anticipate the final equilibrium price. Clearly, they will refuse to make sales at a lower price, even though they would have done so if were the final that price. On the other hand, they will sell more above the equilib- rium price, since they will be able to make an arbitrage profit by selling their horses above the equilibrium price and buying them back at the equilibrium price. Thus, the supply curve, with such anticipations, may change as shown in Figure 20. The supply curve changes, as a result of anticipating the equilibrium ′ S ′ . price, from SS to S Let us suppose the highly unlikely event that demanders all and suppliers are able to forecast exactly the final, equilibrium price. What would be the pattern of supply and demand curves on the market in such an extreme case? It would be as follows: At a price above equilibrium (say 89) no one would demand the good, and suppliers would supply their entire stock. At a price below equilibrium, no one would supply the good, and every- one would demand as much as he could purchase, as shown in Figure 21. Such unanimously correct forecasts are not likely to take place in human action, but this case points up the fact that, the more this anticipatory, or speculative , element enters into supply and demand, the more quickly will the market price tend toward equilibrium. Obviously, the more the actors anticipate the final price, the further apart will be supply and demand at

199 Power and Market with 134 Man, Economy, and State any price differing from equilibrium, the more drastic the shortages and surpluses will be, and the more quickly will the final price be established. Up to now we have assumed that this speculative supply and demand, this anticipating of the equilibrium price, has been correct, and we have seen that these correct anticipations have hastened the establishment of equilibrium. Suppose, however, that most of these expectations are erroneous. Suppose, for example, that the demanders tend to assume that the equilib- rium price will be lower than it actually is. Does this change the equilibrium price or obstruct the passage to that price? Sup- pose that the demand and supply schedules are as shown in Figure 22. Suppose that the basic demand curve is DD, but that the demanders anticipate lower equilibrium prices, thus chang- ing and lowering the demand curve to D ′ D ′ . With the supply curve given at SS , this means that the intersection of the sup- ply and demand schedules will be at Y instead of X, say at 85 instead of 89. It is clear, however, that this will be only a pro- visional resting point for the price. As soon as the price settles at 85, the demanders see that shortages develop at this price, that they would like to buy more than is available, and the overbidding of the demanders raises the price again to the gen- uine equilibrium price.

200 Direct Exchange 135 The same process of revelation of error occurs in the case of errors of anticipation by suppliers, and thus the forces of the market tend inexorably toward the establishment of the gen- uine equilibrium price, undistorted by speculative errors, which tend to reveal themselves and be eliminated. As soon as suppli- ers or demanders find that the price that their speculative errors have set is not really an equilibrium and that shortages and/or surpluses develop, their actions tend once again to establish the equilibrium position. The actions of both buyers and sellers on the market may be related to the concepts of psychic revenue, profit, and cost. We remember that the aim of every actor is the highest posi- tion of psychic revenue and thus the making of a psychic profit compared to his next best alternative—his cost. Whether or buys depends on whether it is his best alter- not an individual native with his given resources—in this case, his fish. His expected revenue in any action will be balanced against his expected cost—his next best alternative. In this case, the rev- enue will be either ( a ) the satisfaction of ends from the direct use of the horse or ( b ) expected resale of the horse at a higher price—whichever has the highest utility to him. His cost will be either ( ) the marginal utility of the fish given up in direct a b use or ( ) (possibly) the exchange-value of the fish for some other good or ( c ) the expected future purchase of the horse at a lower price—whichever has the highest utility. He will buy the horse if the expected revenue is greater; he will fail to buy if the expected cost is greater. The expected revenue is the marginal utility of the added horse for the buyer; the expected cost is the marginal utility of the fish given up. For either rev- enue or cost, the higher value in direct use or in exchange will be chosen as the marginal utility of the good. Now let us consider the seller. The seller, as well as the buyer, attempts to maximize his psychic revenue by trying to attain a revenue higher than his psychic cost—the utility of the next best alternative he will have to forgo in taking his action. The seller will weigh the marginal utility of the added sale-good

201 Power and Market with 136 Man, Economy, and State (in this case, fish) against the marginal utility of the purchase- good given up (the horse), in deciding whether or not to make the sale at any particular price. The psychic revenue for the seller will be the higher of the utilities stemming from one of the following sources: ( a ) the value in direct use of the sale-good (the fish) or ( b ) the specula- tive value of re-exchanging the fish for the horse at a lower price in the future. The cost of the seller’s action will be the highest utility forgone among the following alternatives: ( ) the value in a b ) the speculative value of direct use of the horse given up or ( c ) the exchange-value selling at a higher price in the future or ( of acquiring some other good for the horse. He will sell the horse if the expected revenue is greater; he will fail to sell if the expected cost is greater. We thus see that the situations of the sellers and the buyers are comparable. Both act or fail to act in accordance with their estimate of the alternative that will yield them the highest utility. It is the position of the utilities on the two sets of value scales—of the individual buyers and sellers— that determines the market price and the amount that will be exchanged at that price. In other words, it is, for every good, and utility alone that determines the price and the quan- utility tity exchanged. Utility and utility alone determines the nature of the supply and demand schedules. It is therefore clearly fallacious to believe, as has been the popular assumption, that utility and “costs” are equally and in- dependently potent in determining price. “Cost” is simply the utility of the next best alternative that must be forgone in any action, and it is therefore part and parcel of utility on the in- present dividual’s value scale. This cost is, of course, always a consideration of a future event, even if this “future” is a very near one. Thus, the forgone utility in making the purchase might be the direct consumption of fish that the actor might have engaged in within a few hours. Or it might be the possi- bility of exchanging for a cow, whose utility would be enjoyed over a long period of time. It goes without saying, as has been indicated in the previous chapter, that the present consideration

202 Direct Exchange 137 of revenue and of cost in any action is based on the present value of expected future revenues and costs. The point is that both the utilities derived and the utilities forgone in any action refer to some point in the future, even if a very near one, and past costs play no role in human action, and hence in deter- that mining price. The importance of this fundamental truth will be made clear in later chapters. 8. Stock and the Total Demand to Hold There is another way of treating supply and demand sched- ules, which, for some problems of analysis, is more useful than the schedules presented above. At any point on the market, sup- pliers are engaged in offering some of their stock of the good and withholding their offer of the remainder. Thus, at a price of 86, suppliers supply three horses on the market and withhold the other five in their stock. This withholding is caused by one of the factors mentioned above as possible costs of the exchange: either the direct use of the good (say the horse) has greater utility than the receipt of the fish in direct use; or else the horse could be exchanged for some other good; or, finally, the seller expects the final price to be higher, so that he can profitably delay the sale. The amount that sellers will withhold on the market is termed their This is not, like the demand studied reservation demand. above, a demand for a good in exchange ; this is a demand to hold stock . Thus, the concept of a “demand to hold a stock of goods” will always include both demand-factors; it will include the demand for the good in exchange by nonpossessors, plus the demand to hold the stock by the possessors. The demand for the good in exchange is also a demand to hold, since, regardless of what the buyer intends to do with the good in the future, he must hold the good from the time it comes into his ownership and possession by means of exchange. We therefore arrive at the concept of a “total demand to hold” for a good, differing from the previous concept of exchange-demand, although including the latter in addition to the reservation demand by the sellers.

203 Power and Market with 138 Man, Economy, and State If we know the total stock of the good in existence (here, eight horses), we may, by inspecting the supply and demand schedules, arrive at a “total demand to hold”—or total demand for the market. For example, at a price of 82, nine schedule horses are demanded by the buyers, in exchange, and 8 - 1 = 7 horses are withheld by the sellers, i.e., demanded to be held by the sellers. Therefore, the total demand to hold horses on the 7 = 16 horses. On the other hand, at the price of market is 9 + 97, no horses are withheld by sellers, whose reservation demand is therefore zero, while the demand by buyers is two. Total demand to hold at this price is 0 + 2 = 2 horses. Table 4 shows the total demand to hold derived from the supply and demand schedule in Table 2, along with the total stock, which is, for the moment, considered as fixed. Figure 23 represents the total demand to hold and the stock. It is clear that the rightward-sloping nature of the total de- mand curve is even more accentuated than that of the demand curve. For the demand schedule increases or remains the same T ABLE 4 OTAL T OTAL T EMAND T OTAL D EMAND T OTAL D P RICE TO H OLD S TOCK P RICE TO H OLD S TOCK 80 17 horses 8 horses 6 horses 8 horses 91 8 4 8 81 16 92 8 93 4 8 82 16 83 15 94 4 8 8 84 14 8 95 4 8 85 13 8 96 2 8 86 12 97 2 8 8 87 11 8 98 2 8 88 10 8 99 1 8 89 8 8 100 1 8 90 6 8 101 0 8

204 Direct Exchange 139 as the price falls, while the reservation demand schedule of the sellers also tends to increase as the price falls. The total demand schedule is the result of adding the two schedules. Clearly, the reservation demand of the sellers increases as the price falls for the same reason as does the demand curve for buyers. With a lower price, the value of the purchase-good in direct use or in other and future exchanges relatively increases, and therefore the seller tends to withhold more of the good from exchange. In other words, the reservation demand curve is the obverse of the supply curve. Another point of interest is that, at the equilibrium price of 89, the total demand to hold is eight, equal to the total stock in existence. Thus, the equilibrium price not only equates the sup- ply and demand on the market; it also equates the stock of a good to be held with the desire of people to hold it, buyers and sellers included. The total stock is included in the foregoing diagram at a fixed figure of eight. It is clear that the market always tends to set the price of a good so as to equate the stock with the total demand to hold the

205 Power and Market with 140 Man, Economy, and State stock. Suppose that the price of a good is higher than this equi- librium price. Say that the price is 92, at which the stock is eight and the total demand to hold is four. This means four horses exist which their possessors do not want to possess. It is clear that someone must possess this stock, since all goods must be property; otherwise they would not be objects of human action. Since all the stock must at all times be possessed by someone, the fact that the stock is greater than total demand means that there is an imbalance in the economy, that some of the posses- sors are unhappy with their possession of the stock. They tend to lower the price in order to sell the stock, and the price falls until finally the stock is equated with the demand to hold. Con- versely, suppose that the price is below equilibrium, say at 85, where 13 horses are demanded compared to a stock of eight. The bids of the eager nonpossessors for the scarce stock push up the price until it reaches equilibrium. In cases where individuals correctly anticipate the equilib- rium price, the speculative element will tend to render the total demand curve even more “elastic” and flatter. At a higher-than- equilibrium price few will want to keep the stock—the buyers will demand very little, and the sellers will be eager to dispose of the good. On the other hand, at a lower price, the demand to hold will be far greater than the stock; buyers will demand heav- ily, and sellers will be reluctant to sell their stock. The dis- crepancies between total demand and stock will be far greater, and the underbidding and overbidding will more quickly bring about the equilibrium price. We saw above that, at the equilibrium price, the most capa- ble (or “most urgent”) buyers made the exchanges with the most capable sellers. Here we see that the result of the exchange process is that the stock finally goes into the hands of the most capable possessors. We remember that in the sale of the eight horses, the most capable buyers, X1–X5, purchased from the most capable sellers of the good, Z1–Z5. At the conclusion of the exchange, then, the possessors are X1–X5, and the excluded sellers Z6–Z8. It is these individuals who finish by possessing

206 Direct Exchange 141 the eight horses, and these are the most capable possessors. At a price of 89 barrels of fish per horse, these were the ones who preferred the horse on their value scales to 89 barrels of fish, and they acted on the basis of this preference. For five of the individuals, this meant exchanging their fish for a horse; for three it meant refusing to part with their horses for the fish. The other nine individuals on the market were the less capable possessors, and they concluded by possessing the fish instead of the horse (even if they started by possessing horses). These were the ones who ranked 89 barrels of fish above one horse on their value scale. Five of these were original possessors of horses who exchanged them for fish; four simply retained the fish without purchasing a horse. The total demand-stock analysis is a useful twin companion to the supply-demand analysis. Each has advantages for use in different spheres. One relative defect of the total demand-stock analysis is that it does not reveal the differences between the buyers and the sellers. In considering total demand, it abstracts from actual exchanges, and therefore does not, in contrast to the supply-demand curves, determine the quantity of exchanges. It reveals only the equilibrium price, without demonstrating the equilibrium quantity exchanged. However, it focuses more sharply on the fundamental truth that price is determined solely by utility . The supply curve is reducible to a reservation demand curve and to a . The quantity of physical stock demand-stock analysis therefore shows that the supply curve is not based on some sort of “cost” that is independent of utility on individual value scales. We see that the fundamental deter- minants of price are the value scales of all individuals (buyers and sellers) in the market and that the physical stock simply 28 assumes its place on these scales. 28 On the total demand-stock analysis, see Philip H. Wicksteed, The Common Sense of Political Economy and Selected Papers (London: Rout- ledge and Kegan Paul, 1933), I, 213–38; II, 493–526, and 784–88. Also see Boulding, Economic Analysis , pp. 51–80.

207 Power and Market with 142 Man, Economy, and State It is clear, in these cases of direct exchange of useful goods, that even if the utility of goods for buyers or sellers is at present determined by its subjective exchange-value for the individual, the sole ultimate source of utility of each good is its direct use- value. If the major utility of a horse to its possessor is the fish or the cow that he can procure in exchange, and the major value of the latter to their possessors is the horse obtainable in exchange, etc., the ultimate determinant of the utility of each good is its direct use-value to its individual consumer. 9. Continuing Markets and Changes in Price How, then, may we sum up the analysis of our hypothetical horse-and-fish market? We began with a stock of eight horses in existence (and a certain stock of fish as well), and a situation where the relative positions of horses and fish on different peo- ple’s value scales were such as to establish conditions for the exchange of the two goods. Of the original possessors, the “most capable sellers” sold their stock of horses, while among the original nonpossessors, the “most capable buyers” pur- chased units of the stock with their fish. The final price of their sale was the equilibrium price determined ultimately by their various value scales, which also determined the quantity of exchanges that took place at that price. The net result was a shift of the stock of each good into the hands of its most capa- ble possessors in accordance with the relative rank of the good on their value scales. The exchanges having been completed, the relatively most capable possessors own the stock, and the market for this good has come to a close. With arrival at equilibrium, the exchanges have shifted the goods to the most capable possessors, and there is no further motive for exchange. The market has ended, and there is no longer an active “ruling market price” for either good because there is no longer any motive for exchange. Yet in our experi- ence the markets for almost all goods are being continually renewed.

208 Direct Exchange 143 The market can be renewed again only if there is a change in the relative position of the two goods under consideration on the value scales of at least two individuals, one of them a pos- sessor of one good and the other a possessor of the second good. Exchanges will then take place in a quantity and at a final price determined by the intersection of the new combination of sup- ply and demand schedules. This may set a different quantity of exchanges at the old equilibrium price or at a new price, depending on their specific content. Or it may happen that the new combination of schedules—in the new period of time—will be identical with the old and therefore set the same quantity of exchanges and the same price as on the old market. The market is always tending quickly toward its equilibrium position, and the wider the market is, and the better the com- munication among its participants, the more quickly will this position be established for any set of schedules. Furthermore, a growth of specialized speculation will tend to improve the fore- casts of the equilibrium point and hasten the arrival at equi- librium. However, in those cases where the market does not ar- rive at equilibrium before the supply or demand schedules themselves change, the market does not reach the equilibrium point. It becomes continuous , moving toward a new equilibrium 29 position before the old one has been reached. 29 This situation is not likely to arise in the case of the market equilib- ria described above. Generally, a market tends to “clear itself” quickly by establishing its equilibrium price, after which a certain number of ex- plain state of changes take place, leading toward what has been termed the rest —the condition after the various exchanges have taken place. These equilibrium market prices, however (as will be seen in later chapters), in turn tend to move toward certain long-run equilibria, in accordance with the demand schedule and the effect on the size of stock produced. The final state of rest involves the ultimate deci- supply curve involved in this sions in producing a commodity and differs from the market supply curve. In the movements toward this “final state,” conditions, such as the demand curve, always change in the interim, thus setting a new final state as the goal of market prices. The final state is never reached. See Mises, Human Action , pp. 245 ff.

209 Power and Market with 144 Man, Economy, and State The types of change introduced by a shift in the supply and/or the demand schedule may be depicted by the diagrams in Figure 24. These four diagrams depict eight types of situations that may develop from changes in the supply and demand schedules. It must be noted that these diagrams may apply to a market either that has already reached equilibrium and is then renewed at some later date or to one continuous market that experiences a change in supply and/or demand conditions before reaching the old equilibrium point. Solid lines depict the old schedules, while broken lines depict the new ones. In all these diagrams straight lines are assumed purely for convenience, since the lines may be of any shape, provided the aforementioned restrictions on the slope of the schedules are met (rightward-sloping demand schedules, etc.). In diagram (a), the demand schedule of the individuals on the market increases . At each hypothetical price, people will wish to

210 Direct Exchange 145 add more than before to their stock of the good—and it does not matter whether these individuals already possess some units of the good or not. The supply schedule remains the same. As a result, the new equilibrium price is higher than the old, and the quantity of exchanges made at the new equilibrium position is greater than at the old position. In diagram (b), the while the demand supply schedule increases, schedule remains the same. At each hypothetical price, people will wish to dispose of more of their stock. The result is that the new equilibrium price is than the old, and the equilibrium lower quantity exchanged is greater. Diagrams (a) and (b) also depict what will occur when the de- mand curve decreases and the supply curve decreases, the other schedule remaining the same. All we need do is think of the bro- ken lines as the old schedules, and the solid lines as the new ones. On diagram (a) we see that a decrease in the demand sched- ule leads to a fall in price and a fall in the quantity exchanged. On diagram (b) , we see that a decrease in the supply schedule leads to a rise in price and a fall in the quantity exchanged. For diagrams (c) and (d), the restriction that one schedule must remain the same while the other one changes is removed. In diagram (c), the demand curve decreases and the supply fall in equilibrium curve increases. This will definitely lead to a , although what will happen to the quantity exchanged price depends on the relative proportion of change in the two sched- ules, and therefore this result cannot be predicted from the fact of an increase in the supply schedule and a decrease in the demand schedule. On the other hand, a decrease in the supply schedule plus an increase in the demand schedule will definitely lead to a rise in the equilibrium price. Diagram (d) discloses that an in both demand and increase supply schedules will definitely lead to an increase in the quan- tity exchanged, although whether or not the price falls depends on the relative proportion of change. Also, a decrease in both supply and demand schedules will lead to a decline in the quan- tity exchanged. In diagram (c) what happens to the quantity, and

211 Power and Market with 146 Man, Economy, and State in diagram (d) what happens to the price, depends on the spe- cific shape and change of the curves in question. The conclusions from these diagrams may be summarized in Table 5. If these are the effects of changes in the demand and sup- ply schedules from one period of time to another, the next problem is to explain the causes of these changes themselves. A change in the demand schedule is due purely to a change in the relative utility-rankings of the two goods (the purchase-good and the sale-good) on the value scales of the individual buyers on the market. An increase in the demand schedule, for exam- ple, signifies a general rise in the purchase-good on the value (a ) a rise in the scales of the buyers. This may be due to either direct use-value of the good; ( b ) poorer opportunities to exchange the sale-good for some other good—as a result, say, of a higher price of cows in terms of fish; or ( ) a decline in specu- c lative waiting for the price of the good to fall further. The last case has been discussed in detail and has been shown to be self- correcting, impelling the market more quickly towards the true equilibrium. We can therefore omit this case now and conclude that an increase in the demand schedule is due either to an T ABLE 5 IF . . . THEN EMAND UPPLY E QUILIBRIUM Q UANTITY S D S &S CHEDULE P RICE & E XCHANGED CHEDULE increases. . . . . . . the same increases . . . . . . . increases decreases . . . . . . the same decreases . . . . . . . decreases the same . . . . . . . increases decreases . . . . . . . increases the same. . . . . . . decreases increases . . . . . . . decreases decreases . . . . . . increases decreases . . . . . . . . . . . . . . . increases. . . . . . . decreases increases . . . . . . . . . . . . . . . increases. . . . . . . increases . . . . . . . . . . . . . . . increases decreases . . . . . . decreases . . . . . . . . . . . . . . . decreases

212 Direct Exchange 147 increase in the direct use-value of the good or to a higher price of other potential purchase-goods in terms of the sale-good that buyers offer in exchange. A decrease in demand schedules is due precisely to the converse cases—a fall in the value in direct use or greater opportunities to buy other purchase-goods for this sale-good. The latter would mean a greater exchange-value—of fish, for example—in other fields of exchange. Changes in opportunities for other types of exchange may be a result of higher or lower prices for the other purchase-goods, or they may be the result of the fact that new types of goods are being offered for fish on the market. The sudden appearance of cows being offered for fish where none had been offered before is a widening of exchange opportunities for fish and will result in a horses general decline of the demand curve for in terms of fish. A change in the market supply curve is, of course, also the result of a change in the relative rankings of utility on the sell- ers’ value scales. This curve, however, may be broken down into the amount of physical stock and the reservation-demand schedule of the sellers. If we assume that the amount of physical stock is constant in the two periods under comparison, then a shift in supply curves is purely the result of a change in reservation- demand curves. A decrease in the supply curve caused by an in- crease in reservation demand for the stock may be due to either a ) an increase in the direct use-value of the good for the sellers; ( ( b ) greater opportunities for making exchanges for other purchase-goods; or ( c ) a greater speculative anticipation of a higher price in the future. We may here omit the last case for the same reason we omitted it from our discussion of the demand curve. Conversely, a fall in the reservation-demand a ) a decrease in the direct use- schedule may be due to either ( value of the good to the sellers, or ( b ) a dwindling of exchange opportunities for other purchase-goods. Thus, with the total stock constant, changes in both supply and demand curves are due solely to changes in the demand to hold the good by either sellers or buyers, which in turn are due to shifts in the relative utility of the two goods. Thus, in both

213 Power and Market with 148 Man, Economy, and State A B above, the increase in the demand schedule diagrams and decrease in the supply schedule from S and a S ′ to SS are a result ′ of increased total demand to hold. In one case the increased total demand to hold is on the part of the buyers, in the other case of the sellers. The relevant diagram is shown in Figure 25. In both cases of an increase in the total demand-to-hold sched- ule, say from TD to T ′ D , the equilibrium price increases. On the ′ contrary, when the demand schedule declines, and/or when the supply schedule increases, these signify a general decrease in the total demand-to-hold schedule and consequently a fall in equi- librium price. A total demand-stock diagram can convey no information about the quantity exchanged, but only about the equilibrium price. Thus, in diagram (c), the broken lines both represent a fall in demand to hold, and we could consequently be sure that the total demand to hold declined, and that therefore price declined. (The opposite would be the case for a shift from the broken to the solid lines.) In diagram (d), however, since an increase in the supply schedule represented a fall in demand to hold, and an increase in demand was a rise in the demand to hold, we could not always be sure of the net effect on the total demand to hold and hence on the equilibrium price.

214 Direct Exchange 149 From the beginning of the supply-demand analysis up to this point we have been assuming the existence of a constant physi- cal stock. Thus, we have been assuming the existence of eight horses and have been considering the principles on which this stock will go into the hands of different possessors. The analy- sis above applies to all goods —to all cases where an existing stock is being exchanged for the stock of another good. For some goods this point is as far as analysis can be pursued. This applies to those goods of which the stock is fixed and cannot be increased through production. They are either once produced by man or given by nature, but the stock cannot be increased by human action. Such a good, for example, is a Rembrandt paint- ing after the death of Rembrandt. Such a painting would rank high enough on individual value scales to command a high price in exchange for other goods. The stock can never be increased, however, and its exchange and pricing is solely in terms of the previously analyzed exchange of existing stock, determined by the relative rankings of these and other goods on numerous value scales. Or assume that a certain quantity of diamonds has been produced, and no more diamonds are available anywhere. Again, the problem would be solely one of exchanging the exist- ing stock. In these cases, there is no further problem of produc- tion —of deciding how much of a stock should be produced in a certain period of time. For most goods, however, the problem of deciding how much to produce is a crucial one. Much of the remainder of this volume, in fact, is devoted to an analysis of the problem of production. We shall now proceed to cases in which the existing stock of a good changes from one period to another. A stock may increase from one period to the next because an amount of the newly produced in the meantime. This amount of good has been new pro duction constitutes an addition to the stock . Thus, three days after the beginning of the horse market referred to above, two new horses might be produced and added to the existing stock. If the demand schedule of buyers and the reservation

215 Power and Market with 150 Man, Economy, and State demand schedule of sellers remain the same, what will occur can be represented as in Figure 26. The increased stock will lower the price of the good. At the old equilibrium price, individuals find that their stock is in excess of the total demand to hold, and the consequence is an under- bidding to sell that lowers the price to the new equilibrium. In terms of supply and demand curves, an increase in stock, with demand and reservation-demand schedules remaining the same, is equivalent to a uniform increase in the supply schedule by the amount of the increased stock—in this case by two horses. The amount supplied would be the former total plus the added two. Possessors with an excess of stock at the old equilibrium price must underbid each other in order to sell the increased stock. If we refer back to Table 2, we find that an increase in the supply schedule by two lowers the equilibrium price to 88, where the demand is six and the new supply is six. Diagrammatically, the situation may be depicted as in Figure 27. The increased stock is reflected in a uniform increase in the supply curve, and a consequent fall in price and an increase in the quantity exchanged.

216 Direct Exchange 151 Of course, there is no reason to assume that, in reality, an increased stock will necessarily be accompanied by an unchanged reservation-demand curve. But in order to study the various causal factors that interact to form the actual his- torical result, it is necessary to isolate each one and consider what would be its effect if the others remained unchanged. Thus, if an increased stock were at the same time absorbed by an equivalent increase in the reservation-demand sched- ule, the supply curve would not increase at all, and the price and quantity exchanged would remain unchanged. (On the total demand-stock schedule, this situation would be reflected in an increase in stock, accompanied by an offset- ting rise in the total-demand curve, leaving the price at the original level.) A decrease in stock from one period to another may result from the using up of the stock. Thus, if we consider only con- sumers’ goods, a part of the stock may be consumed. Since goods are generally used up in the process of consumption, if there is not sufficient production during the time considered, the total stock in existence may decline. Thus, one new horse may be produced, but two may die, from one point of time to the next, and the result may be a market with one less horse in existence. A decline in stock, with demand remaining the same, has the exactly reverse effect, as we may see on the diagrams by moving from the broken to the solid lines. At the old equilib- rium price, there is an excess demand to hold compared to the stock available, and the result is an upbidding of prices to the new equilibrium. The supply schedule uniformly decreases by the decrease in stock, and the result is a higher price and a smaller quantity of goods exchanged. We may summarize the relation between stock, production, and time, by stating that the stock at one period (assuming that a period of time is defined as one during which the stock remains unchanged) is related to the stock at a previous period as follows:

217 Power and Market with 152 Man, Economy, and State S t ) If: equals stock at a certain period ( t equals stock at an earlier period ( ) which is n S t – n t– n units of time before period ( t ) P equals production of the good over the period n n U n equals amount of the good used up over the period n Then: S = S + P – U n t n t – n Thus, in the case just mentioned, if the original stock is eight horses, and one new horse is produced while two die, the new stock of the good is 8 1 – 2 = 7 horses. + It is important to be on one’s guard here against a common confusion over such a term as “an increase in demand.” When- ever this phrase is used by itself in this work, it always signifies increase in the demand schedule , i.e., an increase in the amounts an that will be demanded at each hypothetical price. This “shift of the demand schedule to the right” always tends to cause an increase in price. It must never be confused with the “increase in quantity demanded” that takes place, for example, in response to an increased supply. An increased supply schedule, by lowering price, induces the market to demand the larger quantity offered. This, however, is not an increase in the demand schedule, but an extension along the same demand sched- ule. It is a larger quantity demanded in response to a more attractive price offer. This simple movement along the same schedule must not be confused with an increase in the demand schedule at each possible price. The diagrams in Figure 28 high- light the difference. Diagram I depicts an increase in the demand schedule, while diagram II depicts an extension of quantity demanded along the same schedule as a result of an increase in the supply offered. In both cases, the value scales of the various individuals determine the final result, but great confusion can ensue if the concepts are not clearly distinguished when such terms as “increase” or “de- crease” in demand are being used.

218 Direct Exchange 153 10. Specialization and Production of Stock We have analyzed the exchanges that take place in existing changes in the stock of a good. The ques- stock and the effect of tion still remains: On what principles is the size of the stock itself determined? Aside from the consumers’ or producers’ goods all goods must be produced by man. given directly by nature, (And even seemingly nature-given products must be searched for and then used by man, and hence are ultimately products of human effort.) The size of the stock of any good depends on the rate at which the good has been and is being produced . And since human wants for most goods are continuous, the goods that are worn out through use must constantly be replaced by new production. An analysis of the rate of production and its determinants is thus of central importance in an analysis of human action. A complete answer to this problem cannot be given at this point, but certain general conclusions on production can be made. In the first place, while any one individual can at different times be both a buyer and a seller of existing stock, in the pro- duction of that stock there must be specialization . This omnipres- ence of specialization has been treated above, and the further an exchange economy develops, the further advanced will be the specialization process. The basis for specialization has been shown to be the varying abilities of men and the varying location

219 Power and Market with 154 Man, Economy, and State of natural resources. The result is that a good comes first into existence by production, and then is sold by its producer in exchange for some other good, which has been produced in the same way. The initial sales of any new stock will all be made by original producers of the good. Purchases will be made by buy- ers who will use the good either for their direct use or for hold- ing the good in speculative anticipation of later reselling it at a higher price. At any given time, therefore, new stock will be a ) sold by its original producers. The old stock will be sold by: ( original producers who through past reservation demand had b ) previous buyers who had bought in accumulated old stock; ( c speculative anticipation of reselling at a higher price; and ( ) previous buyers on whose value scales the relative utility of the good for their direct use has fallen. market supply schedule is formed by the At any time, then, the addition of the supply schedules of the following groups of sell- 30 ers: ( a ) The supply offered by producers of the good. 1. The initial supply of new stock. 2. The supply of old stock previously reserved by the producers. b ( ) The supply of old stock offered by previous buyers. 1. Sales by speculative buyers who had anticipated reselling at a higher price. 2. Sales by buyers who had purchased for direct use, but on whose value scales the relative utility of the good has fallen. 30 The addition of supply schedules is a simple process to conceive: if at a price X , the class (a) sellers will supply T tons of a good and the class (b) sellers will supply T ′ the total market supply for that price is T + T ′ tons. The same process applies to each hypothetical price.

220 Direct Exchange 155 The market demand schedule at any time consists of the sum of the demand schedules of: c ) Buyers for direct use. ( ( d ) Speculative buyers for resale at a higher price. Since the good consists of equally serviceable units, the buy- ers are necessarily indifferent as to whether it is old or new stock that they are purchasing. If they are not, then the “stock” refers to two different goods, and not the same good. The supply curve of the class ( b ) type of sellers has already been fully analyzed above, e.g., the relationship between stock and reservation demand for speculative resellers and for those whose utility position has changed. What more can be said, however, of the supply schedule of the class ( a ) sellers—the original producers of the good? In the first place, the stock of newly produced goods in the hands of the producers is also for any given point in time fixed Say that for the month of December the producers of copper decide to produce 5,000 tons of copper. At the end of that month their stock of newly produced copper is 5,000 tons. They might regret their decision and believe that if they could have made it again, they would have produced, say, 1,000 tons. But they have their stock, and they must use it as best they can. The distinguishing feature of the original producers is that, as a result of specialization, the direct use-value of their product to them is likely to be almost nonexistent. The further specializa- tion proceeds, the less possible use-value the product can have for its producer. Picture, for example, how much copper a cop- per manufacturer could consume in his personal use, or the direct use-value of the huge number of produced automobiles to the Ford family. Therefore, in the supply schedule of the producers, the direct-use element in their reservation demand disappears. The only reason for a producer to reserve, to hold on to, any of his stock is speculative—in anticipation of a higher price for the good in the future. (In direct exchange, there is

221 Power and Market with 156 Man, Economy, and State also the possibility of exchange for a third good—say cows instead of fish, in our example.) If, for the moment, we make the restrictive assumptions that b ) sellers on the market and that the produc- there are no class ( ers have no present or accumulated past reservation demand, then the market supply-demand schedules can be represented as SS , DD in Figure 29. Thus, with no reservation demand, the supply curve will be a vertical straight line ( SS ) at the level of the new stock. It seems more likely, however, that a price below equilibrium will tend to call forth a reservation demand to hold by the producers in anticipation of a higher price (called “build- ing up inventory”), and that a price above equilibrium will result in the unloading of old stock that had been accumulated as a result of past reservation demand (called “drawing down inventory”). In that case, the supply curve assumes a more ′ S ′ ). familiar shape (the broken line above— S The removal of direct use-value from the calculation of the sellers signifies that all the stock must eventually be sold, so that

222 Direct Exchange 157 none of the stock can be reserved from sale by the ultimately producers. The producers will make their sales at that point at which they expect the market price to be the greatest that they can attain—i.e., at the time when the market demand for the 31 given stock is expected to be the greatest. The length of time that producers can reserve supply is, of course, dependent on the durability of the good; a highly perishable good like straw- berries, for example, could not be reserved for long, and its market supply curve is likely to be a vertical line. Suppose that an equilibrium price for a good has been reached on the market. In this case, the speculative element of reservation demand drops out. However, in contrast to the market in re-exchange of existing stock, the market for new pro- duction does not end. Since wants are always being renewed in each successive period of time, new stock will also be produced in each period, and if the amount of stock is the same and the demand schedule given, the same amount will continue to be sold at the same equilibrium price. Thus, suppose that the cop- per producers produce 5,000 tons in a month; these are sold (no reservation demand) at the equilibrium price of 0 X on the fore- S . The following going diagram. The equilibrium quantity is 0 month, if 5,000 tons are produced, the equilibrium price will be the same. If more is produced, then, as we saw above, the equi- librium price is lower; if less, the equilibrium price will be higher. If the speculative elements are also excluded from the demand schedule, it is clear that this schedule will be determined solely by the utility of the good in direct use (as compared with the util- ity of the sale-good). The only two elements in the value of a good are its direct use-value and its exchange-value, and the demand schedule consists of demand for direct use plus the speculative demand in anticipation of reselling at a higher price. 31 Strictly, of course, costs of storage will have to be considered in their calculations.

223 Power and Market with 158 Man, Economy, and State If we exclude the latter element (e.g., at the equilibrium price), the only ultimate source of demand is the direct use-value of the good to the purchaser. If we abstract from the speculative ele- ments in a market, therefore, the sole determinant of the market price of the stock of a good is its relative direct use-value to its purchasers. It is clear, as has been shown in previous sections, that pro- duction must take place over a period of time. To obtain a cer- tain amount of new stock at some future date, the producer must first put into effect a series of acts, using labor, nature, and capital goods, and the process must take time from the ini- tial and intermediary acts until the final stock is produced. Therefore, the essence of specialized production is anticipation of the future state of the market by the producers. In deciding whether or not to produce a certain quantity of stock by a future date, the producer must use his judgment in estimating the market price at which he will be able to sell his stock. This market price is likely to be at some equilibrium, but an equi- librium is not likely to last for more than a short time. This is especially true when (as a result of ever-changing value scales), the demand curve for the good continually shifts. Each pro- ducer tries to use his resources—his labor and useful goods— in such a way as to obtain, in the production of stock, the max- imum psychic revenue and hence a psychic profit. He is ever liable to error, and errors in anticipating the market will bring him a psychic loss. The essence of production for the market, therefore, is entrepreneurship. The key consideration is that the demand schedules, and consequently the future prices, are not and can never be definitely and automatically known to the producers. They must estimate the future state of demand as best they can. Entrepreneurship is also the dominant characteristic of buy- ers and sellers who act speculatively, who specialize in antici- pating higher or lower prices in the future. Their entire action consists in attempts to anticipate future market prices, and their success depends on how accurate or erroneous their forecasts

224 Direct Exchange 159 are. Since, as was seen above, correct speculation quickens the movement toward equilibrium, and erroneous speculation tends to correct itself, the activity of these speculators tends to hasten the arrival of an equilibrium position. The direct users of a good must also anticipate their desires for a good when they purchase it. At the time of purchase, their actual use of a good will be at some date in the future, even if in the very near future. The position of the good on their value scales is an estimate of its expected future value in these periods, discounted by time preferences. It is very possible for the buyer to make an erroneous forecast of the value of the good to him in the future, and the more durable the good, the greater the likelihood of error. Thus, it is more likely that the buyer of a house will be in error in forecasting his own future valuation than the buyer of strawberries. Hence, entrepreneurship is also a feature of the buyer’s activity—even in direct use. However, in the case of specialized producers, entrepreneurship takes the form of estimating other people’s future wants, and this is obvi- ously a far more difficult and challenging task than forecasting own valuations. one’s Human action occurs in stages, and at each stage an actor must make the best possible use of his resources in the light of expected future developments. The past is forever bygone. The role of errors in different stages of human action may be con- sidered in the comparatively simple case of the man who buys a good for direct use. Say that his estimate of his future uses is such that he purchases a good—e.g., 10 quarts of milk—in exchange for 100 barrels of fish, which also happens to be his maximum buying price for 10 quarts of milk. Suppose that after the purchase is completed he finds, for some reason, that his valuations have changed and that the milk is now far lower on his value scale. He is now confronted with the question of the best use to make of the 10 quarts of milk. The fact that he has made an error in using his resources of 100 barrels of fish does not remove the problem of making the best use of the 10 quarts of milk. If the price is still 100 barrels of fish, his best

225 Power and Market with 160 Man, Economy, and State course at present would be to resell the milk and reobtain the 100 barrels of fish. If the price is now above 100, he has made a speculative gain, and he can resell the milk for more fish. And if the price of milk has fallen, but the fish is still higher on his value scale than the 10 quarts of milk, it would maximize his psychic revenue to sell the milk for less than 100 barrels of fish. It is important to recognize that it is absurd to criticize such X an action by saying that he suffered a clear loss of barrels of fish from the two exchanges. To be sure, if he had correctly forecast later developments, the man would not have made the original exchange. His original exchange can therefore be termed erroneous in retrospect. But once the first exchange has been made, he must make the best possible present and future use of the milk, regardless of past errors, and therefore his sec- ond exchange was his best possible choice under the circum- stances. If, on the other hand, the price of milk has fallen below his new minimum buying price, then his best alternative is to use the milk in its most valuable direct use. Similarly, a producer might decide to produce a certain amount of stock, and, after the stock has been made, the state of the market turns out to be such as to make him regret his deci- sion. However, he must do the best he can with the stock, once it has been produced, and obtain the maximum psychic revenue from it. In other words, if we consider his action from the beginning—when he invested his resources in production—his act in retrospect was a psychic loss because it did not yield the best available alternative from these resources. But once the stock is produced, this is his available resource, and its sale at the best possible price now nets him a psychic gain. At this point, we may summarize the expected (psychic) rev- enue and the expected (psychic) cost, factors that enter into the decision of buyers and sellers in any direct exchange of two goods.

226 Direct Exchange 161 Buyer Revenue Seller Revenue Either Either *A. Direct use of purchase- *A. Direct use of sale-good good or B. Anticipated later sale at B. Anticipated later purchase at or higher price lower price (whichever is the greater on (whichever is the greater his value scale) on his value scale) Buyer Cost Seller Cost Either Either A. Direct use of sale-good A. Direct use of purchase-good or B. Anticipated later purchase *B. Exchange for a third good or at lower price or * C. Exchange for a third good or C. Later sale at a higher price (whichever is the greatest (whichever is the greatest on on his value scale) his value scale) If we eliminate the temporary speculative element, we are A A , cost C for buyers; and rev- left with factors: revenue , cost , cost A , cost B for sellers . Similarly, if we consider the enue A sellers as the specialized original producers—and this will be more true the greater the proportion of the rate of production A to accumulated stock—cost drops out for the sellers. If we also remember that, since the exchange involves two goods, the set of buyers for one good the set of sellers for the other good, is A is eliminated as a factor for buyers as well. Only the fac- cost tors asterisked above ultimately remain. The revenue for both the buyers and the sellers is the expected direct use of the goods acquired; the costs are the exchange for a third good that is for- gone because of this exchange. The revenue and costs that are involved in making the origi- nal decision regarding the production of stock are, as we have indi- cated, of a different order, and these will be explored in subse- quent chapters.

227 Power and Market with 162 Man, Economy, and State 11. Types of Exchangeable Goods For the sake of clarity, the examples of exchangeable goods commodi- in this chapter have mainly been taken from tangible ties , such as horses, fish, eggs, etc. Such commodities are not the only type of goods subject to exchange, however. A may personal services for the commodity of B exchange his . Thus, for example, may give his labor services to farmer B in exchange A for farm produce. Furthermore, may give personal services A that function directly as consumers’ goods in exchange for another good. An individual may thus exchange his medical advice or his musical performance for food or clothing. These services are as legitimately consumers’ goods as those goods that are embodied in tangible, physical commodities. Similarly, individual labor services are as much producers’ goods as are tangible capital goods. As a matter of fact, tangible goods are valued not so much for their physical content as for their serv- to the user, whether he is a consumer or a producer. The ices services in providing nourishment, actor values the bread for its the house for its services in providing shelter, the machine for its service in producing a lower-order good. In the last analysis, tangible commodities are also valued for their services, and are thus on the same plane as intangible personal “services.” Economics, therefore, is a science that deals particularly not with “material goods” or “material welfare.” It deals in general with the action of men to satisfy their desires, and, specifically, with the process of exchange of goods as a means for each indi- vidual to “produce” satisfactions for his desires. These goods may be tangible commodities or they may be intangible per- sonal services. The principles of supply and demand, of price determination, are exactly the same for any good, whether it is in one category or the other. The foregoing analysis is applica- ble to all goods. Thus, the following types of possible exchanges have been covered by our analysis:

228 Direct Exchange 163 a ( ) A commodity for a commodity; such as horses for fish. ) A commodity for a personal service; such as medical ( b advice for butter, or farm labor for food. c ) A personal service for a personal service; such as mutual ( log-rolling by two settlers, or medical advice for garden- 32 ing labor, or teaching for a musical performance. In cases where there are several competing homogeneous units, supply and demand schedules can be added; in cases where one or both parties are isolated or are the only ones exchanging, the zone of price determination will be established as indicated above. Thus, if one arithmetic teacher is bargaining with one violinist for an exchange of services, their respective utility rankings will set the zone of price determination. If several arithmetic teachers and several violinists who provide homoge- neous services form a market for their two goods, the market price will be formed with the addition and intersection of sup- ply and demand schedules. If the services of the different indi- viduals are not considered as of equal quality by the demanders, they will be evaluated separately, and each service will be priced 33 separately. The supply curve will then be a supply of units of a commodity possessed by only one individual. This individual supply curve is, of course, sloped upward in a rightward direc- tion. Where only one individual is the supplier of a good on the market, his supply curve is identical with the market supply curve. One evident reason for the confusion of exchange with a mere trade of material objects is the fact that much intangible prop- erty cannot , by its very nature, be exchanged. A violinist may own his musicianly ability and exchange units of it, in the form of 32 On the importance of services, see Arthur Latham Perry, Political Economy (21st ed.; New York: Charles Scribner’s Sons, 1892), pp. 124–39. 33 This is not to deny, of course, that the existence of several violinists of different quality will affect the consumer’s evaluations of each one.

229 Power and Market with 164 Man, Economy, and State the services of a physician. But other personal attri- service, for butes, which cannot be exchanged, may be desired as goods. Thus, Brown might have a desired end: to gain the genuine approval of Smith. This is a particular consumers’ good which he cannot purchase with any other good, for what he wants is the genuine approval rather than a show of approval that might be purchased. In this case, the consumers’ good is a property of Smith’s that cannot be exchanged; it might be acquired in some way, but not by exchange. In relation to exchange, this intangible good is an inalienable property of Smith’s, i.e., it cannot be given up. Another example is that a man cannot permanently transfer his will, even though he may transfer much of his services and his property. As mentioned above, a man may not agree to perma- nent bondage by contracting to work for another man for the rest of his life. He might change his mind at a later date, and then he cannot, in a free market, be compelled to continue working thereafter. Because a man’s self-ownership over his will is inalien- able, he cannot, on the unhampered market, be compelled to continue an arrangement whereby he submits his will to the orders of another, even though he might have agreed to this 34, 35 On the other hand, when property arrangement previously. can be alienated is transferred, it, of course, becomes the that 34 If he has taken the property of another by means of such an agree- ment, he will, on the free market, have to return the property. Thus, if A has agreed to work for life for B in exchange for 10,000 grams of gold, he will have to return the proportionate amount of property if he terminates the arrangement and ceases the work. 35 In other words, he cannot make enforceable contracts binding his future personal actions. (On contract enforcement in an unhampered market, see section 13 below. This applies also to marriage contracts . Since human self-ownership cannot be alienated, a man or a woman, on a free market, could not be compelled to continue in marriage if he or she no longer desired to do so. This is regardless of any previous agreement. Thus, a marriage contract, like an individual labor contract, is, on an unhampered market, terminable at the will of either one of the parties.

230 Direct Exchange 165 property—under the sole and exclusive jurisdiction—of the per- son who has received it in exchange, and no later regret by the original owner can establish any claim to the property. Thus, exchange may occur with alienable goods; they may be con- sumers’ goods, of varying degrees of durability; or they may be pro- ducers’ goods. They may be tangible commodities or intangible per- sonal services. There are other types of exchangeable items, which are based on these alienable goods. For example, sup- pose that Jones deposits a good—say 1,000 bushels of wheat— in a warehouse for safekeeping. He retains ownership of the good, but transfers its physical possession to the warehouse warehouse owner, Green, for safekeeping. Green gives Jones a for the wheat, certifying that the wheat is there for safe- receipt claim to receive keeping and giving the owner of the receipt a the wheat whenever he presents the receipt to the warehouse. In exchange for this service as a guardian of the wheat, Jones pays him a certain agreed amount of some other good, say emeralds. Thus, the claim originates from an exchange of a commodity for a service—emeralds for storage—and the price of this exchange is determined according to the principles of the foregoing analysis. Now, however, the warehouse receipt has come into existence as a claim to the wheat. On an unham- pered market, the claim would be regarded as absolutely secure and certain to be honored, and therefore Jones would be able substitute for actual physical to exchange the claim as a exchange of the wheat. He might find another party, Robinson, who wishes to purchase the wheat in exchange for horses. They claim on the agree on a price, and then Robinson accepts the warehouse as a perfectly good substitute for actual transfer of the wheat. He knows that when he wants to use the wheat, he will be able to redeem the claim at the warehouse; the claim therefore functions here as a In this case, the goods-substitute. claim is to a present good , since the good can be redeemed at any time that the owner desires. Here, the nature and function of the claim is simple. The claim is a secure evidence of ownership of the good. Even sim pler

231 Power and Market with 166 Man, Economy, and State is a case where ownership of property, say a farm, is transferred from A to B by transferring written title , or evidence of owner- ship, which may be considered a claim. The situation becomes more complicated, however, when ownership is divided into pieces, and these pieces are transferred from person to person. Thus, suppose that Harrison is the owner of an iron mine. He decides to divide up the ownership, and sell the various divided pieces, or shares , of the good to other individuals. Assume that he creates 100 tickets, with the total constituting the full own- ership of the mine, and then sells all but 10 tickets to numerous 2 /100 other individuals. The owner of two shares then becomes a owner of the mine. Since there is very little practical scope for such activity in a regime of direct exchange, analysis of this situ- ation will be reserved for later chapters. It is clear, however, that 2 owner is entitled to his proportionate share of direc- /100 the tion and control of, and revenue from, the jointly owned prop- erty. In other words, the share is evidence of part-ownership, or a claim to part-ownership, of a good. This property right in a proportionate share of the use of a good can also be sold or bought in exchange. A third type of claim arises from a (or credit credit exchange transaction ). Up to this point we have been discussing exchanges of one for another—i.e., the good can be used at present good present —or at any desired time—by each receiver in the exchange. In a credit transaction, a present good is exchanged for a future good , or rather, a claim on a future good. Suppose, for example, that Jackson desires to acquire 100 pounds of cotton at once. He makes the following exchange with Peters: Peters to give Jackson 100 pounds of cotton now (a present good); and, in return, Jackson gives Peters a claim on 110 pounds of cotton one year from now. This is a claim on a future good—110 pounds of cotton one year from now. The price of the present good in terms of the future good is 1.1 pounds of future cotton (one year from now) per pound of present cotton. Prices in such exchanges are determined by value scales and the meeting of supply and demand schedules, just as in the case of exchanges of

232 Direct Exchange 167 present goods. Further analysis of the pricing of credit transac- tions must be left for later chapters; here it may be pointed out that, as explained in the previous chapter, every man will evalu- ate a homogeneous good more highly the earlier in time is his prospect of attaining it. A present good (a good consisting of units capable of rendering equivalent satisfaction) will always be valued more highly than the same good in the future, in accor- dance with the individual’s rate of time preference. It is evident that the various rates of time preference—ultimately deter- mined by relative positions on individual value scales—will act to set the price of credit exchanges. Moreover, the receiver of the debtor the present good— greater —will always have to repay a amount of the good in the future to the creditor —the man who receives the claim, since the same number of units is worth more as a present good than as a future good. The creditor is rendering the debtor the service of using a good in the present , while the debtor pays for this service by repaying a greater amount of the good in the future. At the date when the claim finally falls due, the creditor re- deems the claim and acquires the good itself, thus ending the existence of the claim. In the meanwhile, however, the claim is in existence, and it can be bought and sold in exchange for other goods. Thus, Peters, the creditor, might decide to sell the claim—or promissory note—to Williams in exchange for a wagon. The price of this exchange will again be determined by supply and demand schedules. Demand for the note will be based on its security as a claim to the cotton. Thus, Williams’ demand for the note (or Peters’ demand to hold) in terms of wagons will be based on ( a ) the direct utility and exchange-value of the wagon, and ( ) the marginal utility of the added units of b cotton, discounted by him on two possible grounds: (l) the length of time the claim has left until the date of “maturity,” and (2) the estimate of the security of the note. Thus, the less time there remains to elapse for a claim to any given good, the higher will it tend to be valued in the market. Also, if the eventual payment is considered less than absolutely secure, because of possible

233 Power and Market with 168 Man, Economy, and State failure to redeem, the claim will be valued less highly in accor- dance with people’s estimates of the likelihood of its failure. After a note has been transferred, it becomes the property of the new owner, who becomes the creditor and will be entitled to redeem the claim when due. When a claim is thus transferred in exchange for some other claim ), this in itself is not a credit transaction. A credit good (or unfinished payment on the part of the debtor; exchange sets up an in this case, Peters pays Williams the claim in return for the other good, and the transaction is finished. Jackson, on the other hand, remains the debtor as a result of the original trans- action, which remains unfinished until he makes his agreed- 36 upon payment to the creditor on the date of maturity. The several types of claims, therefore, are: on present goods, by such means as warehouse receipts or shares of joint ownership in a good; and on future goods, arising from credit transactions. These are evidences of ownership, or, as in the latter case, objects that will become evidence of ownership at a later date. Thus, in addition to the three types of exchanges mentioned above, there are three other types whose terms and principles are included in the preceding analysis of this chapter: ( d ) A commodity for a claim; examples of this are: (1) the de- posit of a commodity for a warehouse receipt—the claim to a present good; (2) a credit transaction, with a com- modity exchanged for a claim to a future commodity; (3) the purchase of shares of stock in a commodity by exchanging another type of commodity for them; (4) the purchase of promissory notes on a debtor by exchanging 36 In a credit transaction, it is not necessary for the present and the future goods exchanged to be the same commodity. Thus, a man can sell wheat now in exchange for a certain amount of cor n at a future date. The example in the text, however, highlights the importance of time prefer- ence and is also more likely to occur in practice.

234 Direct Exchange 169 a commodity. All four of these cases have been described above. e ) A claim for a service; an example is personal service being ( exchanged for a promissory note or warehouse receipt or stock. f ) A claim for a claim; examples would be: exchange of a ( promissory note for another one; of stock shares for a note; of one type of stock share for another; of a ware- house receipt for any of the other types of claims. With all goods analyzable into categories of tangible commodities, services, or claims to goods (goods-substitutes), all six possible types of exchanges are covered by the utility and supply-demand analysis of this chapter. In each case, different concrete considerations enter into the formation of the value scales–such as time preference in the case of credit exchanges; and this permits more to be said about the various specific types of exchanges. The level of analysis presented in this chapter, however, encompasses all possible exchanges of goods. In later chapters, when indirect exchange has been introduced, the pres- ent analysis will apply also, but further analysis will be made of production and exchange problems involved in credit exchanges (time preference); in exchanges for capital goods and consumer goods; and in exchanges for labor services (wages). 12. Property: The Appropriation of Raw Land As we have stated above, the origin of all property is ulti- mately traceable to the appropriation of an unused nature-given factor by a man and his “mixing” his labor with this natural fac- tor to produce a capital good or a consumers’ good. For when we trace back through gifts and through exchanges, we must reach a man and an unowned natural resource. In a free society, any piece of nature that has never been used is unowned and is subject to a man’s ownership through his first use or mixing of his labor with this resource.

235 Power and Market with 170 Man, Economy, and State How will an individual’s title to the nature-given factor be determined? If Columbus lands on a new continent, is it legiti- mate for him to proclaim all the new continent his own, or even that sector “as far as his eye can see”? Clearly, this would not be the case in the free society that we are postulating. Columbus or Crusoe would have to use the land, to “cultivate” it in some way, before he could be asserted to own it. This “cultivation” does not have to involve tilling the soil, although that is one possible form of cultivation. If the natural resource is land, he may clear it for a house or a pasture, or care for some plots of timber, etc. If there is more land than can be used by a limited labor supply, then the unused land must simply remain unowned until a first user arrives on the scene. Any attempt to claim a new resource that someone does not use would have to be considered invasive of the property right of whoever the first user will turn out to be. There is no requirement, however, that land continue to be used in order for it to continue to be a man’s property. Suppose that Jones uses some new land, then finds it is unprofitable, and lets it fall into disuse. Or suppose that he clears new land and therefore obtains title to it, but then finds that it is no longer useful in production and allows it to remain idle. In a free so- ciety, would he lose title? No, for once his labor is mixed with the natural resource, it remains his owned land. His labor has been irretrievably mixed with the land, and the land is therefore his or his assigns’ in perpetuity. We shall see in later chapters that the question whether or not labor has been mixed with land is irrelevant to its market price or capital value; in catallactics, the past is of no interest. In establishing the ownership of property, however, the question is important, for once the mixture takes place, the man and his heirs have appropriated the nature-given factor, and for anyone else to seize it would be an invasive act. As Wolowski and Levasseur state: Nature has been appropriated by him (man) for his use; she has become his own ; she is his property . This property is legitimate; it constitutes a right as sacred for man as is the free exercise of his faculties. It is his

236 Direct Exchange 171 because it has come entirely from himself, and is in no way anything but an emanation from his being. Before him, there was scarcely anything but matter; since him, and by him, there is interchangeable wealth. The producer has left a fragment of his own person in the thing which has thus become valuable, and may hence be regarded as a prolongation of the faculties of man acting upon external nature. As a free being he belongs to himself; now, the cause, that is to say, the productive force, is himself; the effect, that is to say, the wealth produced, is still himself. Who shall dare contest his title of ownership so clearly marked 37 by the seal of his personality? Some critics, especially the Henry Georgists, assert that, while a man or his assigns may be entitled to the produce of his own labor or anything exchanged for it, he is not entitled to an original, nature-given factor, a “gift of nature.” For one man to appropriate this gift is alleged to be an invasion of a common heritage that all men deserve to use equally. This is a self- contradictory position, however. A man cannot produce any- thing without the co-operation of original nature-given factors, if only as standing room. In order to produce and possess any capital good or consumers’ good, therefore, he must appropri- ate and use an original nature-given factor. He cannot form products purely out of his labor alone; he must mix his labor with original nature-given factors. Therefore, if property in land or other nature-given factors is to be denied man, he can- not obtain property in the fruits of his labor. Furthermore, in the question of land, it is difficult to see what better title there is than the first bringing of this land from a simple unvaluable thing into the sphere of production. For that is what the first user does. He takes a factor that was 37 Léon Wolowski and Émile Levasseur, “Property,” Lalor’s Cyclopedia of Political Science, etc. (Chicago: M.B. Cary & Co., 1884), III, 392.

237 Power and Market with 172 Man, Economy, and State previously unowned and unused, and therefore worthless to anyone, and converts it into a tool for production of capital and consumers’ goods. While such questions as communism of property will be discussed in later parts of this book, it is diffi- cult indeed to see why the mere fact of being born should auto- matically confer upon one some aliquot part of the world’s land. For the first user has mixed his labor with the land, while neither the newborn child nor his ancestors have done anything with the land at all. The problem will be clearer if we consider the case of ani- mals . Animals are “economic land,” because they are equivalent to physical land in being original, nature-given factors of pro- duction. Yet will anyone deny title to a cow to the man that finds and domesticates her, putting her to use? For this is precisely what occurs in the case of land. Previously valueless “wild” land, like wild animals, is taken and transformed by a man into goods useful for man. The “mixing” of labor gives equivalent title in one case as in the other. We must remember, also, what “production” entails. When man “produces,” he does not create matter. He uses given ma- terials and transforms and rearranges them into goods that he desires. In short, he moves matter further toward consumption. His finding of land or animals and putting them to use is also such a transformation. Even if the value accruing to a piece of land at present is sub- stantial, therefore, it is only “economic land” because of the innumerable past efforts of men at work on the land. When we are considering legitimacy of title, the fact that land always 38 embodies past labor becomes extremely important. 38 See the vivid discussion by Edmond About, Handbook of Social Econ- omy (London: Strahan & Co., 1872), pp. 19–30. Even urban sites embody much past labor. Cf. Herbert B. Dorau and Albert G. Hinman, Urban Land Economics (New York: Macmillan & Co., 1928), pp. 205–13.

238 Direct Exchange 173 If animals are also “land” in the sense of given original nature factors, so are water and air. We have seen that “air” is in- appropriable, a condition of human welfare rather than a scarce good that can be owned. However, this is true only of air for breathing under usual conditions. For example, if some people want their air to be changed, or “conditioned,” then they will have to pay for this service, and the “conditioned air” becomes is owned by its producers. a scarce good that Furthermore, if we understand by “air” the medium for the transmission of such things as radio waves and television images, there is only a limited quantity of wave lengths available for radio and for television purposes. This scarce factor appropri- is able and ownable by man. In a free society, ownership of these channels would accrue to individuals just like that of land or ani- mals: the first users obtain the property. The first user, Jones, of the wave length of 1,000 kilocycles, would be the absolute owner of this length for his wave area, and it will be his right to con- tinue using it, to abandon it, to sell it, etc. Anyone else who set up a transmitter on the owner’s wave length would be as guilty of invasion of another’s property right as a trespasser on some- 39, 40 one else’s land or a thief of someone else’s livestock. water . Water, at least in rivers and oceans, The same is true of has been considered by most people as also inappropriable and unownable, although it is conceded to be ownable in the cases of (small) lakes and wells. Now it is true that the high seas, in re- lation to shipping lanes, are probably inappr opriable, because of 39 If a channel has to be a certain number of wave lengths in width in order to permit clear transmission, then the property would accrue to the first user, in terms of such width. 40 Professor Coase has demonstrated that Federal ownership of air- waves was arrogated, in the 1920’s, not so much to alleviate a preceding “chaos,” as to forestall this very acquisition of private property rights in air waves, which the courts were in the process of establishing according to common law principles. Ronald H. Coase, “The Federal Communications Commission,” Journal of Law and Economics, October, 1959, pp. 5, 30–32.

239 Power and Market with 174 Man, Economy, and State 41 This is their abundance in relation to shipping routes. not rights in oceans. Fish are definitely not fishing true, however, of available in unlimited quantities relatively to human wants. Therefore, they are appropriable—their stock and source just as the captured fish themselves. Indeed, nations are always quar- reling about “fishing rights.” In a free society, fishing rights to the appropriate areas of oceans would be owned by the first users of those areas and then usable or salable to other individ- uals. Ownership of areas of water that contain fish is directly analogous to private ownership of areas of land or forests that contain animals to be hunted. Some people raise the difficulty that water flows and has no fixed position, as land does. This is a completely invalid objection, however. Land “moves” too, as when soil is uprooted in dust storms. Most important, water can definitely be marked off in terms of latitudes and longitudes. These boundaries, then, would circumscribe the area owned by individuals, in the full knowledge that fish and water can move from one person’s property to another. The value of the prop- 42 erty would be gauged according to this knowledge. Another argument is that appropriation of ownership by a first user would result in an uneconomic allocation of the 41 are It is rapidly becoming evident that air lanes for planes becom- ing scarce and, in a free society, would be owned by first users—thus obviating a great many plane crashes. 42 Flowing water should be owned in proportion to its rate of use by the first user—i.e., by the “appropriation” rather than the “riparian” method of ownership. However, the appropriator would then have absolute control over his property, might transfer his share, etc., some- thing which cannot be done in those areas, e.g., states in the West, where an approach to appropriation ownership now predominates. See Murray N. Rothbard, “Concerning Water,” The Freeman, March, 1956, pp. 61–64. Also see the excellent article by Professor Jerome W. Milli- man, “Water Law and Private Decision-Making: A Critique,” The Jour- nal of Law and Economics, October, 1959, pp. 41–63; Milliman, “Com- monality, the Price System, and Use of Water Supplies,” Southern Eco- nomic Journal, April, 1956, pp. 426–37.

240 Direct Exchange 175 given factors. Thus, suppose that one man can fence, cul- nature- tivate, or otherwise use, only five acres of a certain land, while the most economic allocation would be units of 15 acres. How- first ownership by the first user , followed in a free ever, the rule of society, would not mean that ownership must end with this allo- cation. On the contrary. In this case, either the owners would pool their assets in one corporate form, or the most efficient individual owners would buy out the others, and the final size of each unit of land in production would be 15 acres. It must be added that the theory of land ownership in a free society set forth here, i.e., first ownership by the first user, has nothing in common with another superficially similar theory of land ownership—advanced by J.K. Ingalls and his disciples in the late nineteenth century. Ingalls advocated continuing own- ership only for actual occupiers and personal users of the land. This is in contrast to original ownership by the first user. The Ingalls system would, in the first place, bring about a highly uneconomic allocation of land factors. Land sites where small “homestead” holdings are uneconomic would be forced into use in spite of this, and land would be prevented from enter- ing other lines of use greatly demanded by consumers. Some land would be artificially and coercively withdrawn from use, since land that could not be used by owners in person would have to lie idle. Furthermore, this theory is self-contradictory, since it would not really permit ownership at all. One of the prime con- ditions of ownership is the right to buy, sell, and dispose of prop- erty as the owner or owners see fit. Since small holders would not have the right to sell to nonoccupying large holders, the small holders would not really be owners of the land at all. The result is that on the ownership question, the Ingalls thesis reverts, in the final analysis, to the Georgist view that Society (in 43 the alleged person of the State) should own the land. 43 On Ingalls and his doctrines, see James J. Martin, Men Against the State (DeKalb, Ill.: Adrian Allen Associates, 1953), pp. 142–52, 220 ff.,

241 Power and Market with 176 Man, Economy, and State 13. Enforcement Against Invasion of Property This work is largely the analysis of a market society un- hampered by the use of violence or theft against any man’s per- son or property. The question of the means by which this con- dition is best established is not at present under consideration. For the present purpose, it makes no difference whether this refrain from condition is established by every man’s deciding to against others or whether some agency is estab- invasive action lished to enforce the abandonment of such action by every indi- vidual. ( Invasive action may be defined as any action—violence, theft, or fraud—taking away another’s personal freedom or property without his consent.) Whether the enforcement is undertaken by each person or by some sort of agency, we assume here that such a condition—the existence of an unham- pered market—is maintained in some way. One of the problems in maintaining the conditions of a free market is the role of the enforcing agency—whether individual or organizational—in exchange contracts. What type of con- tracts are to be enforced to maintain the conditions of an unhampered market? We have already seen that contracts assigning away the will of an individual cannot be enforced in such a market, because the will of each person is by its nature inalienable. On the other hand, if the individual made such a contract and received another’s property in exchange, he must forfeit part or all of the property when he decides to terminate the agreement. We shall see that fraud may be considered as theft, because one individual receives the other’s property but does not fulfill his part of the exchange bargain, thereby taking 246 ff. Also cf. Benjamin R. Tucker, Instead of a Book (2nd ed.; New York: B.R. Tucker, 1897), pp. 299–357, for the views of Ingalls’ most able dis- ciple. Despite the underlying similarity and their many economic errors, the Ingalls-Tucker group launched some interesting and effective cri- tiques of the Georgist position. These take on value in the light of the excessive kindness often accorded to Georgist doctrines by economists.

242 Direct Exchange 177 the other’s property without his consent. This case provides the clue to the role of contract and its enforcement in the free soci- ety. Contract must be considered as an agreed-upon exchange between two persons of two goods, present or future. Persons would be free to make any and all property contracts that they wished; and, for a free society to exist, all contracts, where the good is naturally alienable, must be enforced. Failure to fulfill contracts must be considered as theft of the other’s property. Thus, when a debtor purchases a good in exchange for a prom- ise of future payment, the good cannot be considered his prop- erty until the agreed contract has been fulfilled and payment made. Until then, it remains the creditor’s property, and non- payment would be equivalent to theft of the creditor’s property. An important consideration here is that contract not be en- forced because a promise has been made that is not kept. It is not the business of the enforcing agency or agencies in the free market to enforce promises merely because they are promises; its business is to enforce against theft of property, and contracts are enforced because of the implicit theft involved. promise to pay property is an enforceable claim, Evidence of a because the possessor of this claim is, in effect, the owner of the property involved, and failure to redeem the claim is equivalent to theft of the property. On the other hand, take the case of a promise to contribute personal services without an advance ex- change of property. Thus, suppose that a movie actor agrees to act in three pictures for a certain studio for a year. Before re- ceiving any goods in exchange (salary), he breaks the contract and decides not to perform the work. Since his personal will is inalienable, he cannot, on the free market, be forced to perform the work there. Further, since he has received none of the movie company property in exchange, he has committed no theft, and thus the contract cannot be enforced on the free market. Any suit for “damages” could not be entertained on an unhampered market. The fact that the movie company may have made con- siderable plans and investments on the expectation that the actor would keep the agreement may be unfortunate for the

243 Power and Market with 178 Man, Economy, and State company, but it could not expect the actor to pay for its lack of foresight and poor entrepreneurship. It pays the penalty for placing too much confidence in the man. The movie actor has not received and kept any of the company’s property and there- fore cannot be held accountable in the form of payment of 44 goods as “damages.” Any such enforced payment would be an invasion of his property rights on the free market rather than an attack upon invasion. It may be considered more moral to keep promises than to break them, but the condition of a free market is that each individual’s rights of person and property be main- further standard of morals be coer- tained, and not that some cively imposed on all. Any coercive enforcement of such a moral code, going beyond the abolition of invasive acts, would in itself constitute an invasion of individual rights of person and prop- 45 erty and be an interference in the free market. 44 This is true even if the actor had previously agreed in a contract that he would pay damages. For this is still merely a promise; he has not implicitly seized someone else’s property. The object of an enforcing agency in a free society is not to uphold promise-keeping by force, but to redress any invasions of person and property. 45 Sir Frederick Pollock thus describes original English contract law: Money debts, it is true, were recoverable from an early time. But this was not because the debtor had promised to repay the loan; it was because the money was deemed still to belong to the creditor, as if the identical coins were merely in the debtor’s custody. The creditor sued to recover money . . . in exactly the same form which he would have used to demand possession of land . . . and down to Blackstone’s time the creditor was said to have a property in the debt—property which the debtor had granted him. Giving credit, in this way of thinking, is not reliance on the right to call thereafter for an act . . . to be performed by the debtor, but merely suspension of the immediate right to possess one’s own particular money, as the owner of a house lot suspends his right to occupy it. . . . The foundation of the plaintiff’s right was not bargain or promise, but the unjust detention by the defendant of

244 Direct Exchange 179 It certainly would be consonant with the free market, how- ever, for the movie company to ask the actor to pay a certain sum in consideration of his breaking the contract, and, if he re- fuses, to refuse to hire him again, and to notify other prospec- tive contracting parties (such as movie companies) of the per- son’s action. It seems likely that his prospect of making exchanges in the future will suffer because of his action. Thus, the “blacklist” is permissible on the free market. Another legit- boycott imate action on the free market is the , by which A urges B not to make an exchange with C, for whatever reason. Since A’s and B’s actions are purely voluntary and noninvasive, there is no reason for a boycott not to be permitted on the unhampered market. On the contrary, any coercive action against a boycott is an invasion against the rights of free persons. If default on contracted debts is to be considered as equiva- lent to theft, then on the unhampered market its treatment by the enforcing agency will be similar to that of theft. It is clear— for example, in the case of burglary—that the recovery of the stolen property to its owner would be the fundamental consid- eration for the enforcing agency. Punishment of the wrongdoer would be a consideration subsidiary to the former. Thus, sup- pose A has stolen 100 ounces of gold from B . By the time A has been apprehended by the enforcing agency, he has dissipated the 100 ounces and has no assets by which the 100 ounces can be obtained. The main goal of the enforcement agency should be to force A to return the 100 ounces. Thus, instead of simply idle imprisonment, the agency could force the thief to labor and to attach his earnings to make up the amount of the theft, plus a compensation for the delay in time. Whether this forced labor is done in or out of prison is immaterial here. The main point is that the invader of another’s rights on the free market gives the plaintiff’s money or goods. (Sir Frederick Pollock, “Contract,” Encyclopedia Britannica [14th ed.; London, 1929], VI, 339–40)

245 Power and Market with 180 Man, Economy, and State up his rights to the same extent. The first consideration in the punishment of the aggressor against property in the free market 46 is the forced return of the equivalent property. On the other hand, suppose that B voluntarily decides to forgive A and grant the latter a gift of the property; he refuses to “press charges” against the thief. In that case, the enforcement agency would take no action against the robber, since he is now in the position of the receiver of a gift of property. This analysis provides the clue to the treatment of defaulting debtors on the free market. If a creditor decides to forget about the debt and not press charges, he in effect grants a gift of his property to the debtor, and there is no further room for enforce- ment of contract. What if the creditor insists on keeping his property? It is clear that if the debtor can pay the required amount but refuses to do so, he is guilty of pure fraud, and the enforcing agency would treat his act as such. Its prime move would be to make sure that the debtor’s assets are transferred to their rightful owner, the creditor. But suppose that the debtor has not got the property and would be willing to pay if he had it? Does this entitle him to special privilege or coerced elimination of the debt, as in the case of bankruptcy laws? Clearly not. The prime consideration in the treatment of the debtor would be his continuing and primary responsibility to redeem the property of the creditor. The only way by which this treatment could be eliminated would be for the debtor and the creditor to agree, as part of the original contract, that if the debtor makes certain investments and fails to have the property at the date due, the 46 Wordsworth Donisthorpe, Law in A Free State (London: Macmil- lan & Co., 1895), p. 135: In Rome one could recover stolen goods, or damages for their loss, by what we should call a civil process, without in the least affecting the relation between the thief and the public by reason of the theft. Restitution first and punish- ment afterwards was the rule.

246 Direct Exchange 181 creditor will forgive the debt; in short, he grants the debtor the rights of a partial co-owner of the property. There could be no room, in a free society such as we have outlined, for “negotiable instruments.” Where the government designates a good as “negotiable,” if A steals it from B and then sells it to C without the latter’s knowledge of the theft, B can- not take the good back from C. Despite the fact that A was a thief and had no proper title to the good, C is decreed to be the legitimate owner, and B has no way of regaining his property. The law of negotiability is evidently a clear infringement of property right. Where property rights are fully defended, theft cannot be compounded in this manner. The buyer would have to purchase at his own risk and make sure that the good is not stolen; if he nonetheless does buy stolen goods, he must try to obtain restitution from the thief, and not at the expense of the rightful owner. What of a cartel agreement? Would that be enforceable in a free society? If there has been no exchange of property, and A, B, C . . . firms agree among themselves to set quotas on their production of a good, this agreement would surely not be ille- gal, but neither would it be enforceable. It could be only a sim- 47 ple promise and not an enforceable case of implicit theft. One difficulty often raised against a free society of individual property rights is that it ignores the problem of “external diseconomies” or “external costs.” But cases of “external disec- onomy” all turn out to be instances of failure of — government the enforcing agency—adequately to enforce individual prop- erty rights. The “blame,” therefore, rests not on the institution of private property, but on the failure of the government to 47 This reason for the unenforceability of a cartel agreement in a free society has no relation to any common-law hostility to agreements allegedly “in restraint of trade.” However, it is very similar to the English common-law doctrine finally worked out in the Mogul Steamship Case (1892). See William L. Letwin, “The English Common Law Concerning Monopolies,” University of Chicago Law Review, Spring, 1954, pp. 382 ff.

247 Power and Market with 182 Man, Economy, and State enforce this property right against various subtle forms of inva- sion—the failure, e.g., to maintain a free society. One instance of this failure is the case of smoke, as well as air pollution generally. In so far as the outpouring of smoke by factories pollutes the air and damages the persons and property of others, it is an invasive act. It is equivalent to an act of van- dalism and in a truly free society would have been punished after court action brought by the victims. Air pollution, then, is not an example of a defect in a system of absolute property rights, but of failure on the part of the government to preserve property rights. Note that the remedy, in a free society, is not the creation of an administrative State bureau to prescribe reg- ulations for smoke control. The remedy is judicial action to pun- ish and proscribe pollution damage to the person and property 48 of others. In a free society, as we have stated, every man is a self- owner. No man is allowed to own the body or mind of another, that being the essence of slavery. This condition completely overthrows the basis for a law of defamation, i.e., libel (written defamation) or slander (oral defamation). For the basis of out- lawing defamation is that every man has a “property in his own reputation” and that therefore any malicious or untruthful attack on him or his character (or even more, a truthful attack!) injures his reputation and therefore should be punished. How- ever, a man has no such objective property as “reputation.” His reputation is simply what others think of him, i.e., it is purely a function of the subjective thoughts of others. But a man can- not own the minds or thoughts of others. Therefore, I cannot 48 Noise is also an invasive act against another, a transmission of sound waves assaulting the eardrums of others. On “external diseconomies,” the only good discussion by an economist is the excellent one in Mises, Human Action , pp. 650–53. For an appreciation of the distinction between judicial and administrative action in a free society, as well as a fine grasp of property rights and governmental enforcement, see the classic discus- sion of adulteration in Donisthorpe, Law in A Free State , pp. 132–58.

248 Direct Exchange 183 invade a man’s property right by criticizing him publicly. Fur- ther, since I do not own others’ minds, either, I cannot force 49 anyone else to think less of the man because of my criticism. The foregoing observations should firmly remind us that what the enforcing agency combats in a free society is invasion not person and property, values of of the physical injury to the property. For physical property is what the person owns; he does not have any ownership in monetary values, which are a will pay for his property. Thus, some- others function of what one’s vandalism against, or robbery of, a factory is an invasion of physical property and is outlawed. On the other hand, some- one’s shift from the purchase of this factory’s product to the pur- chase of a competing factory’s product may lower the monetary value of the former’s property, but this is certainly not a pun- ishable act. It is precisely the condition of a free society that a property owner have no unearned on the property of any- claim one else; therefore, he has no vested right in the value of his property, only in its physical existence. As for the value, this must take its chance on the free market. This is the answer, for example, to those who believe that “undesirable” businesses or people must be legally prevented from moving into a certain neighborhood because this may or will “lower the existing property value.” One method of acquiring property that we have not dis- cussed yet is . Fraud involves cases where one party to an fraud agreed-upon exchange deliberately refuses to fulfill his part of the contract. He thus acquires the property of the other person, but he sacrifices either none of the agreed-upon goods or less than he had agreed. We have seen that a debtor’s deliberate fail- ure to pay his creditor is equivalent to an outright theft of the creditor’s property. 49 Similarly, blackmail would not be illegal in the free society. For blackmail is the receipt of money in exchange for the service of not publicizing certain information about the other person. No violence or threat of violence to person or property is involved.

249 Power and Market with 184 Man, Economy, and State Another example of fraudulent action is the following ex- change: Smith agrees to give up 15 ounces of gold to Jones in exchange for a package of certain specified chinaware. When he receives the package, after having given up the gold, Smith finds that he has received an empty crate instead of the goods that the two had agreed to exchange. Jones has falsely represented the goods that he would exchange, and here again this is equivalent to outright theft of Smith’s property. Since the exchange has been made falsely, the actual form of which might not have been contracted had the other party not been deceived, this is not an example of voluntary exchange, but of one-sided theft. We therefore exclude both explicit violence and the implicit vio- lence of fraud from our definition of the market—the pattern of voluntary interpersonal exchanges. At this point we are dealing only with an analysis of the market unhampered by fraud or vio- lence. We have not here been discussing what type of enforcing agency will be set up or the means it will use, but what type of actions the agency will combat and what type will be per- missible. In a free market, all invasive acts by one person against another’s property, either against his person or his material goods, will be combatted by the enforcing agency or agencies. We are assuming here that there are no invasive acts in the soci- ety, either because no individuals commit them or because they are successfully combatted and prevented by some sort of en- forcing agency. The problem then becomes one of defining in- vasive, as distinguished from noninvasive, acts, and this is what has been done here in various typical examples. Each man would be entitled to ownership over his own person and over any property that he has acquired by production, by appropria- tion of unowned factors, by receiving gifts, or by voluntary exchange. Never has the basis of the free, noninvasive, or “vol- untaryist” society been described more clearly in a brief space than by the British political philosopher Auberon Herbert: (1) The great natural fact of each person being born in possession of a separate mind and separate body

250 Direct Exchange 185 implies the ownership of such mind and body by each person, and rights of direction over such mind and body; it will be found on examination that no other deduction is reasonable. (2) Such self-ownership implies the restraint of vio- lent or fraudulent aggressions made upon it. (3) Individuals, therefore, have the right to protect themselves by force against such aggressions made forcibly or fraudulently, and they may delegate such acts of self-defense to a special body called a gov- ernment . . . Condensed into a few words, our Voluntaryist for- mula would run: “The sovereignty of the individual must remain intact, except where the individual coerced has aggressed upon the sovereignty of another unaggressive individual.” Elaborating on the first point, Herbert continued: If there is one thing on which we can safely build, it is the great natural fact that each human being forms with his or her body and mind a separate entity— from which we must conclude that the entities belong to themselves and not to each other. As I have said, no other deduction is possible. If the entities do not belong to themselves, then we are reduced to the most absurd conclusion. A or B cannot own himself; 50 but he can own, or part own, C or D. 50 Auberon Herbert, in A. Herbert and J.H. Levy, Taxation and An- archism (London: The Personal Rights Assn., 1912), pp. 24, 36–39; and Herbert, “A Cabinet Minister’s Vade Mecum” in Michael Goodwin, ed., Nineteenth-Century Opinion (London: Penguin Books, 1951), pp. 206–07.


252 3 ATTERN P HE T XCHANGE E NDIRECT I OF 1. The Limitations of Direct Exchange E HAVE SEEN IN THE PREVIOUS how exchange ben- W chapter efits each participant and how the division of labor on a market increases productivity. The only exchange so far discussed, , or direct exchange however, has been —the exchange of barter one useful good for another, each for purposes of direct use by the party to the exchange. Although a treatment of direct exchange is important for economic analysis, the scope for direct exchange in society is extremely limited. In a very primi- tive society, for example, Crusoe could employ Jackson to labor on his farm in exchange for a part of the farm produce. There could, however, be no advanced system of production in a direct-exchange society and no accumulation of capital in higher stages of production—indeed no production at all beyond the most primitive level. Thus, suppose that A is a house-builder; he builds a house on contract and employs masons, carpenters, etc. In a regime of direct exchange, how would it be possible to pay these men? He could not give pieces of the house to each of the laborers. He would have to try to sell the house for precisely that combination of useful goods that each of the laborers and each of the sellers of raw material would accept. It is obvious that production could not be carried on and that the difficulties would be insuperable. 187

253 with Power and Market 188 Man, Economy, and State This problem of the lack of “coincidence of wants” holds even for the simple, direct exchange of consumers’ goods, in addition to the insoluble problem of production. Thus, suppose with a supply of eggs for sale, wants a pair of shoes in , that A exchange. B has shoes but does not want eggs; there is no way for the two to get together. For anyone to sell the simplest com- modity, he must find not only one who wants to purchase it, but one who has a commodity for sale that he wants to acquire. The market for anyone’s commodities is therefore extremely limited, the extent of the market for any product is very small, and the scope for division of labor is negligible. Furthermore, someone with a less divisible commodity, such as a plow, is in worse with a plow, would like to exchange it straits. Suppose that D , for eggs, butter, shoes, and various other commodities. Obvi- ously, he cannot divide his plow into several pieces and then exchange the various pieces for eggs, butter, etc. The value of each piece to the others would be practically nil. Under a sys- mar- tem of direct exchange, a plow would have almost no ketability in exchange, and few if any would be produced. In addition to all these difficulties, which render a regime of direct exchange practically impossible, such a society could not solve the various problems of estimation, which (as was seen in 1 Since there would be no chapter 1) even Crusoe had to face. common denominator of units, there could be no way of esti- mating which line of production various factors should enter. Is it better to produce automobiles or tractors or houses or steel? Is it more productive to employ fewer men and more land on a certain product or less land and more men? Is the capital struc- ture being maintained or consumed? None of these questions could be answered, since, in the stages beyond immediate con- sumption, there would be no way of comparing the usefulness or the productivity of the different factors or products. The conclusion is evident that no sort of civilized society can be built on the basis of direct exchange and that direct exchange, 1 See, for example, chapter 1 above, pp. 57–58.

254 The Pattern of Indirect Exchange 189 as well as Crusoe-like isolation, could yield only an economy of 2 the most primitive type. 2. The Emergence of Indirect Exchange The tremendous difficulties of direct exchange can be over- indirect exchange, come only by where an individual buys a com- modity in exchange, not as a consumers’ good for the direct satisfaction of his wants or for the production of a consumers’ good, but simply to exchange again for another commodity that he does desire for consumption or for production. Offhand, this might seem a clumsy and roundabout operation. Actually, it is indispensable for any economy above the barely primitive level. Let us return, for example, to the case of A, with a supply of eggs, who wants a pair of shoes in exchange. B, the shoemaker, has shoes for sale but does not desire any more eggs than he has in stock. A cannot acquire shoes by means of direct exchange. If A wants to purchase a pair of shoes, he must find out what com- modity B does want in exchange, and procure it. If A finds that B wants to acquire butter, A may exchange his eggs for the but- ter of C and then exchange this butter for B’s shoes. In this case, of indirect exchange. The but- butter has been used as a medium ter was worth more to A than the eggs (say the exchange was 10 dozen eggs for 10 pounds of butter, then for one pair of shoes), not because he wanted to consume the butter or to use the but- ter to produce some other good in a later stage of production, but because the butter greatly facilitated his obtaining the shoes marketable than in exchange. Thus, for A, the butter was more his eggs and was worth purchasing of its superior mar- because ketability. The pattern of the exchange is shown in Figure 30. Or consider the enormous benefit that D, the owner of a plow, acquires by using a medium of exchange. D, who would like to 2 For a vivid and accurate contrast between man’s condition in a mar- ket society and that in a primitive society, see About, Handbook of Social Economy , pp. 5–17.

255 Power and Market with 190 Man, Economy, and State acquire many commodities but finds that his plow has a very lim- ited marketability, can sell it in exchange for quantities of a more marketable commodity, e.g., butter. Butter, for one thing, is more marketable because, unlike the plow, its nature is such that it does not lose its complete value when divided into smaller pieces. D now uses the butter as a medium of indirect exchange to obtain the various commodities that he desires to consume. Just as it is fundamental to human experience that there is great variety in resources, goods desired, and human skills, so is there great variety in the marketability of various commodities. Tending to increase the marketability of a commodity are its de- mand for use by more people, its divisibility into small units without loss of value, its durability, and its transportability over large distances. It is evident that people can vastly increase the extent of the market for their own products and goods by ex- changing them for more marketable commodities and using the latter as media to exchange for goods that they desire. Thus, the pattern of D’s, the plow-producer’s, exchanges will be as shown in Figure 31. D first exchanges his plow for X ’s butter, and then uses the 1 butter to exchange for the various goods that he desires to use, with X for eggs, X for shoes, X for horses, etc. 3 4 2

256 The Pattern of Indirect Exchange 191 As the more marketable commodities in any society begin to be picked by individuals as media of exchange, their choices will most marketable commodities available. quickly focus on the few If D saw, for example, that eggs were a more marketable com- modity than butter, he would exchange his plow for eggs instead and use them as his medium in other exchanges. It is evident that, as the individuals center on a few selected commodities as the media of exchange, the demand for these commodities on the market greatly increases. For commodities, in so far as they are used as media, have an additional component in the demand for them—not only the demand for their direct use, but also a demand for their use as a medium of indirect exchange. This demand for their use as a medium is superimposed on the demand for their direct use, and this increase in the composite demand for the selected media greatly increases their marketabil- ity. Thus, if butter begins as one of the most marketable com- modities and is therefore more and more chosen as a medium, this increase in the market demand for butter greatly increases the very marketability that makes it useful as a medium in the first place. The process is cumulative, with the most marketable commodities becoming enormously more marketable and with this increase spurring their use as media of exchange. The

257 Power and Market with 192 Man, Economy, and State process continues, with an ever-widening gap between the mar- ketability of the medium and the other commodities, until finally one or two commodities are far more marketable than 3 any others and are in general use as media of exchange. Economic analysis is not concerned about which commodities are chosen as media of exchange. That is subject matter for eco- nomic history . The economic analysis of indirect exchange holds true regardless of the type of commodity used as a medium in any particular community. Historically, many different com- modities have been in common use as media. The people in each community tended to choose the most marketable com- modity available: tobacco in colonial Virginia, sugar in the West Indies, salt in Abyssinia, cattle in ancient Greece, nails in Scot- land, copper in ancient Egypt, and many others, including 4 beads, tea, cowrie shells, and fishhooks. Through the centuries, gold and silver (specie) have gradually evolved as the commodi- ties most widely used as media of exchange. Among the factors in their high marketability have been their great demand as ornaments, their scarcity in relation to other commodities, their ready divisibility, and their great durability. In the last few hun- dred years their marketable qualities have led to their general adoption as media throughout the world. as a medium of ex- A commodity that comes into general use . It is evident that, whereas money change is defined as being a the concept of a “medium of exchange” is a precise one, and indirect exchange can be distinctly separated from direct ex- change, the concept of “money” is a less precise one. The point 3 For further analysis of this process of the emergence of common media, see Mises, Theory of Money and Credit , pp. 30–33, and Human Action , pp. 402–04. Menger, Principles of Economics , pp. 257–63. Also see For an historical description, J. Laurence Laughlin, A New Exposition see of Money, Credit, and Prices (Chicago: University of Chicago Press, 1931), I, 3–15, 28–31. 4 Cf. Adam Smith, (New York: Modern Library, The Wealth of Nations 1937), pp. 22–24; Menger, Principles of Economics , pp . 263–71; and Laugh- lin, A New Exposition of Money, Credit, and Prices , pp . 15–23, 38–43.

258 The Pattern of Indirect Exchange 193 at which a medium of exchange comes into “common” or “gen- eral” use is not strictly definable, and whether or not a medium is a money can be decided only by historical inquiry and the judgment of the historian. However, for purposes of simplifica- tion, and since we have seen that there is a great impetus on the market for a medium of exchange to become money, we shall henceforth refer to all media of exchange as . moneys 3. Some Implications of the Emergence of Money The establishment of a money on the market enormously increases the scope for specialization and division of labor, immensely widens the market for every product, and makes pos- sible a society on a civilized productive level. Not only are the problems of coincidence of wants and indivisibility of goods eliminated, but individuals can now construct an ever-expanding edifice of remote stages of production to arrive at desired goods. Intricate and remote stages of production are now possible, and specialization can extend to every part of a production process as well as to the type of good produced. Thus, an automobile pro- ducer can sell an automobile in exchange for the money, e.g., butter or gold, and then exchange the gold partly for labor, partly for steel, partly for chrome, partly for rubber tires, etc. The steel producers can exchange the gold partly for labor, partly for iron, partly for machines, etc. Then the various labor- ers, landowners, etc., who receive the gold in the production process can use it as a medium to purchase eggs, automobiles, or clothing, as they desire. The whole pattern of a modern society is thus built on the use of money, and the enormous importance of the use of money 5 will become clearer as the analysis continues. It is evident that it is a mistake on the part of many writers who wish to set forth the doctrines of modern economics to analyze direct exchange 5 On the significance of money for civilized society, cf. Wicksteed, Common Sense of Political Economy , I, 140 ff.

259 with Power and Market 194 Man, Economy, and State only and then to insert money somewhere at the end of the analysis, considering the task finished. On the contrary, the analysis of direct exchange is useful only as an introductory aid to the analysis of a society of indirect exchange; direct exchange would leave very little scope for the market or for production. With the great variety in human skills and natural resources resulting in enormous advantages from the division of labor, the existence of money permits the splitting of production into minute branches, each man selling his product for money and using money to buy the products that he desires. In the field of consumers’ goods, a doctor can sell his services, or a teacher his, for money, and then use the money to purchase goods that he demands. In production, a man can produce a capital good, sell it for money, and use the gold received to purchase the labor, land, and capital goods of a higher order needed for its produc- tion. He may use the surplus of money income over money out- lay on factors to purchase consumers’ goods for his own needs. Thus, at any stage in the production of any product, a man employs land and labor factors, exchanging money for their services as well as for the needed capital goods, and then sells the product for money to help in the next lower stage of pro- duction. This process continues until the final consumers’ goods are sold to consumers. These consumers, on the other it through the sale of purchasing hand, obtain their money by their own goods— either durable consumers’ goods or services in production. The latter may include the sale of labor services, the sale of services of their land, the sale of their capital goods, or inheritance from those who had previously contributed such 6 services. 6 Later sections will deal further with the receipt of money income in the production process. Here it must be noted that since the owner and seller of capital goods must pay for the land, labor, and capital goods in their production, in the last analysis the owner of capital receives income only as a holder of goods over a period of time .

260 195 The Pattern of Indirect Exchange Thus, nearly all exchanges are made against money, and money impresses its stamp upon the entire economic system. Producers of consumers’ goods as well as owners of durable consumers’ goods, owners of capital goods, and sellers of labor services, all sell their goods against money and purchase with money the factors that they need. They use their net money income to purchase consumers’ goods produced by others in the society. Thus, all individuals, in their capacity as producers and owners, supply goods (commodities and services) and demand money in exchange. And, in their capacity as producers purchasing factors, as well as in their capacity as consumers, they supply money and demand an almost infinite variety of goods in exchange. The economy is therefore a “money econ- omy,” and almost all goods are compared with and exchanged against the money commodity. This fact is of crucial impor- tance to the analysis of any society beyond the most primitive level. We may sum up the complex pattern of exchanges in a money economy in the following way: Men in their capacity as: Producers Buy: Sell: Consumers’ Goods, Producers’ Goods Labor Producers’ Goods Labor Land Land Capital Goods Capital Goods For Money With Money Consumers Buy: Consumers’ Goods With Money

261 with Power and Market 196 Man, Economy, and State 4. The Monetary Unit We have seen that every good is “in supply” if it can be divided into units, each of which is homogeneous with every other. Goods can be bought and sold only in terms of such units, and those goods which are indivisible and unique may be described as being in a supply of one unit only. Tangible com- modities are generally traded in terms of , such as units of weight tons, pounds, ounces, grains, grams, etc. The money commod- ity is no exception to this rule. The most universally traded commodity in the community, it is bought and sold always in terms of units of its weight. It is characteristic of units of weight, as of other metrical scales, that each unit is convertible into every other. Thus, one pound equals 16 ounces; and one ounce equals 437.5 grains, or 28.35 grams. Therefore, if Jones sells his tractor for 15 pounds of gold, he may also be described as hav- ing sold the tractor for 240 ounces of gold, or for 6,804 grams of gold, etc. It is clear that the size of the unit of the money commodity chosen for any transaction is irrelevant for economic analysis and is purely a matter of convenience for the various parties. All the units will be units of weight, and they will be convertible into pounds, ounces, etc., by multiplying or dividing by some constant number, and therefore all will be convertible into one another in the same manner. Thus, one pound of gold will equal 16 ounces and will, of course, exchange for 16 ounces, should such an exchange be desired on the market. The economic irrelevance of the names or sizes of the units may be seen from the following example. Suppose that the residents of Texas use, in their exchanges, a unit known as the Houston, equalling 20 grains of gold, while the residents of Massachusetts use the Adams, equalling 10 grains. The citizens of the respective areas may make their exchanges and calculations in these terms, e.g., Jones sells his car for “2,000 Houstons of gold,” or, more sim- ply, “2,000 Houstons,” or Jones might consider the money price 1 / 2 Houston per dozen.” On the other hand, of eggs as being “

262 The Pattern of Indirect Exchange 197 Smith might buy a house for “10,000 Adamses.” It is obvious that the use of the different names will complicate matters, but . The “Houston” is still a unit of insignificant it is economically weight of gold, and is a shorthand name for “20 grains of gold.” It is clear that, on the market, one Houston will exchange for 7 two Adamses. To avoid unnecessary complications and to clarify the analy- sis, therefore, the names of the monetary units in this work will be in terms of universally acceptable units of weight (such as ounces, grams, etc.) rather than in terms of accidental names of only local significance (such as dollars or francs). Obviously, the more valuable the units of a commodity are, the smaller the size of the units used in daily transactions; thus, platinum will be traded in terms of ounces, while iron is traded in terms of tons. Relatively valuable money commodities like gold and silver will tend to be traded in terms of smaller units of weight. Here again, this fact has no particular economic significance. The form in which a unit weight of any commodity is traded depends on its usefulness for any specific, desired purpose. Thus, iron may be sold in the form of bars or chunks, cheese in rectangular or triangular shape, etc. Whereas other commodi- ties will be traded in those forms suitable for production or con- sumption, money will be traded in forms suitable for exchange or storing until an exchange is made. Historically, the shapes of 7 The names of the units can be, and have been, anything conceivable, depending on custom, language, etc. Such names as dollars, francs, marks, shekels, are examples. The “dollar” originated as the generally applied name of ounce weights of silver coined by the Count of Schlick in Bohemia. The Count, who lived in Joachim’s Valley (or Joachims thal ) began coining ounces of silver in 1518, and their uniformity and fineness earned a reputation throughout Europe. They became known as thalers. The name “dollar” is Joachimsthalers, finally abbreviated to derived from “thaler.” Cf. Charles A. Conant, The Principles of Money and Banking (New York: Harper & Bros., 1905), I, 135–40; Menger, Princi- ples of Economics , p. 283.

263 with Power and Market 198 Man, Economy, and State 8 money have been innumerable. In recent centuries large bars of gold or silver have been used for storage or for exchange in larger transactions, while smaller, circular pieces, known as coins , are used for smaller transactions. 5. Money Income and Money Expenditures In a money economy, each individual sells goods and services that he owns for money and uses the money to buy desired goods. Each person may make a record of such monetary exchanges for any period of time. Such a record may be called for that period. his balance of payments One record may be the transactions of goods sold for money in a certain period to other individuals. Suppose, for example, that Mr. Brown draws up the record of goods sold for money for the month of September, 1961. Suppose that he has sold his services as a carpenter to a Mr. Jones in building the latter’s house and has sold his services as a handyman to Messrs. Jones and Smith during the same period. Also, he has disposed of an old radio to Mr. Johnson. His account of money received, i.e., is as follows: money purchased for goods and services sold, September, 1961—James Brown For Goods and Services Sold Money Purchased Labor as carpenter to Jones 20 ounces of gold Labor as handyman to Jones & Smith 5 ounces of gold 1 ounce of gold Old radio to Johnson 26 ounces of gold 8 Gold, for example, has been traded as money in the raw form of nuggets, as gold dust in sacks, or as jewelry and other ornaments. One interesting example of a money shape was the iron money of central Africa. Iron was a valuable commodity, in use as hoes. The money form was made to be divisible into two parts, easily shaped into hoes. See Laughlin, A New Exposition of Money, Credit, and Prices , p. 40.

264 199 The Pattern of Indirect Exchange From the account, we know that by his sales of goods and services during this period, Brown has purchased 26 ounces of money income gold. This total of money purchased is his total of for that period. It is clear that the more money income a man receives dur- ing any period, the more money he will be able to spend on Other things being equal desired goods. (an important qualifica- he will strive to earn tion that will be examined in later sections), as much money income in any prospective period as he can. Mr. Brown acquired his income by selling his labor services and a durable consumers’ good. There are other ways of acquir- ing money income on an unhampered market. The owner of land may sell it for agricultural, locational, industrial, as well as other, purposes. The owner of capital goods may sell them to those interested in using them as factors of production. Tangi- ble land and capital goods may be sold for money outright, or the owner may retain ownership of the good while selling own- ership of its services over a certain period of time. Since any good is bought only for the services that it can bestow, there is no rea- son why a certain period of service of a good may not be pur- chased. This can be done, of course, only where it is technically possible. Thus, the owner of a plot of land or a sewing machine or a house may “rent it out” for a certain period of time in may leave legal ownership exchange for money. While such hire of the good in the hands of the “landlord,” the actual owner of the good’s service for that period is the renter, or “tenant.” At the end of the hire period, the good is returned to the original owner, who may use or sell the remainder of the services. In addition to the sale of goods and services, a man may the money he receive money as a gift. He does not purchase receives in gifts. His money income for any period equals his money purchased, plus the money he receives in gifts. (One common form of receipt of a gift is an inheritance, the result of a bequest at death.) Thus, Mr. Green’s account of money income for June to De- cember, 1961, may be as follows:

265 Power and Market with Man, Economy, and State 200 Money Income From Sale of Goods and Services P URCHASED 28 ounces of gold Rent of land to Mr. Jones Sale of (other) land to Mr. Forrest 300 ounces of gold Sale of threshing machine to Mr. Woods 15 ounces of gold IVEN From Gifts G 400 ounces of gold Inheritance from uncle 743 ounces of gold As was seen in the previous chapter, in order first to acquire the good or service that a man can sell for money, he must first either produce it himself or buy it from someone who has pro- duced it (or who, in turn, has bought it from the original pro- ducer). If he has been given money, the original owner must have acquired it through producing a good, etc. Thus, in the last analysis, the first seller of a capital good or a durable con- sumers’ good is the original producer, and later purchasers must have produced some service of their own in order to obtain the money to acquire it. The seller of labor service, of course, pro- duces the service directly at the time. The seller of pure land must originally have appropriated unused land which he had found and transformed. On the unhampered market of a money economy, producers of commodities and services sell their goods for the money commodity, then use the money acquired to buy other desired goods. Money is acquired in this way by all except the producers of the original gold on the market—those who mined and mar- keted it. However, the production of the money commodity, as with all other valuable commodities, itself requires the use of land, labor, and capital goods, and these must be paid for by the use of money. The gold miner, then, receives no money by gift, but must actively find and produce gold to acquire his money.

266 201 The Pattern of Indirect Exchange With the use of money acquired in these various ways, indi- viduals purchase desired goods. They do so in two capacities: as consumers and as producers. As consumers, they purchase consumers’ goods that they desire; in the case of durable goods, they may purchase the entire good, or they may hire the services of goods for some specified period of time. As produc- ers, they use money to purchase the services of factors of pro- duction needed to produce consumers’ goods or lower-order capital goods. Some factors they may purchase outright, to use all their anticipated future services; some they may hire for their services for a specified period of time. Thus, they may purchase capital goods that function as “raw material”; they may purchase some capital goods called “machines” and hire others; or they may hire or purchase the land that they need to work on. In general, just as consumers cannot very well hire short-lived, nondurable goods, so producers cannot very well hire capital goods, dubbed “raw material” or “inventory,” that are used up quickly in the process of production. On a free market, they cannot purchase labor services outright, as was explained in the preceding chapter. Since man’s personal will is inalienable, he cannot, in a voluntary society, be compelled to work for another against his present will, and therefore no con- tracts can be made for purchase of his future will. Labor serv- ices, therefore, can only be bought for “hire,” on a “pay-as- you-go” basis. Any individual may draw up an account of his purchases of other goods with money for any period of time. The total money expen- amount of money given up in such exchanges is his money outlays for that period. Here it must be noted ditures or that his expenditure account, as well as his income account, can be itemized for each transaction or may be grouped into various classes. Thus, in Brown’s account above, he might have tabu- lated his income as 25 ounces from labor in general, and one ounce from his radio. How broad or narrow the classes are depends purely on the convenience of the person drawing up

267 with Power and Market 202 Man, Economy, and State the account. The total, of course, is always unaffected by the type of classification chosen. for goods and money purchased Just as money income equaled services sold money received as gifts, so money expenditure plus equals money plus for goods and services bought money sold given away as gifts. Thus, Mr. Brown’s money expenditure ac- count for September, 1961, might be the following: September, 1961—James Brown Money Expended For Goods and Services Bought Money Sold Food 12 ounces of gold Clothing 6 ounces of gold Rent of House 3 ounces of gold 2 ounces of gold Entertainment Money Given 1 ounce of gold Charity 24 ounces of gold In this account, Brown is spending money purely as a con- , and his total money expenditures for the period are 24 sumer ounces. If he had desired it, he could have subdivided the account 1 / further into such items as apples, ounce; hat, one ounce; etc. 5 Here it may be noted that an individual’s total money income for any period may be termed his exports , and the goods sold may be termed the “goods exported”; on the other hand, his total money expenditure may be termed his , and the goods imports and services bought are the “goods imported.” These terms apply to goods purchased by producers or consumers. Now, let us observe and compare Mr. Brown’s income and expenditure accounts for September, 1961. Brown’s total money income was 26 ounces of gold, his money expenditures 24 ounces. This must mean that two ounces of the 26 earned in this

268 The Pattern of Indirect Exchange 203 period remained unspent. These two ounces remain in the pos- session of Mr. Brown, and are therefore added to whatever pre- vious stock of gold Brown might have possessed. If Brown’s stock of money on September 1, 1961, was six ounces of gold, his stock of money on October 1, 1961, is eight ounces of gold. The stock of money owned by any person at any point in time is c ash balance called his or c ash holding at that time. The two ounces of income remaining unspent on goods and services con- stituted a net addition to Brown’s cash balance over the month of September. For any period, therefore, a person’s money income is equal to his money outlay plus his addition to cash balance. If we subdivide this income-expenditure account into smaller periods of time, the picture of what is happening to the cash balance within the larger period is likely to be far different from a simple addition of two ounces. Thus, suppose that all of Brown’s money income came in two chunks on the first and fif- teenth of September, while his expenditures occurred every day in varying amounts. As a result, his cash balance rose drastically on September 1, say to six plus 13 or a total of 19 ounces. Then, the cash balance was gradually drawn down each day until it equaled six again on the 15th; then it rose sharply again to 19, finally being reduced to eight at the month’s end. The pattern of Brown’s supplies and demands on the market supplied various goods and services on the mar- is clear. Brown ket and money in exchange. With this money income, demanded he demanded various goods and services on the market and sup- must go into the c ash bal- plied money in exchange. The money 9 before it can be spent on goods and services. ance Suppose, on the other hand, that Brown’s expenditures for September had been 29 ounces instead of 24 ounces. This was accomplished by drawing down Brown’s previous cash balance by three ounces and leaving him with three ounces in his cash 9 This is also true if the income is gradual and the expenditure is in dis- crete sums, or for any other pattern of money income and expenditures.

269 Power and Market with Man, Economy, and State 204 holding. In this case, his money expenditures for the period the decrease in his cash balance. plus equaled his money income In sum, the following formula always holds true for any indi- vidual over any period of time: + Money Income = Money Expenditures Net Additions to Cash Balance – Net Subtractions from Cash Balance Alternatively, the term Exports can be substituted for Income, and Imports for Expenditures, in the above equation. Let us assume for purposes of simplification that the total stock of the money commodity in the community has remained unchanged over the period. (This is not an unrealistic assump- tion, since newly mined gold is small compared to the existing stock.) Now it is obvious that, like all valuable property, all . At any money must, at any point in time, be owned by someone point in time, the sum of the cash holdings of all individuals is of money in the community. Thus, if we stock equal to the total group of five persons living in a village, consider Brown among a and their respective cash balances on September 1 were: 6, 8, 3, 12, and 5 ounces, then the total stock of money held in the vil- lage on that date was 34 ounces. If the data were available, the same sort of summation could be performed for the world as a whole, and the total stock of money discovered. Now it is obvious that Brown’s addition of two ounces to his cash balance for September must have been counterbalanced by a subtraction of two ounces from Since the stock of the cash balances of one or more other individuals. money has not changed, Brown’s addition to his cash balance must have been acquired by drawing down the cash balances of other individuals. Similarly, if Brown had drawn down his cash balance by three ounces, this must have been counterbalanced by the addition of three ounces to the cash balance of one or more individuals. It is important to recognize that the additions to, or subtrac- tions from, a cash balance are all voluntary acts on the part of the individuals concerned. In each period, some individuals

270 The Pattern of Indirect Exchange 205 decide to add to their cash balances, and others decide to reduce them, and each makes that decision which he believes will ben- 10 efit him most. For centuries, however, fallacious popular usage has asserted that one whose income is greater than expen- ditures (exports greater than imports) has a “favorable balance of trade,” while one whose expenditures have been greater than income for a period (imports greater than exports) has suffered an “unfavorable balance of trade.” Such a view implies that the active, important part of the balance of payments is the “trade” part, the exports and imports, and that the changes in the indi- vidual’s cash balance are simply passive “balancing factors,” serving to keep the total payments always in balance. In other words, it assumes that the individual spends as much as he wants to on goods and services and that the addition or subtraction from his cash balance appears as an afterthought. On the con- trary, changes in cash balance are actively decided upon by each individual in the course of his market actions. Thus, Brown decided to increase his cash balance by two ounces and sold his labor services to obtain the money, forgoing purchases of con- sumers’ goods to the extent of two ounces. Conversely, in the later example, when he spent three ounces more than he earned in the month, he decided that his cash balance had been exces- sive and that he would rather spend some of it on consumers’ goods and services. There is therefore never a need for anyone to worry about anyone else’s balance of payments. A person’s “unfavor- able” balance of trade will continue so long as the individual wishes to reduce his cash balance (and others are willing to pur- chase his money for goods). His maximum limit is, of course, the point when his cash balance is reduced to zero. Most likely, 10 This section is limited to a discussion of expenditures on con- sumers’ goods. A later section will discuss producers’ expenditures on producers’ goods. It will be seen, however, that even unwelcome losses from cash balances suffered by producers are purely the result of volun- tary action that, in a later period, proved erroneous.

271 with Power and Market 206 Man, Economy, and State however, he will stop reducing his cash balance long before this 11 point. 6. Producers’ Expenditures The previous section concentrated on the case of Mr. Brown, goods. His whose entire money expenditures were on consumers’ money income, aside from the sale of old, previously produced goods, came from the sale of current productive labor services. His expenditures were purely on consumption; his income was derived almost solely from his production of labor services. Every man must be a consumer, and therefore this analysis of consumer spending applies to all persons. Most people earn their income from the sale of their labor services. However, if we except previously produced goods, because someone must have originally produced them, all other money incomes must derive from new production of capital goods or consumers’ goods. (This is apart from the sellers of land or its services, whose ownership must have originally derived from the finding and reshaping of unappropriated land.) Producers of capital goods and consumers’ goods are in a dif- ferent position from sellers of labor service only. Mr. Brown, for example, a seller solely of labor service, need not spend any money on purchasing capital goods. Purely from his expendi- ture on desired consumers’ goods, he derives the energy to be able to produce and sell labor services on the market. But the producers of capital goods and consumers’ goods—the nub of any civilized society, since labor services alone could produce very little—are not and cannot be in such a fortunate position. 11 The assertion has also been made that a person who spends most or all of his income on food and clothing must also have an “unfavorable ba- lance of trade,” since his money expenditures must be at a certain mini- mum amount. However, if the man has spent all his cash balance, he can no longer continue to have an “unfavorable balance,” regardless of what goods he buys or what his standard of living is.

272 207 The Pattern of Indirect Exchange For a man to produce a consumers’ good, he must obtain labor services and the services of land and capital goods, in order to use the technological “know-how” available in the production of the good. Pushing the problem back, we find that, in order to produce a capital good, the would-be producer must obtain the necessary land, labor, and capital goods. Each such individ- ual producer (or group of individuals in partnership) obtains the required factors and then directs the combination of factors into producing a capital good. This process is repeated among numerous individuals, until the lowest stage of production is reached and a consumers’ good is produced. The producer of the capital good must obtain the needed factors (land, labor, and capital) by purchasing them for money, and, when the (lower- order) capital good is completed, he sells it for money. This cap- ital good is, in turn, used for the production of a still lower- order capital good, and the latter is sold for money. This process continues until the final producer of the consumers’ good sells it for money to the ultimate consumer. A simplified schematic representation of this process is shown in Figure 32. in exchange, as The solid arrows depict the movement of goods factors are bought by the producers at each stage, worked into a lower-order capital good, and then sold to lower-order produc- ers. The broken arrows in the reverse direction depict the move- in the same exchanges. The producer of a capital ment of money good employed money that he owned to purchase factors of pro- duction. He then used these owned factors, along with hired labor services, to produce a lower-order capital good that he owned until he could sell it for money to another producer. The producer of a consumers’ good went through the same process, except that his final sale for money was to the ultimate consumer. Now let us call those producers who use their money to in the purchase of factors (either outright or for hire) invest capitalists . The capitalists then produce and own the various stages of capital goods, exchanging them for money until their products reach the consumers. Those who participate in the

273 Power and Market with Man, Economy, and State 208 productive process are therefore the capitalists and the sellers of land and labor services. The capitalists are the only ones who spend money on producers’ goods , and they, therefore, may here be termed “the producers.” It is evident that a dominant characteristic of the production in anticipation of process is that each individual must produce the sale of his product. Any investment in production is made in anticipation of later sale to lower-order producers and, finally, to consumers. Clearly, the consumer must have money in his cash balance in order to spend it on consumers’ goods, and, likewise, the

274 The Pattern of Indirect Exchange 209 producer must have the original money to invest in factors. Where does the consumer get the money? As has been shown above, he may obtain it from gifts or from the sale of previously produced goods, but in the last analysis he must have obtained it from the sale of some productive service. The reader can inspect the final destinations of the broken arrows; these are the sellers of labor services and of the services of land. These labor- ers and landowners use the money thus obtained to buy the final products of the production system. The capitalist-producers also receive income at each stage of the production process. Evidently, the principles regulating these incomes require care- ful investigation, which will be undertaken below. Here it might be noted that the net incomes accruing to the owners of capital goods are not simply the result of the contribution to produc- tion by the capital goods, since these capital goods are in turn the products of other factors. producers acquire their money for invest- Where, then, do the ment? Clearly, from the same sources only. From the income acquired in production, individuals can, in addition to buying consumers’ goods, purchase factors of production and engage in the productive process as producers of a good that is not simply their own labor service. In order to obtain the money for invest- save money ment, then, an individual must by restricting his pos- sible consumption expenditures. This saved money first goes in the purchase of fac- invested into his cash balance and then is tors in the anticipation of a later sale of the produced good. It is obvious that investment can come only from funds that are saved by individuals from their possible consumption spending. The producers restrict their consumption expenditures, save their money, and “go into business” by investing their funds in 12 factors that will yield them products in the future. 12 Producers could also borrow the saved funds of others, but the whole process of lending and borrowing is omitted in this section in order to clarify the analysis. Loans will be analyzed in a later chapter.

275 Power and Market with Man, Economy, and State 210 Thus, while every man must spend part of his money income in consumption, some decide to become producers of capital or consumers’ goods and to save money to invest in the required factors. Every person’s income may be spent on con- sumption, on investment in the production of goods, or on an addition to his cash balance. For any period, an individual’s + Investment Money Income = his Consumption Expenditures Additions to Cash Balance – Subtractions from Cash Expenditures + (Investment expenditures may be defined as the sum of Balance. the money expenditures made in investment in factors of pro- duction.) Let us take the hypothetical case of Mr. Fred Jones and his “balance of payments” for November, 1961. Suppose his income from various sources during this month is 50 ounces. He decides to spend, during the month, 18 ounces on con- sumers’ goods; to add two ounces to his cash balance; and to invest the other 30 ounces in a “business” for the production of some good. It must be emphasized that this business can involve the production of any good at all; it could be a steel factory, a farm, or a retail shoe store. It could be for the purchase of wheat in one season of the year in anticipation of sale in another sea- son. All of this is productive enterprise, since, in each instance, a good is produced, i.e., goods are moved a step forward in their progress to the ultimate consumer. Since the investment is always in anticipation of later sale, the investors are also engaged in entrepreneurship , in enterprise. Let us assume that Jones expends the saved funds on invest- ment in a paper factory. His income-expenditure account for November may appear as follows in the diagram below. Of course, these figures are purely illustrative of a possible situa- tion; there are innumerable other illustrations; e.g., there could have been a subtraction from cash balance to enable greater in- vestment. Investment expenditures are always made in anticipation of future sale. Factors are purchased, and transformed into the product, and the product is then sold by the enterpriser for

276 The Pattern of Indirect Exchange 211 November, 1961—Fred Jones Expenditures Income Food . . . . . . . . . . . . . . . . 7 oz. From sale of land . . . . 20 oz. From sale of a building . 30 oz. Clothing . . . . . . . . . . . . . 4 oz. Shelter . . . . . . . . . . . . . . . 4 oz. 50 oz. Entertainment . . . . . . . . . 3 oz. Consumption Expenditures . . . . . . . . . 18 oz. On Paper Machinery . . 12 oz. On Wood Pulp . . . . . . . 10 oz. On Labor Services . . . . . 8 oz. Investment Expenditures . . . . . . . . . 30 oz. Addition to Cash Balance . . . . . . . . . 2 oz. Total . . . . . . . . . . . . . . . 50 oz. money. The “businessman” makes his outlays with the expecta- tion of being able to sell the product at a certain price on a cer- tain future date. Suppose that Jones makes the investment of 30 ounces with the expectation of being able to transform his fac- tors into the product (in this case, paper) and sell the product for 40 ounces at some date in November, 1962. If his expectation proves correct, he will succeed in selling the paper for 40 ounces at that date, and his income account, for any period that includes that date in November, 1962, will include “40 ounces from sale of paper.” It is obvious that, other things being equal, an investor will attempt to acquire the greatest possible net income from his investment, just as, with the same qualification, everyone attempts to acquire the greatest income from other types of sales.

277 with Power and Market 212 Man, Economy, and State If Jones is confronted with investment opportunities for his 30 ounces in different possible lines or processes of production, and he expects one will net him 40 ounces in a year, another 37 ounces, another 34, etc., Jones will choose that investment promising the greatest return. A crucial difference, then, between man as an entrepreneur and man as a consumer is that in the latter case there is no drive to have exports greater than imports. A man’s imports are his purchase of consumers’ goods and are therefore the ends of his activity. The goods he imports are a source of satisfaction to him. On the other hand, the busi- nessman is “importing” only producers’ goods, which by defini- tion are useless to him directly. He can gain from them only by selling them or their product, and therefore his imports are merely the necessary means to his later “exports.” Therefore, he tries to attain the greatest net income, or, in other words, to attain the largest surplus of exports over imports. The larger his business income, the more the owner of the business will be able to spend (i.e., to import) on consumers’ goods that he desires. , has no considered as a whole It is clear, however, that the man, particular desire to export more than he imports or to have a “favorable balance of trade.” He tries to export more than he imports of producers’ goods in his business; then he uses this sur- imports of consumers’ goods for his personal wants. plus to spend on On total balance, he may, like Mr. Brown above, choose to add to his cash balance or subtract from his cash balance, as he sees 13 Let us take as an example Mr. fit and considers most desirable. Jones, after he has been established in his business. Over a cer- tain period, he may decide to subtract five ounces from his cash balance. Even though he tries his best to achieve the largest net income from business and thus add to his cash balance as much as possible from , in total he may well decide to reduce this source his cash balance. Thus: 13 It was partly confusion between the total action of the individual and his action as a businessman that led writers to extrapolate from the behavior of the businessman and conclude that “nations” are “better off” if “they” export more than “they” import.

278 The Pattern of Indirect Exchange 213 Fred Jones Expenditures Income In business, on factors From business. . . . . 150 oz. of production (producers’ goods). . . . 100 oz. For consumers’ goods . . . 55 oz. 155 oz. Subtraction from cash balance . . . . . . . . . . 5 oz. 7. Maximizing Income and Allocating Resources We have seen that, in the money economy, other things being equal, men will attempt to attain the highest possible money income: if they are investors, they will try to obtain the largest net return; if they sell their labor service, they will sell it for the largest return. The higher their money income, the more money they will have available for expenditure on consumers’ goods. Before we proceed to a deeper analysis of the money economy, it is important to examine the “other things being , qualification. equal,” or the ceteris paribus In chapter 1, we examined the truth that in every action, men try to obtain the greatest advantage, i.e., to attain the end located on the highest possible point on their value scale. This was also called attempting to “maximize psychic revenue” or “psychic income.” This is a praxeological truth, a general law holding for all human action, with no qualification whatsoever. Now the establishment of indirect exchange, or a money econ- omy, enables every person to obtain a vast number of con- sumers’ goods that he could not obtain, or could barely obtain, in isolation or by way of barter. As we have demonstrated in this chapter, these consumers’ goods are acquired by producing and selling a good for the money commodity and then using money to purchase them. Despite this development, however,

279 Power and Market with Man, Economy, and State 214 by no means can all goods be bought and sold on the market. Some goods are attainable in this way; some cannot be. As was explained in chapter 2, some goods cannot be alienated from a person and therefore cannot be exchanged. They cannot come within the money nexus; they cannot be bought or sold for money. This fact does not mean that individuals disparage or revere them on that account. To some people, many of the unexchangeable consumers’ goods are very precious and hold a high place on their value scale. To others, these goods mean lit- tle, as compared to those consumers’ goods that can be bought in exchange. The ranking on his value scale depends entirely on the voluntary choice of each individual. It is nonsense to place the blame on “money” for the tendencies of some people to value exchangeable goods highly as compared to some nonex- changeable goods. There is no force in the existence of the money economy that compels men to make such choices; money simply enables men to expand enormously their acquisi- tion of exchangeable goods. But the existence of the market leaves it to each individual to decide how he will value money and the goods that money will buy, as against other goods that are unexchangeable. As a matter of fact, the existence of the money economy has the reverse effect. Since, as we know from the law of utility, the marginal utility of a unit of any good diminishes as its supply increases, and the establishment of money leads to an enormous increase in the supply of exchangeable goods, it is evident that this great supply enables men to enjoy unexchangeable goods to a far greater extent than would otherwise be the case. The very fact that exchangeable consumers’ goods are more abundant enables each individual to enjoy more of the nonexchangeable ones. There are many possible examples of grading exchangeable and nonexchangeable goods on one’s value scale. Suppose that a man owns a piece of land containing an historic monument, which he prizes on aesthetic grounds. Suppose also that he has an offer for sale of the property for a certain sum of money, knowing that the purchaser intends to destroy the monument

280 The Pattern of Indirect Exchange 215 and use it for other purposes. To decide whether or not to sell the property, he must weigh the value to him of keeping the monument intact as against the value to him of the consumers’ goods that he could eventually buy with the money. Which will take precedence depends on the constitution of the individual’s value scale at that particular time. But it is evident that a greater abundance of consumers’ goods already at his disposal will tend to raise the value of the (unexchangeable) aesthetic good to him as compared with the given sum of money. Contrary, therefore, to the common accusation that the establishment of a money economy tends to lead men to slight the importance of nonex- changeable goods, the effect is precisely the reverse. A destitute person is far less likely to prefer the nonexchangeable to the exchangeable than one whose “standard of living” in terms of 14 the latter is high. Examples such as these are of great importance for human action, but of little importance for the rest of this volume, which is mainly concerned with analysis of the market under a system of indirect exchange. In this study of money exchanges—the —there is not subdivision of praxeology known as catallactics much more that could be said about this problem. Other exam- ples of such choices, however, are more important for catallac- tics. Consider the case of a man who has three offers for the purchase of his labor services, one of a money income of 30 ounces per month, another of 24 ounces, and a third of 21 ounces. Now—and here we return to the original problem of this section—the man will clearly choose to accept the offer of 14 The terms “nonexchangeable” (or “unexchangeable”) and “exchange- able” goods are far superior to the terms “ideal” and “material.” The lat- ter classification errs on two counts, aside from failing to convey the essen- tial difference between the two types of goods. In the first place, as has been stated above, many exchangeable goods are intangible services rather than tangible, “material” things. Secondly, many of the nonexchangeable goods valued by some persons would hardly be considered “ideal” by oth- ers, so that a less colored term is necessary.

281 Power and Market with Man, Economy, and State 216 that the psychic, or more precisely, the 30 ounces, provided nonexchangeable, factors are “equal” between the various alter- natives. If the man is indifferent to any variations in conditions of work among the three offers, then no factors enter into his choice except money income and leisure, and, if he works at all, he will choose the income of 30 ounces. On the other hand, he may well have great differences in taste for the work itself and the varying conditions; thus, the job earning 30 ounces may be for a firm, or in a type of labor, that he dislikes. Or the job offer- ing 24 ounces may have positive qualities that the man likes a great deal. We have seen in chapter 1 that labor is evaluated on the basis, not only of the monetary return, but also in terms of the individual’s liking for or dislike of the work itself. The valu- ations that a man attaches to the work itself are nonexchange- able positive or negative goods, because they are, for the actor, inseparable attachments to the work itself. They may be weighed against monetary considerations, but they cannot be exchanged away or ignored. Thus, in the above case, along with the prospective money income, the man must weigh the nonex- changeable “consumers’ goods” attached to the different jobs in his value scale. What he is weighing, in essence, is two “bun- a ) the utility of 30 ounces per month plus work dles” of utility: ( in what he considers an immoral trade or in unpleasant sur- roundings, vs. ( b ) the utility of 24 ounces per month plus work in a job that he likes. The choice will be made in accordance with the value scale of each individual; one man may choose the 30-ounce job, and another may choose the 24-ounce job. The important fact for catallactics is that a man always chooses a money income plus other psychic factors and that he will bundle of maximize his money income only if psychic factors are neutral with respect to his choices. If they are not, then these factors must always be kept in view by the economist. Another similar example is the case of a prospective investor. Suppose an investor faces the choice of investing his saved money in various alternative production projects. He can, say, invest 100 ounces, with the prospect of earning a net return of

282 The Pattern of Indirect Exchange 217 10 percent in a year, in one project; 8 percent in a second; and 6 percent in a third. Other nonexchangeable psychic factors being equal, he will tend to invest in that line where he expects the greatest net money return—in this case, the 10 percent line. Suppose, however, that he has a great dislike for the product that would offer a 10 percent return, while he has a great fondness for the process and the product promising the 8 percent return. Here again, each prospect of investment carries with it a nonde- tachable positive or negative psychic factor. The pleasure in pro- ducing one product as against the distaste for producing another are nonexchangeable consumers’ goods, positive and negative, which the actor has to weigh in deciding where to make his invest- ment. He will weigh not simply 10 percent vs. 8 percent, but “10 percent plus a disliked production process and product” vs. “8 percent plus a delightful production process.” Which alternative he chooses depends on his individual value scale. Thus, in the case of enterprise as well as in the case of labor, we must say that the entrepreneur will tend to choose the course that maximizes that other nonex- his prospective money income, provided changeable factors are neutral with respect to the various alter- natives. In all cases whatsoever, of course, each man will move to maximize the psychic income on his value scale, on which scale 15 all exchangeable and unexchangeable goods are entered. In deciding on the course that will maximize his psychic in- come, man therefore considers all the relevant factors, exchangeable and nonexchangeable. In considering whether to work and at what job, he must also consider the almost univer- sally desired consumers’ good, leisure. Suppose that, on the basis of the money return and the nonexchangeable values attached, the laborer in the example given above chooses to work at the 24-ounce job. As he continues to work at the job, the marginal 15 The belief of the classical economists, notably John Stuart Mill, as well as their critics, that economics must postulate a mythical “economic man,” who is interested only in acquiring money income, is thus a com- pletely erroneous one.

283 with Power and Market 218 Man, Economy, and State utility of the money wage per unit of time that he earns (whether 1 / it be 24 ounces per month or ounce per hour, etc.), will 4 decline. The marginal utility of money income will tend to decline as more money is acquired, since money is a good. In so far as money is desired for a nonmonetary use (such as orna- ments) or for use as an addition to one’s cash balance (see below for a discussion of the components in the demand for money), addition to its stock will lead to a decline in its marginal utility, just as in the case of any other good. In so far as money is desired for the purchase of consumers’ goods, an “ounce-worth” of con- sumers’ goods will also decline in utility as new ounces are acquired. The first ounce of money spent on consumers’ goods will fulfill the highest-ranking wants on the person’s value scale, the next ounce spent the wants ranking second highest, etc. (Of course, this will not be true for a good costing more than one ounce, but this difficulty can be met by increasing the size of the monetary units so that each is homogeneous in what it can buy.) Consequently, the marginal utility of money income tends to decline as the income is increased. On the other hand, as the input of labor increases, the stock of possible units of leisure declines, and the marginal utility of leisure forgone increases. As was seen in chapter 1, labor will tend to be supplied until the point at which the marginal utility reaped from labor no longer outweighs the marginal utility of leisure on the individual’s value scale. In the money economy, labor will cease when the marginal utility of the additional money income per unit of time no longer exceeds the marginal utility of the leisure forgone by working for the additional 16 time. 16 Of course, the concrete result differs with the individual and with the unit of time selected for consideration. In terms of income per hour, the point at which labor stops may come fairly quickly; in terms of income per year, it may never come. Regardless of his money income per hour, in other words, he is likely to stop work after a certain number of hours worked, whereas he is likely to take a year off from work only if his annual income is substantial.

284 219 The Pattern of Indirect Exchange Thus, man allocates his time between leisure and productive labor, between labor for money and labor on unexchangeable items, etc., in accordance with the principle of maximizing his psychic income. In deciding between labor and leisure, he weighs the marginal advantages of work with the marginal advantages of leisure. Similarly, man as a prospective investor must weigh, not only the advantages and disadvantages, monetary and otherwise, from each prospective investment, but also whether or not to invest at all. Every man must allocate his money resources in three and only three ways: in consumption spending, in investment expenditure, and in addition to his cash balance. Assume that to the investor cited above, the 10 percent project is highest in utility in his value scale, all factors considered. But then he must decide: Shall he invest at all, or shall he buy consumers’ goods now, or add to his cash balance? The marginal advantage of making the investment will be the prospective money return, weighted by the nonex- changeable utilities or disutilities involved. The advantage of a money return will be that he will have more money, in the future, that he could spend on consumers’ goods. If he has 100 ounces of money now and invests it, in a year he might have 110 ounces which he could spend on consumers’ goods. On the other hand, what chiefly militates against investment, as was explained in chapter 1, is the fact of time preference, the fact that If we assume he is giving up possible consumption in the present. that an ounce of money will buy the same quantity of goods as an ounce a year from now (an assumption that will be removed in later chapters), then one ounce of money now will always be more than one ounce a year from now, simply because en- worth joyment of a given good is always preferred as early as possible. Therefore, in deciding whether or not to invest, he must balance return against his desire to consume in the present the additional rather than the future. He must decide: if I value 100 ounces now more than 100 ounces a year from now, do I value 100 ounces now more or less than 110 ounces a year from now? He will decide in accordance with his value scale. Similarly, he must

285 Power and Market with 220 Man, Economy, and State weigh each against the marginal utility of adding to his cash bal- ance (in what this consists will be examined below). Thus, every unit of the money commodity in a man’s stock (his money resources owned) is always being allocated to the three categories of use in accordance with his value scale. The more money that he allocates to consumption, the lower will be the marginal utility of the goods consumed. Each further unit spent will be devoted to less urgently desired goods. And each further unit so spent will decrease his available stock of invest- ment goods and his available cash balance, and therefore will, in accordance with the law of utility, raise the marginal utility for- gone in each of these uses. The same will be true for each of the other uses; the more money he spends on each use, the less will be the marginal utility from that use, and the higher will be the marginal utility of other uses forgone. Every man will allocate his money resources on the same principles that the hypotheti- cal actor allocated his stock of horses in chapter 1 above; each unit will be used for the most useful end not yet achieved. It is in accordance with these principles—the maximizing of his psy- chic income—that each man will allocate his money stock. In accordance with his value scale, each man will judge the respec- tive marginal utilities to be obtained by each monetary unit in each use, and his allocation of money expenditures as revealed in his balance of payments will be determined by such judg- ments. Just as, within the general category of investment expendi- ture, there are different projects with different expected returns, so there are an innumerable variety of consumers’ goods within the general category of consumption. On what principles does a man allocate his expenditures among the numerous types of consumers’ goods available? On precisely corresponding princi- ples. His first unit of money spent on consumers’ goods will be spent on that good satisfying the most highly valued end, the next unit on the next most highly valued end, etc. Each parcel of a consumers’ good bought decreases the marginal utility of

286 The Pattern of Indirect Exchange 221 this good to the man and increases the marginal utility of all other goods forgone. Again, a man will allocate his money resources within the consumption category by apportioning each unit of money to that good with the highest marginal util- ity on his value scale. A judgment of relative marginal utilities determines the allocation of his money expenditures. It is evi- dent that we may eliminate the words “within the consumption category” in the sentence before the preceding, to arrive at the rule which governs all a man’s money allocation within and between categories. Our analysis may now be generalized still further. Each man, at every point in time, has in his ownership a certain stock of useful goods, a certain stock of resources , or assets . These resources may include not only money, but also consumers’ goods, nonpersonal producers’ goods (land and capital goods), personal energy, and . He will allocate each one of these resources time according to the same principles by which he has allocated money—so that each unit goes into the use with the highest prospective marginal utility on his value scale. Here we must note that the sale of personal labor service is not always made to an investing “employer” who purchases the labor service for money and then tries to sell the resulting prod- uct. In many cases, the man who invests also works directly in the production of the product. In some cases, the investor spends saved funds on factors of production and hires the labor of someone to direct the actual production operation. In other cases, the investor also spends his labor-time in the details of the production process. It is clear that this is just as much “labor” as the labor of an employee who does not own and sell the prod- uct. What principles will decide whether a prospective investor uses his labor in his own investment in production (i.e., will be “self-employed”) or will invest only his money and sell his labor elsewhere as an employee? Clearly, the principle again will be the best psychic advantage from the action. Thus, suppose that

287 Power and Market with 222 Man, Economy, and State Jones finds what he considers to be the best and most remuner- ative investment project, which he estimates will yield him a net money income of 150 ounces for the forthcoming year, pro- vided that he does not labor on the project itself, but hires oth- ers for its direction and management. He also estimates that, if he were to perform the direction himself instead of hiring a manager to do it, he would be able to net a further income from the project of 50 ounces a year. With his own labor involved, then, the net income from the project would be 200 ounces for the year. This figure will be the higher, the more skilled his direction would be than the man he replaces, and the lower, the less comparatively skilled he is. In this case, the 200-ounce net income would include a 150-ounce investment income and 50 ounces for the labor income of direction. Whether or not he takes this course depends (setting leisure aside) on whether he can sell his labor service for a greater income elsewhere. This “greater income” will, of course, be in terms of psychic income, but, if nonexchangeable factors are assumed in this case to be neutral, then the “greater income” will be the greater money ceteris paribus , Jones can earn 60 ounces as an income. If, employee for some other investing producer, then he will take this job and hire someone else to use labor on his investment. His total money income will then be: 150 ounces from the proj- ect plus 60 ounces from the sale of his labor services to a pro- ducer, totaling 210 ounces. Of course, if nonexchangeable psy- chic factors countervail, such as a great preference for being self-employed in the use of his labor, then he may accept the 200-ounce income. It is clear from this discussion that the common concept of the productive laborer, limited to the man who works in the fields or on an assembly line, is completely fallacious. Laborers are all those who expend their labor in the productive process. This labor is expended for a money income (which may be weighted by other psychic factors). If the labor service is sold to an investing employer who owns the final good produced by the co-operating factors, it might be rendered in any required task

288 The Pattern of Indirect Exchange 223 from that of a ditchdigger to that of a company president. On the other hand, labor income may be the result of the “self- employment” of the investing enterpriser. This type of laborer is also the owner of the final product, and his net monetary return from the sale of the product will include his labor income as well as his return from the money invested. The larger and more complex the enterprise and the production process, the greater will tend to be the development of specialized skill in management, and therefore the less will be the tendency for self-employment by the enterpriser. The smaller the enterprise, and the more direct the production methods, the more likely is self-employment to be the rule. We have so far specifically treated the principles of allocating labor and money. The other exchangeable resources that a man may possess (and it is the resources that catallactics exchangeable is interested in) are consumers’ goods and nonpersonal produc- ers’ goods (land and capital goods). durable ones. The consumers’ goods in a man’s stock are the The nondurable goods and services will have disappeared in the process of consuming them. Now, as we have seen in chapter 2, any good may have either direct use-value to its owner or ex- change-value or a mixture of both. At any time, each owner of a consumers’ good must judge on his value scale whether its ex- change-value or its highest direct use-value is the greater. In the money economy, the problem of exchange-value is simplified, since it will be exchange for that will be especially im- money portant. The utility on his value scale of the highest direct use- value will be compared to the utility of the sum of money the good could procure in exchange. Suppose, for example, that Mr. Williams owns a house; he determines that he could sell the house for 200 ounces of gold. Now he judges the ranking of the direct use as against the exchange-value on his value scale. Thus, he might have three alternative direct uses for the house ( a ) liv- ing in it; ( b ) living in it part of the time and letting his brother live in it part of the time; ( c ) living in it part of the time, with no

289 Power and Market with 224 Man, Economy, and State participation by his brother, and he may weigh each of these against the exchange-value as follows: Williams’ Value Scale Ranking 1. Direct Use (a). 2. Exchanging good for 200 ounces of money. 3. Direct Use (b). 4. Direct Use (c). In this case, Williams will decide to live in the house and not sell it. His decision will be determined solely by his value scale; someone else might rank the exchange above the direct use and therefore sell the house for money. It is obvious that it is true, without qualification, that for any given good , the seller will try to obtain as high a money price for it as possible. The proof of this is analogous to the demonstra- tion given in chapter 2 that the seller of a given good always tries to obtain the highest price, except that here the markets are simplified by being exchanges solely for money , and there- fore it is the that is important. The money income that money price a man will get from the sale of a good will always equal the money price of the sale times the quantity of units of the good. Thus, if he sells one house at a money price of 200 ounces per house, his total money income from the good will be 200 ounces. His de- sire to sell at the highest price does not, of course, mean that he will always sell at that price. The highest money price for a good may still be lower than the psychic value of direct use to him, as was the case with Williams. It is possible, however, that if the money price for selling the house rose to 250 ounces, the exchange-value of the house would have ranked higher than Di- rect Use ( a ), and he would have sold the house. It is clear that, if the owner of the consumers’ good is also the original producer, the direct use-value to him will be almost nil. The specialized producer who produces and owns houses or

290 The Pattern of Indirect Exchange 225 television sets or washing machines finds that the direct use- value to him of this stock is practically nonexistent. For him, the exchange-value is the only important factor, and his interest lies solely in maximizing his money income from the stock and therefore in attaining the highest money prices in the sale of each good. The nonexchangeable factors that might loom large to the prospective investor or laborer in a certain line of pro- duction will be negligible to the producer who already has a stock of goods, since he had already taken the nonexchangeable factors into account when he made his original investment or his original choice of occupation. Thus, to the producer of a consumers’ good, the way to maximize his psychic income from this revenue is to obtain the highest possible money price from its sale. When will an owner sell the good, and when will he rent out its services? Clearly, he will take the course that he believes will yield him the highest money income, or, more precisely, the highest present value of money income. What of the owner of a stock of nonpersonal producers’ goods ? How will he allocate these goods to attain the highest psychic income? In the first place, it is clear that, by definition, produc- ers’ goods can have no direct use-value to him as consumers’ goods. But they may well have direct use-value as producers’ goods, i.e., as factors of production in the making of a product further along in the process of being transformed into con- sumers’ goods. For any given stock of a producers’ good, or for any unit of that stock, there might be an exchange-value, a value in use for transformation into another product that would then have exchange-value, or both. It is also true for the owner of producers’ goods that nonexchangeable factors will generally play a negligible role. The fact that he has already invested and perhaps worked in producing or purchasing these goods signi- fies that he has already accounted for the possible positive or negative psychic values in the work itself. Furthermore, in the economy of indirect exchange, it is only exchange of goods pro- duced for money that is important, as there will be very little

291 Power and Market with 226 Man, Economy, and State scope for barter. The owner of producers’ goods is therefore interested in judging whether the goods will yield a higher money income from exchanging them directly for money or from transforming them via production into a product of “lower-order,” and then selling the product for money. As an example of the choices facing the owner of producers’ goods, let us take Robertson. Robertson has invested in, and therefore owns, the following factors: X 10 units of Producers’ Good 5 units of Producers’ Good Y Z 6 units of Producers’ Good He knows, because of his technological knowledge, that he can transform these units of co-operating factors , and Z, X, Y P . (The various “units,” of into 10 units of a final product course, are purely physical units of the various goods and are therefore completely incommensurable with one another.) He estimates that he will be able to sell these units of P for 15 ounces each, a total money income of 150 ounces. On the other hand, he sees that he could sell (or resell) the factors directly for money, without himself transforming them into , as follows: P X @ 6 oz. of gold per unit (the money 10 units of X ) a money income from stock of X of. . . . . 60 ounces price of 5 units of Y @ 9 oz. per unit, a money income of . . . . . 45 ounces 6 units of @ 4 oz. per unit, a money income of . . . . . 24 ounces Z His total money income from the sale of the stock of each pro- ducers’ good separately and directly is 129 ounces. However, Robertson must also consider the money expenditures that he would have to make in buying labor services to help in this transformation. In a free economy, he cannot own a stock of laborers. If his expenditure on labor service is less than 21 ounces , then it will pay him to transform the factors and sell the

292 The Pattern of Indirect Exchange 227 P product for 150 ounces; if the required expenditures on labor- service are more than 21 ounces, then it will pay him to sell the producers’ goods directly for money. In each one of these prospective sales, of course, it is to the owner’s interest to be able to sell at the highest possible price, thus yielding the highest money income from each good. Suppose, now, that Robertson had decided to go ahead with P. the production and that he now has in his stock 10 units of There is no prospect of his immediately going into the business that would make use of P as a factor in making another product. Therefore, there is only one alternative left to this owner—to sell the product for money, for the highest price that he can acquire. However, in those cases where P is durable, he still has the option of holding off the sale if he believes that its money price in the future will be higher, and provided that the higher price will cover the disadvantage to him of waiting (his time preference) and the expenses of storing until the sale is made. P The owner of a producers’ good, whether a product to him or a factor, may rent it out if he does not sell the entire good. In order for this to be feasible, of course, the good would have to be relatively durable. Here again, as in the case of a consumers’ good, the owner will decide on outright sale of the good or hir- ing out of its services over a period of time in accordance with his judgment of which alternative will yield him the highest money income (precisely, the highest present value). We have thus analyzed the actions of an owner of a stock of consumers’ goods or of producers’ goods in attempting to attain his most highly valued ends, i.e., to maximize his psychic in- come. Nonexchangeable factors for him will generally be negli- gible in importance, since they had already been discounted when the investment in them was made. If we set aside the value of the durable consumers’ good in direct use for some owners, the aim of the owners will be to maximize their money income from the stock of the good. Since money income from sale of a good is the money price of the good multiplied by the quantity

293 Power and Market with 228 Man, Economy, and State sold, this means that the sellers will try to attain the highest money price for their stock. At this point we may, at least briefly, begin to answer the question we did not have the information to answer in chapter 2: Granted the behavior of the owner of a given stock, what de- termines the size of that stock of goods? Now obviously, except in the case of personal energy, these goods must have been (or previously found and trans- previously produced by someone formed in the case of pure nature-given factors). This previous production was undertaken either by the present owner or by someone in the past, from whom he had acquired, by exchange or gift, this stock of goods. The past investment must have been made for the reason that we saw above: the expectation of a future money return from the investment, compensating for the sacrifice of waiting to consume in the future instead of the pres- ent. This previous investor expected that he would be able to sell the good for a money income greater than the money ex- penditures that he had to make on the factors of its production. As an example, let us take Robertson with a stock of 10 units of P. How did he acquire this stock? By investing money in buying factors of its production, and then producing it, in the hope of making a certain net money income, i.e., in the expectation that the money income from the sale of P would be greater by a cer- tain amount than the money expenditures invested in the vari- ous factors. Now how did the previously produced stock of the factors X , Y, and Z come into existence? By the same process. Various investors engaged in the production of these factors in the expectation of a net money income from the investment (total money income from the investment greater than total money expenditures). This investment decision accounts for the existence of all the stock of all producers’ goods and durable con- sumers’ goods for any community at any given point in time. In addition, the stock of pure nature-given factors was acquired through the owner’s or some previous person’s finding and using previously unused factors in a production process. The stock of the money commodity was, like that of the consumers’

294 The Pattern of Indirect Exchange 229 and producers’ goods, the result of an investment decision by an investing producer, who expected his money income to be higher than his money expenditure. On the other hand, the owned by any person is inherent in his stock of personal energy nature as a human being. We have thus analyzed each type of exchangeable resource that a person may have, what governs his use of them in order to maximize his psychic income, and to what extent such maximiza- tion involves attempted maximization of money income from the resource. In analyzing the determinants of the money income from any sale, we have seen that they are the quantity and the money price, and we have just seen how the quantities involved in the “given stock” of any good can be accounted for. What yet remains unaccounted for is the money prices. All we know about them so far is that the seller of any good—con- sumers’ or producers’ good or labor service—wishes to sell it for high a money price as possible. Nonexchangeable goods on the as owner’s value scale may modify this rule, but generally these modifications will be important only for sellers of labor services. We have so far been considering man as the allocator, or seller, of a given good. What of man as a of a good? (And buyer here we recall the discussion in the early parts of this chapter.) As a buyer, he uses money for investment expenditures and for consumption expenditures. In our discussion of an individual’s consumption expenditures, we saw that he decided on them upon considering a “unit’s worth” of goods. But what deter- mines what his unit’s worth shall be? What is an ounce of money’s worth of eggs, or hats, or butter, etc.? This can be determined only by the money price that the buyer would have to 1 pay for the good. If a man can buy eggs at of an ounce per /10 dozen, then one ounce’s worth of eggs is 10 dozen. Now it is obvious that man, in his capacity as a buyer of consumers’ goods with money, will seek to buy each particular good at the lowest money price possible . For a man who owns money and seeks to buy consumers’ goods, it is clear that the lower the money prices of the goods he seeks to buy, the greater is his psychic income; for the

295 Power and Market with 230 Man, Economy, and State more goods he can buy, the more uses he can make with the same amount of his money. The buyer will therefore seek the lowest money prices for the goods he buys. Thus, ceteris paribus , the psychic income of man as a seller for money is maximized by selling the good at the highest money price obtainable; the psychic income of man as a buyer with money is maximized by buying the good for the lowest money price obtainable. Let us now sum up the results of the analysis of this chapter. We have seen how the common medium of exchange emerges in the market out of direct exchange; we have noted the pattern of exchanges with and for money in an economy of indirect exchange; we have described how each individual has a pattern of money income and money expenditures. Then, we investi- gated what is involved in the maximization of psychic income in a money economy, how this principle governs the actions of people in their various functions—as owners of different types of resources and as laborers or investors. We have seen to what extent such pursuit after the most highly valued ends involves the maximization of money income in the various cases, and to what extent it does not. We have just concluded that such max- imization of psychic income always leads the seller of a good to seek the highest money price for it, and the buyer of a good to seek the lowest money price, with such exceptions as the laborer who spurns a higher money price for his labor because of the nonexchangeable conditions attached to the work, or the investor who spurns a greater prospective income for a line of production that he prefers for its own sake. These exceptions aside, pursuit of the rule: “Buy on the cheapest market and sell on the dearest” leads to satisfaction of the most highly valued ends for each individual, both as a consumer and as a producer. Although we know that man tries to maximize his psychic income, and therefore his money income, ceteris paribus , we still do not know on what basis the money income that he does acquire is determined. We know that the nonexchangeable

296 The Pattern of Indirect Exchange 231 values are simply determined by the value scales of each indi- vidual. But though we know that, , a man will sell ceteris paribus a service or a good for a greater rather than a lesser money price and income, we do not yet know what makes the money prices what they are. What determines the money prices of consumers’ goods, of labor services, of capital goods, of nature-given fac- tors? What determines the money price of the entire durable good and the money price of the “hired-out” services? And, with the enormous importance of investment as the determinant of the given stock of every good, what determines the spread between gross money income from goods and the money expen- ditures on the factors needed to produce them? It is only the anticipation of this spread between money income from the sale of the product, and money expenditure on factors, that brings about investment and production. And what, if any, are the rela- tions that tend to be established among the various prices? To put it differently, all human action uses scarce resources to attempt to arrive at the most highly valued of not-yet- attained ends, i.e., to maximize psychic income. We have seen how this is done by individuals in isolation and by individuals in direct exchange—although these can exist only to a drasti- cally limited extent. We have seen how it is done, on an immensely greater scale, in the money economy; and we have seen that the specific components of psychic maximization in the money economy are, ultimately, nonexchangeable values, quantities of goods in stock, and the money prices that these goods can exchange for on the market. We have explained the operations of the nonexchangeable values, and we have very briefly indicated how the quantity of the given stock of each good is determined. We have now to investigate the classic problem in the analysis of indirect exchange: the determination of money prices. The analysis of money prices, moreover, will enable investigation into the reasons for, and the determinants of, the “spread” between expected gross money income from sales and the expenditure on factors, which induces people to invest in the production of stock.


298 4 ONSUMPTION C RICES AND P 1. Money Prices importance of the money prices E HAVE SEEN THE ENORMOUS W of goods in an economy of indirect exchange. The money income of the producer or laborer and the psychic income of the consumer depend on the configuration of these prices. How are they determined? In this investigation, we may draw exten- sively from almost all of the discussion in chapter 2. There we saw how the prices of one good in terms of others are deter- mined under conditions of direct exchange. The reason for devoting so much consideration to a state of affairs that can have only a very limited existence was that a similar analysis can be applied to conditions of indirect exchange. In a society of barter, the that established prices (as- markets suming that the system could operate) were innumerable mar- kets of one good for every other good. With the establishment number of a money economy, the of markets needed is immea- surably reduced. A large variety of goods exchange against the money commodity, and the money commodity exchanges for a large variety of goods. Every single market, then (with the exception of isolated instances of barter) includes the money commodity as one of the two elements. Aside from loans and claims (which will be considered below), the following types of exchange are made against money: 233

299 Power and Market with Man, Economy, and State 234 Old Consumer Goods against Money against Money New Consumer Goods and Services Capital Goods against Money against Money Labor Services Land Factors against Money For durable goods, each unit may be sold in toto , or it may be hired out for its services over a certain period of time. Now we remember from chapter 2 that the price of one good in terms of another is the amount of the other good divided by the amount of the first good in the exchange. If, in a certain exchange, 150 barrels of fish exchanged for three horses, then the price of horses in terms of fish, the “fish-price of horses,” was 50 barrels of fish per horse in that exchange. Now suppose that, in a money economy, three horses exchange for 15 ounces money price of horses in this exchange is of gold (money). The five ounces per horse . The money price of a good in an exchange, therefore, is the quantity of units of gold, divided by the quan- tity of units of the good, yielding a numerical ratio. To illustrate how money prices may be computed for any exchange, suppose that the following exchanges are made: 15 ounces of gold for 3 horses 5 ounces of gold for 100 barrels of fish 1 ounce of gold for 2 dozen eggs /8 X ’s labor 24 ounces of gold for 8 hours of The money prices of these various exchanges were:

300 Prices and Consumption 235 The last ratios on each line are the money prices of the units of each good for each exchange. It is evident that, with money being used for all exchanges, money prices serve as a of all exchange common denominator ratios. Thus, with the above money prices, anyone can calculate that if one horse exchanges for five ounces and one barrel of fish 1 exchanges for /20 ounces, then one horse can, indirectly, 5 exchange for 100 barrels of fish, or for 80 dozen eggs, or of /3 ’s labor, etc. Instead of a myriad of isolated markets X an hour of for each good and every other good, each good exchanges for money, and the exchange ratios between every good and every other good can easily be estimated by observing their money prices. Here it must be emphasized that these exchange ratios are only hypothetical, and can be computed at all only because of the exchanges against money. It is only through the use of money that we can hypothetically estimate these “barter ratios,” and it is only by intermediate exchanges against money that one good can finally be exchanged for the other at the hypothetical 1 ratio. Many writers have erred in believing that money can somehow be abstracted from the formation of money prices and that analysis can accurately describe affairs “as if ” exchanges really took place by way of barter. With money and money prices pervading all exchanges, there can be no abstraction from money in analyzing the formation of prices in an economy of indirect exchange. Just as in the case of direct exchange, there will always be a tendency on the market for one money price to be established for each good. We have seen that the basic rule is that each seller tries to sell his good for the highest attainable money price, and each buyer tries to buy the good for the lowest attainable money price. The actions of the buyers and sellers will always 1 The exceptions are direct exchanges that might be made between two goods on the basis of their hypothetical exchange ratios on the mar- ket. These exchanges, however, are relatively isolated and unimportant and depend on the money prices of the two goods.

301 with Power and Market 236 Man, Economy, and State and rapidly tend to establish one price on the market at any given time. If the “ruling” market price for 100 barrels of fish, for example, is five ounces—i.e., if sellers and buyers believe that they can sell and buy the fish they desire for five ounces per 100 barrels—then no buyer will pay six ounces, and no seller will accept four ounces for the fish. Such action will obtain for all goods on the market, establishing the rule that, for the entire market society, every homogeneous good will tend to be bought and sold at one particular money price at any given time. What, then, are the forces that determine at what point this uniform money price for each good tends to be set? We shall soon see that, as demonstrated in chapter 2, the determinants are the individual value scales, expressed through demand and supply schedules. We must remember that, in the course of determining the “fish-price of horses” in the direct exchange of fish as against horses, at the same time there was also determined the “horse- price of fish.” In the exchanges of a money economy, what is the “goods-price of money” and how is it determined? Let us consider the foregoing list of typical exchanges against money. These exchanges established the money prices of four different goods on the market. Now let us reverse the process and divide the quantities of goods by the quantity of money in the exchange. This gives us: This sort of list, or “array,” goes on and on for each of the myr- iad exchanges of goods against money. The inverse of the money price of any good gives us the “goods-price” of money in terms of that particular good. Money, in a sense, is the only good that remains, as far as its prices are concerned, in the same state that every

302 237 Prices and Consumption good was in a regime of barter. In barter, every good had only its : fish-price of every other good ruling market price in terms of eggs, horse-price of movies, etc. In a money economy, every market price in terms of money. one good except money now has still has an almost infinite Money, on the other hand, of array “goods-prices” that establish the “goods-price of money.” The entire array, considered together, yields us the general “goods- price of money.” For if we consider the whole array of goods- prices, we know what one ounce of money will buy in terms of any desired combination of goods, i.e., we know what that “ounce’s worth” of money (which figures so largely in con- sumers’ decisions) will be. Alternatively, we may say that the money price of any good discloses what its “purchasing power” on the market will be. Suppose a man possesses 200 barrels of fish. He estimates that the ruling market price for fish is six ounces per 100 barrels, and that therefore he can sell the 200 barrels for 12 ounces. The “purchasing power” of 100 barrels on the market is six ounces of money. Similarly, the purchasing power of a horse may be five ounces, etc. The purchasing power of a stock of any good is equal to the amount of money it can “buy” on the market and is therefore directly determined by the money price that it can obtain. As a the purchasing power of a unit of any quantity of a matter of fact, good is equal to its money price. If the market money price of a 1 dozen eggs (the unit) is ounce of gold, then the purchasing /8 1 power of the dozen eggs is also of an ounce. Similarly, the /8 purchasing power of a horse, above, was five ounces; of an hour X ’s labor, three ounces; etc. of For every good except money, then, the purchasing power of its unit is identical to the money price that it can obtain on the What is the purchasing power of the monetary unit market. ? Obvi- ously, the purchasing power of, e.g., an ounce of gold can be all considered only in relation to the goods that the ounce could purchase or help to purchase. The purchasing power of the mone- tary unit consists of an array of all the particular goods-prices in the

303 with Power and Market Man, Economy, and State 238 2 society in terms of the unit. It consists of a huge array of the type 1 above: /5 horse per ounce; 20 barrels of fish per ounce; 16 dozen eggs per ounce; etc. It is evident that the money commodity and the determi- nants of its purchasing power introduce a complication in the demand and supply schedules of chapter 2 that must be worked out; there cannot be a mere duplication of the demand and sup- ply schedules of barter conditions, since the demand and supply situation for money is a unique one. Before investigating the “price” of money and its determinants, we must first take a long detour and investigate the determination of the money prices of all the other goods in the economy. 2. Determination of Money Prices Let us first take a typical good and analyze the determinants of its money price on the market. (Here the reader is referred back to the more detailed analysis of price in chapter 2.) Let us take a homogeneous good, Grade A butter, in exchange against money. The money price is determined by actions decided according to individual value scales. For example, a typical buyer’s value scale may be ranked as follows: 2 Many writers interpret the “purchasing power of the monetary unit” as being some sort of “price level,” a measurable entity consisting of some sort of average of “all goods combined.” The major classical economists did not take this fallacious position: When they speak of the value of money or of the level of prices without explicit qualification, they mean the array of prices, of both commodities and services, in all its particu- larity and without conscious implication of any kind of statistical average. (Jacob Viner, Studies in the Theory of Inter- national Trade [New York: Harper & Bros., 1937], p. 314) Also cf. Joseph A. Schumpeter, History of Economic Analysis (New York: Oxford University Press, 1954), p. 1094.

304 Prices and Consumption 239 The quantities in parentheses are those which the person does not possess but is considering adding to his ownership; the oth- ers are those which he has in his possession. In this case, the buyer’s maximum buying money price for his first pound of butter is six grains of gold. At any market price of six grains or under, he will exchange these grains for the butter; at a market price of seven grains or over, he will not make the purchase. His maxi- mum buying price for a second pound of butter will be consid- erably lower. This result is always true, and stems from the law of utility; as he adds pounds of butter to his ownership, the mar- ginal utility of each pound declines. On the other hand, as he dispenses with grains of gold, the marginal utility to him of each remaining grain increases. Both these forces impel the maxi- mum buying price of an additional unit to decline with an 3 From this value scale, we increase in the quantity purchased. 3 The tabulations in the text are simplified for convenience and are not strictly correct. For suppose that the man had already paid six gold grains for one ounce of butter. When he decides on a purchase of another pound the units of money rise, since he now has a all of butter, his ranking for lower stock of money than he had before. Our tabulations, therefore, do not fully portray the rise in the marginal utility of money as money is , rather than modifies, our con- reinforces spent. However, the correction clusion that the maximum demand-price falls as quantity increases, for we see that it will fall still further than we have depicted.

305 Power and Market with Man, Economy, and State 240 can compile this buyer’s demand schedule , the amount of each good that he will consume at each hypothetical money price on the market. We may also draw his demand curve, if we wish to see the schedule in graphic form. The individual demand sched- ule of the buyer considered above is as shown in Table 6. 6 T ABLE EMAND P RICE Q UANTITY D ARKET M (P URCHASED ) Grains of gold Pounds per pound of of butter butter 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 We note that, because of the law of utility, an individual demand curve must be either “vertical” as the hypothetical price declines, or else rightward-sloping (i.e., the quantity demanded, as the money price falls, must be either the same or greater), not leftward-sloping (not a lower quantity demanded). If this is the necessary configuration of every buyer’s demand schedule, it is clear that the existence of more than one buyer will tend greatly to reinforce this behavior. There are two and only two possible classifications of different people’s value scales: either they are all identical, or else they differ. In the extremely unlikely case that everyone’s relevant value scales are identical with everyone else’s (extremely unlikely because of the immense variety of valuations by human beings), then, for example, buyers B, C, D, etc. will have the same value scale and

306 Prices and Consumption 241 therefore the same individual demand schedules as buyer A who has just been described. In that case, the shape of the aggregate market-demand curve (the sum of the demand curves of the individual buyers) will be identical with the curve of buyer A, although the aggregate quantities will, of course, be much greater. To be sure, the value scales of the buyers will almost always differ, which means that their maximum buying prices for any given pound of butter will differ. The result is that, as the market price is lowered, more and more buyers of different units are brought into the market. This effect greatly reinforces the rightward-sloping feature of the market-demand curve. As an example of the formation of a market-demand sched- ule from individual value scales, let us take the buyer described above as buyer A and assume two other buyers on the market, B and C, with the following value scales: From these value scales, we can construct their individual demand schedules (Table 7). We notice that, in each of the varied patterns of individual demand schedules, none can ever be left- ward-sloping as the hypothetical price declines. Now we may summate the individual demand schedules, A, B, and C, into the market-demand schedule. The market-demand

307 with Power and Market 242 Man, Economy, and State T ABLE 7 Buyer B Buyer C Q UANTITY UANTITY Q EMANDED D RICE D EMANDED P RICE P Grains/lb lbs. butter Grains/lb. lbs. butter 5 . . . . . . . . . . . . 0 7 . . . . . . . . . . . . . 0 4 . . . . . . . . . . . . 0 6 . . . . . . . . . . . . . 0 3 . . . . . . . . . . . . 1 5 . . . . . . . . . . . . . 1 2 . . . . . . . . . . . . 3 4 . . . . . . . . . . . . . 2 3 . . . . . . . . . . . . . 2 1 . . . . . . . . . . . . 5 2 . . . . . . . . . . . . . 2 1 . . . . . . . . . . . . . 4 schedule yields the total quantity of the good that will be bought by all the buyers on the market at any given money price for the good. The market-demand schedule for buyers A, B, and C is as shown in Table 8. Figure 33 is a graphical representation of these schedules and of their addition to form the market-demand schedule. T ABLE 8 A GGREGATE M ARKET -D EMAND S CHEDULE P Q UANTITY RICE D EMANDED 7. . . . . . . . . . . . . . . . . . . . . . . . . . . 0 7. . . . . . . . . . . . . . . . . . . . . . . . . . . 0 6. . . . . . . . . . . . . . . . . . . . . . . . . . . 1 5. . . . . . . . . . . . . . . . . . . . . . . . . . . 2 4. . . . . . . . . . . . . . . . . . . . . . . . . . . 4 3. . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2. . . . . . . . . . . . . . . . . . . . . . . . . . . 8 1. . . . . . . . . . . . . . . . . . . . . . . . . . . 12

308 Prices and Consumption 243 The principles of the formation of the market-supply sched- ule are similar, although the causal forces behind the value 4 Each supplier ranks each unit to be sold and scales will differ. the amount of money to be obtained in exchange on his value scale. Thus, one seller’s value scale might be as follows: 4 On market-supply schedules, cf. Friedrich von Wieser, Social Eco- nomics (London: George Allen & Unwin, 1927), pp. 179–84.

309 Power and Market with 244 Man, Economy, and State If the market price were two grains of gold, this seller would sell no butter, since even the first pound in his stock ranks above the acquisition of two grains on his value scale. At a price of three grains, he would sell two pounds, each of which ranks below three grains on his value scale. At a price of four grains, he would sell three pounds, etc. It is evident that, as the hypothet- ical price is lowered, the individual supply curve must be either vertical or leftward-sloping, i.e., a lower price must lead either to a lesser or to the same supply, never to more. This is, of course, equivalent to the statement that as the hypothetical price increases , the supply curve is either vertical or rightward- sloping. Again, the reason is the law of utility; as the seller dis- poses of his stock, its marginal utility to him tends to rise, while the marginal utility of the money acquired tends to fall. Of course, if the marginal utility of the stock to the supplier is nil, and if the marginal utility of money to him falls only slowly as he acquires it, the law may not change his quantity supplied during the range of action on the market, so that the supply curve may be vertical throughout almost all of its range. Thus, a supplier Y might have the following value scale:

310 Prices and Consumption 245 This seller will be willing to sell, above the minimum price of one grain, every unit in his stock. His supply curve will be shaped as in Figure 34. In seller X ’s case, his minimum selling price was three grains for the first and second pounds of butter, four grains for the third pound, five grains for the fourth and fifth pounds, and six grains for the sixth pound. Seller Y ’s minimum selling price for the first

311 Power and Market with Man, Economy, and State 246 pound and for every subsequent pound was one grain. In no case, however, can the supply curve be rightward-sloping as the price declines; i.e., in no case can a lower price lead to more units supplied. Let us assume, for purposes of exposition, that the suppliers X of butter on the market consist of just these two, , with Y and the foregoing value scales. Then their individual and aggregate market-supply schedules will be as shown in Table 9. T ABLE 9 UANTITY S UPPLIED Q Price Market XY 6 12 8 . . . . . . 6 6 6 7 . . . . . . 12 6 . . . . . . 6 6 12 5 . . . . . . 5 6 11 4 . . . . . . 3 9 6 2 8 3 . . . . . . 6 0 6 2 . . . . . . 6 1 . . . . . . 0 0 0 This market-supply curve is diagramed above in Figure 33. We notice that the intersection of the market-supply and mar- ket-demand curves, i.e., the price at which the quantity supplied and the quantity demanded are equal, here is located at a point in between two prices. This is necessarily due to the lack of divis- ibility of the units; if a unit grain, for example, is indivisible, there is no way of introducing an intermediate price, and the market-equilibrium price will be at either 2 or 3 grains. This will be the best approximation that can be made to a price at which the market will be precisely cleared, i.e., one at which the would- be suppliers and the demanders at that price are satisfied. Let us, however, assume that the monetary unit can be further

312 247 Prices and Consumption divided, and therefore that the equilibrium price is, say, two and a half grains. Not only will this simplify the exposition of price formation; it is also a realistic assumption, since one of the important characteristics of the money commodity is precisely into minute units, which can be exchanged on the its divisibility market. It is this divisibility of the monetary unit that permits us to draw continuous lines between the points on the supply and demand schedules. The money price on the market will tend to be set at the equilibrium price—in this case, at two and a half grains. At a higher price, the quantity offered in supply will be greater than the quantity demanded; as a result, part of the supply could not be sold, and the sellers will underbid the price in order to sell their stock. Since only one price can persist on the market, and the buyers always seek their best advantage, the result will be a general lowering of the price toward the equilibrium point. On the other hand, if the price is below two and a half grains, there are would-be buyers at this price whose demands remain unsat- isfied. These demanders bid up the price, and with sellers look- ing for the highest attainable price, the market price is raised toward the equilibrium point. Thus, the fact that men seek their greatest utility sets forces into motion that establish the money price at a certain equilibrium point, at which further exchanges tend to be made. The money price will remain at the equilib- until rium point for further exchanges of the good, demand or supply schedules change. Changes in demand or supply condi- tions establish a new equilibrium price, toward which the mar- ket price again tends to move. What the equilibrium price will be depends upon the config- uration of the supply and demand schedules, and the causes of these schedules will be subjected to further examination below. The stock of any good is the total quantity of that good in existence. Some will be supplied in exchange, and the remain- der will be reserved . At any hypothetical price, it will be reserved demand of recalled, adding the demand to buy and the the supplier gives the total demand to hold on the part of both

313 with Power and Market 248 Man, Economy, and State 5 groups. The total demand to hold includes the demand in exchange by present nonowners and the reservation demand to hold by the present owners. Since the supply curve is either ver- tical or increasing with a rise in price, the sellers’ reservation demand will fall with a rise in price or will be nonexistent. In either case, the total demand to hold rises as the price falls. Where there is a rise in reservation demand, the increase in the total demand to hold is greater—the curve far more elas- tic—than the regular demand curve, because of the addition of 6 Thus, the higher the the reservation-demand component. market price of a stock, the less the willingness on the market to hold and own it and the greater the eagerness to sell it. Con- versely, the lower the price of a good on the market, the greater the willingness to own it and the less the willingness to sell it. always It is characteristic of the total demand curve that it intersects the physical stock available at the same equilibrium price as the one at which the demand and supply schedules in- tersect. The Total Demand and Stock lines will therefore yield the same market equilibrium price as the other, although the quantity exchanged is not revealed by these curves. They do dis- close, however, that, since all units of an existing stock must be possessed by someone, the market price of any good tends to be such that the aggregate demand to keep the stock will equal the stock itself. Then the stock will be in the hands of the most eager, or most capable, possessors. These are the ones who are willing to demand the most for the stock. That owner who would just sell his stock if the price rose slightly is the marginal possessor: that nonowner who would buy if the price fell slightly 7 is the . marginal nonpossessor 5 The reader is referred to the section on “Stock and the Total Demand to Hold” in chapter 2, pp. 137–42. 6 If there is no reservation-demand schedule on the part of the sellers, then the total demand to hold is identical with the regular demand sched- ule. 7 The proof that the two sets of curves always yield the same equilib- rium price is as follows: Let, at any price, the quantity demanded = D , the

314 Prices and Consumption 249 Figure 35 is a diagram of the supply, demand, total demand, and stock curves of a good. The total demand curve is composed of demand plus reserved supply; both slope rightward as prices fall. The equi- librium price is the same both for the intersection of the and S D and Stock. TD curves, and for If there is no reservation demand, then the supply curve will be vertical, and equal to the stock. In that case, the diagram becomes as in Figure 36. 3. Determination of Supply and Demand Schedules Every money price of a good on the market, therefore, is de- termined by the supply and demand schedules of the individual buyers and sellers, and their action tends to establish a uniform quantity supplied = , the quantity of existing stock = K , the quantity of S reserved demand = R , and the total demand to hold = T . The following are always true, by definition: K R – S = R D + = T S is obviously D and S Now, at the equilibrium price, where intersect, . But if S = D , then T = K – R + R equal to T = K . D , or

315 Power and Market with 250 Man, Economy, and State equilibrium price on the market at the point of intersection, 8 which changes only when the schedules do. Now the question arises: What are the determinants of the demand and supply schedules themselves? Can any conclusions be formed about the value scales and the resulting schedules? In the first place, the analysis of speculation in chapter 2 can be applied directly to the case of the money price. There is no 9 need to repeat that analysis here. Suffice it to say, in summary, that, in so far as the equilibrium price is anticipated correctly by speculators, the demand and supply schedules will reflect the fact: above the equilibrium price, demanders will buy less than 8 Of course, this equilibrium price might be a zone rather than a single price in those cases where there is a zone between the valuations of the marginal buyer and those of the marginal seller. See the analysis of one In such rare cases, buyer and one seller in chapter 2, above, pp. 107–10 . where there generally must be very few buyers and very few sellers, there is a zone within which the market is cleared at any point, and there is room for “bargaining skill” to maneuver. In the extensive markets of the money economy, however, even one buyer and one seller are likely to have one determinate price or a very narrow zone between their maxi- mum buying- and minimum selling-prices. 9 See chapter 2 above, pp. 130–37.

316 251 Prices and Consumption they otherwise would because of their anticipation of a later drop in the money price; below that price, they will buy more because of an anticipation of a rise in the money price. Simi- larly, sellers will sell more at a price that they anticipate will soon be lowered; they will sell less at a price that they anticipate will soon be raised. The general effect of speculation is to make both the supply and demand curves more elastic, viz., to shift S ′ D ′ and from SS to in Figure 37. The ′ S ′ DD D to them from more people engage in such (correct) speculation, the more elastic will be the curves, and, by implication, the more rapidly will the equilibrium price be reached. We also saw that preponderant errors in speculation tend in- exorably to be self-correcting. If the speculative demand and ′ D ′ – S ′ S ′ ) preponderantly do not estimate D supply schedules ( the correct equilibrium price and consequently intersect at another price, then it soon becomes evident that that price does not really clear the market. Unless the equilibrium point set by the speculative schedules is identical to the point set by the schedules minus the speculative elements, the market again tends to bring the price (and quantity sold) to the true equilib- rium point. For if the speculative schedules set the price of eggs at two grains, and the schedules without speculation would set

317 with Power and Market 252 Man, Economy, and State it at three grains, there is an excess of quantity demanded over quantity supplied at two grains, and the bidding of buyers 10 finally brings the price to three grains. Setting speculation aside, then, let us return to the buyer’s demand schedules. Suppose that he ranks the unit of a good above a certain number of ounces of gold on his value scale. of his sources demand for the good ? In What can be the possible other words, what can be the sources of the utility of the good to him? There are only three sources of utility that any purchase 11 One of these is ( a ) the anticipated good can have for any person. later sale of the same good for a higher money price. This is the speculative demand, basically ephemeral—a useful path to uncovering the more fundamental demand factors. This demand has just been analyzed. The second source of demand is ( ) direct b ) direct use as a c use as a consumers’ good; the third source is ( ) can apply only to consumers’ goods; producers’ good. Source ( b c ) to producers’ goods. The former are directly consumed; the ( latter are used in the production process and, along with other co-operating factors, are transformed into lower-order capital goods, which are then sold for money. Thus, the third source applies solely to the investing producers in their purchases of producers’ goods; the second source stems from consumers. If b ) is the source of we set aside the temporary speculative source, ( c ) the the individual demand schedules for all consumers’ goods, ( source of demands for all producers’ goods. seller What of the of the consumers’ good or producers’ good—why is he demanding money in exchange? The seller 10 This and the analysis of chapter 2 refute the charge made by some writers that speculation is “self-justifying,” that it distorts the effects of the underlying supply and demand factors, by tending to establish pseu- doequilibrium prices on the market. The truth is the reverse; speculative errors in estimating underlying factors are self-correcting, and anticipa- tion tends to establish the true equilibrium market-price more rapidly. 11 Compare this analysis with the analysis of direct exchange, chapter 2 above, pp. 160–61.

318 253 Prices and Consumption demands money because of the marginal utility of money to him, and for this reason he ranks the money acquired above posses- sion of the goods that he sells. The components and determi- nants of the utility of money will be analyzed in a later section. Thus, the buyer of a good demands it because of its direct use-value either in consumption or in production; the seller demands money because of its marginal utility in exchange. This, however, does not exhaust the description of the compo- nents of the market supply and demand curves, for we have still not explained the rankings of the good on the seller’s value scale and the rankings of money on the buyer’s. When a seller keeps his stock instead of selling it, what is the source of his reserva- tion demand for the good? We have seen that the quantity of a good reserved at any point is the quantity of stock that the seller refuses to sell at the given price. The sources of a reservation ) anticipation of later sale at a a demand by the seller are two: ( higher price; this is the speculative factor analyzed above; and ( b ) direct use of the good by the seller. This second factor is not often applicable to producers’ goods, since the seller produced the producers’ good for sale and is usually not immediately pre- pared to use it directly in further production. In some cases, however, this alternative of direct use for further production does exist. For example, a producer of crude oil may sell it or, if the money price falls below a certain minimum, may use it in his own plant to produce gasoline. In the case of consumers’ goods, which we are treating here, direct use may also be feasible, par- ticularly in the case of a sale of an old consumers’ good previ- ously used directly by the seller—such as an old house, painting, etc. However, with the great development of specialization in the money economy, these cases become infrequent. ) as being a temporary factor and realize that If we set aside ( a ) is frequently not present in the case of either consumers’ or b ( producers’ goods, it becomes evident that many market-supply curves will tend to assume an almost vertical shape. In such a case, after the investment in production has been made and the

319 Power and Market with Man, Economy, and State 254 stock of goods is on hand, the producer is often willing to sell it at any money price that he can obtain, regardless of how low the market price may be. This, of course, is by no means the same will be made if the investment in further production as saying that seller a very low money price from the sale of the anticipates product. In the latter case, the problem is to determine how at present in the production of a good to be pro- much to invest duced and sold at a point In the case of the mar- in the future. ket-supply curve, which helps set the day-to-day equilibrium price, we are dealing with already given stock and with the reservation demand for this stock. In the case of production, on the other hand, we are dealing with investment decisions con- cerning how much stock to produce for some later period. What we have been discussing has been the market-supply , what to do with given stock curve. Here the seller’s problem is with already produced goods. The problem of production will be treated in chapter 5 and subsequent chapters. Another condition that might obtain on the market is a pre- vious buyer’s re-entering the market and reselling a good. For him to be able to do so, it is obvious that the good must be durable . (A violin-playing service, for example, is so nondurable that it is not resalable by the purchasing listeners.) The total stock of the good in existence will then equal the producers’ the supply new supply plus the producers’ reserved demand plus plus the reserved demand of the old offered by old possessors possessors (i.e., the amount the old buyers retain). The market- supply curve of the old possessors will increase or be vertical as the price rises; and the reserved-demand curve of the old pos- sessors will increase or be constant as the price falls. In other words, their schedules behave similarly to their counterpart schedules among the producers. The aggregate market-supply curve will be formed simply by adding the producers’ and old possessors’ supply curves. The total-demand-to-hold schedule will equal the demand by buyers plus the reservation demand (if any) of the producers and of the old possessors.

320 255 Prices and Consumption If the good is Chippendale chairs, which cannot be further with the identical produced, then the market-supply curves are supply curves of the old possessors. There is no new produc- tion, and there are no additions to stock. It is clear that the greater the proportion of old stock to new production, other things being equal, the greater will tend to be the importance of the supply of old possessors compared to that of new producers. The tendency will be for old stock to be more important the greater the durability of the good. There is one type of consumers’ good the supply curve of which will have to be treated in a later section on labor and earnings. This is personal service , such as the services of a doctor, a lawyer, a concert violinist, a servant, etc. These services, as we have indicated above, are, of course, nondurable. In fact, they are consumed by the seller immediately upon their production. Not being material objects like “commodities,” they are the direct emanation of the effort of the supplier himself, who pro- duces them instantaneously upon his decision. The supply curve depends on the decision of whether or not to produce— supply—personal effort, not on the sale of already produced stock. There is no “stock” in this sphere, since the goods disap- pear into consumption immediately on being produced. It is evident that the concept of “stock” is applicable only to tangi- ble objects. The price of personal services, however, is deter- mined by the intersection of supply and demand forces, as in the case of tangible goods. For all goods, the establishment of the equilibrium price tends to establish a state of rest ; a cessation of exchanges. After the price is established, sales will take place until the stock is in the hands of the most capable possessors, in accordance with the value scales. Where new production is continuing, the market however, because of the inflow of new continuing, will tend to be stock from producers coming into the market. This inflow alters the state of rest and sets the stage for new exchanges, with producers eager to sell their stock, and consumers to buy. When total stock is fixed and there is no new production, on the other

321 with Power and Market 256 Man, Economy, and State hand, the state of rest is likely to become important. Any changes in price or new exchanges will occur as a result of changes of valuations, i.e., a change in the relative position of money and the good on the value scales of at least two individ- uals on the market, which will lead them to make further exchanges of the good against money. Of course, where valua- tions are changing, as they almost always are in a changing 12 world, markets for old stock will again be continuing. An example of that rare type of good for which the market may be intermittent instead of continuous is Chippendale chairs, where the stock is very limited and the money price rel- atively high. The stock is always distributed into the hands of the most eager possessors, and the trading may be infrequent. Whenever one of the collectors comes to value his Chippendale below a certain sum of money, and another collector values that sum in his possession below the acquisition of the furniture, an exchange is likely to occur. Most goods, however, even nonre- producible ones, have a lively, continuing market, because of continual changes in valuations and a large number of partici- pants in the market. In sum, buyers decide to buy consumers’ goods at various ranges of price (setting aside previously analyzed speculative demand for the good for direct use . They factors) because of their reservation demand because of their abstain from buying decide to for money , which they prefer to retain rather than spend on that particular good. Sellers supply the goods, in all cases, because , and those cases where they reserve a demand for money of their stock for themselves are due (aside from speculation on price increases) to their demand for the good for direct use. Thus, the general factors that determine the supply and demand schedules of any and all consumers’ goods, by all persons on the are the balancing on their value scales of their demand market, for the good for direct use and their demand for money, either 12 See chapter 2 above, pp. 142–44.

322 257 Prices and Consumption for reservation or for exchange. Although we shall further dis- cuss investment-production decisions below, it is evident that decisions to invest are due to the demand for an expected not to invest, as we have in the future. money return A decision seen above, is due to a competing demand to use a stock of in the present. money 4. The Gains of Exchange As in the case considered in chapter 2, the sellers who are included in the sale at the equilibrium price are those whose value scales make them the most capable, the most eager, sellers. Similarly, it will be the most capable, or most eager, buyers who will purchase the good at the equilibrium price. With a price of two and a half grains of gold per pound of butter, the sellers will be those for whom two and a half grains of gold is worth more than one pound of butter; the buyers will be those for whom the reverse valuation holds. Those who are excluded from sale or purchase by their own value scales are the “less capable,” or “less eager,” buyers and sellers, who may be referred to as “submar- ginal.” The “marginal” buyer and the “marginal” seller are the ones whose schedules just barely permit them to stay in the mar- ket. The marginal seller is the one whose minimum selling price is just two and a half; a slightly lower selling price would drive him out of the market. The marginal buyer is the one whose maximum buying price is just two and a half; a slightly higher selling price would drive him out of the market. Under the law of price uniformity, all the exchanges are made at the equilib- rium price (once it is established), i.e., between the valuations of the marginal buyer and those of the marginal seller, with the demand and supply schedules and their intersection determining the point of the margin. It is clear from the nature of human action that all buyers will benefit (or decide they will benefit) from the exchange. Those who abstain from buying the good have decided that they would lose from the exchange. These propositions hold true for all goods.

323 with Power and Market 258 Man, Economy, and State Much importance has been attached by some writers to the “psychic surplus” gained through exchange by the most capable buyers and sellers, and attempts have been made to measure or compare these “surpluses.” The buyer who would have bought the same amount for four grains is obviously attaining a subjec- tive benefit because he can buy it for two and a half grains. The same holds for the seller who might have been willing to sell the same amount for two grains. However, the psychic surplus of the “supramarginal” cannot be contrasted to, or measured against, that of the marginal buyer or seller. For it must be remembered that the marginal buyer or seller also receives a psychic surplus: he gains from the exchange, or else he would not make it. Value scales of each individual are purely ordinal, and there is no way whatever of measuring the distance between the rankings; indeed, any concept of such distance is a fallacious one. Consequently, there is no way of making interpersonal comparisons and measurements, and no basis for saying that 13 one person subjectively benefits more than another. We may illustrate the impossibility of measuring utility or benefit in the following way. Suppose that the equilibrium mar- ket price for eggs has been established at three grains per dozen. The following are the value scales of some selected buyers and would-be buyers: 13 We might, in some situations, make such comparisons as historians, using imprecise judgment. We cannot, however, do so as praxeologists or economists.

324 Prices and Consumption 259 The money prices are divided into units of one-half grain; for purposes of simplification, each buyer is assumed to be consid- one unit —one dozen eggs. C is obviously ering the purchase of a submarginal buyer; he is just excluded from the purchase because three grains is higher on his value scale than the dozen eggs. A and B, however, will make the purchase. Now A is a marginal buyer; he is just able to make the purchase. At a price of three and a half grains, he would be excluded from the mar- , ket, because of the rankings on his value scale. B on the other hand, is a supramarginal buyer: he would buy the dozen eggs even if the price were raised to four and a half grains. But can we say that B benefits from his purchase more than A ? No, we cannot. Each value scale, as has been explained above, is purely ordinal, a matter of rank. Even though B prefers the eggs to four and a half grains, and A prefers three and a half grains to the eggs, we still have no standard for comparing the two sur- pluses. All we can say is that the price of three grains, B above has a psychic surplus from exchange, while A becomes submar- ginal, with no surplus. But, even if we assume for a moment that the concept of “distance” between ranks makes sense, for all we know, A’s surplus over three grains may give him a far greater subjective utility than B’s surplus over three grains, even though the latter is also a surplus over four and a half grains. There can be no interpersonal comparison of utilities, and the relative rankings of money and goods on different value scales cannot be used for such comparisons. Those writers who have vainly attempted to measure psychic gains from exchange have concentrated on “consumer sur- pluses.” Most recent attempts try to base their measurements on the price a man would have paid for the good if confronted with the possibility of being deprived of it. These methods are completely fallacious. The fact that A would have bought a suit at 80 gold grains as well as at the 50 grains’ market price, while B would not have bought the suit if the price had been as high as 52 grains, does not, as we have seen, permit any measurement of the psychic surpluses, nor does it permit us to say that A’s gain was in any way “greater” than B’s. The fact that even if we could

325 with Power and Market 260 Man, Economy, and State identify the marginal and supramarginal purchasers, we could never assert that one’s gain is greater than another’s is a con- clusive reason for the rejection of all attempts to measure con- sumers’ or other psychic surpluses. There are several other fundamental methodological errors in such a procedure. In the first place, individual value scales are here separated from concrete action. But economics deals with the universal aspects of real action, not with the actors’ inner psychological workings. We deduce the existence of a specific ; we have no knowledge of real act value scale on the basis of the that part of a value scale that is not revealed in real action. The question how much one would pay if threatened with dep- rivation of the whole stock of a good is strictly an academic question with no relation to human action. Like all other such constructions, it has no place in economics. Furthermore, this particular concept is a reversion to the classical economic fallacy of dealing with the whole supply of a good as if it were relevant marginal to individual action. It must be understood that only units are relevant to action and that there is no determinate re- lation at all between the marginal utility of a unit and the util- ity of the supply as a whole. It is true that the total utility of a supply increases with the size of the supply. This is deducible from the very nature of a good. Ten units of a good will be ranked higher on an indi- vidual’s value scale than four units will. But this ranking is com- pletely unrelated to the utility ranking of each unit when the sup- ply is 4, 9, 10, or any other amount. This is true regardless of the size of the unit. We can affirm only the trivial ordinal re- lationship, i.e., that five units will have a higher utility than one unit, and that the first unit will have a higher utility than the sec- ond unit, the third unit, etc. But there is no determinate way of 14 lining up the single utility with the “package” utility. Total 14 For more on these matters, see Rothbard, “Toward a Reconstruction of Utility and Welfare Economics,” pp. 224–43. Also see Mises, Theory of Money and Credit , pp. 38–47.

326 Prices and Consumption 261 utility, indeed, makes sense as a real and relevant rather than as a hypothetical concept only when actual decisions must be made concerning the whole supply. In that case, it is still mar- ginal utility, but with the size of the margin or unit now being the whole supply. The absurdity of the attempt to measure consumers’ surplus all would become clearer if we considered, as we logically may, the consumers’ goods at once and attempted to measure in any way the undoubted “consumers’ surplus” arising from the fact that production for exchange exists at all. This has never been 15 attempted. 5. The Marginal Utility of Money T HE C ONSUMER A. We have not yet explained one very important problem: the ranking of money on the various individual value scales. We know that the ranking of units of goods on these scales is deter mined by the relative ranking of the marginal utilities of the units. In the case of barter, it was clear that the relative rank- ings were the result of people’s evaluations of the marginal importance of the direct uses of the various goods. In the case of a monetary economy, however, the direct use-value of the money commodity is overshadowed by its exchange-value. In chapter 1, section 5, on the law of marginal utility, we saw that the marginal utility of a unit of a good is determined in the following way: (1) if the unit is in the possession of the actor, the marginal utility of the unit is equal to the ranked value he places 15 It is interesting that those who attempt to measure consumers’ sur- plus explicitly rule out consideration of all goods or of any good that looms “large” in the consumers’ budget. Such a course is convenient, but illogi- cal, and glosses over fundamental difficulties in the analysis. It is, however, typical of the Marshallian tradition in economics. For an explicit state- ment by a leading present-day Marshallian, see D.H. Robertson, Utility and All That (London: George Allen & Unwin, 1952), p. 16.

327 Power and Market with Man, Economy, and State 262 on the least important end, or use, that he would have to give up on losing the unit; or (2) if the unit is not yet in his possession, of adding the marginal utility the unit is equal to the value of the most important end that the unit could serve. On this basis, a man allocates his stock of various units of a good to his most important uses first, and his less important uses in succession, least while he gives up his important uses first. Now we saw in chapter 3 how every man allocates his stock of money among the various uses. The money commodity has numerous differ- ent uses, and the number of uses multiplies the more highly developed and advanced the money economy, division of labor, and the capital structure. Decisions concerning numerous con- sumer goods, numerous investment projects, consumption at present versus expected increased returns in the future, and ad- dition to cash balance, must all be made. We say that each in- dividual allocates each unit of the money commodity to its most important use first, then to the next most important use, etc., thus determining the allocation of money in each possible use and line of spending. The least important use is given up first, as with any other commodity. We are not interested here in exploring all aspects of the analysis of the marginal utility of money, particularly the cash- balance decision, which must be left for later treatment. We are interested here in the marginal utility of money as relevant to consumption decisions. Every man is a consumer, and therefore the analysis applies to everyone taking part in the nexus of monetary exchange. Each succeeding unit that the consumer allocates among dif- ferent lines of spending, he wishes to allocate to the most highly is the marginal valued use that it can serve. His psychic revenue utility—the value of the most important use that will be served. His psychic cost is the next most important use that must be for- gone—the use that must be sacrificed in order to attain the most forgone important end. The highest ranked utility , therefore, is cost of any action. defined as the

328 Prices and Consumption 263 The utility a person derives or expects to derive from an act of exchange is the marginal utility of adding the good pur- chased, i.e., the most important use for the units to be acquired. The utility that he forgoes is the highest utility that he could have derived from the units of the good that he gives up in the exchange. When he is a consumer purchasing a good, his mar- ginal utility of addition is the most highly valued use to which he could put the units of the good; this is the psychic revenue that he expects from the exchange. On the other hand, what he forgoes is the use of the units of money that he “sells” or gives up. His , then, is the value of the most important use to cost 16 which he could have put the money. Every man strives in action to achieve a psychic revenue greater than his psychic cost, and thereby a psychic profit; this is true of the consumer’s purchases as well. Error is revealed when his choice proves to be mistaken, and he realizes that he would have done better to have pursued the other, forgone course of action. Now, as the consumer adds to his purchases of a good, the marginal utility which the added good has for him must dimin- , in accordance with the law of marginal utility. On the other ish hand, as he gives up units of a good in sale, the marginal utility that this good has for him becomes greater, in accordance with the same law. Eventually, he must cease purchasing the good, because the marginal utility of the good forgone becomes greater than the marginal utility of the good purchased. This is clearly true of direct goods, but what of money? It is obvious that money is not only a useful good, but one of the most useful in a money economy. It is used as a medium in practically every exchange. We have seen that one of a man’s most important activities is the allocation of his money stock to that money obeys the various desired uses. It is obvious, therefore, law of marginal utility, just as any other commodity does. Money is a commodity divisible into homogeneous units. Indeed, one of 16 See chapter 2 above, p. 161.

329 with Power and Market 264 Man, Economy, and State the reasons the commodity is picked as money is its ready divis- ibility into relatively small homogeneous units. The first unit of money will be allocated to its most important and valued use to an individual; the second unit will be allocated to its second most valued use, etc. Any unit of money that must be given up will be surrendered at the sacrifice of the least highly valued use previously being served or which would have been served. Therefore, it is true of money, as of any other commodity, that as its stock increases, its marginal utility declines; and that as its stock 17 declines, its marginal utility to the person increases. Its marginal utility of addition is equal to the rank of the most highly valued end the monetary unit can attain; and its marginal utility is that would have to equal in value to the most highly valued end if the unit were surrendered. be sacrificed What are the various ends that money can serve? They are: ) the nonmonetary uses of the money commodity (such as the a ( use of gold for ornament); ( b ) expenditure on the many differ- c ) investment in various alter- ent kinds of consumers’ goods; ( ) additions d native combinations of factors of production; and ( to the cash balance. Each of these broad categories of uses encompasses a large number of types and quantities of goods, is ranked on the individual’s and each particular alternative value scale. It is clear what the uses of consumption goods are: they provide immediate satisfaction for the individual’s desires and are thus immediately ranked on his value scale. It is also clear that when money is used for nonmonetary purposes, it becomes a direct consumers’ good itself instead of a medium of exchange. Investment, which will be further discussed below, aims at a greater level of future consumption through investing in capital goods at present. What is the usefulness of keeping or adding to a cash bal- ance? This question will be explored in later chapters, but here we may state that the desire to keep a cash balance stems from 17 For a further discussion of this point, see Appendix A below, on “The Diminishing Marginal Utility of Money.”

330 265 Prices and Consumption as to the right time for making pur- fundamental uncertainty chases, whether of capital or of consumers’ goods. Also impor- uncertainty about the individual’s own future tant are a basic value scale and the desire to keep cash on hand to satisfy any changes that might occur. Uncertainty, indeed, is a fundamen- tal feature of all human action, and uncertainty about changing prices and changing value scales are aspects of this basic uncer- tainty. If an individual, for example, anticipates a rise in the pur- chasing power of the monetary unit in the near future, he will tend to postpone his purchases toward that day and add now to his cash balance. On the other hand, if he anticipates a fall in purchasing power, he will tend to buy more at present and draw down his cash balance. An example of general uncertainty is an individual’s typical desire to keep a certain amount of cash on hand “in case of a rainy day” or an emergency that will require an unanticipated expenditure of funds in some direction. His “feeling safer” in such a case demonstrates that money’s only value is not simply when it makes exchanges; because of its very in the hands of an individual marketability, its mere possession performs a service for that person. That money in one’s cash balance is performing a service demonstrates the fallacy in the distinction that some writers make between “circulating” money and money in “idle hoards.” always in someone’s cash balance. In the first place, all money is It is never “moving” in some mysterious “circulation.” It is in A’s cash balance, and then when A buys eggs from B , it is shifted to B’s cash balance. Secondly, regardless of the length of time any given unit of money is in one person’s cash balance, it is per- forming a service to him, and is therefore never in an “idle hoard.” What is the marginal utility and the cost involved in any act of consumption exchange? When a consumer spends five grains of gold on a dozen eggs, this means that he anticipates that the most valuable use for the five grains of gold is to acquire the dozen eggs. This is his marginal utility of addition of the five

331 Power and Market with Man, Economy, and State 266 grains. This utility is his anticipated psychic revenue from the exchange. What, then, is the “opportunity cost” or, simply, the “cost,” of the exchange, i.e., the next best alternative forgone? This is the most valuable use that he could have made with the five grains of gold. This could be any one of the following a alternatives, whichever is the highest on his value scale: ( ) expenditure on some other consumers’ good; ( b ) use of the ) c money commodity for purposes of direct consumption; ( expenditure on some line of investment in factors of production ) addi- to increase future monetary income and consumption; ( d tion to his cash balance. It should be noted that since this cost refers to a decision on a marginal unit, of whatever size, this is also the “marginal cost” of the decision. This cost is subjective and is ranked on the individual’s value scale. The nature of the cost, or utility forgone, of a decision to spend money on a particular consumers’ good, is clear in the case where the cost is the value that could have been derived from another act of consumption. When the cost is forgone investment, then what is forgone is expected future increases in consumption, expressed in terms of the individual’s rate of time preference, which will be further explored below. At any rate, when an individual buys a particular good, such as eggs, the more he continues to buy, the lower will be the marginal util- ity of addition that each successive unit has for him. This, of course, is in accordance with the law of marginal utility. On the other hand, the more money he spends on eggs, the greater will be the marginal utility forgone in whatever is the next best good—e.g., butter. Thus, the more he spends on eggs, the less will be his marginal utility derived from eggs, and the greater will be his marginal cost of buying eggs, i.e., the value that he must forgo. Eventually, the latter becomes greater than the for- mer. When this happens and the marginal cost of purchasing eggs becomes greater than the marginal utility of addition of the commodity, he switches his purchases to butter, and the same process continues. With any stock of money, a man’s con- sumption expenditures come first, and expenditures on each

332 267 Prices and Consumption good follow the same law. In some cases, the marginal cost of consumption on a consumers’ good becomes investment in some line, and the man may invest some money in factors of production. This investment continues until the marginal cost of such investment, in terms of forgone consumption or cash balance, is greater than the present value of the expected return. Sometimes, the most highly valued use is an addition to one’s cash balance, and this continues until the marginal utility derived from this use is less than the marginal cost in some other line. In this way, a man’s monetary stock is allocated among all the most highly valued uses. And in this way, individual demand schedules are con- structed for every consumers’ good, and market-demand sched- ules are determined as the summation of the individual demand schedules on the market. Given the stocks of all the consumers’ will be analyzed in succeeding chapters), their goods (this given market prices are thereby determined. It might be thought, and many writers have assumed, that money has here performed the function of measuring and rendering comparable the utilities of the different individuals. It has, however, done nothing of the sort. The marginal utility of money differs from person to person, just as does the marginal utility of any other good. The fact that an ounce of money can buy various goods on the market and that such opportunities may be open to all does not give us any information about the ways in which various people will rank these different combina- There is no measuring or comparability in the field tions of goods. prices to be comparable, of values or ranks. Money permits only by establishing money prices for every good. It might seem that the process of ranking and comparing on value scales by each individual has established and determined the prices of consumers’ goods without any need for further analysis. The problem, however, is not nearly so simple. Neglect or evasion of the difficulties involved has plagued eco- nomics for many years. Under a system of barter, there would

333 Power and Market with Man, Economy, and State 268 be no analytic difficulty. All the possible consumers’ goods would be ranked and compared by each individual, the demand schedules of each in terms of the other would be established, etc. Relative utilities would establish individual demand sched- ules, and these would be summed up to yield market-demand schedules. But, in the monetary economy, a grave analytic diffi- culty arises. To determine the price of a good, we analyze the market- demand schedule for the good; this in turn depends on the in- dividual demand schedules; these in their turn are determined by the individuals’ value rankings of units of the good and units yet of money as given by the various alternative uses of money; the latter alternatives depend in turn on given prices of the other . A hypothetical demand for eggs must assume as given goods But how, then, can some money price for butter, clothes, etc. value scales and utilities be used to explain the formation of money prices, when these value scales and utilities themselves depend upon the existence of money prices? B. R EGRESSION ONEY M T HE It is obvious that this vitally important problem of circularity ( Y depends on X ) exists not only in X depends on Y , while regard to decisions by consumers but also in regard to any exchange decision in the money economy. Thus, let us consider seller the of the stock of a consumers’ good. At a given offered money price, he must decide whether to sell the units of his stock or whether to hold on to them. His eagerness to sell in ex- change for acquiring money is due to the use that the money would have for him. The money would be employed in its most important uses for him, and this will determine his evaluation of marginal the money—or its marginal utility of addition. But the is based on its utility of addition of money to the seller of the stock already being money and its ready command of other goods that the seller will buy—consumers’ goods and factors of production efore also depends on the alike. The seller’s marginal utility ther

334 Prices and Consumption 269 previous existence of money prices for the various goods in the economy. Similarly, for the laborer, landowner, investor, or owner of a capital good: in selling his services or goods, money has a mar- ginal utility of addition, which is a necessary prior condition to his decision to sell the goods and therefore a determinant in his supply curve of the good for money. And yet this marginal util- ity always depends on there being a previous array of money prices in existence. The seller of any good or service for money, therefore, ranks the marginal utility of the money that he will obtain against the marginal utility of holding on to the good or service. Whoever spends money to buy any good or service ranks the marginal utility which keeping the money has for him against the marginal utility of acquiring the good. These value scales of the various buyers and sellers determine the individual supply-demand schedules and hence all money prices; yet, in order to rank money and goods on his value scale, money must already have a marginal utility for each person, and this marginal utility be based on the fact of pre-existing money prices of must 18 the various goods. The solution of this crucial problem of circularity has been provided by Professor Ludwig von Mises, in his notable theory 19 The theory of money regression may of the money regression. 18 It is true that he who considers acquiring or giving away money is, of course, first of all interested in its future purchasing power and the future structure of prices. But he cannot form a judgment about the future purchasing power of money otherwise than by looking at its configuration in the immediate past. (Mises, Human Action , p. 407) 19 See Mises, Theory of Money and Credit , pp. 97–123, and Human Action , pp. 405–08. Also see Schumpeter, History of Economic Analysis , p. 1090. This problem obstructed the development of economic science until Mises provided the solution. Failure to solve it led many economists to despair of ever constructing a satisfactory economic analysis of money

335 with Power and Market 270 Man, Economy, and State be explained by examining the period of time that is being con- sidered in each part of our analysis. Let us define a “day” as the period of time just sufficient to determine the market prices of , then, the money price of X every good in the society. On day each good is determined by the interactions of the supply and demand schedules of money and the good by the buyers and sellers on that day. Each buyer and seller ranks money and the given good in accordance with the relative marginal utility of X of day end the two to him. Therefore, a money price at the is determined by the marginal utilities of money and the good as beginning of day they existed at the . But the marginal utility X exist- previously of money is based, as we have seen above, on a ing array of money prices. Money is demanded and considered useful because of its already existing money prices. Therefore, X is determined by the marginal util- the price of a good on day ity of the good on day X and the marginal utility of money on day X , which last in turn depends on the prices of goods on day – 1. X prices. They were led to abandon fundamental analysis of money prices and to separate completely the prices of goods from their money compo- nents. In this fallacious course, they assumed that individual prices are determined wholly as in barter, without money components, while the supply of and the demand for money determined an imaginary figment called the “general price level.” Economists began to specialize separately in the “theory of price,” which completely abstracted from money in its real functions, and a “theory of money,” which abstracted from individ- ual prices and dealt solely with a mythical “price level.” The former were solely preoccupied with a particular price and its determinants; the latter solely with the “economy as a whole” without relation to the individual components—called “microeconomics” and “macroeconomics” respec- tively. Actually, such fallacious premises led inevitably to erroneous con- clusions. It is certainly legitimate and necessary for economics, in work- ing out an analysis of reality, to isolate different segments for concentra- tion as the analysis proceeds; but it is not legitimate to falsify reality in this separation, so that the final analysis does not present a correct pic- ture of the individual parts and their interrelations.

336 271 Prices and Consumption cir- The economic analysis of money prices is therefore not cular. If prices today depend on the marginal utility of money yesterday . Thus, today, the latter is dependent on money prices in every money price in any day, there is contained a time com- so that this price is partially determined by the money ponent, not mean specifically that the prices of yesterday. This does price of eggs today is partially determined by the price of eggs yesterday, the price of butter today by that of yesterday, etc. On the contrary, the time component essential to each specific price general array today is the of yesterday’s money prices for all goods, and, of course, the subsequent evaluation of the mone- gen- tary unit by the individuals in the society. If we consider the eral array of today’s prices, however, an essential time compo- nent in their determination is the general array of yesterday’s prices. This time component is purely on the money side of the determining factors. In a society of barter, there is no time component in the prices of any given day. When horses are being exchanged against fish, the individuals in the market decide on the relative marginal utilities solely on the basis of the direct uses of the commodities. These direct uses are immediate and do not require any previously existing prices on the market. Therefore, the marginal utilities of direct goods, such as horses and fish, have no previous time components. And, therefore, there is no problem of circularity in a system of barter. In such a society, if all previous markets and knowledge of previous prices were somehow wiped out, there would, of course, be an initial period of confusion while each individual consulted his value scales and tried to estimate those of others, but there would be no great dif- ficulty in speedily re-establishing the exchange markets. The case is different in a monetary economy. Since the marginal util- ity of the money commodity depends on previously existing money prices, a wiping out of existing markets and knowledge of money prices would render impossible the direct re-establish- ment of a money economy. The economy would be wrecked and thrown back into a highly primitive state of barter, after which a

337 Power and Market with Man, Economy, and State 272 money economy could only slowly be re-established as it had been before. Now the question may be raised: Granted that there is no circularity in the determination of money prices, does not the regress backward in time simply fact that the causes partially push the unexplained components back further without end? If today’s prices are partly determined by yesterday’s prices, and yesterday’s by those of the day before yesterday, etc., is not the regression simply pushed back infinitely, and part of the deter- mination of prices thus left unexplained? The answer is that the regression is not infinite, and the clue to its stopping point is the distinction just made between condi- tions in a money economy and conditions in a state of barter. major We remember that the utility of money consists of two elements: the utility of the money as a medium of exchange, and the utility of the money commodity in its direct, commodity use (such as the use of gold for ornaments). In the modern econ- omy, after the money commodity has fully developed as a medium of exchange, its use as a medium tends greatly to over- shadow its direct use in consumption. The demand for gold as money far exceeds its demand as jewelry. However, the latter use and demand continue to exist and to exert some influence on the total demand for the money commodity. In any day in the money economy, the marginal utility of gold and therefore the demand for it enter into the determina- tion of every money price. The marginal utility of gold and the demand for it today depend on the array of money prices exist- ing yesterday, which in turn depended on the marginal utility of gold and the demand for it yesterday, etc. Now, as we regress backwards in time, we must eventually arrive at the original point when people first began to use gold as a medium of first day on which people passed exchange. Let us consider the from the system of pure barter and began to use gold as a medium of exchange. On that day, the money price, or rather, the gold price, of every other good depended partially on the

338 Prices and Consumption 273 marginal utility of gold. This marginal utility had a time compo- namely, the previous array of gold prices, which had been nent, determined in barter. In other words, when gold first began to be used as a medium of exchange, its marginal utility for use in that capacity depended on the existing previous array of gold prices established through . But if we regress one day fur- barter ther the gold prices of various goods on to the last day of barter, that day, like all other prices, had no time components. They were determined, as were all other barter prices, solely by the marginal utility of gold and of the other goods on that day, and only the marginal utility of gold, since it was used for direct con- sumption, had temporal component. no The determination of money prices (gold prices) is there- fore completely explained, with no circularity and no infinite regression. The demand for gold enters into every gold price, and today’s demand for gold, in so far as it is for use as a medium of exchange , has a time component, being based on yes- terday’s array of gold prices. This time component regresses until the last day of barter, the day before gold began to be used as a medium of exchange. On that day, gold had no utility in that use; the demand for gold was solely for direct use, and consequently, the determination of the gold prices, for that day and for all previous days, had no temporal component what- 20, 21 ever. 20 As we regress in time and approach the original days of barter, the exchange use in the demand for gold becomes relatively weaker as com- pared to the direct use of gold, until finally, on the last day of barter, it dies out altogether, the time component dying out with it. 21 It should be noted that the crucial stopping point of the regression is the cessation of the use of gold as “money,” but the cessation of its not use as a medium of exchange. It is clear that the concept of a “general” medium of exchange (money) is not important here. As long as gold is used as a medium of exchange, gold prices will continue to have tempo- ral components. It is true, of course, that for a commodity used as a lim- ited medium of exchange only a limited array of prices has to be taken into account in considering its utility.

339 Power and Market with 274 Man, Economy, and State The causal-temporal pattern of the regression may be por- trayed as in the diagram in Figure 38. Consecutive days are numbered 1, 2, 3, etc., and, for each period, arrows depict the underlying causal factors determining the gold prices of goods on the market. For each period of time, the gold prices of goods are fundamentally determined by the relative marginal utilities of gold and other goods on individual value scales, and the mar- ginal utilities of gold are based on the gold prices during the preceding period. This temporal component, depicted by an arrow, continues backward until the period of barter, when gold is used only for direct consumption or production purposes and not as a medium of exchange. At that point there is no tempo- ral dependence on preceding gold prices, and the temporal arrow disappears. In this diagram, a system of barter prevails on days 1, 2, and 3, and gold is used as a medium of exchange on day 4 and thereafter. One of the important achievements of the regression theory is its establishment of the fact that money must arise in the man- ner described in chapter 3, i.e., it must develop out of a com- modity already in demand for direct use, the commodity then being used as a more and more general medium of exchange.

340 275 Prices and Consumption be predicated Demand for a good as a medium of exchange must on a previously existing array of prices in terms of other goods. originate only according to A medium of exchange can therefore our previous description and the foregoing diagram; it can arise used directly in a barter situ- only out of a commodity previously and therefore having had an array of prices in terms of ation, other goods. Money must develop out of a commodity with a previ- It can- ously existing purchasing power, such as gold and silver had. not be created out of thin air by any sudden “social compact” or edict of government. On the other hand, it does not follow from this analysis that if an extant money were to lose its direct uses, it could no longer be used as money. Thus, if gold, after being established as money, were suddenly to lose its value in ornaments or indus- trial uses, it would not necessarily lose its character as a money. Once a medium of exchange has been established as a money, money prices continue to be set. If on day X gold loses its direct uses, there will still be previously existing money prices that had – 1, and these prices form the basis been established on day X . Similarly, the money X for the marginal utility of gold on day form the basis for the mar- X prices thereby determined on day 1. From X X + ginal utility of money on day on, gold could be demanded for its exchange value alone, and not at all for its direct use. Therefore, while it is absolutely necessary that a as a commodity with direct uses, it is not money originate absolutely necessary that the direct uses continue after the money has been established. The money prices of consumers’ goods have now been com- pletely explained in terms of individual value scales, and these value scales have been explained up to the point of the content of the subjective use-valuations of each good. Economics is not concerned with the specific content of these ends, but with the any given explanation of various phenomena of action based on ends, and therefore its task in this sphere is fully accomplished

341 with Power and Market 276 Man, Economy, and State by tracing these phenomena back to subjective valuations of 22 useful goods. OSTS C TILITY AND C. U We may sum up the utility and cost considerations in de- cisions of buyers and sellers of consumers’ goods—or, rather, of potential buyers and sellers (cf. chapter 2, pp. 190f.)—as follows: S ELLER : Marginal Utility of Addition of the Units of Money Revenue: = value rank in most valuable prospective use Cost: (1) Marginal Utility of Good in direct use —highest-ranked use that would have to be sacrificed Either OR (2) Marginal Utility of holding for anticipated { future sale at higher price—whichever is the higher on his value scale In cases where neither cost item is present, the sale is costless. : UYER B Marginal Utility of Addition of the Units of the Revenue: Good = highest-ranked direct use of units Marginal Utility of Units of Money—value rank in Cost: highest-ranked use that will have to be sacrificed in making the exchange 22 Professor Patinkin criticizes Mises for allegedly basing the regres- sion theorem on the view that the marginal utility of money refers to the marginal utility of the goods for which money is exchanged rather than the marginal utility of holding money, and charges Mises with in- Theory of Money and consistently holding the latter view in part of his Credit . In fact, Mises’ concept of the marginal utility of money does refer to the utility of holding money, and Mises’ point about the regression the- orem is a different one, namely, that the marginal utility-to-hold is in

342 Prices and Consumption 277 The aim of the actor is always to achieve a psychic profit from an action by having his marginal revenue exceed his mar- ginal cost. Only after the decision has been made, the action taken, and the consequences assessed, can the actor know if his decision was correct, i.e., if his psychic revenue really did exceed his cost. It is possible that his cost may prove to have been greater than his revenue and that therefore he lost on the exchange. It is convenient to distinguish the two vantage points by which an actor judges his action as ex ante and is ex post. Ex ante his position when he must decide on a course of action; it is the relevant and dominant consideration for human action. It is the actor considering his alternative courses and the consequences is his recorded observation of the results of his of each. Ex post past action. It is the judging of his past actions and their results. , then, he will always take the most advantageous course Ex ante of action, and will always have a psychic profit, with revenue Ex post , he may have profited or lost from a exceeding cost. course of action. Revenue may or may not have exceeded cost, depending on how good an entrepreneur he has been in making his original action. It is clear that his ex post judgments are considera- mainly useful to him in the weighing of his ex ante tions for future action. itself based on the prior fact that money can exchange for goods, i.e., on the prior money prices of goods. Hence, it becomes necessary to break out of this circularity—by means of the regression theorem. In short, the prices of goods have to exist in order to have a marginal utility of money to hold. In his own theory, Patinkin very feebly tries to justify circularity, by saying that in analyzing the market (market “experiment”) he begins with utility, and in analyzing utility he begins with prices (individual “experiment”), but the fact remains that he is caught inextricably in a circular trap, which a methodology of cause-and-effect (in contrast to a mathematical type of mutual determination) would quickly reveal. Don Patinkin, Money, Interest, and Prices (Evanston, Ill.: Row, Peterson & Co., 1956), pp. 71–72, 414.

343 with Power and Market 278 Man, Economy, and State Suppose that an ultimate consumer buys a product and then finds he was mistaken in this purchase and the good has little or no value to him. Thus, a man might buy a cake and find that he the (expected) utility of the cake Ex ante does not like it at all. was greater than the marginal utility of the money forgone in ex post purchasing it; he finds that he was in error and that if he had it to do over again, he would not have bought the cake. The purchase was the consumer’s responsibility, and he must bear the loss as well as the gain from his voluntary transaction. Of course, no one can relive the past, but he can use this knowledge, for example, to avoid purchasing such a cake again. It should be obvious that the cake, once purchased, may have little or no value even though the man originally paid several grains of gold cost for it. The of the cake was the forgone marginal utility of the in the past three grains of gold paid for it. But this cost incurred . This would seem obvi- now cannot confer any value on the cake ous, and yet economics has always suffered from neglect of this truth, particularly during the nineteenth century, in the form of various “cost” theories of value. These cost theories asserted that the value of goods is conferred by the costs or sacrifices incurred in their acquisition in the past. On the contrary, it is clear that value can be conferred on a good only by individuals’ present or in the present expecta- desires to use it directly in the 23 future. tion of selling to such individuals in the We may modify the buyer summary above by considering the case in which the buyer is not an ultimate consumer, but rather a speculative buyer anticipating a future price rise. In that 23 As Wicksteed states: “Efforts are regulated by anticipated values, but values are not controlled by antecedent efforts,” and The value of what you have got is not affected by the value of what you have relinquished or forgone in order to get it. But the measure of the advantages you are willing to forgo in order to get a thing is determined by the value that you expect it to have when you have got it. ( Wick- steed, Common Sense of Political Economy , I, 93 and 89)

344 Prices and Consumption 279 case, a higher revenue for him will be the marginal utility of holding for anticipated future sale at a higher price, which he considers net of the cost of storage. D. P C HOICE R ANGE OF LANNING AND THE It should be evident that the establishment of money tremendously broadens the range of choice open to everybody. The range of alternative uses that can be satisfied by units of money is far wider than the number of uses to which individual goods can be put. Horses or houses can be allocated to several uses, raw materials to many areas of production, but money can be allocated in expenditure on single type of exchangeable every good in the society, whether a tangible commodity or an in- tangible service, a consumers’ or a capital or a natural good, or claims to these goods. Money serves greatly to expand the range of choice; and it itself becomes a key means to be allocated to the 24 most highly valued of alternative ends. It might be worthwhile to consider at this point what each person does in action. He is always engaged in allocating means to the most highly valued of his alternative ends, as ranked on his value scale. His actions in general, and his actions in exchange in particular, are always the result of certain expectations on his part, expectations of the most satisfactory course that he could expects will yield him follow. He always follows the route that he the most highly ranked available end at a certain future time (which might in some cases be so near as to be almost im- mediate) and therefore a psychic profit from the action. If he proves to have acted erroneously, so that another course of action would have yielded him a greater psychic revenue, then he appraises his situation, pres- Ex ante he has incurred a loss. ent and prospective future, chooses among his valuations, tries to achieve the highest ones according to his “know-how,” and 24 We shall see below, in chapter 11, that money is unique in not con- ferring any general benefit through an increase in the supply once money has been established on the market.

345 with Power and Market 280 Man, Economy, and State then chooses courses of action on the basis of these plans . Plans are his decisions concerning future action, based on his ranking of ends and on his assumed knowledge of how to attain the plan- ends. Every individual, therefore, is constantly engaged in . This planning may range from an impressive investment ning in a new steel plant to a small boy’s decision to spend two cents 25 It is erroneous, on candy, but it is planning nevertheless. therefore, to assert that a free market society is “unplanned”; on the contrary, each individual plans for himself. But does not “chaos” result from the fact that individual plans do not seem to be co-ordinated? On the contrary, the exchange system, in the first place, co-ordinates individual parties to every exchange. In the sec- plans by benefiting both ond place, the bulk of the present volume is devoted to an explanation and analysis of the principles and order that deter- mine the various exchange phenomena in a monetary econ- omy: prices, output, expenditures, etc. Far from being chaotic, the structure of the monetary economy presents an intricate, systematic picture and is deducible from the basic existence of 26 human action and indirect exchange. 6. Interrelations Among the Prices of Consumers’ Goods Thus, at any given point in time, the consumer is confronted with the previously existing money prices of the various con- sumers’ goods on the market. On the basis of his utility scale, he 25 “Planning” does not necessarily mean that the man has pondered long and hard over a decision and subsequent action. He might have made his decision almost instantaneously. Yet this is still planned action. Since all action is purposive rather than reflexive, there must always, before an action, have been a decision to act as well as valuations. There- fore, there is always planning. 26 Economics “must at any rate include and imply a study of the way in which members of . . . society will spontaneously administer their own resources and the relations into which they will spontaneously enter with each other.” Wicksteed, Common Sense of Political Economy , I, 15–16.

346 281 Prices and Consumption determines his rankings of various units of the several goods and of money, and these rankings determine how much money he will he will spend on each of the various goods. Specifically, spend money on each particular good until the marginal utility of add- ing a unit of the good ceases to be greater than the marginal utility This is the law of that its money price on the market has for him. consumer action in a market economy. As he spends money on a good, the marginal utility of the new units declines, while the marginal utility of the money forgone rises, until he ceases spending on that good. In those cases where the marginal util- ity of even one unit of a good is lower than the marginal utility of its money price, the individual will not buy any of that good. In this way are determined the individual demand schedules for each good and, consequently, the aggregate market-demand schedules for all buyers. The position of the market-demand schedule determines what the market price will be in the im- mediate future. Thus, if we consider action as divided into peri- ods consisting of “days,” then the individual buyers set their rankings and demand schedules on the basis of the prices exist- ing at the end of day 1, and these demand schedules determine what the prices will be by the end of day 2. The reader is now referred back to the discussion in chapter 2 above, sections 9 and 10. The analysis, there applied to barter conditions, applies to money prices as well. At the end of each day, the demand schedules (or rather, the total demand sched- ules) and the stock in existence on that day set the market equi- librium price for that day. In the money economy, these factors determine the money prices of the various goods during that day. The analysis of changes in the prices of a good, set forth in chapter 2, is directly applicable here. In the money economy, the most important markets are naturally continuous, as goods continue to be produced in each day. Changes in supply and demand schedules or changes in total demand schedules and quantity of stock have exactly the same directional effect as in barter. An increase in the market’s total demand schedule over the previous day tends to increase the money price for the day;

347 Power and Market with Man, Economy, and State 282 an increase in stock available tends to lower the price, etc. As in barter, the stock of each good, at the end of each day, has been transferred into the hands of the most eager possessors. Up to this point we have concentrated on the determination of the money price of each consumers’ good, without devoting much attention to the relations among these prices. The inter- relationships should be clear, however. The available goods are ranked, along with the possibility of holding the money com- modity in one’s cash balance, on each individual’s value scale. Then, in accordance with the rankings and the law of utility, the individual allocates his units of money to the most highly valued uses: the various consumers’ goods, investment in various fac- tors, and addition to his cash balance. Let us here set aside the question of the distribution chosen between consumption and investment, and the question of addition to the cash balance, until later chapters, and consider the interrelations among the prices of consumers’ goods alone. The law of the interrelation of consumers’ goods is: The more substitutes there are available for any given good, the more elastic will tend to be the demand schedules (individual and market) for that good. By the definition of “good,” two goods cannot be “perfect substitutes” for each other, since if consumers regarded two goods as completely identical, they would, by definition, be one consumers’ goods are, on the other hand, good. sub- All partial stitutes for one another. When a man ranks in his value scale the myriad of goods available and balances the diminishing utilities of each, he is treating them all as partial substitutes for one another. A change in ranking for one good by necessity changes the rankings of all the other goods, since all the rankings are ordinal and relative. A higher price for one good (owing, say, to a decrease in stock produced) will tend to shift the demand of consumers from that to other consumers’ goods, and therefore their demand schedules will tend to increase. Conversely, an increased supply and a consequent lowering of price for a good will tend to shift consumer demand from other goods to this

348 283 Prices and Consumption one and lower the demand schedules for the other goods (for some, of course, more than for others). It is a mistake to suppose that only technologically similar goods are substitutes for one another. The more money con- sumers spend on pork, the less they have to spend on beef, or the more money they spend on travel, the less they have to spend on TV sets. Suppose that a reduction in its supply raises the price of pork on the market; it is clear that the quantity de- If manded, and the price, of beef will be affected by this change. the demand schedule for pork is more than unitarily elastic in this , then the higher price will cause less money to be spent on range pork, and more money will tend to be shifted to such a substi- tute as beef. The demand schedules for beef will increase, and the price of beef will tend to rise. On the other hand, if the demand schedule for pork is inelastic , more consumers’ money will be spent on pork, and the result will be a fall in the demand schedule for beef and consequently in its price. Such interrela- tions of substitute goods, however, hold true in some degree for all goods, since all goods are substitutes for one another; for every good is engaged in competing for the consumers’ stock of money. Of course, some goods are “closer” substitutes than oth- ers, and the interrelations among them will be stronger than among the others. The closeness of the substitution depends, however, on the particular circumstances of the consumer and his preferences rather than on technological similarity. Thus, consumers’ goods, in so far as they are substitutes for A rises and one another, are related as follows: When the stock of therefore falls , (1) if the demand schedule for A is the price of A elastic, there will be a tendency for a decline in the demand , D, etc., and consequent declines in their schedules for B, C is inelastic, there will be A prices; (2) if the demand schedule for , D , etc., and a consequent B, C a rise in the demand schedules for in their prices; (3) if the demand schedule has exactly neu rise tral (or unitary) elasticity, so that there is no change in the amount of money expended on A , there will be no effect on the demands for and the prices of the other goods.

349 Power and Market with Man, Economy, and State 284 As the money economy develops and civilization flowers, there is a great expansion in the types of goods available and therefore in the number of goods that can be substituted for one another. Consequently, there is a tendency for the demands for the various consumers’ goods to become more elastic, although they will continue to vary from highly elastic to highly inelastic. In so far as the multiplication of substitutes tends to render de- mand curves for individual goods elastic, the first type of inter- action will tend to predominate. Furthermore, when new types of goods are established on the market, these will clearly draw monetary demand away from other, substitute products, and hence bring about the first type of reaction. The substitutive interrelations of consumers’ goods were co- gently set forth in this passage by Philip Wicksteed: It is sufficiently obvious that when a woman goes into the market uncertain whether she will or will not buy new potatoes, or chickens, the price at which she finds that she can get them may determine her either way. . . . For the price is the first and most obvious indi- cation of the nature of the alternatives that she is fore- going, if she makes a contemplated purchase. But it is almost equally obvious that not only the price of these particular things, but the price of a number of other things also will affect the problem. If good, sound, old potatoes are to be had at a low price, the marketer will be less likely to pay a high price for new ones, because there is a good alternative to be had on good terms. . . . If the housewife is thinking of doing honour to a small party of neighbours by providing a couple of chickens for their entertainment at supper, it is possible that she could treat them with adequate respect, though not with distinction, by substituting a few pounds of cod. And in that case not only the price of chickens but the price of cod will tend to affect her choice. . . . But on what does the significance . . . [of the price difference between chicken and cod] depend? Prob- ably upon the price of things that have no obvious

350 Prices and Consumption 285 connection with either chicken or cod. A father and mother may have ambitions with respect to the edu- cation or accomplishments of their children, and may be willing considerably to curtail their expenditure on other things in order to gratify them. Such parents may be willing to incur . . . entertaining their guests less sumptuously than custom demands, and at the same time getting French or violin lessons for their children. In such cases the question whether to buy new or old potatoes, or whether to entertain friends with chicken or cod, or neither, may be affected by the terms on which French or music lessons of a sat- 27 isfactory quality can be secured. While all consumers’ goods compete with one another for to one complementary consumer purchases, some goods are also another. These are goods whose uses are closely linked together by consumers, so that movements in demand for them are likely to be closely tied together. An example of complementary con- golf balls , two goods the demands golf clubs sumers’ goods is and for which tend to rise and fall together. In this case, for exam- fall ple, an increase in the supply of golf balls will tend to cause a in their prices, which will tend to raise the demand schedule for golf clubs as well as to increase the quantity of golf balls de- the price of golf clubs. In so manded. This will tend to increase to each other, when complementary far, then, as two goods are A falls , the de- A therefore rises, and the price of the stock of mand schedule for . B increases and its price will tend to rise Since a fall in the price of a good will always increase the quan- tity of the good demanded (by the law of demand), this will always stimulate the demand schedule for a complementary 28 For this effect the elas- good and thus tend to raise its price. ticity of demand for the original good has no relevance. 27 Wicksteed, Common Sense of Political Economy , I, 21–22. 28 The exception is those cases in which the demand curve for the good is directly vertical, and there will then be no effect on the comple- mentary good.

351 with Power and Market 286 Man, Economy, and State Summing up these interrelations among consumers’ goods: : OODS G UBSTITUTABLE S If stock of A A falls , and Demand Curve rises, and price of is: A for Demand for, Price of, Inelastic: B, C, D, . . . rise Elastic: Demand for, Price of, B, C, D, . . . fall B, C, D, . . . Neutral: No effect on C G OMPLEMENTARY OODS : If stock of rises, price of A falls, A and: Demand for, and Price B, C, D, . . . rise. of, fect.) is vertical, then there is no ef (Unless Demand Curve for A All goods are substitutable for one another, while fewer are complementary. When they are also complementary, then the complementary effect will be mixed with the substitutive effect, and the nature of each particular case will determine which effect will be the stronger. This discussion of the interrelation of consumers’ goods has stock treated the effect only of changes from the , or supply, side. The effects are different when the change occurs in the demand instead of in the quantity of stock. Suppose that the schedule A increases market-demand schedule for good —shifts to the right. This means that, for every hypothetical price, the quan- bought, and therefore the amount of money spent on tity of A A, increases . But, given the supply (stock) of money in the soci- ety, this means that there will be decreases in the demand sched- 29 More money spent on good ules for one or more other goods. A , given the stock of money, signifies that less money is spent . . . The demand curves for the latter goods B, C, D on goods . Therefore, fall “shift to the left,” and the prices of these goods 29 We omit at this point analysis of the case in which the increase in demand results from decreases of cash balance and/or decreases in invest- ment.

352 287 Prices and Consumption the effect of the substitutability of all goods for one another is resulting in a A, rise that an increased demand for in the price falling prices A of , will lead to decreased demand schedules and for goods . . . We can see this relation more fully when B, C, D we realize that the demand schedules are determined by indi- vidual value scales and that a rise in the marginal utility of a unit of necessarily means a relative fall in the utility of the other A consumers’ goods. In so far as two goods are complementary, another effect tends to occur. If there is an increase in the demand schedule for golf clubs, it is likely to be accompanied by an increase in the demand schedule for golf balls, since both are determined by in- creased relative desires to play golf. When changes come from the demand side, the prices of complementary goods tend to rise and fall together. In this case, we should not say that the rise A led to a rise in demand for its complement , in demand for B since both increases were due to an increased demand for the consumption “package” in which the two goods are intimately related. We may now sum up both sets of interrelations of con- sumers’ goods, for changes in stock and in demand (suppliers’ reservation demand can be omitted here, since this speculative element tends toward correct estimates of the basic determi- nant, consumer demand). Table 10 indicates the reactions of other goods, B, C, D, to , in so far as these goods A changes in the determinants for good are substitutable for it or complementary to it. A + sign signifies same direction as that the prices of the other goods react in the ; a – sign signifies that the prices of the other the price of good A direction. opposite goods react in the stock of a good may be evaluated differ- In some cases, an old ently from the new and therefore may become a separate good. Thus, while well-stored old nails might be considered the same good as newly produced nails, an old Ford will not be considered the same as a new one. There will, however, definitely be a close relation between the two goods. If the supply schedule for the

353 Power and Market with 288 Man, Economy, and State ABLE 10 T C HANGE IN P RICES OF B, C, D, . . . A and the If Change in If Change in If Stock of Good are: Demand for A A + Substitutable if Demand for for A is elastic each other – if Demand for – A is inelastic None if Demand for 0 is unitary A Complementary to + – each other new Fords decreases and the price rises, consumers will tend to shift to the purchase of old Fords, tending to raise the price of the latter. Thus, old and new commodities, technologically sim- ilar, tend to be very close substitutes for each other, and their demands and prices tend to be closely related. Much has been written in the economic literature of consumption theory on the “assumption” that each consumers’ good is desired quite independently of other goods. Actually, as we have seen, the desires for various goods are of necessity interdependent, since all are ranged on the consumers’ value scales. Utilities of each of the goods are relative to one another. These ranked values for goods and money permit the formation of individual, and then aggregate, demand schedules in money for each particular good. 7. The Prices of Durable Goods and Their Services Why does a man purchase a consumers’ good? As we saw back in chapter 1, a consumers’ good is desired and sought

354 Prices and Consumption 289 because the actor believes that it will serve to satisfy his urgently valued desires, that it will enable him to attain his valued ends. In other words, the good is valuable because of the expected services that it will provide. Tangible commodities, then, such as food, clothing, houses, etc., and intangible personal services, such as medical attention and concert performances, are similar in the life of the consumer. Both are evaluated by the consumer in terms of their services in providing him with satisfactions. Every type of consumers’ good will yield a certain amount of These may be called services per unit of time. unit services . When they are exchangeable, these services may be sold individually. On the other hand, when a good is a physical commodity and is durable, it may be sold to the consumer in one piece, thereby embodying an expected future accrual of many unit services. What are the interrelations among the markets for, and prices of, the unit services and the durable good as a whole? durable Other things being equal, it is obvious that a more good is more valuable than a durable good, since it embod- less ies more future unit services. Thus, suppose that there are two television sets, each identical in service to the viewer, but that A has an expected life of five years, and B of 10. Though the serv- has twice as many services as A to offer the ice is identical, B consumer. On the market, then, the price of will tend to be B 30 . twice the price of A For nondurable goods, the problem of the separate sale of the service of the good and of the good itself does not arise. Since they embody services over a relatively short span of time, they are almost always sold as a whole. Butter, eggs, Wheaties, etc., are sold as a whole, embodying all their services. Few would think of “renting” eggs. Personal services, on the other 30 Strictly, this is not correct, and the important qualification will be added below. Since, as a result of time preference, present services are worth more than the same ones in the future, and those in the near future more than those in the far future, the price of B will be less than twice the price of A .

355 Power and Market with Man, Economy, and State 290 hand, are never sold as a whole, since, on the free market, slave contracts are not enforceable. Thus, no one can purchase a doc- tor or a lawyer or a pianist for life, to perform services at will with no further payment. Personal services, then, are always sold in their individual units. The problem whether services should be sold separately or with the good as a whole arises in the case of durable commodi- ties, such as houses, pianos, tuxedos, television sets, etc. We have seen that goods are sold, not as a total class, e.g., “bread” or “eggs,” but in separate homogeneous units of their supply, such as “loaves of bread,” or “dozens of eggs.” In the present discussion, a good can be sold either as a complete physical unit—a house, a television set, etc.—or in service units over a period of time. This sale of service units of a durable good is hiring out called renting or renting out or the good. The price of . rent the service unit is called the Since the good itself is only a bundle of expected service service unit. It is units, it is proper to base our analysis on the clear that the demand for, and the price of, a service unit of a consumers’ good will be determined on exactly the same prin- ciples as those set forth in the preceding analysis of this chapter. A durable consumers’ good embodies service units as they will accrue over a period of time. Thus, suppose that a house is expected to have a life of 20 years. Assume that a year’s rental of the house has a market price, as determined by the market sup- ply and demand schedules, of 10 ounces of gold. Now, what will be the market price of the house itself should it be sold? Since the annual rental price is 10 ounces (and if this rental is expected to continue), the buyer of the house will obtain what amounts to 20 x 10, or 200 ounces, of prospective rental income. The price of the house as a whole will tend inexorably to equal the present value of the 200 ounces. Let us assume for convenience at this point that there is no phenomenon of time preference and that the present value of 200 ounces is therefore equal to 200 ounces. In that case, the price of the house as a whole will tend to equal 200 ounces.

356 291 Prices and Consumption Suppose that the market price of the house as a whole is 180 ounces. In that case, there will be a rush to buy the house, since there is an expected monetary profit to be gained by purchasing for 180 ounces and then renting out for a total income of 200 ounces. This action is similar to speculative purchasers’ buying a good and expecting to resell at a higher price. On the other hand, there will be a great reluctance by the present owners of such houses (or of house, if there is no other house adjudged the by the market as the same good), to sell at that price, since it is far more profitable to rent it out than to sell it. Thus, under these conditions, there will be a considerable excess of demand over supply of this type of house for sale, at a price of 180 ounces. The upbidding of the excess demand tends to raise the price toward 200. On the other hand, suppose that the market price is above 200. In that case, there will be a paucity of demand to purchase, since it would be cheaper to pay rental for it instead of paying the sum to purchase it. On the contrary, possessors will be eager to sell the house rather than rent it out, since the price for sale is better. The excess supply over demand at a price over 200 will drive the price down to the equilibrium point. Thus, while every type of market price is determined as in the foregoing sections of this chapter, the market also deter- . We see that there is a definite relationship mines price relations between the price of the unit services of a durable consumers’ good and the price of the good as a whole. If that relationship is disturbed or does not apply at any particular time, the actions of individuals on the market will tend to establish it, because prospects of monetary gain arise until it is established, and action to obtain such gain inevitably tends to eliminate the opportunity. This is a case of “arbitrage” in the same sense as one price the establishment of for a good on the market. If two prices for one good exist, people will tend to rush to purchase in the cheaper market and sell more of the good in the more expensive market, until the play of supply and demand on each market establishes an “equilibrium” price and eliminates the

357 with Power and Market 292 Man, Economy, and State arbitrage opportunity. In the case of the durable good and its which the market equilibrium-price relation, services, there is an The market price of the good as a whole is equal tends to establish. to the present value of the sum of its expected (future) rental incomes or rental prices. The expected future rental incomes are, of course, not neces- sarily a simple extrapolation of present rental prices. Indeed, since prices are always changing, it will almost always be the case that rental prices will change in the future. When a person buys a durable good, he is buying its services for a length of time extending into the future; hence, he is more concerned with than with present rates; he merely takes the latter as a pos- future 31 sible guide to the future. Now, suppose that the individuals on the market generally estimate that rents for this house over the next decade or so will be much lower than at present. The price of the house then will not be 20 x 10 ounces, but some corre- spondingly smaller amount. At this point, we shall define the “price of the good as whole” as its capital value on the market, even though there is risk of capital value confusion with the concept of “capital good.” The of any good (be it consumers’ or capital good or nature-given factor) is the money price which, as a durable good, it presently sells for on the market. The concept applies to durable goods, 32 embodying future services. The capital value of a consumers’ good will tend to equal the present value of the sum of expected unit rentals. 31 It needs to be kept in mind that, strictly, there is no such thing as a “present” price established by the market. When a man considers the price of a good, he is considering that price agreed upon in the last recorded transaction in the market. The “present” price is always, in reality the historically recorded price of the most immediate past (say, a half-hour ago). What always interests the actor is what various prices will be at various times in the future. 32 On the different uses of the term “value,” see Appendix B, “On Value,” below.

358 Prices and Consumption 293 The capital value at any time is based on expectations of fu- ture rental prices. What happens when these expectations are erroneous? Suppose, for example, that the market expects the rental prices of this house to increase in the next few years and therefore sets the capital value higher than 200 ounces. Sup- pose, further, that the rental prices actually decline instead. This means that the original capital value on the market had overestimated the rental income from the house. Those who had sold the house at, say, 250, have gained, while those who bought the house in order to rent it out have lost on the trans- action. Thus, those who have forecast better than their fellows gain, while the poorer forecasters lose, as a result of their spec- ulative transactions. It is obvious that such monetary profits come simply not but from forecasting more correctly than from correct forecasting, other individuals . If all the individuals had forecast correctly, then the original capital value would have been below 200, say, 150, to account for the eventually lower rental prices. In that 33 case no such monetary profit would have appeared. It should be clear that the gains or losses are the consequences of the freely undertaken action of the gainers and losers themselves. The man who has bought a good to rent out at what proves to be an excessive capital value has only himself to blame for being overly-optimistic about the monetary return on his investment. The man who sells at a capital value higher than the eventual rental income is rewarded for his sagacity through decisions voluntarily taken by all parties. And since successful forecasters are, in effect, rewarded, and poor ones penalized, and in pro- portion to good and poor judgment respectively, the market tends to establish and maintain as high a quality of forecasting as is humanly possible to achieve. The equilibrium relation between the capital value on the market and the sum of expected future rents is a day-to-day 33 The concept of monetary profit and loss and their relation to capi- talization will be explored below.

359 Power and Market with Man, Economy, and State 294 equilibrium that tends always to be set by the market. It is sim- price for a good set by market equilibrium ilar to the day-to-day supply and demand. On the other hand, the equilibrium rela- actual tion between present capital value and future rents is only a long-range tendency fostered by the market’s encouragement equilibrium, final of successful forecasters. This relation is a final equilibrium prices that set the goal toward similar to the which the day-to-day prices tend. Study of capital value and rental prices requires additional supply-demand analysis. The determination of the unit rental price presents no problem. Price determination of the capital value, however, needs to be modified to account for this dependence on, and relationship to, the rental price. The for the durable good will now be, not only for direct demand demand for investment in on the part of others, also, use, but future renting out. If a man feels that the market price of the cap- ital value of a good is lower than the income he can obtain from future rentals, he will purchase the good and enter the renting- reserved demand out market as a supplier. Similarly, the for the good as a whole will be not only for direct use or for specula- for future renting out of the good. also tive price increases, but If the possessor of a durable good believes that the selling price (capital value) is lower than what he can get in rents, he will reserve the supply and rent out the good. The capital value of the good will be such as to clear the total stock, and the total of all these demands for the good will be in equilibrium. The reserved demand of the buyers will, as before, be due to their reserved demand for money, while the sellers of both the good as a whole and of its unit services will be demanding money in exchange. In other words, for any consumers’ good, the possessors have the choice of either consuming it directly or selling it for money. In the case of durable consumers’ goods, the posses- sors can do any one of the following with the good: use it directly, sell it whole, or hire it out —selling its unit services over a period of time. We have already seen that if using it

360 295 Prices and Consumption directly is highest on his value scale, then the man uses the good and reserves his stock from the market. If selling it whole is highest on his value scale, he enters the “capital” market for the good as a supplier. If renting it out is highest on his value scale, then he enters the “renting” market for the good as a supplier. Which of these latter alternatives will be higher on his value scale depends on his estimate of which course will yield him the higher money income. The shape of the supply curves in both the capital and rental markets will be either rightward- and upward-sloping or vertical, since the greater the expected income, the less will be the amount reserved for direct use. It is clear that the supply schedules on the two mar- kets are interconnected. They will tend to come into equilib- rium when the equilibrium-price relation is established between them. Similarly, the nonpossessors of a good at any given time will ) not buying it and reserving their money, ( b ) a choose between ( ) renting it. They will choose the buying it outright, and ( c course highest on their value scales, which depends partially on their demand for money and on their estimate of which type of purchase will be cheaper. If they decide to buy, they will buy on what they estimate is the cheaper market; then they can either use the good directly or resell it on the more expensive market. Thus, if the capital value of the house is 200 and a buyer esti- mates that total rental prices will be 220, he buys outright at 200, after which he may either use it directly or enter the rental market as a supplier in order to earn the expected 220 ounces. The latter choice again depends on his value scale. This is an- other example of the arbitrage action already explained, and the effect is to link the demand curves for the two types of mar- kets for durable goods. Here it must be pointed out that in some cases the renting contract itself takes on the characteristics of a capital contract and the estimating of future return. Such is the case of a long-term renting contract. Suppose that A is planning to rent a house to B for 30 years, at a set annual price. Then, instead of continual

361 with Power and Market 296 Man, Economy, and State fixed changes in the rental price, the latter is by the original con- tract. Here again, the demand and supply schedules are set according to the various individual estimates of the changing course of other varying rents for the same type of good. Thus, if there are two identical houses, and it is expected that the sum of for the next 30 years will be 300 A the varying rents on house ounces, then the long-term renting price for house will tend B to be set at 10 ounces per year. Here again, there is a similar The price of presently established connection between markets. long-term rents will tend to be equal to the present value of the sum . If the general of the expected fluctuating rents for identical goods expectation is that the sum of rents will be 360 ounces, then there will be a heavy demand for long-term rent purchases at 300 ounces and a diminished supply for rent at that price, until the long-term rental price is driven to 12 ounces per year, when the sum will be the same. And here again, the ever-present uncertainty of the future causes the more able forecasters to 34 gain and the less able ones to lose. In actuality, time preference exists, and the present value of the future rentals is always less by a certain discount than the sum of these rentals. If this were not so, the capital value of very durable goods, goods which wear out only imperceptibly, would be almost infinite. An estate expected to last and be in demand for hundreds of years would have an almost infinitely high sell- time preference ing price. The reason this does not happen is that discounts future goods in accordance with the length of time being considered. How the rate of time preference is arrived at will be treated in later chapters. However, the following is an illustration of the effect of time preference on the capital-value of a good. Assume a durable good, expected to last for 10 years, with an expected rental value of 10 ounces each year. If the rate of time preference is 10 percent per annum, then the future value are as follows: present rents and their 34 Cf. Fetter, Economic Principles , pp. 158–60.

362 Prices and Consumption 297 3 5 6 7 8 9 10 Years: 1 2 4 Expected Rents: 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 9.0 8.1 7.3 6.7 6.0 5.4 Present Value: 4.0 3.6 4.9 4.4 (assuming first year payment at one year from present date) Sum of these present values = 59.4 ounces = Capital value, as compared to a sum of 100 ounces of future rent. As the date of time recedes into the future, the compounded discount becomes greater, finally reducing the present value to a negligible amount. It is important to recognize that the time-preference factor does not, as does relatively correct forecasting of an uncertain sit- uation, confer monetary profits or losses. If the time-preference rate is 10 percent, purchasing the aforementioned good for 59.4 ounces, holding it, and renting it out for 10 years to acquire 100 ounces does constitute a monetary profit. Present money was not at this premium over future money, and what this man earned was simply the amount of future income that the market had evaluated as equal to 59.4 ounces of present money. In general, we may sum up the action of entrepreneurs in the field of durable consumers’ goods by saying that they will tend to in the outright purchase of (already existing) durable invest consumers’ goods when they believe that the present capital value of the good on the market is less than the sum of future rentals (discounted by time preference) that they will receive. They will sell such goods outright when they believe that the present capital value is higher than the discounted sum of future rentals. Better forecasters will earn profits, and poorer ones will suffer losses. In so far as the forecasting is correct, these “arbi- trage” opportunities will tend to disappear. Although we have analyzed the arbitrage profits and losses of entrepreneurship in the case of selling outright as against

363 with Power and Market 298 Man, Economy, and State renting, we have yet to unravel fully the laws that govern entrepreneurial incomes—the incomes that the producers strive to obtain in the process of production. This problem will be 35 analyzed in later chapters. 8. Welfare Comparisons and the Ultimate Satisfactions of the Consumer In our preoccupation with analysis of the action of man in the monetary economy, it must not be thought that the general truths presented in chapter 1 remain no longer valid. On the contrary, in chapter 1 they were applied to isolated Crusoe-type situations because we logically begin with such situations in order to be able to analyze the more complex interrelations of the monetary economy. However, the truths formulated in the first chapter are applicable still, not only through logical infer- ences applied to the monetary nexus, but also directly to all sit- uations in the monetary economy in which money is not in- volved. There is another sense in which the analysis of the first chap- ter is directly applicable in a money economy. We may be pri- marily concerned in the analysis of exchange with the con- sumer’s allocation of money to the most highly valued of its uses—based on the individual’s value scales. We must not for- ultimate goal of the consumer’s expenditures get, however, the of money. This goal is the actual use of the purchased goods in attaining his most highly valued ends. Thus, for the purposes of , once Jones has purchased three pounds market analysis of the of butter, we have lost interest in the butter (assuming there is no chance of Jones’ re-entering the market to sell the butter). We call the retail sale of the butter the sale of the consumers’ 35 For a discussion of the value of durable goods, see the brilliant treat- ment in Böhm-Bawerk, Positive Theory of Capital , pp. 339–57; Fetter, Eco- nomic Principles , pp. 111–21; and Wicksteed, Common Sense of Political Economy, I, 101–11.

364 299 Prices and Consumption last sale for money along the path of the but- good , since this is its ter’s production. Now the good is in the hands of the ultimate consumer. The consumer has weighed the purchase on his value scale and has decided upon it. Strictly, we must never lose sight of the fact that this pur- the last stopping point of the but- chase by the consumer is not ter, when we consider human action in its entirety. The butter must be carried to the man’s home. Then, Jones allocates the units of butter to their most highly valued uses: buttered toast, butter in a cake, butter on a bun, etc. To use the butter in a cake or sandwich, for example, Mrs. Jones bakes the cake and pre- pares the sandwich and then brings it to the table where Jones eats it. We can see that the analysis of chapter 1 holds true, in that useful goods—horses, butter, or anything else—in the hands of the consumer are allocated, in accordance with their utility, to the most highly valued uses. Also, we can see that actually the butter when last sold for money was not a consumers’ —albeit one of lower order than at any good, but a capital good other previous stage of its production. Capital goods are pro- duced goods that must be combined still further with other fac- tors in order to provide the consumers’ good—the good that finally yields the ultimate satisfaction to the consumer. From the full praxeological point of view, the butter becomes a con- sumers’ good only when it is actually being eaten or otherwise “consumed” by the ultimate consumer. From the standpoint of praxeology proper—the complete formal analysis of human action in all its aspects—it is inadmis- sible to call the good at its last retail sale to the consumer a “consumers’ good.” From the point of view of that subdivision of praxeology that covers traditional economics—that of catal- , the science of monetary exchanges—however, it becomes lactics convenient to call the good at the last retail stage a “consumers’ good.” This is the last stage of the good in the monetary nexus—the last point, in most cases, at which it is open to pro- ducers to invest money in factors. To call the good at this final monetary stage a “consumers’ good” is permissible, provided

365 Power and Market with Man, Economy, and State 300 we are always aware of the foregoing qualifications. We must always remember that without the final stages and the final allo- for the raison d’être cation by consumers, there would be no whole monetary exchange process. Economics cannot afford to dismiss the ultimate consumption stage simply because it has passed beyond the monetary nexus; it is the final goal and end of the monetary transactions by individuals in society. Attention to this point will clear up many confusions. Thus, there is the question of consumers’ income. In chapter 3, we analyzed consumers’ money income and the universal goal of maximizing psychic income, and we indicated to some extent the relation between the two. Everyone attempts to maximize the latter, which includes on its value scale a vast range of all consumers’ goods, both exchangeable and nonexchangeable. Exchangeable goods are generally in the monetary nexus, and therefore can be purchased for money, whereas nonexchange- able goods are not. We have indicated some of the conse- income that monetary and not quences of the fact that it is psychic is being maximized, and how this introduces qualifications into the expenditure of effort or labor and in the investment in pro- ducers’ goods. It is also true that psychic income, being purely subjective, cannot be measured. Further, from the standpoint of praxeology, we cannot even ordinally compare the psychic income or utility of one person with that of another. We cannot say that A’s income or “utility” is greater than B’s. We can—at least, theoretically—measure monetary incomes by adding the amount of money income each person obtains, but this is by no means a measure of psychic income. Furthermore, it does not, as we perhaps might think, give any exact indication of the amount of services that each individual obtains purely exchangeable consumers’ goods. An income of 50 ounces of from gold in one year may not, and most likely will not, mean the same to him in terms of services from exchangeable goods as an income of 50 ounces in some other year. The purchasing power of money in terms of all other commodities is continually chang- ing, and there is no way to measure such changes.

366 301 Prices and Consumption Of course, as historians rather than economists, we can make imprecise judgments comparing the “real” income rather than the monetary income between periods. Thus, if Jones received 1,000 ounces of income in one year and 1,200 in the next, and prices generally rose during the year, Jones’ “real income” in terms of goods purchasable by the money has risen considerably less than the nominal monetary increase or perhaps fallen. However, as we shall see further below, there is no precise method of measuring or even identifying the purchasing power of money and its changes. Even if we confine ourselves to the same period, monetary incomes are not an infallible guide. There are, for example, many consumers’ goods that are obtainable both through mon- etary exchange and outside the money nexus. Thus, Jones may be spending 18 ounces a month on food, rent, and household maintenance, while Smith spends only nine ounces a month. This does not necessarily mean that Jones obtains twice as much of these services as Smith. Jones may live in a hotel, which provides him with these services in exchange for money. Smith, on the other hand, may be married and may obtain household and cooking services outside the monetary nexus. Smith’s psy- chic income from these services may be equal to, or greater than, Jones’, despite the lower monetary expenditures. Neither can we measure psychic incomes if we confine our- selves to goods in the monetary nexus. A and B might live in the same sort of house, but how can the economist-observer deduce from this that the two are deriving the same amount of enjoyment from the house? Obviously, the degree of enjoy- ment will most likely differ, but the mere fact of the income or property will provide no clue to the direction or extent of the difference. It follows that the law of the diminishing marginal utility of each individual person. money applies only to the valuations of There can be no comparison of such utility between persons. Thus, we cannot, as some writers have done, assert that an extra

367 with Power and Market 302 Man, Economy, and State dollar is enjoyed less by a Rockefeller than by a poor man. If Rockefeller were suddenly to become poor, each dollar would be worth more to him than it is now; similarly, if the poor man were to become rich, his value scales remaining the same, each dollar would be worth less than it is now. But this is a far cry from attempting to compare different individuals’ enjoyments or sub- jective valuations. It is certainly possible that a Rockefeller enjoys the services of each dollar more than a poor, but highly ascetic, individual does. 9. Some Fallacies Relating to Utility A doctrine commonly held by writers on utility is that the consumer acts so as to bring the marginal utility that any good equality with the price of that good. To under- has for him into stand this thesis, let us examine the preference scale of Mr. Jones in contemplating the purchase of one or more suits (and we shall assume that each suit is of the same quality—the same “good”). Suppose his value scale is as follows: And suppose also that the market price is 2.9 grains per suit. Jones will buy not one or three, but two, suits. He will buy up to the last unit at which the diminishing marginal utility that the suit

368 Prices and Consumption 303 36 . has for him exceeds the increasing marginal utility of money This is obvious. Now, if a writer couches the exposition in terms of highly divisible goods, such as butter, and in terms of small units of money, such as pennies, it is easy to leap unthinkingly to the conclusion that the consumer for each good will act in such a way as to equalize, at the market price, the marginal utility of the sum of money and the marginal utility of the good. It should be clear, however, that there is never any such “equalization.” In the case of the suit, the rank of the second suit is still consider- ably above the rank of the 2.9 grains. So there is no equaliza- tion. Even in the case of the most divisible of goods, there will difference in rank , not an equalization, between the two still be a utilities. A man may buy 11 ounces of butter at 10 cents an ounce, until there is nothing ranking between the 11th ounce and the 10cents on his utility scale; yet there is still no equality , but a difference in rank, with the last ounce bought ranking higher than the last sum of money spent. Of course, the con- sumer tries to spend his money so as to bring the two as close as possible, but they can never be equal. Furthermore, the marginal utility of each particular good, after the purchases are made, differs in rank from that of every other. Thus, let us take one grain of gold as the monetary unit under consideration. Let us say that the given market-prices of various goods are as follows: — 1 dozen per grain; eggs butter — 1 pound per grain; bread — 1 loaf per grain; candy — 1 bar per grain. Now each individual will purchase each commodity until the last point at which the marginal utility of the unit exceeds the marginal utility of a grain of gold. For one man, this might mean the purchase of five pounds of butter, three loaves of 36 We are omitting possible shifts in rank resulting from the increas- ing utility of money, which would only complicate matters unduly.

369 Power and Market with Man, Economy, and State 304 bread, two bars of candy, etc. This would mean that either a sixth pound of butter or a fourth loaf of bread would have a lower marginal utility than a grain of gold forgone. However, the marginal utility of each good will still differ in rank from that of every other and will not be equal to that of any other. Another, even more curious doctrine holds that in equilib- rium the ratio of the marginal utilities of the various goods equals the ratio of their prices. Without entering in detail into the manner by which these writers arrive at this conclusion, we can see its absurdity clearly, since utilities are not quantities and therefore cannot be divided. These fallacies stem from a related one: the idea that an indi- equalize vidual will act so as to the marginal utility that any good will have in each of its uses. Applied to money, this would imply that the marginal utility of a unit of money is equal for each field of expenditure for each person. This is incorrect, as we have just seen that the marginal utilities of the various goods are not equalized. Successive units of a good are allocated to the most desired end, then to the next most desired satisfaction, etc. If there are several uses for the good, each one involving many possible units, the marginal utility of a unit in each use contin- ues to decline as the supply increases. As goods are purchased, the marginal utility of each good purchased diminishes, and a man may allocate his money first to one use, then to another, and then to the first use again. However, in no case is there any equalization of marginal utilities. The dogma of the equalization of marginal utilities may best be illustrated in the following passage from perhaps the origi- nator of this line of argument: be the whole stock of some commodity, and let Let s it be capable of two distinct uses. Then we may rep- resent the two quantities appropriated to these uses x by y plus y and equal , it being a condition that x 1 l 1 l . The person may be conceived as successively s expending small quantities of the commodity; now it

370 Prices and Consumption 305 is the inevitable tendency of human nature to choose that course which appears to offer the greatest advan- tage at the moment. Hence, when the person remains satisfied with the distribution he has made, it follows that no alteration would yield him more pleasure; which amounts to saying that an increment of com- modity would yield exactly as much utility in one use , be the increments of util- Δ u , Δ as in another. Let u 1 2 ity, which might arise respectively from consuming an increment of commodity in the two different ways. When the distribution is completed, we ought to . . . The same reasoning . . . will evi- = Δ u Δ have u 2 1 dently apply to any two uses, and hence to all uses simultaneously, so that we obtain a series of equations less numerous by a unit than the number of ways of using the commodity. The general result is that the commodity, if consumed by a perfectly wise being, must be consumed with a maximum production of 37 utility. The chief errors here consist in conceiving utility as a certain quantity, a definite function of an increment in the commodity, and in treating the problem in terms of infinitely small steps. Both procedures are fallacious. Utilities are not quantities, but ranks, and the successive amounts of a commodity that are used are always discrete units, not infinitely small ones. If the units are discrete, then the rank of each unit differs from that of every other, and there can be no equalization. Many errors in discussions of utility stem from an assump- tion that it is some sort of quantity, measurable at least in prin- ciple. When we refer to a consumer’s “maximization” of utility, referring to a definite stock or quantity for example, we are not highest-ranking of something to be maximized. We refer to the position on the individual’s value scale. Similarly, it is the 37 W. Stanley Jevons, The Theory of Political Economy (3rd ed.; London: Macmillan & Co., 1888), pp. 59–60.

371 with Power and Market 306 Man, Economy, and State assumption of the infinitely small, added to the belief in utility as a quantity, that leads to the error of treating marginal utility as the mathematical derivative of the integral “total utility” of several units of a good. Actually, there is no such relation, and there is no such thing as “total utility,” only the marginal utility unit. The size of the unit depends on its rele- of a larger-sized 38 vance to the particular action. This illustrates one of the grave dangers of the mathematical method in economics, since this method carries with it the bias of the assumption of continuity, or the infinitely small step. Most writers on economics consider this assumption a harmless, but potentially very useful, fiction, and point to its great success in the field of physics. They overlook the enormous differences between the world of physics and the world of human action. The problem is not simply one of acquiring the microscopic measuring tools that physics has developed. The crucial differ- move but ence is that physics deals with inanimate objects that act . The movements of these objects can be investigated do not as being governed by precise, quantitatively determinate laws, well expressed in terms of mathematical functions. Since these laws precisely describe definite paths of movement, there is no harm at all in introducing simplified assumptions of continuity and infinitely small steps. Human beings, however, do not move in such fashion, but act purposefully, applying means to the attainment of ends. Investigating causes of human action, then, is radically different from investigating the laws of motion of physical objects. In rele- particular, human beings act on the basis of things that are vant to their action. The human being cannot see the infinitely small step; it therefore has no meaning to him and no relevance to his action. Thus, if one ounce of a good is the smallest unit that human beings will bother distinguishing, then the ounce is 38 See Appendix A below, “The Diminishing Marginal Utility of Money,” and Rothbard, “Toward a Reconstruction of Utility and Welfare Economics.”

372 307 Prices and Consumption the basic unit, and we cannot simply assume infinite continuity in terms of small fractions of an ounce. The key problem in utility theory, neglected by the mathe- matical writers, has been the size of the unit . Under the assump- tion of mathematical continuity, this is not a problem at all; it could hardly be when the mathematically conceived unit is in- sizeless finitely small and therefore literally . In a praxeological analysis of human action, however, this becomes a basic ques- tion. The relevant size of the unit varies according to the par- ticular situation, and in each of these situations this relevant unit becomes the marginal unit. There is none but a simple ordinal relation among the utilities of the variously sized units. The tendency to treat problems of human action in terms of equality of utility and of infinitely small steps is also apparent in recent writings on “indifference maps.” Almost the entire edifice of contemporary mathematical economics in consump- tion theory has been built on the “indifference” assumption. Its basis is the treatment of large-sized classes of combinations of two goods, between which the individual is indifferent in his valuations. Furthermore, the differences between them are infinitely small, so that smooth lines and tangents can be that “indifference” cannot be a basis drawn. The crucial fallacy is If a man were really indifferent between two alterna- for action. tives, he could not make any choice between them, and there- fore the choice could not be revealed in action. We are inter- ested in analyzing human action. Any action demonstrates choice based on preference: preference for one alternative over others. There is therefore no role for the concept of indiffer- ence in economics or in any other praxeological science. If it is a matter of indifference for a man whether he uses 5.1 or 5.2 ounces of butter for example, because the unit is too small for him to take into consideration, then there will be no occasion for him to act on this alternative. He will use butter in ounce units, instead of tenths of an ounce. For the same reason, there are no infinitely small steps in human action. Steps are only

373 Power and Market with Man, Economy, and State 308 those that are significant to human beings; hence, they will always be finite and discrete. The error in reasoning on the basis of “indifference” is the failure to appreciate the fact that a problem important in the psychology may have no significance in the realm of prax- field of eology, to which economics belongs. Psychology deals with the or why the individual forms value scales, and for how problem of this question it is relevant to consider whether the individual is decisive or inclined to be “indifferent” between various alter- natives. Praxeology, however, is a logical science based on the existence of action ; it is interested in explaining and inter- per se preting real action in its universal sense rather than in its con- crete content. Its discussion of value scales is therefore a deduc- tion from the nature of human action and not a speculative essay on the internal workings of the mind. It is consequently irrelevant for praxeology whether a man, in having to decide , makes a choice firmly and deci- B and between alternatives A sively, or whether he decides by tossing a coin. This is a prob- lem for psychology; praxeology is concerned only with the fact , and that there- A rather than that he chooses, for example, B B fore A ranked higher in his preference scale than . Utility the- ory is not concerned with psychology or the internal operations of the mind, but is part of a separate science based on the logi- cal consequences of the simple existence of action. Neither is praxeology based on behaviorist psychology. In fact, in so far as praxeology touches on psychology, its principles are the reverse of those of behaviorism. As we have seen, far from simply observing action in the same way as we observe and record the movements of stones, praxeology is based on a fun- damental distinction between human action and the motion of motivated toward inorganic matter, namely, that human action is the achievement of certain ends. Means and resources are used for the achievement of these ends. Far from leaving mind out of the picture, praxeology rests fundamentally on the basic axiom of action, action caused and put into effect by human minds. However, praxeology is not concerned with the content of these

374 Prices and Consumption 309 ends, the manner of arriving at them, or their order; it is con- cerned with analysis of the logical implications of the existence of these ends. Some writers, in their artificial separation of value scales from real action, have actually gone to the length of attempting to discover people’s indifference maps by means of question- naires. These attempts, besides being open to the stricture that indifference is not praxeologically valid, fail to realize that value scales can and do change continually and that therefore such questionnaires have no relevance to the business of economics. Economics is interested not in value scales professed in response to questionnaires, but in the values implied by real action. As Ludwig von Mises states, with regard to all attempts to separate value scales from action: . . . the scale of value is nothing but a constructed tool of thought. The scale of value manifests itself only in real acting; it can be discerned only from the observation of real acting. It is therefore im- permissible to contrast it with real acting and to use 39 it as a yardstick for the appraisal of real actions. Since indifference is not relevant to human action, it follows that two alternatives for choice cannot be ranked equally on an individual’s value scale. If they are really ranked equally, then 39 Mises, Human Action , p. 102. Dr. Bernardelli justly says: If someone asks me in abstracto whether my love for my country is greater than my desire for freedom, I am some- what at a loss how to answer, but actually having to make a choice between a trip in my country and the danger of losing my freedom, the order of intensities of my desire becomes only too determinate. (Harro F. Bernardelli, “What has Philosophy to Contribute to the Social Sci- ences, and to Economics in Particular?” Economica, November, 1936, p. 451) Also see our discussion of “consumer surplus” in section 4 above.

375 with Power and Market 310 Man, Economy, and State they cannot be alternatives for choice, and are therefore not rel- evant to action. Hence, not only are alternatives ranked ordi- ; without ties nally on every man’s value scale, but they are ranked i.e., every alternative has a different rank. The famous illustration used by the indifference theorists to demonstrate the relevance of indifference to human action is the case of Buridan’s ass. This is the fable of the ass who stands, hungry, equidistant from two equally attractive bales of hay, or, thirsty, equidistant from two water holes. Since the two bales or water holes are equally attractive in every way, the ass can choose neither one and must therefore starve. This example is supposed to prove the great relevance of indifference to action and to be an indication of the way that indifference is in revealed action. Compounding confusion, Schumpeter refers to this ass 40 as “perfectly rational.” In the first place, it is of course difficult to conceive of an ass rational. He is confronted not with less or a person that could be two choices, but with three , the third being to starve where he is. Even on the indifferentists’ own grounds, this third choice will be ranked lower than the other two on the actor’s value scale. choose starvation. not He will If both the left and right water holes are equally attractive, and he can find no reason for preferring one or the other, the ass or the man will allow pure chance, such as a flip of a coin, to decide on either one. But on one he must and will decide. as revealed through choice Again, we are interested in preference and not in the psychology of preferences. If the flipped coin indi- cated the left water hole, then the left water hole was finally placed higher on the actor’s value scale, as was revealed when he went toward it. Far from being a proof of the importance of indifference, the case of Buridan’s ass is an excellent demonstra- tion of the fact that indifference can play no part whatever in an analysis of human action. 40 Schumpeter, History of Economic Analysis , pp. 94 n. and 1064.

376 Prices and Consumption 311 Another way of attempting a justification of the indifference analysis is to suppose that a man, Jones, chooses each of two and A B alternatives about 50 percent of the time, upon re- peated opportunities. This shifting is alleged to be a demon- stration that Jones is really indifferent as between the two alternatives. Yet what is the reasonable inference? Clearly, that A was in some cases, to B on Jones’ value scale, and that preferred in the others, the positions were shifted so that B was preferred . was there indifference between the two alterna- to A In no case tives. The shift of choice indicates a shift in the preference scale, and not indifference on a constant value scale. Of course, if we were dealing with psychology, we could enter into a discussion of intensities of preferences and opine that the man, with respect to his underlying personality, was relatively indifferent rather than intensely biased, as between the two alternatives. But in praxeology we are not interested in the concrete content of his value scales nor in his underlying personality. We are interested in value scales as revealed through choice. PPENDIX A A T ONEY ARGINAL U IMINISHING M M HE D TILITY OF Some writers, while admitting the validity of the law of diminishing marginal utility for all other goods, deny its appli- cation to money. Thus, for example, a man may allocate each ounce of money to his most preferred uses. However, suppose that it takes 60 ounces of gold to buy an automobile. Then the acquisition of the 60th ounce, which will enable him to buy an automobile, will have considerably more value than the acquisi- tion of the 58th or of the 59th ounce, which will not enable him to do so. This argument involves a misconception identical with that of the argument about the “increasing marginal utility of 41 There we saw that it is eggs” discussed in chapter 1, above. 41 See chapter 1, pp. 73–74.

377 with Power and Market 312 Man, Economy, and State erroneous to argue that because a fourth egg might enable a man to bake a cake, which he could not do with the first three, the marginal utility of the eggs has increased. We saw that a “good” and, consequently, the “unit” of a good are defined in equally terms of whatever quantity of which the units give an . This last phrase is the key concept. The serviceable supply fourth egg was not equally serviceable as, and therefore not single egg interchangeable with, the first egg, and therefore a . The units of a good must be unit could not be taken as the homogeneous in their serviceability, and it is only to such units that the law of utility applies. The situation is similar in the case of money. The service- ability of the money commodity lies in its use in exchange rather than in its direct use. Here, therefore, a “unit” of money, in its relevance to individual value scales, must be such as to be homo- geneous with every other unit in exchange-value. If another ounce permits a purchase of an automobile, and the issue is rel- evant to the case in question, then the “unit” of the money com- modity must be taken not as one ounce, but as 60 ounces. All that needs to be done, then, to account for and explain “discontinuities” because of possible large purchases is to vary the size of the monetary unit to which the law of utility and the 42 preferences and choices apply. This is what each man actually does in practice. Thus, suppose that a man is considering what to do with 60 ounces of gold. Let us assume, for the sake of sim- plicity, that he has a choice of parceling out the 60 ounces into five-ounce units. This, we will say, is alternative . In that case, A he decides that he will parcel out each five ounces in accordance with the highest rankings on his utility scale. The first five ounces will be allocated to, or spent on, the most highly valued that can be served by five ounces ; the next five ounces to the use next most highly valued use, and so on. Finally, his 12th five 42 Cf. the excellent discussion of the sizes of units in Wicksteed, Com- mon Sense of Political Economy , I, 96–101 and 84.

378 313 Prices and Consumption ounces he will allocate to his 12th most highly valued use. Now, . This alterna- B however, he is also confronted with alternative tive is to spend the entire 60 ounces on whatever single use will be most valuable on his value scale. This will be the single high- unit of 60 ounces of money. Now, to decide est-ranked use for a which alternative course he will take, the man compares the utility of the highest-ranked single use of a lump sum of 60 ounces (say, the purchase of a car) with the utility of the “pack- b , etc. age”—the expenditure of five ounces on a , five ounces on Since the man knows his own preference scale—otherwise he could never choose any action—it is no more difficult to assume that he can rank the utility of the whole package with the util- ity of purchasing a car than to assume that he can rank the uses of each five ounces. In other words, he posits a unit of 60 ounces and determines which alternative ranks higher on his value scale: purchase of the car or a certain package distribution by five-ounce (or other-sized) units. At any rate, the 60 ounces are distributed to what each man believes will be its highest-rank- ing use, and the same can be said for each of his monetary exchange decisions. Here we must stress the fact that there is no numerical rela- tion—aside from pure ordinal rank—between the marginal util- ities of the various five-ounce units and the utilities of the 60- ounce units, and this is true even of the package combination of distribution that we have considered. All that we can say is that the utility of 60 ounces will clearly be higher than any one of the utilities of five ounces. But there is no way of determining the numerical difference. Whether or not the rank of the utility of this package is higher or lower than the utility of the car pur- chase, moreover, can be determined only by the individual him- self. We have reiterated several times that utility is only ranked, and never measurable. There is no numerical relationship whatever between the utility of large-sized and smaller-sized units of a good. Also, there is no numerical relationship between the utilities of one unit and several units of the same

379 with Power and Market 314 Man, Economy, and State size. Therefore, there is no possible way of adding or combin- ing marginal utilities to form some sort of “total utility”; the lat- utility of a large-sized unit, and there marginal ter can only be a is no numerical relationship between that and the utilities of small units. As Ludwig von Mises states: Value can rightly be spoken of only with regard to specific acts of appraisal. . . . Total value can be spo- ken of only with reference to a particular instance of an individual . . . having to choose between the total available quantities of certain economic goods. Like every other act of valuation, this is complete in itself. . . . When a stock is valued as a whole, its marginal utility, that is to say, the utility of the last available unit of it, coincides with its total utility, since the total 43 supply is one indivisible quantity. There are, then, two laws of utility, both following from the apodictic conditions of human action: first, that given the size of a unit of a good, the (marginal) utility of each unit decreases as the supply of units increases; second, that the (marginal) utility of a larger-sized unit is greater than the (marginal) utility of a smaller- sized unit . The first is the law of diminishing marginal utility. The second has been called the law of increasing total utility. The relationship between the two laws and between the items considered in both is purely one of rank, i.e., ordinal. Thus, four eggs (or pounds of butter, or ounces of gold) are worth more on a value scale than three eggs, which in turn are worth more than two eggs, two eggs more than one egg, etc. This illustrates the second law. One egg will be worth more than a second egg, which will be worth more than a third egg, etc. This illustrates 43 Mises, Theory of Money and Credit , pp. 46–47. Also see Harro F. Ber- nardelli, “The End of the Marginal Utility Theory,” Economica, May, 1938, pp. 205–07; and Bernardelli, “A Reply to Mr. Samuelson’s Note,” Economica, February, 1939, pp. 88–89.

380 Prices and Consumption 315 the first law. But there is no arithmetical relationship between 44 the items apart from these rankings. The fact that the units of a good must be homogeneous in serviceability means, in the case of money, that the given array of money prices remains constant. The serviceability of a unit of money consists in its direct use-value and especially in its exchange-value, which rests on its power to purchase a myriad of different goods. We have seen in our study of the money regression and the marginal utility of money that the evaluation and the marginal utility of the money commodity rests on an already given structure of money prices for the various goods. It is clear that, in any given application of the foregoing law, the money prices cannot change in the meantime. If they do, and for example, the fifth unit of money is valued more highly than the fourth unit because of an intervening change in money prices, then the “units” are no longer equally serviceable and therefore cannot be considered as homogeneous. As we have seen above, this power of the monetary unit to purchase quantities of various goods is called the purchasing power of the monetary unit. This purchasing power of money consists of the of all the given money prices on the mar- array ket at any particular time, considered in terms of the prices of goods per unit of money. As we saw in the regression theorem above, today’s purchasing power of the monetary unit is deter- mined by today’s marginal utilities of money and of goods, expressed in demand schedules, while today’s marginal utility of money is directly dependent on yesterday’s purchasing power of 45 money. 44 It must always be kept in mind that “total” and “marginal” do not have the same meaning, or mutual relation, as they do in the calculus. “Total” is here another form of “marginal.” Failure to realize this has plagued economics since the days of Jevons and Walras. 45 For further analysis of the determination of the purchasing power of money and of the demand for and the supply of money, see chapter 11 below on “Money and Its Purchasing Power.”

381 Power and Market with Man, Economy, and State 316 B A PPENDIX O V N ALUE Economics has made such extensive use of the term “value” that it would be inexpedient to abandon it now. However, there is undoubtedly confusion because the term is used in a variety of different ways. It is more important to keep distinct the sub- and preference, jective use of the term in the sense of valuation purchasing power as against the “objective” use in the sense of or price on the market. Up to this chapter, “value” in this book has meant the subjective individual “valuing” process of ranking goods on individual “value scales.” In this chapter, the term “value of capital” signifies the pur- chasing power of a durable good in terms of money on the mar- ket. If a house can be sold on the market for 250 ounces of gold, then its “capital value” is 250 ounces. The difference between this and the subjective type of value is apparent. When a good is being subjectively valued, it is ranked by someone in relation to other goods on his value scale. When a good is being “eval- uated” in the sense of finding out its capital value, the evaluator how much the good could be sold for in terms of estimates appraisement money. This sort of activity is known as and is to be distinguished from subjective evaluation. If Jones says: “I shall be able to sell this house next week for 250 ounces,” he is “appraising” its purchasing power, or “objective exchange- value,” at 250 ounces of gold. He is not thereby ranking the house and gold on his own value scale, but is estimating the money price of the house at some point in the future. We shall see below that appraisement is fundamental to the entire eco- nomic system in an economy of indirect exchange. Not only do the renting and selling of consumers’ goods rest on appraise- ment and on hope of monetary profits, but so does the activity of all the investing producers, the keystone of the entire pro- ductive system. We shall see that the term “capital value” applies, not only to durable consumers’ goods, but to all non- human factors of production as well—i.e., land and capital goods, singly and in various aggregates. The use and purchase

382 Prices and Consumption 317 of these factors rest on appraisement by entrepreneurs of their eventual yield in terms of monetary income on the market, and it will be seen that their capital value on the market will also tend to be equal to the discounted sum of their future yields of 46 money income. 46 On appraisement and valuation, cf. Mises, Human Action , pp. 328–30.


384 5 TRUCTURE S HE :T RODUCTION P 1. Some Fundamental Principles of Action —the actions that HE ANALYSIS OF PRODUCTION ACTIVITIES T eventually result in the attainment of consumers’ goods—is a highly intricate one for a complex, monetary market economy. It is best, therefore, to summarize now some of the most appli- cable of the fundamental principles formulated in chapter 1. In that chapter we applied those principles to a Crusoe economy only. Actually, however, they are applicable to any type of econ- omy and are the indispensable keys to the analysis of the com- plex modern economy. Some of these fundamental principles are: (1) Each individual acts so that the expected psychic revenue, or achievement of utility, from his action will exceed its psychic cost. The latter is the forgone utility of the next best alternative that he could adopt with the available means. Both the psychic revenue and the psychic cost are purely subjective to the indi- vidual. Since all action deals with units of supply of a good, we may refer to these subjective estimates as marginal utility and marginal signifying action in steps. marginal cost, the present (2) Each person acts in the instant, on the basis of end results in the present value scales, to obtain anticipated . Each person acts, therefore, to arrive at a certain satis- future factory state in the future. Each has a temporal horizon of 319

385 Power and Market with Man, Economy, and State 320 future dates toward which his actions are directed. He uses , according to his technological ideas, to means present given attain his ends in the future. (3) Every person prefers and will attempt to achieve the sat- isfaction of a given end in the present to the satisfaction of that end in the future. This is the law of time preference. (4) All goods are distributed by each individual in accordance with their utility to him. A stock of the units of a good is allo- cated first to its most highly valued uses, then to its next most highly valued use, etc. The definition of a is that it consists good of an interchangeable supply of one or more units. Therefore, every unit will always be valued equally with every other. If a least highly valued unit of a stock is given up or disposed of, the use for one unit will be the one given up. Therefore, the value of each unit of the supply of a good is equal to the utility of the least highly valued of its present uses. This marginal utility diminishes as the stock of each good increases. The marginal addition of a unit to the stock equals the utility of a unit utility of the most highly valued of in its next most highly valued use, i.e., the not yet satisfied ends . This provides us with the law of mar- ginal utility and the law of allocation of goods. (5) In the technical combination of factors of production to yield a product, as one factor varies and the others remain con- stant, there is an optimum point—a point of maximum average product produced by the factor. This is the law of returns. It is based on the very fact of the existence of human action. (6) And we know from chapter 2 that the price of any good on the market will tend to be uniform throughout the market. The price is determined by supply and demand schedules, which are themselves determined by the value scales of the indi- viduals in the market. 2. The Evenly Rotating Economy Analysis of the activities of production in a monetary market economy is a highly complex matter. An explanation of these

386 321 Production: The Structure activities, in particular the determination of prices and therefore the return to factors, the allocation of factors, and the formation of capital, can be developed only if we use the mental construc- evenly rotating economy tion of the . This construction is developed as follows: We realize that the real world of action is one of continual change. Individual value scales, technological ideas, and the quantities of means available are always changing. These changes continually impel the economy in various directions. Value scales change, and consumer demand shifts from one good to another. Technolog- ical ideas change, and factors are used in different ways. Both types of change have differing effects on prices. Time prefer- ences change, with certain effects on interest and capital forma- tion. The crucial point is this: before the effects of any one change are completely worked out, other changes intervene. What we must consider, however, by the use of reasoning, is what would happen if no changes intervened. In other words, what would occur if value scales, technological ideas, and the given resources remained constant? What would then happen to prices and production and their relations? Given values, technology, and resources, whatever their concrete form, remain constant. In that case, the economy tends toward a state i.e., in which the same of affairs in which it is evenly rotating, activities tend to be repeated in the same pattern over and over again. Rates of production of each good remain constant, all prices remain constant, total population remains constant, etc. Thus, if values, technology, and resources remain constant, we a have two successive states of affairs: ( ) the period of transition to an unchanging, evenly rotating economy, and ( b ) the unchanging round of the evenly rotating economy itself. This . It is to be distin- latter stage is the state of final equilibrium guished from the market equilibrium prices that are set each The final equilib- day by the interaction of supply and demand. rium state is one which the economy is always tending to approach. If our data —values, technology, and resources—remained con- stant, the economy would move toward the final equilibrium

387 Power and Market with Man, Economy, and State 322 position and remain there. In actual life, however, the data are always changing, and therefore, before arriving at a final equi- librium point, the economy must shift direction, towards some other final equilibrium position. Hence, the final equilibrium position is always changing, and consequently no one such position is ever reached in practice. But even though it is never reached in practice, it has a very real importance. In the first place, it is like the mechanical rabbit being chased by the dog. It is never reached in practice and it is always changing, but it explains the direction in which the dog is moving. Secondly, the complexity of the market system is such that we cannot analyze factor prices and incomes in a world of continual change unless we first analyze their determination in an evenly rotating world where there is no change and where given conditions are allowed to work themselves out to the full. Certainly at this stage of inquiry we are not interested in ethical evaluations of our knowledge. We are attaching no eth- ical merit to the equilibrium position. It is a concept for scien- tific explanation of human activity. The reader might ask why such an “unrealistic” concept as final equilibrium is permissible, when we have already pre- sented and will present grave strictures against the use of vari- ous unrealistic and antirealistic premises in economics. For example, as we shall see, the theory of “pure competition,” so prevalent among writers today, is based on impossible premises. The theory is then worked out along these lines and not only applied uncritically to the real world, but actually used as an ethical base from which to criticize the real “deviations” from this theory. The concepts of “indifference classes” and of infi- nitely small steps are other examples of false premises that are used as the basis of highly elaborate theoretical structures. The concept of the evenly rotating economy, however, when used with care, is not open to these criticisms. For this is an ever- present force, since it is the goal toward which the actual system at which, on the basis is always moving, the final position of rest,

388 323 Production: The Structure of the given, actually existing value scales, all individuals would have attained the highest positions on their value scales, given the technology and resources. This concept, then, is of legiti- mate and realistic importance. We must always remember, however, that while a final equi- librium is the goal toward which the economy is moving at any particular time, changes in the data alter this position and there- fore shift the direction of movement. Therefore, there is nothing in a dynamic world that is ethically better about a final equilibrium As a matter of fact, since wants are unsatisfied (otherwise position. there would be no action), such a position of no change would be most unfortunate, since it would imply that no further want- satisfaction would be possible. Furthermore, we must remember that a final equilibrium situation tends to be, though it can never condition of of market activity, and not the actually be, the result such activity. Far too many writers, for example, discerning that in the evenly rotating economy entrepreneurial profits and losses would all be zero, have somehow concluded that this must for any legitimate activity on the market. There be the condition could hardly be a greater misconception of the market or a greater abuse of the equilibrium concept. Another danger in the use of this concept is that its purely static, essentially timeless, conditions are all too well suited for the use of mathematics. Mathematics rests on , which equations portray mutual relationships between two or more “functions.” Of themselves, of course, such mathematical procedures are un- important, since they do not establish causal relationships. They are of the greatest importance in physics, for example, because that science deals with certain observed regularities of motion by particles of matter that we must regard as unmotivated. These particles move according to certain precisely observable, exact, quantitative laws. Mathematics is indispensable in formu- lating the laws among these variables and in formulating theo- retical explanations for the observed phenomena. In human action, the situation is entirely different, if not diametrically opposite. Whereas in physics, causal relations can only be

389 with Power and Market 324 Man, Economy, and State assumed hypothetically and later approximately verified by referring to precise observable regularities, in praxeology we the causal force at work. This causal force is human action, know , purposeful behavior, directed at certain ends. The motivated universal aspects of this behavior can be logically analyzed. We are not dealing with “functional,” quantitative relations among variables, but with human reason and will causing certain action, which is not “determinable” or reducible to outside forces. Furthermore, since the data of human action are always changing, there are no precise, quantitative relationships in human history. In physics, the quantitative relationships, or laws, are constant; they are considered to be valid for any point in human history, past, present, or future. In the field of human action, there are no such quantitative constants. There are no constant relationships valid for different periods in human his- tory. The only “natural laws” (if we may use such an old-fash- ioned but perfectly legitimate label for such constant regulari- quantitative . rather than qualitative ties) in human action are They are, for example, precisely the laws educed in praxeology and economics—the fact of action, the use of means to achieve 1 ends, time preference, diminishing marginal utility, etc. Mathematical equations, then, are appropriate and useful where there are constant quantitative relations among unmoti- vated variables. They are singularly inappropriate in praxeology and economics. In the latter fields, verbal, logical analysis of 1 Another difference is one we have already discussed: that mathemat- ics, particularly the calculus, rests in large part on assumptions of infi- nitely small steps. Such assumptions may be perfectly legitimate in a field where behavior of unmotivated matter is under study. But human action disregards infinitely small steps precisely because they are infinitely small and therefore have no relevance to human beings. Hence, the action under study in economics must always occur in finite, discrete steps. It is therefore incorrect to say that such an assumption may just as well be made in the study of human action as in the study of physical particles. In human action, we may describe such assumptions as being not simply unrealistic, but antirealistic .

390 Production: The Structure 325 action and its processes through time is the appropriate method. It is not surprising that the main efforts of the “math- ematical economists” have been directed toward describing the final equilibrium state by means of equations. For in this state, since activities merely repeat themselves, there seems to be more scope for describing conditions by means of functional equations. These equations, at best, however, can do no more than describe this equilibrium state. Aside from doing no more than verbal logic can do, and therefore violating the scientific principle of Occam’s razor —that science should be as simple and clear as possible—such a use of mathematics contains grave errors and defects within itself. In by which the economy path the first place, it cannot describe the approaches the final equilibrium position. This task can be per- formed only by verbal, logical analysis of the causal action of human beings. It is evident that this task is the important one, since it is this analysis that is significant for human action. Action moves along a path and is not describable in an unchang- ing, evenly rotating world. The world is an uncertain one, and we shall see shortly that we cannot even pursue to its logical conclusion the analysis of a static, evenly rotating economy. The assumption of an evenly rotating economy is only an aux- iliary tool in aiding us in the analysis of real action. Since math- ematics is least badly accommodated to a static state, mathe- matical writers have tended to be preoccupied with this state, thus providing a particularly misleading picture of the world of action. Finally, the mathematical equations of the evenly rotat- 2 ing economy describe only a static situation, outside of time. They differ drastically from the mathematical equations of 2 The mathematical economists, or “econometricians,” have been try- ing without success for years to analyze the path of equilibrium as well as the equilibrium conditions themselves. The econometrician F. Zeuthen recently admitted that such attempts cannot succeed. All that mathematics can describe is the final equilibrium point. See the remarks of F. Zeuthen at the 16th European meeting of the Econometric Society, in Econometrica, April, 1955, pp. 199–200.

391 Power and Market with Man, Economy, and State 326 physics, which describe a process through time ; it is precisely through this description of constant, quantitative relations in of elements that mathematics renders its great serv- the motion ice in natural science. How different is economics, where math- ematics, at best, can only inadequately describe a timeless end 3 result! The use of the mathematical concept of “function” is particularly inappropriate in a science of human action. On the 3 see For a brilliant critique of the use of mathematics in economics, Mises, Human Action Also see Mises, , pp. 251, 347–54, 697–99, 706–11. “Comments about the Mathematical Treatment of Economic Problems,” Studium Generale VI, 2 (1953), (Springer Verlag: unpublished translation by Helena Ratzka); Niksa, “Role of Quantitative Thinking in Modern Economic Theory”; Ischboldin, “Critique of Econometrics”; Paul Pain- levé, “The Place of Mathematical Reasoning in Economics” in Louise Sommer, ed., Essays in European Economic Thought (Princeton, N.J.: D. Van Nostrand, 1960), pp. 120–32; and Wieser, Social Economics, pp. 51 ff. For a discussion of the logical method of economics, see Mises, Human and the neglected work, J.E. Cairnes, Action The Character and Logical Method of Political Economy (2nd ed.; London: Macmillan & Co., 1888). Marian Bowley, Also see (New York: Nassau Senior and Classical Economics Augustus M. Kelley, 1949), pp. 55–65. If any mathematics has been used in this treatise, it has been only along the lines charted by Cairnes: I have no desire to deny that it may be possible to employ geometrical diagrams or mathematical formulae for the purpose of exhibiting economic doctrines reached by other paths. . . . What I venture to deny is the doctrine which Professor Jevons and others have advanced—that economic knowledge can be extended by such means; that Mathematics can be applied to the development of economic truth, as it has been applied to the develop- ment of mechanical and physical truth and unless it can be shown either that mental feelings admit of being expressed in precise quantitative forms, or, on the other hand, that economic phenomena do not depend on mental feelings, I am unable to see how this conclusion can be avoided. (Cairnes, Character and Logical Method of Political Economy, pp. iv–v)

392 Production: The Structure 327 not one hand, action itself is a function of anything, since “func- tion” implies definite, unique, mechanical regularity and determination. On the other hand, the mathematics of simulta- neous equations, dealing in physics with unmotivated motion, stresses mutual determination. In human action, however, the known causal force of action unilinearly determines the results. This gross misconception by mathematically inclined writers on the study of human action was exemplified during a running attack on Eugen Böhm-Bawerk, one of the greatest of all econ- omists, by Professor George Stigler: . . . yet the postulate of continuity of utility and demand functions (which is unrealistic only to a minor degree, and essential to analytic treatment) is never granted. A more important weakness is Böhm- Bawerk’s failure to understand some of the most essential elements of modern economic theory, the concepts of mutual determination and equilibrium (developed by the use of the theory of simultaneous equations). Mutual determination is spurned for the 4 older concept of cause and effect. The “weakness” displayed here is not that of Böhm-Baw- erk, but of those, like Professor Stigler, who attempt vainly and fallaciously to construct economics on the model of math- 5 ematical physics, specifically, of classical mechanics. 4 Production and Distribution Theories George J. Stigler, (New York: Macmillan & Co., 1946), p. 181. For Carl Menger’s attack on the concept of mutual determination and his critique of mathematical economics in general, T.W. Hutchison, A Review of Economic Doctrines, 1870–1929 see (Oxford: The Clarendon Press, 1953), pp. 147–48, and the interesting article by Emil Kauder, “Intellectual and Political Roots of the Older Aus- trian School,” Zeitschrift für Nationalökonomie XVII, 4 (1958), 412 ff. 5 Stigler appends a footnote to the above paragraph which is meant as the coup de grace to Böhm-Bawerk: “Böhm-Bawerk was not trained in mathematics.” Stigler, Production and Distribution Theories . Mathematics, it must be realized, is only the servant of logic and reason, and not their mas- ter. “Training” in mathematics is no more necessary to the realization of

393 Power and Market with Man, Economy, and State 328 To return to the concept of the evenly rotating economy, the error of the mathematical economists is to treat it as a real and even ideal state of affairs, whereas it is simply a mental concept enabling us to analyze the market and human activities on the market. It is indispensable because it is the goal, though ever- shifting, of action and exchange; on the other hand, the data can never remain unchanged long enough for it to be brought into being. We cannot conceive in all consistency of a state of affairs without change or uncertainty, and therefore without action. The evenly rotating state, for example, would be incompatible with the existence of money, the very medium at the center of the entire exchange structure. For the money commodity is de- manded and held only because it is more marketable than other commodities, i.e., because the holder is more sure of being able to exchange it. In a world where prices and demands remain perpetually the same, such demand for money would be unnec- essary. Money is demanded and held only because it gives greater assurance of finding a market and because of the uncer- tainties of the person’s demands in the near future. If everyone, for example, knew his spending precisely over his entire future—and this would be known under the evenly rotating sys- tem—there would be no point in his keeping a cash balance of money. It would be invested so that money would be returned its uselessness for and inapplicability to the sciences of human action than, for example, “training” in agricultural techniques is essential to knowing that they are not applicable on board an ocean liner. Indeed, training in mathematics, without adequate attention to the epistemology of the sciences of human action, is likely to yield unfortunate results when applied to the latter, as this example demonstrates. Böhm-Bawerk’s great- ness as an economist needs no defense at this date. For a sensitive tribute to Böhm-Bawerk, see Joseph A. Schumpeter, “Eugen von Böhm-Bawerk, 1851–1914” in Ten Great Economists (New York: Oxford University Press, 1951), pp. 143–90. For a purely assertive and unsupported depreciation of Böhm-Bawerk’s stature as an economist, see Howard S. Ellis’ review of Schumpeter’s book in the Journal of Political Economy, October, 1952, p. 434.

394 Production: The Structure 329 in precisely the needed amounts on the day of expenditure. But if no one wishes to hold money, there will be no money and no system of money prices. The entire monetary market would break down. Thus, the evenly rotating economy is unrealistic, for it cannot actually be established and we cannot even con- ceive consistently of its establishment. But the idea of the evenly rotating economy is indispensable in analyzing the real econ- omy; through hypothesizing a world where all change has worked itself out, we can analyze the directions of actual change. 3. The Structure of Production: A World of Specific Factors Crucial to understanding the process of production is the specificity of factors, a problem we touched on in question of the chapter 1. A specific factor is one suitable to the production of only one product. A purely nonspecific factor would be one equally suited to the production of all possible products. It is clear that not all factors could be purely nonspecific, for in that case all fac- tors would be purely interchangeable, i.e., there would be need for only one factor. But we have seen that human action implies more than one existing factor. Even the existence of purely one nonspecific factor is inconceivable if we properly consider “suit- terms rather than in technological ability in production” in value 6 In fact, if we analyze the concept, we find that there is no terms. sense in saying that a factor is “equally suitable” in purely tech- nological terms, since there is no way of comparing the physical quantities of one product with those of another. If can help to X B , there is no way by A produce three units of or two units of of con- which we can compare these units. Only the valuation sumers establishes a hierarchy of valued goods, their interaction 6 The literature in economics has been immeasurably confused by writers on production theory who deal with problems in terms of tech- nology rather than valuation. For an excellent article on this problem, cf. Lionel Robbins, “Remarks upon Certain Aspects of the Theory of Costs,” Economic Journal, March, 1934, pp. 1–18.

395 Power and Market with Man, Economy, and State 330 setting the prices of the consumers’ goods. (Relatively) nonspe- cific factors, then, are allocated to those products that the con- sumers have valued most highly. It is difficult to conceive of any good that would be purely nonspecific and equally valuable in all processes of production. Our major distinction, then, is between the specific factor, which can be used in only one line of produc- factor (of varying degrees of convertibil- tion, and the nonspecific ity), which can be used in more than one production process. Now let us for a time consider a world where every good is only by several specific factors. In this world, a world produced that is conceivable, though highly unlikely, every person, every piece of land, every capital good, would necessarily be irrevoca- bly committed to the production of one particular product. There would be no alternative uses of any good from one line of production to another. In the entire world of production, then, there would be little or no “economic problem,” i.e., no problem of allocating scarce means to alternative ends. Cer- would still have to allocate their scarce consumers tainly, the monetary resources to be most preferred consumers’ goods. In the nonmarket sphere, everyone—again as a consumer—would have to allocate his time and energies to the enjoyment of vari- ous consumers’ goods. There would still, in the sphere of pro- one duction of exchangeable goods, be allocation that every man would make: how much time to devote to labor and how much field to labor to leisure. But there would be no problem of which in, no problem of what to do with any piece of land, no prob- lem of how to allocate capital goods. The employment of the factors would all depend on the consumers’ demand for the final product. The structure of production in such a world of purely specific factors would be somewhat as in Figure 39. In this diagram, we . Each, depicted as a see two typical consumers’ goods, A and B solid rectangle at the bottom of the diagram, is produced by co- 1, or the operating factors of the next higher rank, designated P first order of producers’ goods. The capital goods of the first rank are, in turn, produced with the help of co-operating factors,

396 331 Production: The Structure these being of the second-rank, and so on upward. The process logically continues upward until capital goods are produced completely by land and labor factors, although this stage is not depicted on the diagram. Lines connect the dots to designate the causal pattern of the factors. In the diagram, all factors are , since no good is used at different stages of the purely specific process or for different goods. The center arrows indicate the causal direction of effort downward, from the highest ranked producers’ goods through the intermediate ranks, finally con- cluding in consumers’ goods. At each stage, labor uses nature- given factors to produce capital goods, and the capital goods are again combined with labor and nature-given factors, trans- formed into lower and lower orders of capital goods, until con- sumers’ goods are reached. Now that we have traced the direction of productive effort, we must trace the direction of monetary income. This is a re- verse one, from the consumers back to the producers. The consumers purchase the stock of a consumers’ good at a price determined on the market, yielding the producers a certain in- come. Two of the crucial problems of production theory are the method by which the monetary income is allocated and the corollary problem of the pricing of the factors of production. First, let us consider only the “lowest” stage of production, the product. In that stage, numer- stage that brings about the final ous factors, all now assumed to be specific, co-operate in pro- ducing the consumers’ good. There are three types of such

397 with Power and Market 332 Man, Economy, and State 7 factors: labor, original nature, and produced capital goods. Let us assume that on a certain day, consumers purchase a cer- for, say, 100 ounces of gold. Given X tain quantity of a good price of the total quantity is the quantity of the good sold, the equal to the (gross) income obtained from the sale of the good. How will these 100 ounces be allocated to the producing fac- tors? In the first place, we must make an assumption about the ownership of the consumers’ good just before it is sold. It is obvi- recip- ous that this owner or these owners will be the immediate ients of the 100 ounces of gold income. Let us say that, in the final stage, there have been seven factors participating in the production: two types of labor, two types of land, and three types of capital goods. There are two alternatives in regard to before it is sold to the con- the final ownership of the product ( own the final sumer): ( a ) all the owners of these factors jointly product; or ( b ) the owner of each of the factors sells the services of his factor to someone else, and the latter (who may himself contribute a factor) sells the good at a later date to the con- sumer. Although the latter is the nearly universal condition, it will be convenient to begin by analyzing the first alternative. Those who own the final product, whatever the alternative adopted, are “capitalists,” since they are the owners of capital goods. It is better, however, to confine the term “capitalists” to those who have saved money capital with which to buy factors. This, by definition, does not occur under the first alternative, where owners of factors are joint owners of the products. The 7 We must hasten to add that this does not signify adoption of the old classical fallacy that treated each of these groups of factors as homoge- neous. Clearly, they are heterogeneous and for pricing purposes and in human action are treated as such. Only the same good, homogeneous for human valuation, is treated as a common “factor,” and all factors are treated alike—for their contribution to revenue—by producers. The categories “land, labor, and capital goods” are essential, however, for a deeper analysis of production problems, in particular the analysis of var- ious income returns and of the relation of time to production.

398 Production: The Structure 333 term “product-owner” suffices for designating the owner of the capital assets, whatever the alternative adopted. Product-own- ers are also “entrepreneurs,” since they assume the major entrepreneurial burden of adjusting to uncertain future condi- tions. To call them “entrepreneurs” alone, however, is to run the danger of forgetting that they are also capitalists or product- owners and that they would continue to perform that function in an evenly rotating economy. 4. Joint Ownership of the Product by the Owners of the Factors Let us first consider the case of joint ownership by the own- 8 ers of all the final co-operating factors. It is clear that the 100 ounces of gold accrue to the owners jointly. Let us now be purely arbitrary and state that a total of 80 ounces accrues to the own- ers of capital goods and a total of 20 ounces to the owners of labor and nature-given factors. It is obvious that, whatever the allocation, it will be, on the unhampered market, in accordance with the voluntary contractual agreement of each and every fac- tor-owner concerned. Now it is clear that there is an important difference between what happens to the monetary income of the laborer and the landowner , on the one hand, and of the owner of capital goods , on the other. For the capital goods must in turn be produced by labor, nature, and other capital goods. Therefore, while the contributor of personal “labor” energy (and this, of course, includes the energy of direction as well as what are called “laborers” in popular parlance) has earned a pure return, the owner of capital goods has previously spent some money for the production or the purchase of his owned factors. 8 It must be understood that “factors of production” include every serv- ice that advances the product toward the stage of consumption. Thus, such services as “marketing costs,” advertising, etc., are just as legiti- mately productive services as any other factors. The fallacy in the spuri- ous distinction between “production costs” and “selling costs” has been definitely demonstrated by Mises, Human Action , p. 319.

399 Power and Market with 334 Man, Economy, and State Now it is clear that, since only factors of production may obtain income from the consumer, the price of the consumers’ good—i.e., the income from the consumers’ good, equals the sum of the prices accruing to the producing factors, i.e., the income accruing to the factors . In the case of joint ownership, this is a truism, since only a factor can receive income from the sale of a good. It is the same as saying that 100 ounces equals 100 ounces. But what of the 80 ounces that we have arbitrarily allocated to the owners of capital goods? To whom do they finally accrue? Since we are assuming in this example of joint ownership that all products are owned by their factor-owners, it also follows that capital goods, which are products, are themselves jointly also owned by the factors on the second rank of production. Let us say that each of the three first-order capital goods was produced by five co-operating factors: two types of labor, one type of land, two types of capital goods. All these factor-owners jointly own the 80 ounces. Let us say that each of the first-order capi- tal goods had obtained the following: Capital good A : 30 ounces B : 30 ounces Capital good Capital good : 20 ounces C The income to each capital good will then be owned by five fac- tor-owners on the second rank of production. It is clear that, conceptually, no one, in the last analysis, receives a return as the owner of a capital good . Since every capital good analytically resolves itself into original nature-given and labor factors, it is evident that no money could accrue to the owner of a capital good. All 100 ounces must eventually be allocated to labor and owners of nature-given factors exclusively. Thus, the 30 ounces accruing to the owners of capital good A will be allo- cated to the five factor-owners, while the, say, four ounces accruing to one of the capital goods of third rank helping to produce good A will, in turn, be allocated to land, labor, and capital-goods factors of the fourth rank, etc. Eventually, all the

400 Production: The Structure 335 money is allocated to labor and nature-given factors only. The diagram in Figure 40 illustrates this process. At the bottom of the diagram, we see that 100 ounces of gold are transferred from the consumers to the producers. Some of this money goes to owners of capital goods, some to landowners, some to owners of labor. (The proportion going to one group and the other is arbitrarily assumed in the example and is of no importance for this analysis.) The amount accru- ing to the capital-goods owners is included in the shaded por- tion of the diagram and the amount accruing both to labor and nature-owners is included in the clear portion of the diagram. In the lowest, the first block, the 20 ounces received by owners of land and of labor factors is marked with an upward arrow, fol- lowed by a similar upward arrow at the top of the diagram, the top line designating the money ultimately received by the own- ers of the various factors. The width of the top line (100 ounces) must be equal to the width of the bottom line (100 ounces), Income to Land and Labor 100 ounces 20 6 10 20 5 30 15 4 15 45 3 20 60 2 20 80 1 100 ounces Consumer Expenditure F A IGURE CCRUING TO THE 40. I NCOME RODUCTION F P ACTORS OF

401 Power and Market with Man, Economy, and State 336 since the money ultimately received by the owners of the factors must equal the money spent by the consumers. Moving up to line 2, we follow the fortunes of the 80 ounces which had accrued to the owners of capital goods of the first order. We assume that 60 ounces accrue to the owners of sec- ond-order capital goods and 20 ounces to second-order labor and nature-given factors. Once again, the 20 ounces’ clear area is marked with an upward arrow designating the ultimate receipt of money by the owners of the factors and is equally marked off on the top line of the diagram. The same process is repeated as we go further and further upward in the order of capital goods. At each point, of course, the amount obtained by owners of capital goods becomes smaller, because more and more has accrued to labor and nature owners. Finally, at the highest conceivable stage, all the remaining 20 ounces earned by the owners of capital goods accrue to land and labor factors only, since eventually we must come to the stage where no cap- ital good has yet been produced and only labor and nature remain. The result is that the 100 ounces are all eventually allo- cated to the clear spaces, to the land and labor factors. The large upward arrow on the left signifies the general upward course of the monetary income. To the truism that the income from sale of the consumers’ good equals the consumers’ expenditure on the good, we may add a corresponding truism for each stage of production, namely, that the income from sale of a capital good equals the income accruing to the factors of its production. In the world that we have been examining, where all prod- ucts, at whatever stage, are owned jointly by the owners of their work is done on the highest stage. factors, it is clear that first their land and labor to pro- Owners of land and of labor invest duce the highest-order (in this case the fifth) capital good; then these owners turn the good over to the owners of labor and land at the next lower stage; these produce the fourth-order capital good, which in turn co-operates with labor and land factors on

402 Production: The Structure 337 that stage to produce the lower-order good, etc. Finally, the lowest stage is reached, and the final factors co-operate to pro- duce the consumers’ good. The consumers’ good is then sold to 9 consumers. In the case of joint ownership, then, there does not arise any separate class of owners of capital goods. All the capital goods produced are jointly owned by the owners of the producing land and labor factors; the capital goods of the next lower order are owned by the owners of the land and labor factors at the next lower stage along with the previously co-operating owners, etc. In sum, the entire capital-goods structure engaged in any line of production is jointly owned by the owners of land and labor. And the income gained from the final sale of the product to the consumers accrues only to the owners of land and labor; there is no separate group of owners of capital goods to whom income 10 accrues. It is obvious that the production process takes time , and the more complex the production process the more time must be taken. During this time, all the factors have had to work with- out earning any remuneration; they have had to work only in expectation of future income. Their income is received only at a much later date. The income that would be earned by the factors, in a world of purely specific factors, depends entirely on consumer demand for the particular final product. If consumers spend 100 ounces on the good, then the factors will jointly earn 100 ounces. If they spend 500 ounces, the factors will earn that amount. If they spend nothing on the product, and the producers have made the 9 On the structure of production, see Wieser, Social Economics , pp. 47 ff. 10 In practice, one or more persons can be the owners of any of the fac- tors. Thus, the original factors might also be jointly owned by several persons. This would not affect our analysis. The only change would be that the joint owners of a factor would have to allocate the factor’s income according to voluntary contract. But the type of allocation would remain the same.

403 with Power and Market 338 Man, Economy, and State enormous entrepreneurial error of working on a product that the consumers do not buy, the factors earn precisely zero. The joint monetary income earned by the owners of the factors fluc- tuates pari passu with consumer demand for the product. At this point, a question naturally arises: What happens to owners of factors who earn a zero return? Must they “starve”? Fundamentally, we cannot answer this question for concrete individual persons, since economics demonstrates truths about “functional” earnings in production, and not about the entire earnings of a given person. A particular person, in other words, may experience a zero return on this good, while at the same time earning a substantial return on ownership of another piece of land. In cases where there is no such ownership in another area, the individual may pursue isolated production that does not yield a monetary return, or, if he has an accumulated mon- etary cash balance, he may purchase goods by reducing the bal- ance. Furthermore, if he has such a balance, he may invest in land or capital goods or in a production organization owning them, in some other line of production. His labor, on our money is usable in assumptions, may be a specific factor, but his every line of production. Suppose we assume the worst possible case—a man with no cash balance, with no assets of capital, and whose labor is a specific factor the product of which has little or no consumer 11 demand. Is he not truly an example of an individual led astray by the existence of the market and the specialization prevalent on it? By subjecting himself to the consumer has he not placed his happiness and existence in jeopardy? Even granting that people chose a market, could not the choice turn out to be tragic for many people? The answer is that there is no basis whatever for such stric- tures on the market process. For even in this impossible case, 11 Actually, this case cannot occur, since labor, as we shall see below, is always a nonspecific factor.

404 Production: The Structure 339 the individual is no worse off than he would have been in isola- tion or barter. He can always revert to isolation if he finds he cannot attain his ends via the market process. The very fact that we consider such a possibility ludicrous is evidence of the enor- mous advantages that the market confers upon everyone. Indeed, empirically, we can certainly state that, without the modern, developed market, and thrown back into isolation, the overwhelming majority of individuals could not obtain enough exchangeable goods to exist at all. Yet this choice always remains open to anyone who, for any reason, voluntarily prefers isola- tion to the vast benefits obtainable from the market system. Certainly, therefore, complaints against the market system by disgruntled persons are misplaced and erroneous. Any person or group, on the unhampered market, is free to abandon the social market at any time and to withdraw into any other desired form of co-operative arrangement. People may withdraw into individual isolation or establish some sort of group isolation or start from the beginning to re-create their own market. In any case, on the free market, their choice is entirely their own, and they decide according to their preferences unhampered by the 12 use or threat of violence. Our example of the “worst possible case” enables us to ana- lyze one of the most popular objections to the free society: that “it leaves people free to starve.” First, from the fact that this objection is so widespread, we can easily conclude that there will be enough charitable people in the society to present these unfortunates with gifts. There is, however, a more fundamental refutation. It is that the “freedom-to-starve” argument rests on a basic confusion of “freedom” with “abundance of exchange- able goods.” The two must be kept conceptually distinct. Free- dom is meaningfully definable only as absence of interpersonal 12 It is therefore our contention that the term “consumers’ sover- eignty” is highly inapt and that “individual sovereignty” would be a more appropriate term for describing the free market system. For an analysis of the concept of “consumers’ sovereignty,” see chapter 10 below.

405 Power and Market with Man, Economy, and State 340 restrictions. Robinson Crusoe on the desert island is absolutely free, since there is no other person to hinder him. But he is not necessarily living an abundant life; indeed, he is likely to be con- stantly on the verge of starvation. Whether or not man lives at the level of poverty or abundance depends upon the success that he and his ancestors have had in grappling with nature and in transforming naturally given resources into capital goods and consumers’ goods. The two problems, therefore, are logically separate. Crusoe is absolutely free, yet starving, while it is cer- tainly possible, though not likely, for a given person at a given instant to be a slave while being kept in riches by his master. Yet there is an important connection between the two, for we have seen that a free market tends to lead to abundance for all of its participants, and we shall see below that violent intervention in the market and a hegemonic society tend to lead to general a con- not poverty. That a person is “free to starve” is therefore demnation of the free market, but a simple fact of nature: every child comes into the world without capital or resources of his own. On the contrary, as we shall see further below, it is the free market in a free society that furnishes the only instrument to reduce or eliminate poverty and provide abundance. 5. Cost At this point, let us reintroduce the concept of “cost” into the analysis. We have seen above that the cost, or “marginal” cost, of any decision is the next highest utility that must be for- gone because of the decision. When a means M must be dis- tributed among ends E E E , , with E ranked highest on , and 1 1 2 3 the individual’s value scale, the individual attempts to allocate the means so as to attain his most highly valued ends and to forgo those ranked lower, although he will attain as many of his ends as he can with the means available. If he allocates his means to E , and must forgo and E , E is the marginal cost E 3 3 2 1 of his decision. If he errs in his decision, and arrives at E 3

406 Production: The Structure 341 , then ex post —in retrospect—he is seen to have suf- instead of E 2 fered a loss compared to the course he could have taken. What are the costs involved in the decisions made by the owners of the factors? In the first place, it must be stressed that these costs are subjective and cannot be precisely determined by outside observers or be gauged ex post by observing account- 13 ants. Secondly, it is clear that, since such factors as land and the produced capital goods have only one use, namely, the produc- tion of this product (by virtue of being purely specific), they no cost involve to their owner in being used in production. By the very terms of our problem, the only alternative for their owner would be to let the land lie unused, earning no return. The use of labor, however, does have a cost, in accordance with the value of the leisure forgone by the laborers. This value is, of course, unmeasurable in money terms, and necessarily differs for each individual, since there can be no comparison between the value scales of two or more persons. Once the final product has been produced, the analysis of the previous chapter follows, and it becomes clear that, in most cases, the sale of the good at the market price, whatever the price costless , except for rare cases of direct consumption by may be, is the producer or in cases of anticipation of a price increase in the costless from the proper point of view— near future. This sale is the point of view of acting man at the relevant instant of action. The fact that he would not have engaged in the labor at all if he had known in advance of the present price might indicate a deplorable instance of poor judgment, but it does not affect the present situation. At present, with all the labor already exerted and the product finished, the original—subjective—cost has already been incurred and vanished with the original making of 13 Cf. the excellent discussion of cost by G.F. Thirlby, “The Subjective Theory of Value and Accounting ‘Cost,’ ” Economica, February, 1946, pp. 33 f.; and especially Thirlby, “Economists’ Cost Rules and Equilibrium Theory,” Economica , May, 1960, pp. 148–53.

407 Power and Market with Man, Economy, and State 342 the decision. At present, there is no alternative to the sale of the 14 good at the market price, and therefore the sale is costless. It is evident, therefore, that once the product has been made, “cost” has on the price of the product. Past no influence costs, being ephemeral, are irrelevant to present determination of prices. The agitation that often takes place over sales “below cost” is now placed in its proper perspective. It is obvious that, in the relevant sense of “cost,” no such sales can take place. The sale of an already produced good is likely to be costless, and if it is not, and price is below its costs, then the seller will hold on to the good rather than make the sale. That costs do have an influence in production is not denied by anyone. However, the influence is not directly on the price, but on the amount that will be produced or, more specifically, on the degree to which factors will be used. We have seen in our example that land and capital goods will be used to the fullest extent practicable, since there is no return or benefit in allowing 15 them to remain idle. But man laboring bears the cost of leisure forgone. What he expects will be the monetary return from his labor is the deciding factor in his decision concerning how much 14 As Thirlby says, “Cost is ephemeral. The cost involved in a particu- lar decision loses its significance with the making of a decision because the decision displaces the alternative course of action.” Thirlby, “Subjective Theory of Value,” p. 34. And Jevons: Labor once spent has no influence on the future value of any article : it is gone and lost forever. In commerce bygones are forever bygones and we are always starting clear at each moment, judging the values of things with a view to future utility. Industry is essentially prospective, not ret- rospective. (Jevons, Theory of Political Economy , p. 164) 15 There will undoubtedly be exceptions, such as cases where the owner obtains enjoyment from the land or capital good from its lying idle—such as the esthetic enjoyment of using it as an uncultivated forest. These alternatives are then also costs, when a decision is made on the use of the land.

408 Production: The Structure 343 or whether or not to employ his labor on the product. The mon- etary return is ranked on his subjective value scale along with the costs of forgoing leisure, and his decision is made on the quan- tity of labor he will put forth in production. The height of costs on individual value scales, then, is one of the determinants of the , that will be produced. This stock, of course, stock quantity, the plays a role in the determination of market price, since later stock is evaluated by consumers according to the law of dimin- ishing marginal utility. This, however, is a far cry from stating that cost either determines, or is co-ordinate with utility in determining, price. We may briefly summarize the law of price (which can be stated at this point only in regard to specific fac- tors and joint ownership, but which will be later seen as true for any arrangement of production): Individuals, on their value scales, evaluate a given stock of goods according to their utili- ties, setting the prices of consumers’ goods; the stock is pro- duced according to previous decisions by producers, who had weighed on their value scales the expected monetary revenue from consumers against the subjective costs (themselves simply ) of engaging in the production. In the former utilities forgone case, the utility valuations are generally (though by no means ; in the latter case, they are always) the ones made by consumers . But it is clear that the determinants of price made by producers are in valuing given con- only the subjective utilities of individuals ditions and alternatives. There are no “objective” or “real” costs 16 that determine, or are co-ordinate in determining, price. 16 It is unfortunate that these truths, substantially set forth by the “Aus- trian School of economics” (which included some Englishmen and Amer- icans) close to three-quarters of a century ago, should have been almost entirely obscured by the fashionable eclectic doctrine that “real costs” and utility are somehow co-ordinate in price determination, with “cost” being “really” more important “in the long run.” How often has Alfred Mar- shall’s homely analogy of utility and cost being “two blades of a scissors” been invoked as a substitute for analysis! Emil Kauder has supplied an interesting interpretation of the reason for the failure of British thought to adopt the nascent subjective value approach in pre vious cen turies. He

409 with Power and Market 344 Man, Economy, and State If we investigate the costs of laborers in production more closely, we see that what is involved is not simply a question of leisure forgone. There is another, though in this case inter- are being forgone in exchange for present goods twined, element: in the future an expectation of return . Thus, added to the leisure-labor element, the workers, in this case, must wait for some time before earning the return, while they must give up their leisure in the present or in various periods earlier than the return is obtained. Time, therefore, is a critical element in pro- duction, and its analysis must pervade any theory of production. When the owners of the factors embark on a process of pro- duction the yield of which will be necessarily realized in the future, they are giving up leisure and other consumers’ goods that they either could have enjoyed without working or could have earned earlier from shorter processes of production. In their labor and land in a process of production, invest order to then, they must restrict their present consumption to less than its possible maximum. This involves forgoing either immediate consumption or the consumption made possible from shorter Present consumption is given up in processes of production. consumption. Since we have seen that the future anticipation of universal law of time preference holds that any given satisfac- tion will be preferred earlier than later, an equivalent satisfac- tion will be preferred as early as possible. Present consumption of a good will be given up only in anticipation of a greater future attributes the emphasis on labor and real cost, as contrasted to subjective utility and happiness, to the Calvinist background of the British classicists, typified by Smith and Locke. Of particular interest here is his citation of the strongly Evangelical background of Marshall. Implicit in his treat- ment is the view that the second major reason for the classicists’ failure to follow subjectivist leads was their search for an invariable measurement of value. This search embodied the “scientistic” desire to imitate the meth- ods of the natural sciences. Emil Kauder, “The Retarded Acceptance of the Marginal Utility Theory,” Quarterly Journal of Economics, November, 1953, pp. 564–75.

410 345 Production: The Structure consumption, the degree of the premium being dependent on time preferences. This restriction of present consumption is . (See the discussion in chapter 1.) saving In a world where products are all jointly owned by owners of factors, the original owners of land and labor must do their own saving; there is no monetary expression to represent total saving, even in a monetary economy. The owners of land and labor forgo a certain amount of present or earlier consumption and save in various amounts in order to invest their time and labor to produce the final product. Their income is finally earned, say after one year, when the good is sold to the con- sumers and the 100 ounces is received by the joint owners. It is impossible, however, for us to say what this saving or invest- ment was in monetary terms. 6. Ownership of the Product by Capitalists: Amalgamated Stages Up to this point we have discussed the case in which the owners of land and labor, i.e., of the original factors, restrict their possible consumption and invest their factors in a produc- tion process, which, after a certain time, produces a consumers’ good to be sold to consumers for money. Now let us consider a own the final not situation in which the owners of the factors do product. How could this come about? Let us first forget about the various stages of the production process and assume for the moment that all the stages can be lumped together as one. An at individual or a group of individuals acting jointly can then, present , offer to pay money to the owners of land and labor, thus buying the services of their factors. The factors then work and produce the product, which, under the terms of their agreement, belongs to the new class of product-owners. These product- owners have purchased the services of the land and labor factors as the latter have been contributing to production; they then sell the final product to the consumers. What has been the contribution of these product-owners, or “capitalists,” to the production process? It is this: the saving and

411 Power and Market with Man, Economy, and State 346 restriction of consumption, instead of being done by the own- . The cap- capitalists ers of land and labor, has been done by the italists originally saved, say, 95 ounces of gold which they could have then spent on consumers’ goods. They refrained from advanced doing so, however, and, instead, the money to the the latter for their original owners of the factors. They paid services while they were working, thus advancing them money before the product was actually produced and sold to the con- sumers. The capitalists, therefore, made an essential contribu- tion to production. They relieved the owners of the original factors from the necessity of sacrificing present goods and wait- , the capitalists have supplied pres- ing for future goods. Instead (i.e., money with which to buy ent goods from their own savings present goods) to the owners of the original factors. In return for this supply of present goods, the latter contribute their pro- ductive services to the capitalists, who become the owners of the product. More precisely, the capitalists become the owners of the capital structure, of the whole structure of capital goods as they are produced. Keeping to our assumption that one capital- ist or group of capitalists owns all the stages of any good’s pro- duction, the capitalists continue to advance present goods to owners of factors as the “year” goes on. As the period of time continues, highest-order capital goods are first produced, are then transformed into lower-order capital goods, etc., and ulti- mately into the final product. At any given time, this whole structure is owned by the capitalists. When one capitalist owns the whole structure, these capital goods, it must be stressed, do him no good whatever. Thus, suppose that a capitalist has already advanced 80 ounces over a period of many months to owners of labor and land in a line of production. He has in his ownership, as a result, a mass of fifth-, fourth-, and third-order capital goods. None of these capital goods is of any use to him, how- ever, until the goods can be further worked on and the final product obtained and sold to the consumer. Popular literature attributes enormous “power” to the capitalist and considers his owning a mass of capital goods as of

412 347 Production: The Structure enormous significance, giving him a great advantage over other people in the economy. We see, however, that this is far from the case; indeed, the opposite may well be true. For the capitalist has already saved from possible consumption and hired the services of factors to produce his capital goods. The owners of these fac- tors have the money already for which they otherwise would have had to save and wait (and bear uncertainty), while the cap- italist has only a mass of capital goods, a mass that will prove worthless to him unless it can be further worked on and the product sold to the consumers. When the capitalist purchases factor services, what is the precise exchange that takes place? The capitalist gives money (a present good) in exchange for receiving factor services (labor and land), which work to supply him with capital goods. They supply him, in other words, with . The capital goods future goods for which he pays are way stations on the route to the final product—the consumers’ good. At the time when land and labor are hired to produce capital goods, therefore, these capi- tal goods, and therefore the services of the land and labor, are future goods; they represent the embodiment of the expected yield of a good in the future—a good that can then be con- sumed. The capitalist who buys the services of land and labor in year one to work on a product that will eventually become a consumers’ good ready for sale in year two is advancing money (a present good) in exchange for a future good—for the present anticipation of a yield of money in the future from the sale of the final product. A present good is being exchanged for an expected future good. Under the conditions of our example, we are assuming that the capitalists own no original factors, in contrast to the first case, in which the products were jointly owned by the owners of these factors. In our case, the capitalists originally owned money, with which they purchased the services of land and labor in order to produce capital goods, which are finally transformed by land and labor into consumers’ goods. In this example we

413 Power and Market with Man, Economy, and State 348 have assumed that the capitalists do not at any time own any of the co-operating labor or land factors. In actual life, of course, there may be and are capitalists who both work in some mana- gerial capacity in the production process and also own the land on which they operate. Analytically, however, it is necessary to isolate these various functions. We may call those capitalists who own only the capital goods and the final product before sale “pure capitalists.” Let us now add another temporary restriction to our analy- sis—namely, that all producers’ goods and services are only , never bought outright. This is a convenient assumption hired that will be maintained long after the assumption of specific fac- tors is dropped. We here assume that the pure capitalists never purchase as a whole a factor that in itself could yield several the services of factors per units of service. They can only hire unit of time. This situation is directly analogous to the condi- tions described in chapter 4, section 7 above, in which con- sumers bought or “rented” the unit services of goods rather than the goods as a whole. In a free economy, of course, this hir- ing or renting must always occur in the case of labor services. ; i.e., he cannot The laborer, being a free man, cannot be bought be paid a cash value for his total future anticipated services, after which he is at the permanent command of his buyer. This would be a condition of slavery, and even “voluntary slavery,” as we have seen, cannot be enforced on the free market because of the inalienability of personal will. A laborer cannot be bought, then, services can be bought over a period of time; i.e., he can but his be rented or hired. 7. Present and Future Goods: The Pure Rate of Interest We are deferring until later the major part of the analysis of the pricing of productive services and factors. At this point we can see, however, that the purchasing of labor and land services are directly analogous. The classical discussion of productive income treats labor as earning wages whereas land earns rents,

414 349 Production: The Structure and the two are supposed to be subject to completely different laws. Actually, however, the earnings of labor and land services are analogous. Both are original and productive factors; and in the case in which land is hired rather than bought, both are rented per unit of time rather than sold outright. Generally, writers on economics have termed those capitalists “entrepre- neurs” who buy labor and land factors in expectation of a future monetary return from the final product. They are entre- preneurs, however, only in the actual economy of uncertainty. , where all the market actions are re- In an evenly rotating economy peated in an endless round and there is therefore no uncer- tainty, entrepreneurship disappears. There is no uncertain future to be anticipated and about which forecasts are made. To call these capitalists simply entrepreneurs, then, is tacitly to imply that in the evenly rotating economy there will be no capitalists, i.e., no group that saves money and hires the services of factors, thereby acquiring capital and consumers’ goods to be sold to the consumers. Actually, however, there is no reason why pure capitalists should not continue in the ERE (the evenly rotating economy). Even if final returns and consumer demand are cer- the capitalists are still providing present goods to the owners of tain, labor and land and thus relieving them of the burden of waiting until the future goods are produced and finally transformed into consumers’ goods. Their function, therefore, remains in the ERE to provide present goods and to assume the burden of waiting for future returns over the period of the production process. Let us assume simply that the sum the capitalists paid out was 95 ounces and that the final sale was for 100 ounces. The five ounces accruing to the capitalists is payment for their function of supplying present goods and waiting for a future return. In short, the capitalists, in year one, bought future goods for 95 ounces and then sold the transformed product in year present good. In other two for 100 ounces when it had become a words, in year one the market price of an anticipated (certain) income of 100 ounces was only 95 ounces. It is clear that this arises out of the universal fact of time preference and of the

415 Power and Market with Man, Economy, and State 350 resulting premium of a given good at present over the present acquisition. future of its prospect In the monetary economy, since money enters into all trans- actions, the discount of a future good against a present good can, in all cases, be expressed in terms of one good: money. This is so because the money commodity is a present good and because claims to future goods are almost always expressed in terms of future money income. The factors of production in our discussion have all been as- specific sumed to be purely to a particular line of production. When the capitalists have saved money (“money capital”), how- ever, they are at liberty to purchase factor services in any line of Money, the general medium of exchange, is precisely production. . If, for example, the saver sees that he can invest 95 nonspecific ounces in the aforementioned production process and earn 100 ounces in a year, whereas he can invest 95 ounces in some other process and earn 110 ounces in a year, he will invest his money in the process earning the greater return. Clearly, the line in which he will feel impelled to invest will be the line that earns him the greatest rate of return on his investment. The concept of rate of return is necessary in order for him to compare different potential investments for different periods of time and involving different sums of money. For any amount of money that he saves, he would like to earn the greatest amount of net return, i.e., the greatest rate of net return. The absolute amount of return has to be reduced to units of time, and this is done by determining the rate per unit of time. Thus, a return of 20 ounces on an investment of 500 ounces after two years is 2 percent per annum, while a return of 15 ounces on the same in- vestment after one year is a return of 3 percent per annum. After data work themselves out and continue without change, the rate of net return on the investment of money cap- in every line of production. If ital will, in the ERE, be the same capitalists can earn 3 percent per annum in one production process and 5 percent per annum in another, they will cease

416 Production: The Structure 351 investing in the former and invest more in the latter until the rates of return are uniform. In the ERE, there is no entrepre- neurial uncertainty, and the rate of net return is the pure exchange ratio between present and future goods. This rate of will be uni- return is the rate of interest . This pure rate of interest form for all periods of time and for all lines of production and 17 will remain constant in the ERE. Suppose that at some time the rates of interest earned are not uniform as between several lines of production. If capital- ists are generally earning 5 percent interest, and a capitalist is obtaining 7 percent in a particular line, other capitalists will enter this line and bid away the factors of production from him by raising factor prices. Thus, if a capitalist is paying factors 93 ounces out of 100 income, a competing capitalist can offer 95 ounces and outbid the first for the use of the factors. The first, then, forced to meet the competition of other capitalists, will have to raise his bid eventually to 95 (disregarding for simplic- ity the variation in percentages based on the investment figure rather than on 100). The same equalization process will occur, of course, between capitalists and firms within the same line of production—the same “industry.” There is always competitive pressure, then, driving toward a uniform rate of interest in the economy. This competition, it must be pointed out, does not take place simply between firms in the same industry or pro- ducing “similar” products. Since money is the general medium of exchange and can be invested in all products, this close com- petition extends throughout the length and breadth of the pro- duction structure. A fuller discussion of the determination of the rate of inter- est will take place in chapter 6 below. But one thing should here be evident. The classical writers erred grievously in their dis- cussion of the income-earning process in production. They be- lieved that wages were the “reward” of labor, rents the “reward” 17 The term “pure rate of interest” corresponds to Mises’ term “orig- inary rate of interest.” See Mises, Human Action , passim .

417 with Power and Market 352 Man, Economy, and State of land, and interest the “reward” of capital goods, the three supposedly co-ordinate and independent factors of production. But such a discussion of interest was completely fallacious. As not we have seen and shall see further below, capital goods are independently productive. They are the imputable creatures of land and labor (and time). Therefore, capital goods generate no interest income. We have seen above, in keeping with this anal- ysis, that as income accrues to the owners of capital goods no 18 . such If the owners of land and labor factors receive all the income (e.g., 100 ounces) when they own the product jointly, why do their owners consent to sell their services for a total of five ounces less than their “full worth”? Is this not some form of “exploitation” by the capitalists? The answer again is that the earn income from their possession of capital do not capitalists goods or because capital goods generate any sort of monetary income. The capitalists earn income in their capacity as pur- chasers of future goods in exchange for supplying present goods to own- ers of factors . It is this time element, the result of the various indi- not viduals’ time preferences, and the alleged independent pro- ductivity of capital goods, from which the interest rate and interest income arise. The capitalists earn their interest income, therefore, by sup- plying the services of present goods to owners of factors in ad- vance of the fruits of their production, acquiring their products at the later date when by this purchase, and selling the products . Thus, capitalists supply present goods they become present goods in exchange for future goods (the capital goods), hold the future goods, and have work done on them until they become present 18 Here the reader is referred to one of the great works in the history of economic thought, Eugen von Böhm-Bawerk’s Capital and Interest (New York: Brentano’s, 1922), where the correct theory of interest is outlined; in particular, the various false theories of interest are brilliantly dissected. This is not to say that the present author endorses all of Böhm-Bawerk’s theory of interest as presented in his Positive Theory of Capital .

418 353 Production: The Structure goods. They have given up money in the present for a greater sum of money in the future, and the interest rate that they have earned is the agio, or discount on future goods as compared with present goods, i.e., the premium commanded by present goods over future goods. We shall see below that this exchange rate between present and future goods is not only uniform in the production process, but throughout the entire market sys- tem. It is the “social rate of time preference.” It is the “price of time” on the market as the resultant of all the individual valua- tions of that good. How the agio, or pure interest rate, is determined in the particular time-exchange markets, will be discussed below. Here we shall simply conclude by observing that there is some agio which will be established uniformly throughout the economy and which will be the pure interest rate on the certain expecta- tion of future goods as against present goods. 8. Money Costs, Prices, and Alfred Marshall In the ERE, therefore, every good sold to consumers will sell at a certain “final equilibrium” price and at certain total sales. These receipts will accrue in part to capitalists in the form of interest income, and the remainder to owners of land and la- bor. The payments of income to the producers have also been popularly termed “costs.” These are clearly money costs, or money expenses, and obviously are not the same thing as “costs” in the psychic sense of subjective opportunity forgone. Money as well as (In the ERE, of course, ex costs may be ex ante. ex post ex post calculations are always the same.) However, the ante and two concepts become linked when psychic costs are appraised as much as possible in monetary terms. Thus, payment to factors may be 95 ounces and recorded as a cost, while the capitalist who earns an interest of five ounces considers 100 as an oppor- tunity cost, since he could have invested elsewhere and earned five (actually, a bit higher) percent interest.

419 with Power and Market 354 Man, Economy, and State If, money costs factor payments for the moment , we include as 19 and interest, then in the ERE, money costs equal total money sales for every firm in every line of production. A firm earns profits when its return is more than interest, suf- entrepreneurial fers entrepreneurial when its return is less. In our produc- losses tion process, consumers will pay 100 ounces (money sales), and money costs are 100 ounces (factor plus interest income) and there will be similar equality for all other goods and processes. What this means, in essence, is that there are no entrepreneur- ial profits or losses in the ERE, because there is no change of data or uncertainty about possible change. If total money sales equal total money costs, then it evidently follows that total money sales per unit sold will equal total money costs per unit sold. This follows from elementary rules of arithmetic. But the money sales per unit are equal to the of the good, by money price definition; while we shall call the total money costs per unit the of the good. It likewise follows, therefore, that average money cost price will equal average money cost for every good in the ERE . Strange as it may seem, a great many writers on economics have deduced from this a curious conclusion indeed. They have deduced that “in the long run” (i.e., in the ERE), the fact that costs costs equal sales or that “cost equals price” implies that . The price of the good discussed above is 100 determine price because the cost (average money cost) ounces per unit, allegedly is 100 ounces per unit. This is supposed to be the law of price determination “in the long run.” It would seem to be crystal clear, however, that the truth is precisely the reverse. The price 19 Strictly, this assumption is incorrect, and we make it in this section only for purposes of simplicity. For interest may be an opportunity cost for an individual investor, but it is not a money cost , nor is it an opportunity cost for the aggregate of capitalists. For the implications of this widely see André Gabor and I.F. Pearce, “The held error in economic literature, Place of Money Capital in the Theory of Production,” Quarterly Journal of Economics, November, 1958, pp. 537–57; and Gabor and Pearce, “A New Approach to the Theory of the Firm,” Oxford Economic Papers , Octo- ber, 1952, pp. 252–65.

420 Production: The Structure 355 of the final product is determined by the valuations and demands of the consumers, and this price . If determines what the cost will be the consumers value the product mentioned above so that its price is 50 ounces instead of 100 ounces, as a result, say, of a change in their valuations, then it is precisely in the “long run,” when the effects of uncertainty are removed, that “costs of pro- duction” (here, factor payment plus interest payment) will equal the final price. We have seen above how factor incomes are at the mercy of consumer demand and fluctuate according to that result of sales to consumers and demand. Factor payments are the Costs of production, then, do not determine the latter in advance. are at the mercy of final price, and not the other way around. It is ironic that it is precisely in the ERE that this causative phe- nomenon should be the clearest. For in the ERE we see quite evidently that consumers pay and determine the final price of the product; that it is through these payments and these payments alone that factors and interest are paid; that therefore the amount of the payments and the total “costs of production” are determined by price and not vice versa . Money costs are the op- posite of a basic, determining factor; they are dependent on the price of the product and on consumer demands. In the real world of uncertainty it is more difficult to see this, because factors are paid in advance of the sale of the product, since the capitalist-entrepreneurs speculatively advance money of being able to recoup their expectation to the factors in the money with a surplus for interest and profit after sale to the con- 20 sumers. Whether they do so or not depends on their foresight regarding the state of consumer demand and the future prices of consumers’ goods. In the real world of immediate market prices, of course, the existence of entrepreneurial profit and loss will always prevent costs and receipts, cost and price, from being identical, and it is obvious to all that price is solely determined by valuations of stock—by “utilities”—and not at all by money cost. But although most economists recognize that in the real 20 Cf. Menger, Principles of Economics , pp. 149 ff.

421 with Power and Market 356 Man, Economy, and State world (the so-called “short-run”) costs cannot determine price, they are seduced by the habit of the individual entrepreneur of dealing in terms of “cost” as the determining factor, and they apply this procedure to the case of the ERE and therefore to the inherent long-run tendencies of the economy. Their grave error, as will be discussed further below, comes from viewing the economy from the standpoint of an individual entrepreneur rather than from that of an economist. To the individual entre- preneur, the “cost” of factors is largely determined by forces outside himself and his own sales; the economist, however, must see how money costs are determined and, taking account of all the interrelations in the economy, must recognize that they are determined by final prices reflecting consumer demands and valuations. The source of the error will become clearer below when we consider a world of nonspecific as well as specific factors. How- ever, the essentials of our analysis and its conclusion remain the same in that more complex and realistic case. The classical economists were under the delusion that the price of the final product is determined by “costs of produc- tion,” or rather they fluctuated between this doctrine and the “labor theory of value,” which isolated the money costs of labor and picked that segment of the cost of production as the deter- minant of price. They slurred over the determination of the prices of such goods as old paintings that already existed and needed no further production. The correct relation between prices and costs, as outlined above, was developed, along with other outstanding contributions to economics, by the “Aus- trian” economists, including the Austrians Carl Menger, Eugen von Böhm-Bawerk, and Friedrich von Wieser, and the English- man W. Stanley Jevons. It was with the writings of the Austrian School in the 1870’s and 1880’s that economics was truly estab- 21 lished as a science. 21 The very interesting researches by Emil Kauder indicate that the essentials of the Austrian marginal utility theory (the basis of the view that

422 Production: The Structure 357 Unfortunately, in the science of economics, retrogression in knowledge has taken place almost as often as progression. The enormous advance provided by the Austrian School, on this point as on others, was blocked and reversed by the influence of Alfred Marshall, who attempted to rehabilitate the classicists and integrate them with the Austrians, while disparaging the contributions of the latter. It was unfortunately the Marshallian and not the Austrian approach that exerted the most influence over later writers. This influence is partly responsible for the cur- rent myth among economists that the Austrian School is effec- tively dead and has no more to contribute and that everything of lasting worth that it had to offer was effectively stated and inte- Principles grated in Alfred Marshall’s . Marshall tried to rehabilitate the cost-of-production theory of the classicists by conceding that, in the “short run,” in the immediate market place, consumers’ demand rules price. But in the long run, among the important reproducible goods, cost of production is determining. According to Marshall, both utility and money costs determine price, like blades of a scissors, but one blade is more important in the short run, and another in the long run. He concludes that as a general rule, the shorter the period we are consid- ering, the greater must be the share of our attention which is given to the influence of demand on value; and the longer the period, the more important will be the influence of cost of production on value. . . . The actual value at any time, the market value as it is often called, is often more influenced by passing events and price determines cost and not vice versa or mutually) had already been for- mulated by French and Italian economists of the seventeenth and eigh- teenth centuries and that the English classical school shunted economics onto a very wrong road, a road from which economics was extricated only by the Austrians. See Emil Kauder, “Genesis of the Marginal Utility The- ory,” Economic Journal, September, 1953, pp. 638–50; and Kauder, “Retarded Acceptance of the Marginal Utility Theory.”

423 with Power and Market 358 Man, Economy, and State by causes whose action is fitful and shortlived, than by those which work persistently. But in long periods these fitful and irregular causes in large measure efface one another’s influence; so that in the long run per- 22 sistent causes dominate value completely. The implication is quite clear: if one deals with “short-run” market values, one is being quite superficial and dwelling only on fitful and transient causes—so much for the Austrians. But if one wants to deal with the “really basic” matters, the really lasting and permanent causes of prices, he must concentrate on costs of pro- pace duction— the classicists. This impression of the Austrians— their alleged neglect of the “long period,” and “one-sided neglect of costs”—has been stamped on economics ever since. Marshall’s analysis suffers from a grave methodological defect—indeed, from an almost hopeless methodological con- fusion as regards the “short run” and the “long run.” He con- siders the “long run” as actually existing, as being the perma- nent, persistent, observable element beneath the fitful, basically unimportant flux of market value. He admits (p. 350) that “even the most persistent causes are, however, liable to change,” but far less likely to change than the he clearly indicates that they are fitful market values; herein, indeed, lies their long-run nature. He regards the long-run data, then, as underlying the transient market values in a way similar to that in which the basic sea level 23 For Marshall, then, underlies the changing waves and tides. the long-run data are something that can be spotted and marked by an observer; indeed, since they change far more slowly than the market values, they can be observed more accurately. Marshall’s conception of the long run is completely fallacious, and this eliminates the whole groundwork of his theoret ical 22 Alfred Marshall, Principles of Economics (8th ed.; London: Macmillan & Co., 1920), pp. 349 ff. 23 This analogy, though not used in this context, was often used by classical economists as applied to prices and “the price level,” an applica- tion equally erroneous.

424 Production: The Structure 359 structure. The long run, by its very nature, never does and never This does not mean that “long-run,” or ERE, analy- can exist. sis is not important. On the contrary, only through the con- cept of the ERE can we subject to catallactic analysis such crit- ical problems as entrepreneurial profit, the structure of pro- duction, the interest rate, and the pricing of productive factors. The ERE is the goal (albeit shifting in the concrete sense) toward which the market moves. But the point at issue is that it is not observable , or real, as are actual market prices. We have seen above the characteristics of the evenly rotat- ing economy. The ERE is the condition that comes into being and continues to obtain when the present, existing market data (valuations, technology, resources) remain constant. It is a theoretical construct of the economist that enables him to point out in what directions the economy tends to be moving at any given time; it also enables the economist to isolate various ele- ments in his analysis of the economy of the real world. To ana- lyze the determining forces in a world of change, he must con- struct hypothetically a world of nonchange. This is far different from, indeed, it is the reverse of, saying that the long run exists or that it is somehow more permanently or more persistently existent than the actual market data. The actual market prices, exist, and they are on the contrary, are the only ones that ever the resultants of actual market data (consumer demands, resources, etc.) that themselves change continually. The “long not more stable; its data necessarily change along with run” is the data on the market. The fact that costs equal prices in the “long run” does not mean that costs will actually equal prices, but that the tendency exists, a tendency that is continually being in reality by the very fitful changes in market data that disrupted 24 Marshall points out. 24 On this error in Marshall, see F.A. Hayek, The Pure Theory of Capital (Chicago: University of Chicago Press, 1941), pp. 21, 27–28. Marshall is here committing the famous fallacy of “conceptual realism,” in which theoretical constructs are mistaken for actually existing entities. For other

425 with Power and Market 360 Man, Economy, and State In sum, rather than being in some sense more persistent and more real than the actual market, the “long run” of the ERE is not real at all, but a very useful theoretical construct that en- ables the economist to point out the direction in which the mar- ket is moving at any given time—specifically, toward the elimi- nation of profits and losses if existing market data remain the same. Thus, the ERE concept is especially helpful in the anal- ysis of profits and losses as compared to interest. But the mar- ket data are the only actual reality. This is not to deny, and the Austrians never did deny, that subjective costs, in the sense of opportunity costs and utilities forgone, are important in the analysis of production. In partic- ular, the disutilities of labor and of waiting—as expressed in the time-preference ratios—determine how much of people’s ener- gies and how much of their savings will go into the production process. This, in the broadest sense, will determine or help to determine the total supply of all goods that will be produced. But these costs are themselves subjective utilities, so that both “blades of the scissors” are governed by the subjective utility of monistic and not a dualistic causal explana- individuals. This is a tion. The costs, furthermore, have no direct influence on the each good to be produced. Con- relative amount of the stock of How sumers will evaluate the various stocks of goods available. much productive energy and savings will go into producing stock of one particular good and how much into producing another, in other words, the relative stocks of each product, will depend in turn on entrepreneurial expectations of where the greatest monetary profit will be found. These expectations are based on the anticipated direction of consumer demand. nonspecific As a result of such anticipations, the factors will ceteris paribus , move to the production of those goods where, their owners will earn the highest incomes. An exposition of this process will be presented below. examples, cf. Leland B. Yeager, “Some Questions on Growth Econom- ics,” American Economic Review, March, 1954, p. 62.

426 Production: The Structure 361 Marshall’s treatment of subjective costs was also highly falla- cious. Instead of the idea of opportunity costs, he had the notion that they were “real costs” that could be added in terms of measurable units. Money costs of production, then, became the “necessary supply prices” that entrepreneurs had to pay in order “to call forth an adequate supply of the efforts and wait- ings” to produce a supply of the product. These real costs were then supposed to be the fundamental, persisting element that backstops money costs of production, and allowed Marshall to 25 talk of the more persisting, long-run, normal situation. Marshall’s great error here, and it has permeated the works of his followers and of present-day writers, is to regard costs and production exclusively from the point of view of an isolated in- dividual entrepreneur or an isolated individual industry, rather 26 than viewing the whole economy in all its interrelations. Marshall is dealing, of necessity, with particular prices of differ- ent goods, and he is attempting to show that alleged “costs of production” determine these prices in the long run. But it is completely erroneous to tie up particular goods with labor vs. leisure and with consuming vs. waiting costs, for the latter are phenomena, applying and diffusing throughout the only general entire economic system. The price necessary to call forth a non- specific factor is the highest price this factor can earn else- where—an opportunity cost. What it can attain elsewhere is basically determined by the state of consumer demand else- where. The forgone leisure-and-consumption costs, in general, 25 Marshall, Principles of Economics , pp. 338 ff. 26 We must hasten to point out that this is by no means the same criti- cism as the neo-Keynesian charge that economists must deal in broad aggregates, and not with individual cases. The latter approach is even worse, since it begins with “wholes” that have no basis in reality whatever. What we are advocating is a theory that deals with all the individuals as they interact in the economy. Furthermore, this is the “Austrian,” and not the Walrasian approach, which has recently come into favor. The latter deals with interrelations of individuals (“the general equilibrium approach”) but only in the ERE and with mathematical abstractions in the ERE.

427 Power and Market with Man, Economy, and State 362 only help to determine the size—the general stock—of labor and savings that will be applied to production. All this will be treated further below. 9. Pricing and the Theory of Bargaining We have seen that, for all goods, total receipts to sellers will tend to equal total payments to factors, and this equality will be established in the evenly rotating economy. In the ERE, inter- est income will be earned at the same uniform rate by capital- ists throughout the economy. The remainder of income from production and sale to consumers will be earned by the owners of the original factors: land and labor. Our next task will be to analyze the determination of the prices of factor services and the determination of the interest rate, as they tend to be approached in the economy and would be reached in the ERE. Until now, discussion has centered on it were in one compos- the capital-goods structure, treated as if ite stage of production. Clearly, there are numerous stages, but we have seen above that earnings in production ultimately resolve themselves, and certainly do so in the ERE, into the earnings of the original factors: land and labor. Later on, we many stages in shall expand the analysis to include the case of the production process, and we shall defend this type of tempo- ral analysis of production against the very fashionable current view that production is “timeless” under modern conditions and that the original-factor analysis might have been useful for the primitive era but not for a modern economy. As a corollary to this, we shall develop further an analysis of the nature of capital and time in the production process. What will be the process of pricing productive factors in a world of purely specific factors? We have been assuming that only and not whole goods can be acquired. In the case of services labor this is true because of the nature of the free society; in the case of land and capital goods, we are assuming that the capi- talist product-owners hire or rent rather than own any of the productive factors outright. In our example above, the 95

428 Production: The Structure 363 ounces went to all the factor-owners jointly. By what principles can we determine how the joint income is allocated to the vari- factor services? If all the factors are purely spe- ous individual theory of bar- cific, we can resort to what is usually called the two-person . We are in a very analogous situation to the gaining barter of chapter 2. For what we have is not relatively determi- nate prices, or proportions, but exchange ratios with wide zones between the “marginal pairs” of prices. The maximum price of one is widely separated from the minimum price of the other. In the present case, we have, say, 12 labor and land factors, each of which is indispensable to the production of the good. None of the factors, furthermore, can be used anywhere else, in any other line of production. The question for these factor- owners to solve is the proportionate share of each in the total joint income. Each factor-owner’s maximum goal is something slightly less than 100 percent of the income from the con- sumers. What the final decision will be cannot be indicated by praxeology. There is, for all practical purposes, no theory of bargaining; all that can be said is that since the owner of each factor wants to participate and earn some income, all will most likely arrive at some sort of voluntary contractual arrangement. This will be a formal type of partnership agreement if the fac- tors jointly own the product; or it will be the implicit result if a pure capitalist purchases the services of the factors. Economists have always been very unhappy about bargain- ing situations of this kind, since economic analysis is estopped from saying anything more of note. We must not pursue the temptation, however, to condemn such situations as in some way “exploitative” or bad, and thereby convert barrenness for eco- nomic analysis into tragedy for the economy. Whatever agree- ment is arrived at by the various individuals will be beneficial to 27 every one of them; otherwise, he would not have so agreed. 27 Little of value has been said about bargaining since Böhm-Bawerk. See Böhm-Bawerk, Positive Theory of Capital , pp. 198–99. This can be seen in J. Pen’s “A General Theory of Bargaining,” American Economic Review,

429 with Power and Market 364 Man, Economy, and State It is generally assumed that, in the jockeying for propor- tionate shares, labor factors have less “bargaining power” than land factors. The only meaning that can be seen in the term “bargaining power” here is that some factor-owners might have minimum reservation prices for their factors, below which they would not be entered in production. In that case, these factors at least would have to receive the minimum, while factors with no minimum, with no reservation price, would work even at an income of only slightly more than zero. Now it should be evi- minimum some dent that the owner of every labor factor has selling price, a price below which he will not work. In our case, where we are assuming (as we shall see, quite unrealistically) every that factor is specific, it is true that no laborer would be able to earn a return in any other type of work. But he could always enjoy leisure, and this sets a minimum supply price for labor service. On the other hand, the use of land sacrifices no leisure. Except in rare cases where the owner enjoys a valuable esthetic pleasure from contemplating a stretch of his own land not in use, there is no revenue that the land can bring him except a monetary return in production. Therefore, land has no reservation price, and the landowner would have to accept a return of almost zero rather than allow his land to be idle. The bargaining power of the owner of labor, therefore, is almost always superior to that of the owner of land. In the real world, labor, as will be seen below, is uniquely the factor, so that the theory of bargaining could never nonspecific 28 apply to labor incomes. Thus, when two or more factors are specific to a given line of production, there is nothing that economic analysis can say further about the allocation of the joint income from their March, 1952, pp. 24 ff. Pen’s own theory is of little worth because it rests explicitly on an assumption of the measurability of utility. Ibid ., p. 34 n. 28 Contrast the discussion in most textbooks, where bargaining occu- pies an important place in explanation of market pricing only in the dis- cussion of labor incomes.

430 Production: The Structure 365 product; it is a matter of voluntary bargaining between them. Bargaining and indeterminate pricing also take place even between two or more nonspecific factors in the rare case where the proportions in which these factors be used are must identical in each employment. In such cases, also, there is no determinate pricing for any of the factors separately, and the result must be settled by mutual bargaining. Suppose, for example, that a certain machine, containing two necessary parts, can be used in several fields of production. The two parts, however, must always be combined in use in a certain fixed proportion. Suppose that two (or more) individu- als owned these two parts, i.e., two different individuals pro- duced the different parts by their labor and land. The combined machine will be sold to, or used in, that line of production where it will yield the highest monetary income. But the price that will be established for that machine will necessarily be a cumulative price so far as the two factors—the two parts—are concerned. The price of each part and the allocation of the income to the two owners must be decided by a process of bar- gaining. Economics cannot here determine separate prices. This is true because the proportions between the two are always the same, even though the combined product can be used in 29 several different ways. Not only is bargaining theory rarely applicable in the real world, but zones of indeterminacy between valuations, and therefore zones of indeterminacy in pricing, tend to dwindle radically in importance as the economy evolves from barter to an advanced monetary economy. The greater the number and variety of goods available, and the greater the number of people with differing valuations, the more negligible will zones of inde- 30 terminacy become. 29 See Mises, Human Action , p. 336. 30 Any zone of indeterminacy in pricing must consist of the coinci- dence of an absolutely vertical supply curve with an absolutely vertical market demand curve for the good or service, so that the equilibrium price

431 with Power and Market 366 Man, Economy, and State At this point, we may introduce another rare, explicitly empirical, element into our discussion: that on this earth, labor has been a far scarcer factor than land. As in the case of Crusoe, so in the case of a modern economy, men have been able to choose which land to use in various occupations, and which to leave idle, and have found themselves with idle “no-rent” land, i.e., land yielding no income. Of course, as an economy advances, and population and utilization of resources grow, there is a tendency for this superfluity of land to diminish (bar- ring discoveries of new, fertile lands). is in a zone rather than at a point. As Hutt states, “It depends entirely upon the fortuitous coincidence of . . . an unusual and highly improbable demand curve with an absolutely rigid supply curve.” W.H. Hutt, The Theory of Collective Bargaining (Glencoe, Ill.: The Free Press, 1954), pp. 90, and 79–109.

432 6 : RODUCTION P T NTEREST I AT E O F R HE I ETERMINATION D TS AND 1 1. Many Stages: The Pure Rate of Interest been tr eating the structure of pro- U P TO THIS POINT WE HAVE stage. One or several firms duction as amalgamated into one all the stages of production of vertically integrating have all been a product (with all factors specific), until finally the product is sold to the consumer. This is certainly an unrealistic assump- tion. We shall now consider the production situation in the real ) factors are nonspecific as well as specific, and world, where ( a ) production is divided into numerous stages, as the factors ( b continue to work and advance from the higher to the lower 2 Instead of assuming that one stages of the production process. firm—one set of capitalists—purchases factors and retains own- ership of the product up through the sale to consumers, let us suppose that there are different firms and different sets of capi- talists at defin ite intervals, and at each interval the product, in 1 The discussion in this chapter deals with the pure rate of interest, as determined by time preference. On the role of the purchasing-power component in the market rate of interest, cf. chapter 11 on money. 2 On production theory and stages of production, see the important (2nd ed.; London: Prices and Production works of F.A. Hayek, particularly Routledge and Kegan Paul, 1935); and Profits, Interest, and Investment (London: Routledge and Kegan Paul, 1939). 367

433 with Power and Market 368 Man, Economy, and State the stage it has reached up to that point, is sold for money to another capitalist or group of capitalists. It is not necessary to make any restrictive assumptions about how many separate stages occur or what the time intervals between individual stages might be. For purposes of convenience, let us return to our example and the diagram in Figure 40. We shall assume that exchanges of product and service take place at each line marked on the diagram. We shall further assume, for convenience only, that each stage takes the same length of time. Now, instead of collecting interest income for services in one lump sum at the final stage, the capitalist or capitalists acquire 3 If each stage takes one year, then interest income at each stage . the entire production process for the good takes six years. When the stages are all lumped together, or vertically inte- grated, then one capitalist (or set of capitalists) advances the owners of original factors their money six years ahead of time and then waits for this period to acquire his revenue. (Strictly, since the work and pay of labor and land would be continual as the product advanced to its final form, the earliest hired labor and land would be paid, say, in year one, and the latest toward the end of year six.) With separate stages, however, each capi- talist advances the money for only one year. Let us see the picture on a diagram (Figure 41). We must modify the previous diagram somewhat. A lower bar of 100 ounces is added, and the interest income that accrues to the cap- italist at this lowest stage is indicated by an arrow going off to the left side. The upward arrow then represents the amount going to owners of original factors, land and labor, at this stage, and the shaded area the amount going to owners of capital- goods factors of a higher rank, i.e., intermediate products. The diagram in Figure 40 did not depict interest income, but simply presented all income as going to the owners of original factors; the time element had not yet been introduced into our discus- sion. 3 Cf. Böhm-Bawerk, Positive Theory of Capital , pp. 304–05, 320.

434 369 Production: The Rate of Interest and Its Determination Income to Land and Labor 83 ounces Interest Income 17 ounces 19 ounces 6 20 20 1 8 5 2 30 30 13 4 45 2 45 12 3 60 60 3 16 2 4 80 15 1 5 100 ounces C 100 ounces Consumer Expenditure F F IGURE NCOME CCRUING TO 41. I ACTORS A V S TAGES OF P RODUCTION ARIOUS AT The structure of production and payment depicted in this basic diagram is as follows: Consumers spend 100 ounces on the good in question. Of the 100 ounces, five ounces go as interest income to the sellers of the consumers’ good, and 95 are paid out to the owners of factors. In our example, 15 ounces go for the use of land and labor (original) factors, and 80 go into the purchase of factor services of capital goods of a higher order. At the second stage, capitalists receive 80 ounces in revenue from the sale of their product. Of the 80 ounces, 16 go into the purchase of land and labor factors, and four accrue as interest income to the second-level capitalists. The remaining 60 are used for the purchase of higher-order capital goods. The same process is repeated until, on the highest stage, the highest-order capitalists receive 20 ounces of revenue, retain one for themselves, and pay out 19 to land and labor factors. The sum total of income to land and labor factors is 83 ounces; total interest income is 17 ounces.

435 with Power and Market 370 Man, Economy, and State In the foregoing section on interest we showed that money is always nonspecific, and the result is that in the ERE the inter- est return on monetary investment (the pure rate of interest) is the same everywhere in the economy, regardless of the type of product or the specific conditions of its production. Here we Not only must the interest see an amplification of this principle. rate be uniform for each good; it must be uniform for every stage of every good. In our diagram, the interest-rate return received by product-owners, i.e., by capitalists, is equal at each stage. At the lowest stage, producers have invested 95 ounces in factors (both capital goods and original factors) and receive 100 ounces from consumers—a net income of five ounces. This represents a 5 /95 , or approximately 5.2 percent. return on the investment of In the ERE, which we are considering, there are no profits or losses due to uncertainty, so that this return represents the rate 4 The capitalist at the next higher stage invests of pure interest. 60 plus 16 or 76 ounces in factors and receives a net return of four ounces, again approximately 5.2 percent. And so on for each stage of investment, where, except for the vagaries of the arithmetic in our example, the interest rate is uniform for each stage. At the highest stage, the capitalist has invested 19 ounces in land and labor, and receives a net return of one, again about 5.2 percent. The interest rate must be equal for each stage of the produc- tion process. For suppose that the interest rate were higher in the higher stages than in the lower stages. Then capitalists would abandon producing in the lower stage, and shift to the higher stage, where the interest return is greater. What is the effect of such a shift? We can answer by stressing the implications of differences in the interest rate. A higher interest rate in stage price spread between the sum A B means that the than in stage 4 In the ERE of our example, the pure rate of interest is the rate of interest, since, as we shall see, deviations from the pure rate are due solely to uncertainty.

436 Production: The Rate of Interest and Its Determination 371 of factors entering into stage A and the selling price of its prod- is greater uct, , in percentage terms, than the price spread in B stage . Thus, if we compare stage four and stage one in the dia- gram in Figure 41, we find a price spread of 43 to 45 in the for- mer case, and 95 to 100 in the latter, for a net interest return of approximately 5.2 percent in each. Let us suppose, however, that the sum of the factor prices 35 instead of for stage four is 43, while the sum of factor prices in stage one is 98. (The sum of factor prices here excludes interest income, of course.) Capi- talists investing in stage four would earn a net return of 8, or 23 percent, while investors in stage one earned about 2 percent. Capitalists would begin to stop investing in stage one and shift to stage four. As a consequence of this shifting, the aggregate demand in stage one for its factors diminishes, and the prices of the factors used in stage one therefore decline. In the mean- while, greater investment in stage four raises factor prices there, so that the cumulative price rises from 35. Products of stage four increase, and the increased supply lowers the selling price, which falls from 43. These arbitrage actions continue until the percentage spread in each of the two stages is equal. interest rate is equal to the It is important to realize that the rate of price spread in the various stages . Too many writers consider the rate of interest as only the price of loans on the loan mar- ket. In reality, as we shall see further below, the rate of interest pervades all time markets, and the productive loan market is a 5 strictly subsidiary time market of only derivative importance. 5 In the reams of commentary on J.M. Keynes’ General Theory , no one has noticed the very revealing passage in which Keynes criticizes Mises’ discussion of this point. Keynes asserted that Mises’ “peculiar” new the- ory of interest “confused” the “marginal efficiency of capital” (the net rate of return on an investment) with the rate of interest. The point is that the “marginal efficiency of capital” is indeed the rate of interest! It is a price on the time market. It was precisely this “natural” rate, rather than the loan rate, that had been a central problem of interest theory for many years. The essentials of this doctrine were set forth by Böhm-Bawerk in Capital and Interest and should therefore not have been surprising to Keynes. See

437 with Power and Market 372 Man, Economy, and State Not only will the rate of interest be equal in each stage of any given product, but the all rate of interest will prevail in same stages of products in the ERE. In the real world of uncer- all tainty, the of entrepreneurial actions is always in the tendency direction of establishing a uniform rate of interest throughout all time markets in the economy. The reason for the uniformity earns 8 percent and stage one is clear. If stage three of good X earns 2 percent, capitalists will tend to cease invest- of good Y ing in the latter and shift to greater investments in the former. The price spreads change accordingly, in response to the chang- ing demands and supplies, and the interest rates become uni- form. We may now remove our restrictive assumption about the equality of duration of the various stages. Any stage of any product may be as long or as short as the techniques of pro- duction, and the organizational structure of industry require. Thus, a technique of production might require a year’s harvest for any particular stage. On the other hand, a firm might “ver- tically integrate” two stages and advance the money to owners of factors for the period covering both stages before selling the product for money. The net return on the investment in any stage will adjust itself in accordance with the length of the stage. Thus, suppose that the uniform interest rate in the econ- omy is 5 percent. This is 5 percent for a certain unit period of time, say a year. A production process or investment covering a period of two years will, in equilibrium, then earn 10 percent, the equivalent of 5 percent . The same will obtain for a per year Thus, irregularity or stage of production of any length of time. integration of stages does not hamper the equilibrating process in the slightest. John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt, Brace & Co., 1936), pp. 192–93. It is pre- cisely this preoccupation with the relatively unimportant problems of the loan market that constitutes one of the greatest defects of the Keynesian theory of interest.

438 373 Production: The Rate of Interest and Its Determination It is already clear that the old classical trinity of “land, labor, and capital” earning “wages, rents, and interest” must be dras- not tically modified. It is true that capital is an independent pro- ductive factor or that it earns interest for its owner, in the same way that land and labor earn income for their owners. As we have seen above and will discuss further below, capital is not an independently productive factor. Capital goods are vital and of crucial importance in production, but their production is, in the long run, imputable to land, labor, and time factors. Further- more, land and labor are not homogeneous factors within them- types selves, but simply categories of of uniquely varying factors. Each land and each labor factor, then, has its own physical fea- tures, its own power to serve in production; each, therefore, re- ceives its own income from production, as will be detailed below. Capital goods too have infinite variety; but, in the ERE, they earn no incomes. What does earn an income is the con- version of future goods into present goods; because of the uni- versal fact of time preference, future satisfactions are always at a discount compared to present satisfactions. The owning and holding of capital goods from date one, when factor services are purchased, until the product is sold at date two is what capital- ist investors accomplish. This is equivalent to the purchase of future goods (the factor services producing capital goods) with money, followed by the sale at a later date of the present goods for money. The latter occurs when consumers’ goods are being are present goods. When intermedi- sold, for consumers’ goods ate, lower-order capital goods are sold for money, then it is not goods, that are sold. In less distantly future present goods, but other words, capital goods have been advanced from an earlier, more distantly future stage toward the consumption stage, to a stage. The time for this transforma- later or less distantly future tion will be covered by a rate of time preference. Thus, if the market time preference rate, i.e., interest rate, is 5 percent per year, then a present good worth 100 ounces on the market will be worth about 95 ounces for a claim on it one year from now. The present value for a claim on 100 ounces one year from now

439 with Power and Market 374 Man, Economy, and State will be 95 ounces. On this basis, the estimated worth of the good could be worked out for various points in time; thus, the claim for one-half year in the future will be worth roughly 97.5 ounces. The result will be a uniformity of rates over a period of time. Thus, capitalists advance present goods to owners of factors in return for future goods; then, later, they sell the goods which have matured to become present or less distantly future goods in exchange for present goods (money). They have advanced present goods to owners of factors and, in return, wait while these factors, which are future goods, are transformed into more nearly present goods that are than before. The capitalists’ function, and their income is precisely an function is thus a time income representing the agio of present as compared to future derived from the con- goods. This interest income, then, is not goods , but from the generalized crete, heterogeneous capital 6 investment of time. It comes from a willingness to sacrifice present goods for the purchase of future goods (the factor serv- ices). As a result of the purchases, the owners of factors obtain their money in the present for a product that matures only in the future. Thus, capitalists restrict their present consumption and use these of money to supply money (present goods) to fac- savings tor owners who are producing only future goods. This is the service—an advance of time—that the capitalists supply to the owners of factors, and for which the latter voluntarily pay in the form of the interest rate. 6 As Böhm-Bawerk declared: Interest . . . may be obtained from any capital, no matter what be the kind of goods of which the capital consists: from goods that are barren as well as from those that are naturally fruitful; from perishable as well as from durable goods; from goods that can be replaced and from goods that cannot be replaced; from money as well as from com- modities. (Böhm-Bawerk, Capital and Interest , p. 1)

440 Production: The Rate of Interest and Its Determination 375 2. The Determination of the Pure Rate of Interest: 7 The Time Market It is clear that the rate of interest plays a crucial role in the system of production in the complex, monetary economy. How pure rate of interest, with is the rate of interest determined? The which we are now concerned, we have seen will tend to be equal throughout all stages of all production processes in the econ- omy and thus will be uniform in the ERE. The level of the pure rate of interest is determined by the market for the exchange of present goods against future goods, a market which we shall see permeates many parts of the economic system. The establishment of money as a gen- eral medium of exchange has greatly simplified the present- future market as compared to the laborious conditions under barter, where there were separate present-future markets for every commodity. In the monetary economy, the present- future market, or what we may call the “time market,” is expressed completely in terms of money. Money is clearly the . For, aside from the consumption present good par excellence value of the monetary metal itself, the money commodity is the one completely marketable good in the entire society. It is the open sesame to exchange for consumption goods at any time that its owner desires. It is therefore a present good. Since consumers’ goods, once sold, do not ordinarily re-enter the exchange nexus, money is the dominant present good in the market. Furthermore, since money is the medium for all exchanges, it is also the medium for exchanges on the time market. What are the future goods that exchange for money? Future goods are goods that are now expected to become present goods at some They therefore have a present value. Because of the future date. universal fact of time preference, a particular good is worth more 7 Cf. Mises, Human Action , pp. 521–42.

441 Power and Market with Man, Economy, and State 376 of its becoming available as at present than is the present prospect a present good at some time in the future. In other words, a good at present is worth more now than its present value as a future good. Because money is the general medium of exchange, for the time market as well as for other markets, money is the present are present expectations of the future good, and the future goods acquisition of money. It follows from the law of time preference that present money is worth more than present expectations of the same In other words, future money (as we may amount of future money. call present expectations of money in the future) will always exchange at a discount compared to present money. This discount on future goods as compared with present goods (or, conversely, the premium commanded by present goods over future goods) is the rate of interest. Thus, if, on the time market, 100 ounces of gold exchange for the prospect of obtaining 105 ounces of gold one year from now, then the rate of interest is approximately 5 percent per annum. This is the time-discount rate of future to present money. What do we mean specifically by “prospects for obtaining money in the future”? These prospects must be carefully anal- yzed in order to explain all the causal factors in the determina- tion of the rate of interest. In the first place, in the real world, these prospects, like any prospects over a period of time, are uncertain always more or less . In the real world this ever present uncertainty necessarily causes interest and profit-and-loss ele- ments to be intertwined and creates complexities that will be analyzed further below. In order to separate the time market from the entrepreneurial elements, we must consider the cer- tain world of the evenly rotating economy, where anticipations are all fulfilled and the pure rate of interest is equal throughout pure rate of interest will then be the going the economy. The rate of time discount, the ratio of the price of present goods to that of future goods. What, then, are the specific types of future goods that enter written the time market? There are two such types. One is a

442 377 Production: The Rate of Interest and Its Determination claim to a certain amount of money at a future date. The exchange on the time market in this case is as follows: A gives money to B in exchange for a claim to future money. The term generally used to refer to A, the purchaser of the future money, is “lender,” or “creditor,” while B, the seller of the future money, is termed credit transac- the “borrower” or “debtor.” The reason is that this , as contrasted to a in the cash tion transaction, remains unfinished buys a suit for cash, he transfers money in present. When a man exchange for the suit. The transaction is finished. In a credit transaction he receives simply a written I.O.U., or note, en- titling him to claim a certain amount of money at a future date. The transaction remains to be completed in the future, when B, the borrower, “repays the loan” by transferring the agreed money to the creditor. Although the loan market is a very conspicuous type of time transaction, it is by no means the only or even the dominant one. There is a much more subtle, but more important, type of transaction which permeates the entire production system, but which is not often recognized as a time transaction. This is the purchase of producers’ goods and services, which are trans- formed over a period of time, finally to emerge as consumers’ goods. When capitalists purchase the services of factors of shall later see, the factors themselves), production (or, as we they are purchasing a certain amount and value of net produce, present value of that produce. For the land, discounted to the labor, and capital services purchased are , to be trans- future goods formed into final form as present goods . Suppose, for example, that a capitalist-entrepreneur hires labor services, and suppose that it can be determined that this amount of labor service will result in a net revenue of 20 gold ounces to the product-owner. We shall see below that the serv- ice will tend to be paid the net value of its product; but it will earn its product discounted by the time interval until sale. For if the labor service will reap 20 ounces five years from now, it is obvious that the owner of the labor cannot expect to receive from the capitalist the full 20 ounces now , in advance. He will

443 Power and Market with Man, Economy, and State 378 receive his net earnings discounted by the going agio, the rate of interest. And the interest income will be earned by the capi- talist who has assumed the task of advancing present money. The capitalist then waits for five years until the product matures before recouping his money. The pure capitalist, therefore, in performing a capital- advancing function in the productive system, plays a sort of intermediary role. He sells money (a present good) to factor- owners in exchange for the services of their factors (prospective future goods). He holds these goods and continues to hire work on them until they have been transformed into consumers’ goods (present goods), which are then sold to the public for money (a present good). The premium that he earns from the sale of present goods, compared to what he paid for future earned on the exchange. goods, is the rate of interest The time market is therefore not restricted to the loan market. It permeates the entire production structure of the complex economy. All productive factors are future goods: they provide for their owner the expectation of being advanced toward the final goal of consumption, a goal which provides the raison d’être for the whole productive enterprise. It is a time market where the future goods sold do not constitute a credit transaction, as in the case of the loan market. The transaction is complete in itself and needs no further payment by either party. In this case, the buyer of the future goods—the capitalist—earns his income through transforming these goods into present goods, rather than through the presentation of an I.O.U. claim on the origi- nal seller of a future good. The time market, the market where present goods exchange for future goods, is, then, an aggregate with several component parts. In one part of the market, capitalists exchange their money savings (present goods) for the services of numerous factors (future goods). This is one part, and the most important part, of the time market. Another is the consumers’ loan mar- ket, where savers lend their money in a credit transaction, in

444 379 Production: The Rate of Interest and Its Determination exchange for an I.O.U. of future money. The savers are the suppliers of present money, the borrowers the suppliers of future money, in the form of I.O.U.’s. Here we are dealing only with those who borrow to spend on consumption goods, and not with producers who borrow savings in order to invest in production. For the borrowers of savings for production loans are not independent forces on the time market, but rather are completely dependent on the interest agio between present and future goods as determined in the production system, equaling the ratio between the prices of consumers’ and producers’ goods, and between the various stages of producers’ goods. This dependence will be seen below. 3. Time Preference and Individual Value Scales Before considering the component parts of the time market further, let us go to the very root of the matter: the value scale of the individual. As we have seen in the problem of pricing and demand, the individual’s value scale provides the key to the determination of all events on the market. This is no less true in regard to the interest rate. Here the key is the schedule of time-preference valuations of the individual. Let us consider a hypothetical individual, abstracting from any particular role that he may play in the economic system. This individual has, of necessity, a diminishing marginal utility of money, so that each additional unit of money acquired ranks lower on his value scale. This is necessarily true. Conversely, and this also follows from the diminishing marginal utility of money, each successive unit of money given up will rank higher on his value scale. The same law of utility applies to future money, i.e., to prospects of future money. To both present money and future money there applies the general rule that less of it. We may more of a good will have greater utility than illustrate these general laws by means of the following hypo- thetical value scale of an individual:

445 Power and Market with 380 Man, Economy, and State John Smith ... (19 oz. future) (10 yrs. from now) ... 4th unit of 10 oz. ... (18 oz. future) ... (17 oz. future) ... (16 oz. future) ... 3rd unit of 10 oz. ... (15 oz. future) ... (14 oz. future) ... (13 oz. future) ... 2nd unit of 10 oz. ... (12 oz. future) ... 1st unit of 10 oz. ... (11 oz. future) ... (1st added unit of 10 oz.) ... (2nd added unit of 10 oz.) ... (10 oz. future) We see in this value scale an example of the fact that all possible alternatives for choice are ranged in one scale, and the truths of the law of utility are exemplified. The “1st unit of 10 oz.” refers to the rank accorded to the first unit of 10 ounces (the unit arbi- trarily chosen here) to be given up. The “2nd unit of 10 ounces” of money to be given up is accorded higher rank, etc. The “1st added unit of 10 oz.” refers to the rank accorded to the next unit of 10 ounces which the man is considering acquiring, with paren- theses to indicate that he does not now have the good in his pos- session. Above we have a schedule of John Smith’s value scale with respect to time, i.e., his scale of time preferences. Suppose that the market rate of interest, then, is 3 percent; i.e., he can ob- tain 13 ounces of future money (considered here as 10 years from now), by selling 10 ounces of present money. To see what he will do, we are privileged to be able to consult his time-pref- erence scale. We find that 13 ounces of future money is pre- ferred to his first unit of 10 ounces and also to the second unit of 10 ounces, but that the third unit of 10 ounces stands higher in his valuation. Therefore, with a market rate of 3 percent per

446 Production: The Rate of Interest and Its Determination 381 ual will save 20 ounces of gold and sell them for year, the individ future money on the time market. He is a supplier of present 8 goods on the time market to the extent of 20 ounces. If the market rate of interest is 2 percent, so that 12 future ounces would be the price of 10 present ounces, then John Smith would be a supplier of 10 ounces of present money. He is supplier of future money never a because, in his particular case, there are no quantities of future money above 10 ounces that are ranked below “1st added unit of 10 oz.” Suppose, for example, that James Robinson has the following time-value scale: James Robinson ... (19 oz. future) (10 yrs. from now) ... 2nd unit of 10 oz. ... (18 oz. future) ... (17 oz. future) ... 1st unit of 10 oz. ... (16 oz. future) ... (15 oz. future) ... (14 oz. future) ... (1st added unit of 10 oz.) ... (13 oz. future) ... (12 oz. future) ... (2nd added unit of 10 oz.) ... (11 oz. future) ... (3rd added unit of 10 oz.) ... (10 oz. future) 8 This is a highly simplified portrayal of the value scale. For purposes of exposition, we have omitted the fact that the unit of 13 added second future ounces will be worth less than the first, the third unit of 13 less than the second, etc. Thus, in actuality, the demand schedule of future goods will be lower than portrayed here. However, the essentials of the analysis are unaffected, since we can assume a demand schedule of any size that we wish. The only significant conclusion is that the demand curve is shaped so that an individual demands more future goods as the market rate of interest rises, and this conclusion holds for the actual as well as for our simplified version.

447 Power and Market with 382 Man, Economy, and State If the market rate of interest is 3 percent, then Robinson’s valu- ations are such that no savings will be supplied to the time mar- is lower than “1st added ket. On the contrary, 13 ounces future unit of 10 oz.,” which means that Robinson would be willing to exchange 13 ounces of future money for 10 ounces of present money. Thereby he becomes, in contrast to Smith, a supplier of future money. If the rate of interest were 1 percent, then he would supply 22 ounces of future money in exchange for 20 ounces of present money, thus increasing his demand for pres- ent money at the lower price. It will be noticed that there is no listing for less than 10 ounces of future goods, to be compared with 10 ounces of pres- ent goods. The reason is that every man’s time preference is pos- itive, i.e., one ounce of present money will always be preferred to one ounce or less of future money. Therefore, there will never be any question of a zero or negative pure interest rate. Many economists have made the great mistake of believing that the interest rate determines the time-preference schedule and rate of savings, rather than vice versa . This is completely invalid. The interest rates discussed here are simply hypothetical schedules, and they indicate and reveal the time-preference schedules of each individual. In the aggregate, as we shall see presently, the interaction of the time preferences and hence the supply- demand schedules of individuals on the time market determine the pure rate of interest on the market. They do so in the same way that individual valuations determine aggregate supply and demand schedules for goods, which in turn determine market prices. And once again, it is utilities and utilities alone, here in the form of time preferences, that determine the market result; the explanation does not lie in some sort of “mutually determin- ing process” of preferences and market consequences. Continuing with our analysis, let us tabulate the schedules of John Smith and James Robinson, from their time-value scales above, in relation to their position on the time market. John Smith’s schedule is given in Table 11. James Robinson’s schedule is given in Table 12.

448 Production: The Rate of Interest and Its Determination 383 ABLE 11 T P UPPLY OF UPPLY OF F UTURE RESENT S S ONEY = D EMAND M = D ONEY EMAND M UTURE FOR P RESENT F NTEREST I FOR AT E M ONEY = S AVINGS M ONEY R % . OF G OLD OZ . OF G OLD OZ 9 . . . . . . 0 40 30 8 . . . . . . 0 7 . . . . . . 30 0 6 . . . . . . 30 0 20 5 . . . . . . 0 4 . . . . . . 20 0 3 . . . . . . 20 0 2 . . . . . . 10 0 1 . . . . . . 0 0 T ABLE 12 UPPLY OF RESENT S UPPLY OF F UTURE S P ONEY = D EMAND M ONEY = D EMAND M I NTEREST F UTURE FOR P RESENT FOR R M ONEY = S AVINGS M ONEY AT E % OZ . OF G OLD OZ . OF G OLD 9 . . . . . . 20 0 10 0 8 . . . . . . 7 . . . . . . 0 10 6 . . . . . . 0 0 5 . . . . . . 0 0 4 . . . . . . 0 0 3 . . . . . . 0 10 2 . . . . . . 0 10 1 . . . . . . 0 20

449 with Power and Market 384 Man, Economy, and State The Robinson time schedule is of particular interest. Refer- ring to his time-value scale, we find that at an interest rate of 9 percent, 19 ounces of future money is above the second unit of 10 ounces of present money and therefore also above the first unit. At this interest rate, his supply of present money on the time market, i.e., his savings, equals 20 ounces. Because his valu- ation of the first unit (of 10 ounces—an arbitrary size of unit that we have picked for this discussion) is between 16 and 17 ounces of future money, when the market interest rate is 6 percent, his return of 16 ounces is less valuable to him than his first unit. Therefore, he will not be a saver and supplier of present money at this rate. On the other hand, he will not be a supplier of future goods (i.e., a demander of present goods on the time market) either. In order to be a supplier of future goods, his valuation of the future money that he would have to give up at the ruling rate of interest has to be lower than the present money that he would get. In other words, what he gives up in prospective future money will have to be worth less to him than the utility of the “1st additional unit of 10 oz.” on his scale. While the market rate is in the 4-percent to 6-percent range, this will not be true, for the 14 to 16 ounces of future money that he would have to sup- ply would be worth more to him than the additional 10 ounces of present money that he would gain from the exchange. In Robinson’s case, the critical point takes place when the hypo- thetical interest rate drops to 3 percent, for 13 future ounces are worth less than an additional 10 ounces of present money, and he will supply the future ounces on the market. If the interest rate 9 were 1 percent, he would supply 20 ounces of future goods. It should be evident that an individual, at any one time, will either be a net saver (i.e., a net demander of future goods), a net supplier of future goods, or not be on the time market at all. The three categories are mutually exclusive. 9 The reader may drop the parentheses around the future moneys at the lower end of the value scale, for Robinson is considering supplying them as well as demanding them.

450 385 Production: The Rate of Interest and Its Determination The diagram in Figure 42 sketches the schedules of Smith and Robinson in graphic form. Interest rate is on the vertical axis, and money on the horizontal. The supplies of present goods are also demands for future goods, and the demand for present goods is also the supply of future goods. We cannot compare utilities or values between persons, but we certainly may say that Robinson’s time-preference schedule is higher than Smith’s. In other words, it cannot make sense to compare the rankings or utilities that the two men accord to any particular unit of a good, but we can (if we know them) compare their schedules based purely on their demonstrated time preferences. Robinson’s time-preference schedule is than Smith’s, i.e., at each hypothetical rate of interest higher Robinson’s values are such that he will part with less of his 10 present goods in exchange for future goods. 10 In the same way, though we cannot compare utilities, we can com- pare (if we know them) individual demand schedules for goods.

451 with Power and Market 386 Man, Economy, and State Let us explore the typical individual time-preference sched- ule, or time-supply-and-demand schedule, more closely. In the first place, there is no necessity for the unit chosen to be 10 of goods, it is divisible ounces. Since money is perhaps the most possible to break down the units into far smaller sizes. Further- more, because of the arbitrage of the market, the rate of inter- est return on investments of present in future goods will be equal for all the various sizes of units. We may therefore visual- ize a comparatively smooth curve, even for each individual. One inevitable characteristic of an individual’s time-prefer- ence schedule is that eventually, after a certain amount of pres- ent money has been supplied on the market, no conceivable interest rate could persuade him to purchase more future goods. The reason is that as present money dwindles and future money increases in a man’s possession, the marginal utility of the for- mer increases on the man’s value scale, and the marginal utility of the latter decreases. In particular, every man must consume in the present, and this drastically limits his savings regardless of the interest rate. As a result, after a certain point, a man’s time preference for the present becomes infinite, and the line repre- senting his supply of present goods becomes vertical upward. At the other end of the scale, the fact of time preference will imply that at some minimum rate of interest the man will not save at all. At what point the supply curve hits the vertical axis depends on the valuations of the individual; but it must do so, as a result of the operation of the law of time preference. A man could not prefer 10 ounces or even less of future money to 10 ounces of 11 present money. 11 It is not valid to object that some might prefer to use the money in the future rather than in the present. That is not the issue here, which is one of availability for use. If a man wants to “save” money for some future use, he may “hoard” it rather than spend it on a future good, and thus have it always available. We have abstracted from hoarding, which will be dealt with in the chapter on money; it would have no place, anyway, in the evenly rotating world of certainty.

452 387 Production: The Rate of Interest and Its Determination What happens after the individual supply curve hits the ver- tical axis depends entirely on the time preferences of the indi- vidual. In some cases, as in that of John Smith above, the per- son’s marginal utility of money falls too fast, as compared with that of future money, for him to participate as a net demander of present goods at low rates of interest. In other words, Smith’s time-preference ratio is too low in this area for him to become a demander of present goods and a supplier of future goods. On the other hand, Robinson’s higher schedule of time preferences is such that, at low rates of interest, he becomes a supplier of future goods for present goods. (See Figure 42.) We may of course, diagram a typical individual’s supply and demand curve conventionally, as we have done in Figure 42. On the other hand, we may also modify this diagram, so as to make one continuous curve of the individual’s activity on the time mar- ket. We may call this curve the “individual’s time-market curve.” At higher interest rates, down to where it hits the vertical axis, this curve is simply the individual’s supply curve of present goods. But below this, we are reversing his demand curve and continu- ing it on to the left on the horizontal axis. (See Figure 43.)

453 Power and Market with 388 Man, Economy, and State Every individual on the market has a similar type of time- market schedule, reflecting his particular value scale. The schedule of each will be such that at higher rates of interest there will be a greater tendency toward net saving, and at lower rates of interest, less saving, until the individual becomes a net demander. At each hypothetical rate of interest there is a possi- ble net saving, net demanding, or abstaining from the market, for each individual. For some changes in the rate of interest, there will be no change (vertical curve), but there will never be a situation where the supply will be greater, or demand less, with lower rates of interest. The time-market schedules of all individuals are aggregated on the market to form market-supply and market-demand schedules for present goods in terms of future goods. The sup- ply schedule will increase with an increase in the rate of inter- est, and the demand schedule will fall with the higher rates of interest. A typical aggregate market diagram may be seen in Figure 44. Aggregating the supply and demand schedules on the time

454 Production: The Rate of Interest and Its Determination 389 market for all individuals in the market, we obtain curves such DD as is the demand curve for present goods in . and SS DD terms of the supply of future goods; it slopes rightward as the is the supply curve of present goods in rate of interest falls. SS terms of the demand for future goods; it slopes rightward as the rate of interest increases. The intersection of the two curves equilibrium rate of interest —the rate of interest as determines the it would tend to be in the evenly rotating economy. This pure solely by the time preferences rate of interest, then, is determined of the individuals in the society, and by no other factor. The intersection of the two curves determines an equilib- and BA B . rium rate of interest, , an equilibrium amount saved, 0 is the total amount of money that will be saved and invested B 0 in future money. At a higher interest rate than , present BA goods supplied would exceed future goods supplied in exchange, and the excess savings would compete with one another until the price of present goods in terms of future goods would decline toward equilibrium. If the rate of interest were , the demand for present goods by suppliers of future below BA goods would exceed the supply of savings, and the competition of this demand would push interest rates up toward equilibrium. Perhaps more fallacies have been committed in discussions concerning the interest rate than in the treatment of any other aspect of economics. It took a long while for the crucial impor- tance of time preference in the determination of the pure rate of it took even longer for econ- interest to be realized in economics; determining ealize that time preference is the omists to r only factor. Reluctance to accept a monistic causal interpretation has 12 plagued economics to this day. 12 The importance of time preference was first seen by Böhm-Bawerk in his Capital and Interest . The sole importance of time preference has been grasped by extremely few economists, notably by Frank A. Fetter , See Fetter, Economic Principles , pp. 235–316; idem and Ludwig von Mises. “Interest Theories, Old and New,” American Economic Review, March, 1914, pp. 68–92; and Mises, Human Action , pp. 476–534.

455 Power and Market with Man, Economy, and State 390 4. The Time Market and the Production Structure The time market, like other markets, consists of component individuals whose schedules are aggregated to form the market supply and demand schedules. The intricacy of the time market (and of the money market as well) consists in the fact that it is also divided and subdivided into various distinguishable sub- markets. These are aggregable into a total market, but the sub- sidiary components are interesting and highly significant in their own right and deserve further analysis. They themselves, of course, are composed of individual supply and demand schedules. As we have indicated above, we may divide the present- the production structure future market into two main subdivisions: . Let us turn first to the production consumer loan market and the structure. This may be done most clearly by considering once again a typical production-structure diagram. This diagram is the one in Figure 41, with one critical difference. Previously the diagram represented a typical production structure for any Now the same diagram represents the particular consumers’ good. aggregate production structure for all goods. Money moves from consumers’ goods back through the various stages of produc- tion, while goods flow from the higher through the lower stages of production, finally to be sold as consumers’ goods. The pat- tern of production is not changed by the fact that both specific and nonspecific factors exist. Since the production structure is aggregated, the degree of specificity for a particular product is irrelevant in a discussion of the time market. There is no problem in the fact that different production processes for different goods take unequal lengths of time. This is not a difficulty because the flow from one stage to another can be aggregated for any number of processes. There are, however, two more serious problems that seem to be involved in aggregating the production structure for the en- tire economy. One is the fact that in various processes there will not necessarily be an exchange of capital goods for money at

456 391 Production: The Rate of Interest and Its Determination each stage. One firm may “vertically integrate” within itself one or more stages and thereby advance present goods for a greater period of time. We shall see below, however, that this presents no difficulty at all, just as it presented no difficulty in the case of particular processes. A second difficulty is the purchase and use of durable capital goods. We have been assuming, and are continuing to assume, that they are only bought— that no capital goods or land are i.e., “rented” from their owners. The purchase of durable hired, goods presents complications, but again, as we shall see, this will lead to no essential change whatever in our analysis. The production-structure diagram in Figure 45 omits the numbers that indicated the size of payments between the var- S’ s to indicate the D’ s and ious sectors and substitutes instead points where present-future transactions (“time transactions”) take place and what groups are engaging in these various Interest Income D 6 S D D 5 S S D D 4 S S D D 3 S S D D 2 S S D D 1 S S C Consumer Expenditure S = = D Demand for Present Supply of Present Goods by Future Goods Goods for Future Goods IGURE 45. A RODUCTION GGREGATE P F TRUCTURE FOR S A LL OODS G

457 with Power and Market 392 Man, Economy, and State s trans s indicate demanders of present goods, and S’ actions. D’ are suppliers of present goods, for future goods. Let us begin at the bottom—the expenditure of consumers on consumers’ goods. The movement of money is indicated by arrows, and money moves from consumers to the sellers of con- not sumers’ goods. This is a time transaction, because it is an exchange (consumers’ for present goods (money) of present goods 13 goods). These producers of consumers’ goods are necessarily capi- talists who have invested in the services of factors to produce these goods and who then sell their products. Their investment in factors consisted of purchases of the services of land factors and labor factors (the original factors) and first-order capital goods (the produced factors). In both these two large cate- gories of transactions (exchanges that are made a stage earlier than the final sale of consumers’ goods), present goods are exchanging for future goods. In both cases, the capitalists are in exchange for factor services whose supplying present money yield will materialize in the future, and which therefore are . future goods So the capitalists who are producing consumers’ goods, whom we might call “first-stage capitalists,” engage in time transactions in making their investments. The components of this particular subdivision of the time market, then, are: Supply of Present Goods : Capitalists 1 : Landowners, Laborers, Capitalists Supply of Future Goods 2 (Demand for Present Goods) Capitalists are the first-stage capitalists who produce consumers’ 1 goods. They purchase capital goods from the producer-owners — s the second-stage capitalists, or Capitalists . The appropriate S’ 2 13 The fact that consumers may physically consume all or part of these goods at a later date does not affect this conclusion, because any further consumption takes place outside the money nexus, and it is the latter that we are analyzing.

458 Production: The Rate of Interest and Its Determination 393 and D’ s indicate these transactions, and the arrows pointing upward indicate the direction of money payment. At the next stage, the Capitalists have to purchase services 2 of factors of production. They supply present goods and pur- chase future goods, goods which are even more distantly in the 14 These future future than the product that they will produce. . To goods are supplied by landowners, laborers, and Capitalists 3 sum up, at the second stage: : Capitalists Supply of Present Goods 2 : Landowners, Laborers, Capitalists Supply of Future Goods 3 D’ s, These transactions are marked with the appropriate s and S’ and the arrows pointing upward indicate the direction of money payment in these transactions. This pattern is continued until the very last stage. At this final stage, which is here the sixth, the sixth-stage capitalists supply future goods to the fifth-stage capitalists, but also supply present goods to laborers and landowners in exchange for the extremely distant future services of the latter. The transactions for the two highest stages are, then, as follows (with the last stage designated as instead of six): N Fifth Stage: : Capitalists Supply of Present Goods 5 : Landowners, Laborers, Capitalists Supply of Future Goods N 14 No important complication arises from the greater degree of futu- rity of the higher-order factors. As we have indicated above, a dis- more tantly future good will simply be discounted by the market by a greater amount, though at the same rate per annum. The interest rate, i.e., the discount rate of future goods per unit of time, remains the same regard- less of the degree of futurity of the good. This fact serves to resolve one problem mentioned above—vertical integration by firms over one or more stages. If the equilibrium rate of interest is 5 percent per year, then a one-stage producer will earn 5 percent on his investment, while a pro- ducer who advances present goods over three stages—for three years— will earn 15 percent, i.e., 5 percent per annum.

459 Power and Market with Man, Economy, and State 394 N th Stage: : Capitalists Supply of Present Goods N : Landowners, Laborers Supply of Future Goods We may now sum up our time market for any production structure of N stages: Suppliers of Future Goods (Demanders of Present Goods) Suppliers of Present Goods Capitalists All Landowners 1 All Laborers Capitalists 2 Capitalists Capitalists 3 2 ... Capitalists 3 ... ... ... ... Capitalists Capitalists N N To illustrate clearly the workings of the production struc- ture, let us hark back to the numerical example given in Figure 41 and summarize the quantities of present goods supplied and received by the various components of the time market. We may use the same figures here to apply to the aggregate produc- tion structure, although the reader may wish to consider the units as multiples of gold ounces in this case. The fact that dif- ferent durations of production processes and different degrees of vertical integration make no difficulties for aggregation per- mits us to use the diagram almost interchangeably for a single production process and for the economy as a whole. Further- more, the fact that the ERE interest rate will be the same for all stages and all goods in the economy especially permits us to aggregate the comparable stages of all goods. For if the rate is 5 percent, then we may say that for a certain stage of one good, payments by capitalists to owners of factors are 50 ounces, and receipts from sales of products are 52.5 ounces, while we can also assume that the aggregate payments for the whole economy in the same period are 5,000 ounces, and receipts 5,250 ounces.

460 Production: The Rate of Interest and Its Determination 395 The same interest rate connotes the same rate of return on investments, whether considered separately or for all goods lumped together. The following, then, are the supplies and demands for pres- ent goods from Figure 41, the diagram now being treated as an aggregate for the whole economy: (Savers) Demanders of Present Goods Suppliers of Suppliers of Future Goods Present Goods ¬ 15 oz. Land and Labor Owners; Capitalists . . . . . 80 oz. . . . 95 oz. Capitalists 2 1 . . . 76 oz. ¬ 16 oz. Land and Labor Owners; Capitalists . . . . . . 60 oz. Capitalists 3 2 . . . . . . 45 oz. . . . 57 oz. ¬ 12 oz. Land and Labor Owners; Capitalists Capitalists 4 3 Capitalists . . . . 43 oz. ¬ 13 oz. Land and Labor Owners; Capitalists . . . . . . 30 oz. 4 5 ¬ 8 oz. Land and Labor Owners; Capitalists . . . . . . 20 oz. . . . 28 oz. Capitalists 5 N . . 19 oz. ¬ 19 oz. Land and Labor Owners . . . . . . . . . . . . . . . . . Capitalists N 83 oz. 318 oz. 235 oz. The horizontal arrows at each stage of this table depict the movement of money as supplied from the savers to the recipi- ent demanders at that stage. From this tabulation it is easy to derive the money in- net come of the various participants: their gross money income minus their money payments, if we include the entire period of time for all of their transactions on the time market. The case of the owners of land and labor is simple: they receive their money in exchange for the future goods to be yielded by their and their net money income factors; this money is their gross from the productive system. The total of net money income to the owners of land and labor is 83 ounces. This is the sum of the money incomes to the various owners of land and labor at each stage of production. The case of the capitalists is far more complicated. They pay out present goods in exchange for future goods and then sell the

461 Power and Market with Man, Economy, and State 396 maturing less distantly future products for money to lower- money income is derived by sub- net stage capitalists. Their tracting their money outgo from their gross income over the period of the production stage. In our example, the various net incomes of the capitalists are as follows: Net Incomes of Capitalists Producing Capital Goods Capitalists . . . . . . . . . . . . . . . . . . . . . 80 – 76 = 4 oz. 2 Capitalists . . . . . . . . . . . . . . . . . . . . . 60 – 57 = 3 oz. 3 Capitalists . . . . . . . . . . . . . . . . . . . . . 45 – 43 = 2 oz. 4 Capitalists . . . . . . . . . . . . . . . . . . . . . 30 – 28 = 2 oz. 5 Capitalists . . . . . . . . . . . . . . . . . . . . 20 – 19 = 1 oz. N _____ 12 oz. The total net income of the capitalists producing capital goods N ) is (orders 2 through 12 ounces . What, then, of Capitalists , 1 who apparently have not only no net income, but a deficit of 95 ounces? They are recouped, as we see from the diagram (in Figure 41), not from the savings of capitalists, but from the expenditure of consumers, which totals 100 ounces, yielding a net income to Capitalists of five ounces. 1 It should be emphasized at this point that the general pattern of the structure of production and of the time market will be the same in the real world of uncertainty as in the ERE. The dif- ference will be in the amounts that go to each sector and in the relations among the various prices. We shall see later what the discrepancies will be; for example, the rate of return by the cap- italists in each sector will not be uniform in the real market. But pattern of payments, the composition of suppliers and the demanders, will be the same. In analyzing the income-expenditure balance sheets of the production structure, writers on economic problems have seen that we may consolidate the various incomes and consider only the net incomes. The temptation has been simply to write off the various intercapitalist transactions as “duplications.” If that is done here, then the total net income in the mark et is: capitalists,

462 Production: The Rate of Interest and Its Determination 397 17 ounces (12 ounces for capital-good capitalists and five ounces for consumers’-good capitalists); land and labor factors, 83 ounces. The grand total net income is then 100 ounces. This is exactly equal to the total of consumer spending for the period. Total net income is 100 ounces, and consumption is 100 net ounces. There is, therefore, no new saving. We shall deal with savings and their change in detail below. Here the point is that, in the endless round of the ERE, zero savings, as thus net gross defined, would mean that there is just enough saving to keep the structure of productive capital intact, to keep the pro- duction processes rolling, and to keep a constant amount of consumers’ goods produced per given period. It is certainly legitimate and often useful to consider net in- comes and net savings, but it is not always illuminating, and its 15 use has been extremely misleading in present-day economics. Use of the net “national” income figures (it is better to deal with “social income” extending throughout the market community using the money rather than to limit the scope to national boundaries) leads one to believe that the really important ele- ment maintaining the production structure is consumers’ spending. In our ERE example, the various factors and capital- ists receive their net income and plow it back into consumption, thus maintaining the productive structure and future standards of living, i.e., the output of consumers’ goods. The inference from such concepts is clear: capitalists’ savings are necessary to increase and deepen the capital structure, but even without any savings, consumption expenditure is alone sufficient to maintain the productive capital structure intact. This conclusion seems deceptively clear-cut: after all, is not consumer spending the bulwark and end product of activity? This thesis, however, is tragically erroneous. There is no simple automatism in capitalists’ spending, especially when we leave the certain world of the ERE, and it is in this real world that the 15 Very recently, greater realism has been introduced into social accounting by considering intercapitalist “money flows.”

463 with Power and Market 398 Man, Economy, and State conceptual error plays havoc. For with production divided into stages, it is not true that consumption spending is sufficient to provide for the maintenance of the capital structure. When we consider the maintenance of the capital structure, we must con- sider to supply present goods on the present- all the decisions aggregated ; they do not can- future market. These decisions are cel one another out. Total savings in the economy, then, are not zero, but the aggregation of all the present goods supplied to owners of future goods during the production process. This is the sum of the supplies of Capitalists , through Capitalists 1 N 318 ounces . This is the total which totals savings—the sup- gross ply of present goods for future goods in production—and also investment. Investment is the amount of gross equals total money spent on future-good factors and necessarily equals sav- ings. Total expenditures on production are: 100 (Consumption) plus 318 (Investment = Savings), equals 418 ounces . Total gross income from production equals the gross income of Capitalists 1 (100 ounces) plus the gross income of other capitalists (235 ounces) plus the gross income of owners of land and labor (83 418 ounces. ounces), which also equals The system depicted in our diagram of the production struc- ture, then, is of an economy in which 418 gold ounces are earned 100 ounces are spent on consumption, in gross income, and are saved and invested in a certain order in the while 318 ounces production structure. In this evenly rotating economy, 418 ounces are earned and then spent, with no net “hoarding” or “dishoarding,” i.e., no net additions or subtractions from the 16 cash balance over the period as a whole. Thus, instead of no savings being needed to maintain capital and the production structure intact, we see that a very heavy proportion of savings and investment—in our example three 16 Problems of hoarding and dishoarding from the cash balance will be treated in chapter 11 on money and are prescinded from the present analysis.

464 399 Production: The Rate of Interest and Its Determination times the amount spent on consumption—is necessary simply to keep the production structure intact. The contrast is clear who obtains income and who is empowered when we consider to decide whether to consume or to invest. The net-income theorists implicitly assume that the only important decisions in regard to consuming vs. saving-investing are made by the fac- tor-owners out of their net income. Since the net income of capitalists is admittedly relatively small, this approach attributes little importance to their role in maintaining capital. We see, however, that what maintains capital is gross expenditures and investment and not net investment. The capitalists at each gross stage of production, therefore, have a vital role in maintaining capital through their savings and investment, through heavy savings from gross income. Concretely, let us take the case of the Capitalists . According 1 to the net-income theorists, their role is relatively small, since their net income is only five ounces. But actually their gross income is 100 ounces, and it is their decision on how much of this to save and how much to consume that is decisive. In the ERE, of course, we simply state that they save and invest 95 ounces. But when we leave the province of the ERE, we must realize that there is nothing automatic about this investment. There is no natural law that they must reinvest this amount. Suppose, for example, that the Capitalists decide to break up the smooth 1 flow of the ERE by spending all of the 100 ounces for their own consumption rather than investing the 95 ounces. It is evident that the entire market-born production structure would be destroyed. No income at all would accrue to the owners of all the higher-order capital goods, and all the higher-order capital processes, all the production processes longer than the very shortest, would have to be abandoned. We have seen above, and shall see in more detail below, that civilization advances by virtue of additional capital, which lengthens production processes. Greater quantities of goods are made possible only through the employment of more capital in longer processes. Should capitalists shift from saving-investment to consumption,

465 with Power and Market 400 Man, Economy, and State all these processes would be necessarily abandoned, and the economy would revert to barbarism, with the employment of only the shortest and most primitive production processes. The standard of living, the quantity and variety of goods produced, 17 would fall catastrophically to the primitive level. What could be the reason for such a precipitate withdrawal of savings and investment in favor of consumption? The only reason—on the free market—would be a sudden and massive increase in the time-preference schedules of the capitalists, so that present satisfactions become worth very much more in terms of future satisfactions. Their higher time preferences mean that the existing rate of interest is not enough to induce them to save and invest in their previous proportions. They therefore consume a greater proportion of their gross income and invest less. Each individual, on the basis of his time-preference sched- ule, decides between the amount of his money income to be devoted to saving and the amount to be devoted to consump- The aggregate time-market schedules (determined by time pref- tion. erences) determine the aggregate social proportions between (gross) savings and consumption. It is clear that the higher the time-pref- erence schedules are, the greater will be the proportion of con- sumption to savings, while lower time-preference schedules will lower this proportion. At the same time, as we have seen, higher time-preference schedules in the economy lead to higher rates of interest, and lower schedules lead to lower rates of interest. the time preferences of the indi- From this it becomes clear that viduals on the market determine simultaneously and by themselves both the market equilibrium interest rate and the proportions between con- 18 sumption and savings (individual and aggregate). Both of the latter 17 Cf. Knut Wicksell, Lectures on Political Economy (London: Routledge and Kegan Paul, 1934), I, 189–91. 18 For more on the relations between the interest rate, i.e., the price spreads or margins, and the proportions invested and consumed, see below.

466 Production: The Rate of Interest and Its Determination 401 are the obverse side of the same coin. In our example, the increase in time-preference schedules has caused a decline in savings, absolute and proportionate, and a rise in the interest rate. The fallacies of the net product figures have led economists to include some “grossness” in their product and income fig- ures. At present the favorite concept is that of the “gross national product” and its counterpart, gross national expendi- tures. These concepts were adopted because of the obvious 19 errors encountered with the net income concepts. Current “gross” figures, however, are the height of illogicality, because they are not gross at all, but only partly gross. They include durable only gross purchases by capitalists of capital goods and the consumption of their self-owned durable capital, approxi- mated by depreciation allowances set by the owners. We shall consider the problems of durable capital more fully below, but suffice it to say that there is no great difference between durable and less durable capital. Both are consumed in the course of the production process, and both must be paid for out of the gross income and gross savings of lower-order capitalists. In evaluat- ing the payment pattern of the production structure, then, it is inadmissible to leave the consumption of nondurable capital goods out of the investment picture. It is completely illogical to single out durable goods, which are themselves only discounted embodiments of their nondurable services and therefore no dif- ferent from nondurable goods. The idea that the capital structure is maintained intact with- out savings, as it were automatically, is fostered by the use of the “net” approach. If even zero savings will suffice to maintain capital, then it seems as if the aggregate value of capital is a 19 On gross and net product, see Milton Gilbert and George Jaszi, “National Product and Income Statistics as an Aid in Economic Prob- lems” in W. Fellner and B.F. Haley, eds., Readings in the Theory of Income Distribution (Philadelphia: Blakiston, 1946), pp. 44–57; and Simon Kuz- nets, National Income, A Summary of Findings (New York: National Bureau of Economic Research, 1946), pp. 111–21, and especially p. 120.

467 Power and Market with Man, Economy, and State 402 permanent entity that cannot be reduced. This notion of the permanence of capital has permeated economic theory, particu- larly through the writings of J.B. Clark and Frank H. Knight, and through the influence of the latter has molded current “neoclassical” economic theory in America. To maintain this doctrine it is necessary to deny the stage analysis of production 20 time and, indeed, to deny the very influence of in production. The all-pervading influence of time is stressed in the period-of- production concept and in the determination of the interest rate and of the investment-consumption ratio by individual time- preference schedules. The Knight doctrine denies any role to time in production, asserting that production “now” (in a mod- ern, complex economy) is timeless and that time preference has influence on the interest rate. This doctrine has been aptly no called a “mythology of capital.” Among other errors, it leads to the belief that there is no economic problem connected with the 21, 22 replacement and maintenance of capital. A common fallacy, fostered directly by the net-income ap- proach, holds that the important category of expenditures in the 20 If permanence is attributed to the mythical entity, the aggregate value of capital, it becomes an independent factor of production, along with labor, and earns interest. 21 The fallacy of the “net” approach to capital is at least as old as Adam Smith and continues down to the present. See Prices and Pro- Hayek, , pp. 37–49. This book is an excellent contribution to the analysis duction of the production structure, gross savings and consumption, and in application to the business cycle, based on the production and business Also see cycle theories of Böhm-Bawerk and Mises respectively. Hayek, “The Mythology of Capital” in W. Fellner and B.F. Haley, eds., Readings in the Theory of Income Distribution (Philadelphia: Blakiston, 1946), pp. 355–83; idem , Profits, Interest, and Investment , passim . 22 For a critique of the analogous views of J.B. Clark, see Frank A. Fet- ter, “Recent Discussions of the Capital Concept,” Quarterly Journal of Eco- nomics, November, 1900, pp. 1–14. Fetter succinctly criticizes Clark’s fail- ure to explain interest on consumption goods, his assumption of a perma- nent capital fund, and his assumption of “synchronization” in production.

468 403 Production: The Rate of Interest and Its Determination production system is consumers’ spending. Many writers have gone so far as to relate business prosperity directly to con- sumers’ spending, and depressions of business to declines in consumers’ spending. “Business cycle” considerations will be deferred to later chapters, but it is clear that there is little or no relationship between prosperity and consumers’ spending; indeed almost the reverse is true. For business prosperity, the important consideration is the price spreads between the vari- ous stages—i.e., the rate of interest return earned. It is this rate of interest that induces capitalists to save and invest present goods in productive factors. The rate of interest, as we have been demonstrating, is set by the configurations of the time preferences of individuals in the society. It is not the total quan- tity of money spent on consumption that is relevant to capital- margins ists’ returns, but the , the spreads, between the product prices and the sum of factor prices at the various stages— spreads which tend to be proportionately equal throughout the economy. There is, in fact, never any need to worry about the maintenance of consumer spending. There must always be consumption; as we have seen, after a certain amount of monetary saving, there is always an irreducible minimum of his monetary assets that every man will spend on current consumption. The fact of human action insures such an irreducible minimum. And as long as there is a monetary economy and money is in use, it will be spent on the purchase of consumers’ goods. The proportion in toto gives a clue to spent on capital in its various stages and the important consideration—the real output of consumers’ goods in the economy. The total amount of money spent, how- ever, gives no clue at all. Money and its value will be systemati- cally studied in a later chapter. It is obvious, however, that the number of units spent could vary enormously, depending on the quantity of the money commodity in circulation. One hundred or 1,000 or 10,000 or 100,000 ounces of gold might be spent on consumption, without signifying anything except that the quan- tity of money units available was less or greater. The total

469 with Power and Market 404 Man, Economy, and State amount of money spent on consumption gives no clue to the quantity of goods the economy may purchase. The important consideration, therefore, is time preferences and the resultant proportion between expenditure on con- sumers’ and producers’ goods (investment). The lower the pro- portion of the former, the heavier will be the investment in cap- ital structure, and, after a while, the more abundant the supply of consumers’ goods and the more productive the economy. The obverse of the coin is the determining effect of time pref- erences on the price spreads that set the rate of interest, and the income of the capitalist savers-investors in the economy. We have already seen the effect of a lowering of investment on the first rank, and below we shall analyze fully the effect on pro- duction and interest of a lowering of time preferences and the effects of various changes in the quantity of money on time preferences and the production structure. Before continuing with an analysis of time preference and the production structure, however, let us complete our exami- 23 nation of the components of the time market. The pure demanders of present goods on the time market are the various groups of laborers and landowners—the sellers of the services of original productive factors. Their price on the market, as will be seen below, will be set equal to the marginal value prod- of their units, discounted by the prevailing rate of interest. The uct greater the rate of interest, the less will the price of their service discount be, or rather, the greater will be the from their marginal value product considered as the matured present good. Thus, if the marginal value product of a certain labor or land factor is 10 ounces per unit period, and the rate of interest is 10 percent, its earning price will be approximately nine ounces per year if the final product is one year away. A higher rate of interest would lead to a lower price, and a lower rate to a higher price, although the maximum price is one slightly below the full MVP (marginal value product), since the interest rate can never disappear. 23 Cf. Böhm-Bawerk, Positive Theory of Capital , pp. 299–322, 329–38.

470 Production: The Rate of Interest and Its Determination 405 It seems likely that the demand schedule for present goods by the original productive factors will be highly inelastic in response to changes in the interest rate. With the large base amount, the discounting by various rates of interest will very 24 likely make little difference to the factor-owner. Large changes in the interest rate, which would make an enormous difference to capitalists and determine huge differences in inter- est income and the profitableness of various lengthy productive processes, would have a negligible effect on the earnings of the owners of the original productive factors. On the time market, we are considering all factors in the ag- gregate; the interest rate of the time market permeates all particular aspects of the present-future market, including all purchases of land and labor services. Therefore, when we are considering the supply of a certain factor on the market, we are in general , and not its supply schedule for a spe- considering it cific use. A group of homogeneous pieces of land may have three alternative uses: say, for growing wheat, raising sheep, or serving as the site of a steel factory. Its supply schedule for each of the three uses will be elastic (relatively flat curve) and will be determined by the amount it can obtain in the next best use— i.e., the use in which its discounted MVP is next highest. In the present analysis, we are not considering the factor’s supply curve for a particular industry or use; we are considering its , i.e., its supply curve supply curve for all users in the aggregate on the time market in exchange for present goods. We are 24 The rate of interest, however, will make a great deal of difference in so far as he is an owner and seller of a durable good. Land is, of course, durable almost by definition—in fact, generally permanent. So far, we have been dealing only with the sale of factor , i.e., the “hire” or services rent” of the factor, and abstracting from the sale or valuation of durable factors, which embody future services. Durable land, as we shall see, is “capitalized,” i.e., the value of the factor as a whole is the discounted sum of its future MVP’s, and there the interest rate will make a significant dif- ference. The price of durable land, however, is irrelevant to the supply schedule of land services in demand for present money.

471 Power and Market with Man, Economy, and State 406 therefore considering the behavior of all owners of a homoge- neous factor of land (or of one owner if the land factor is reservation no unique, as it often is). Land is very likely to have price, i.e., it will have little subjective-use-value to the owner. A few landlords may place a valuation on the possibility of con- templating the virgin beauty of the unused land; in practice, however, the importance of such reservation-demand for land is likely to be negligible. It will, of course, be greater where the owner can use the land to grow food for himself. Labor services are also likely to be inelastic with respect to the interest discount, but probably less so than land, since labor has a reservation demand, a subjective use-value, even in the aggregate labor market. This special reservation demand stems from the value of leisure as a consumers’ good. Higher prices for labor services will induce more units of labor to enter the market, while lower prices will increase the relative advantages of leisure. Here again, however, the difference that will be made by relatively large changes in the interest rate will not be at all great, so that the aggregate supply-of-labor curve (or rather curves, one for each homogeneous labor factor) will tend to be inelastic with regard to the interest rate. The two categories of independent demanders of present landowners and the goods for future goods, then, are the labor- ers . The suppliers of present goods on the time market are capitalists clearly the , who save from their possible consumption and invest their savings in future goods. But the question may present goods as be raised: Do not the capitalists also demand well as supply them? It is true that capitalists, after investing in a stage of produc- tion, demand present goods in exchange for their product. This particular demand is inelastic in relation to interest changes since these capital goods also can have no subjective use-value for their producers. This demand, however, is strictly derivative and dependent. In the first place, the product for which the owner demands present goods is, of course, a future good, but

472 407 Production: The Rate of Interest and Its Determination than the goods that the it is also one stage less distantly future owner purchased in order to produce it. In other words, Capi- , but they had will sell their future goods to Capitalists talists 3 2 , as well as from landown- bought future goods from Capitalists 4 ers and laborers. Every capitalist at every stage, then, demands more distantly future than the product that he goods that are supplies, and he supplies present goods for the duration of the production stage until this product is formed. He is therefore a net supplier of present goods . , and a net demander of future goods Hence, his activities are guided by his role as a supplier. The higher the rate of interest that he will be able to earn, i.e., the higher the price spread, the more he will tend to invest in pro- duction. If he were not essentially a supplier of present goods, this would not be true. The relation between his role as a supplier and as a demander of present goods may be illustrated by the diagram in Figure 46. This diagram is another way of conveniently representing the structure of production. On the horizontal axis are repre- sented the various stages of production, the dots furthest to the left being the highest stages, and those further to the right being the lower stages. From left to right, then, the stages of production are lower and eventually reach the consumers’-good

473 Power and Market with 408 Man, Economy, and State stage. The vertical axis represents prices, and it could inter- changeably be either the production structure of one particular good or of all the goods in general. The prices that are repre- sented at each stage are the cumulative prices of the factors at each stage, excluding the interest return of the capitalists. At each stage rightward, then, the level of the dots is higher, the difference representing the interest return to the capitalists at that stage. In this diagram, the interest return to capitalists at two adjacent stages is indicated, and the constant slope indicates that this return is equal. 25 Let us now reproduce the above diagram in Figure 47. The original production structure diagram is marked at points A, B , and C. Capitalists X purchase factors at price A and sell their product at point B, Y buy at B and sell their while capitalists C . Let us first consider the highest stage here por- product at trayed—that of capitalists X . They purchase the factors at point A. Here they supply present goods to owners of factors. Capital- ists X, of course, would prefer that the prices of the factors be 25 Strictly, of course, the slope would not be constant, since the return is in equal percentages , not in equal absolute amounts. Slopes are treated as constant here, however, for the sake of simplicity in presenting the analysis.

474 Production: The Rate of Interest and Its Determination 409 A ′ A . Their lower; thus, they would prefer paying rather than interest spread cannot be determined until their selling prices are determined. Their activities as suppliers of present goods in exchange for interest return, therefore, are not really completed with their purchase of factors. Obviously, they could not be. The capitalists must transform the factors into products and sell their products for money before they obtain their interest return from their supply of present goods. The suppliers of future goods (landowners and laborers) their transac- complete tions immediately, as soon as they obtain present money. But the capitalists’ transactions are incomplete until they obtain present money once again. Their demand for present goods is therefore strictly dependent on their previous supply. X Capitalists B to the , as we have stated, sell their products at next lower rank of capitalists. Naturally, they would prefer a higher selling price for their product, and the point B ′ would be B. If we looked only at this sale, we might be preferred to tempted to state that, as demanders of present goods, capitalists X prefer a higher price, and therefore a lower discount for their product, i.e., a lower interest rate. This, however, would be a superficial point of view, for we must look at both of their exchanges, which are necessarily considered together if we con- sider their complete transaction. They prefer a lower buying point and a higher selling point, i.e., a more steeply sloped line, or a In other words, the capitalists prefer higher rate of discount. suppliers a higher rate of interest and therefore always act as of present goods. Of course, the result of this particular change (to a price spread of A B ′ ) is that the next lower rung of capitalists, ′ capitalists Y , suffer a narrowing of their price spread, along the line B ′ C . It is, of course, perfectly agreeable to capitalists X if capitalists suffer a lowering of their interest return, so long as Y the return of the former improves. Each capitalist is interested in improving his own interest return and not necessarily the rate of interest in general. However, as we have seen, there can- not for long be any differences in interest return between one stage and another or between one production process and another . If the A ′ B ′ C

475 Power and Market with Man, Economy, and State 410 situation were established, capitalists would pour out of the Y stage, the increased demand would bid up X stage and into the the sales at B ′ would be increased and the ′ , the price above A demand lowered, and the supply at C lowered, until finally the interest returns were equalized. There is always a tendency for such equalization, and this equalization is actually completed in the ERE. 5. Time Preference, Capitalists, and Individual Money Stock When we state that the time-preference schedules of all indi- viduals in the society determine the interest rate and the individuals, proportion of savings to consumption, we mean all and not some sort of separate class called “capitalists.” There is a temptation, since the production structure is analyzed in terms of different classes—landowners, laborers, and capital- ists—to conclude that there are three definite stratified groups people in society corresponding to these classifications. Actu- of ally, in economic analysis of the market we are concerned with whole persons per se functions rather than . In reality, there is no special class of capitalists set off from laborers and landowners. This is not simply due to the trite fact that even capitalists must also be consumers. It is also due to the more important fact that can be capitalists all consumers if they wish. They will be capital- ists if their time-preference schedules so dictate. Time-market diagrams such as shown above apply to every man, and not sim- ply to some select group known as capitalists. The interchange of the various aggregate supply and demand diagrams through- out the entire time market sets the equilibrium rate of interest on the market. At this rate of interest, some individuals will be suppliers of present goods, some will be demanders, the curves representing the supply and demand schedules of others will be coinciding with their line of origin and they will not be in the time market at all. Those whose time-preference schedules at this rate permit them to be suppliers will be the savers —i.e., they will be the capitalists.

476 411 Production: The Rate of Interest and Its Determination The role of the capitalists will be clarified if we ask the ques- tion: Where did they get the money that they save and invest? First, they may have obtained it in what we might call “current” production; i.e., they could have received the money in their current capacities as laborers, landowners, and capitalists. After they receive the money, they must then decide how to allocate it among various lines of goods, and between consumption and investment. Secondly, the source of funds could have been money earned in past rounds of production and previously “hoarded,” now being “dishoarded.” We are, however, leaving out hoarding and dishoarding at this stage in the analysis. The money, and this too only other source, the third source, is new will be discussed later. For the moment, therefore, we shall consider that the money from which savings derive could only have come from recent earnings from production. Some earnings were obtained as cap- italists, and some as owners of original factors. The reader might here have detected an apparent paradox: How can a laborer or a landowner be a demander of present goods, and then turn around and be a supplier of present goods for investment? This seems to be particularly puzzling since we have stated above that one cannot be a demander and a supplier of present goods at the same time, that one’s time-preference schedule may put one in one camp or the other, but not in both. The solution to this puzzle is that the two acts are not performed , even though both are performed to the same at the same time extent in their turn in the endless round of the evenly rotating economy. Let us reproduce the typical individual time-preference schedule (Figure 48). At a market interest rate of 0 A , the indi- ; at a market interest rate of vidual would supply savings of AB , he would demand money of amount CE. Here, however, we C 0 are analyzing more carefully the horizontal axis. The point 0 is the point of origin. It is the point at which the person deliber- ates on his course of action, i.e., the position he is in when he is

477 Power and Market with 412 Man, Economy, and State consulting, so to speak, his time-preference scales. Specifically, this is his position with respect to the size of his money stock at the O , he has a certain money stock, and he time of origin. At point is considering how much of his stock he is willing to give up in exchange for future goods or how much new stock he would like to acquire while giving up future goods. Suppose that he is a saver. As the curve moves to the right, he is giving up more and more of his present money stock in exchange for future goods; therefore, his minimum interest return becomes greater. The further the curve goes to the right, then, the lower will his final money stock be. On the other hand, consider the same individual when he is a demander of present goods. As the curve proceeds to the left, he increases his stock of present goods and gives up future goods. Considering both sides of the point of origin, then, we see that the further right the curve goes, the less stock he has; the further left, the greater his stock. Given his time-preference schedule, therefore, he is bound to be in a greater supply position the more money he has, and in more of a demand position the less money he has. Before the laborer or landowner sells his services, he has a certain money

478 413 Production: The Rate of Interest and Its Determination stock—a cash balance that he apparently does not reduce below a certain minimum. After he sells his services, he acquires his money income from production, thereby adding to his money stock. He then allocates this income between consumption and savings-investment, and we are assuming no hoarding or dishoarding. At this point, then, when he is allocating, he is in a far different position and at a different point in time. For now he has had a considerable addition to his money stock. Let us consider (Figure 49) the individual’s time-market graph with two different points of origin, i.e., two different sizes of money stock, one before he earns his income (I), and one immediately after (II).

479 Power and Market with 414 Man, Economy, and State Here we see how a laborer or a landowner can be a deman- der at one time, in one position of his money stock, and a sup- plier at another time. With very little money stock, as repre- sented in the first diagram, he is a demander. Then, he acquires money in the productive arena, greatly increases his money stock, and therefore the point of origin of his decision to allo- cate his money income shifts to the left, so that he might well become a supplier out of his income. Of course, in many cases, he is still a demander or is not on the time market at all. To coin a phrase to distinguish these two positions, we may call his original condition a “pre-income position” (before he has sold his services for money), and the latter a “post-income posi- tion”—his situation when he is allocating his money income. Both points of origin are relevant to his real actions. We have seen above that a landowner’s pre-income demand for money is likely to be practically inelastic, or vertical, while a laborer’s will probably be more elastic. Some individuals in a post-income position will be suppliers at the market rate of in- terest; some will be demanders; some will be neutral. The four diagrams in Figure 50 depict various pre-income and post- income time-preference situations, establishing individual time-market curves, with the same market rate of interest applied to each one.

480 Production: The Rate of Interest and Its Determination 415 The line AB, across the page, is our assumed market rate of interest, equilibrated as a result of the individual time-prefer- ence scales. At this rate of interest, the landowner and the laborer (I and II) are shown with demands for present money (pre-income), and diagrams III and IV depict a demander at this rate and a neutral at this rate, one who is moved neither to sup- ply nor to demand money in the time market. Both the latter are in post-income situations. We conclude that any man can be a capitalist if only he wants to be. He can derive his funds solely from the fruits of previous capitalist investment or from past “hoarded” cash balances or solely from his income as a laborer or a landowner. He can, of The only course, derive his funds from several of these sources. thing that stops a man from being a capitalist is his own high time- , in other words, his stronger desire to consume preference scale goods in the present. Marxists and others who postulate a rigid stratification—a virtual structure in society—are in grave caste error. The same person can be at once a laborer, a landowner, 26 and a capitalist, in the same period of time. It might be argued that only the “rich” can afford to be cap- italists, i.e., those who have a greater amount of money stock. This argument has superficial plausibility, since from our dia- any given individual grams above we saw that, for and a given time-preference schedule, a greater money stock will lead to a greater supply of savings, and a lesser money stock to a lesser Ceteris paribus , the same applies to changes in supply of savings. money income, which constitute additions to stock. We , cannot however, assume that a man with (post-income) assets of 10,000 ounces of gold will necessarily save more than a man with 100 ounces of gold. We cannot compare time preferences interpersonally, any more than we can formulate interpersonal laws for any 26 This Marxian error stemmed from a very similar error introduced into economics by Adam Smith. Cf. Ronald L. Meek, “Adam Smith and the Classical Concept of Profit,” Scottish Journal of Political Economy, June, 1954, pp. 138–53.

481 Power and Market with Man, Economy, and State 416 other type of utilities. What we can assert as an economic law for one person we cannot assert in comparing two or more per- sons. Each person has his own time-preference schedule, apart from the specific size of his monetary stock. Each person’s time-preference schedule, as with any other element in his value scale, is entirely of his own making. All of us have heard of the proverbially thrifty French peasant, compared with the rich playboy who is always running into debt. The common- sense observation that it is generally the rich who save more may be an interesting historical judgment, but it furnishes us with no scientific economic law whatever, and the purpose of economic science is to furnish us with such laws. As long as a person has any money at all, and he must have some money if he participates in the market society to any extent, he can be a capitalist. 6. The Post-Income Demanders Up to this point we have analyzed the time-market demand for present goods by landowners and laborers, as well as the derived demand by capitalists. This aggregate demand we may for present goods on the time market. producers’ demand call the This is the demand by those who are selling their services or the services of their owned property in the advancing of produc- as we have defined it; tion. This demand is all pre-income demand i.e., it takes place prior to the acquisition of money income from the productive system. It is all in the form of selling factor serv- ices (future goods) in exchange for present money. But there is another component of net demand for present goods on the component; it is a demand time market. This is the post-income that takes place even after productive income is acquired. Clearly, this demand cannot be a productive demand, since owners of future goods used in production exercise that demand to their sale. It is, on the contrary, a consumers’ demand. prior This subdivision of the time market operates as follows: Jones sells 100 ounces of future money (say, one year from now) to Smith in exchange for 95 ounces of present money. This

482 417 Production: The Rate of Interest and Its Determination future money is not in the form of an expectation created by a factor of production; instead, it is an I.O.U. by Jones promis- ing to pay 100 ounces of money at a point one year in the future. He exchanges this claim on future money for present money—95 ounces. The discount on future money as com- pared with present money is precisely equivalent to that in the other parts of the time market that we have studied heretofore, except that the present case is more obvious. The rate of inter- est finally set on the market is determined by the aggregate net supply and net demand schedules throughout the entire time market, and these, as we have seen, are determined by the time preferences of all the individuals on the market. Thus, in the case of Figure 50 above, in diagram III we have a case of a net (post-income) demander at the market rate of interest The form that his demand takes is the sale of an I.O.U. of future money—usually termed the “borrowing” of present money. On the other hand, the person whose time-market curve is shown in diagram IV has such a time-preference configuration that he is neither a net supplier nor a net demander at the going rate of interest—he is not on the time market at all—in his post- income position. The net borrowers, then, are people who have relatively higher time-preference rates than others at the going rate of interest, in fact so high that they will borrow certain amounts at this rate. It must be emphasized here that we are dealing only with consumption borrowing—borrowing to add to the present use of Jones’ money stock for consumption. Jones’ sale of future money differs from the sales of the landowners and laborers in another respect; their transactions are completed, while Jones has not yet completed his. His I.O.U. establishes a claim to future money on the part of the buyer (or “lender”) Smith, and Smith, to complete his transaction and earn his interest pay- ment, must present his note at the later date and claim the money due. In sum, the time market’s components are as follows :

483 with Power and Market 418 Man, Economy, and State I. Supply of Present Goods for Future Goods: Savings (of all) II. Demand for Present Goods by Suppliers of Future Goods: a. Producers’ Demand Landowners Laborers Consumers’ Demand b. Borrowing Consumers These demands are aggregated without regard to whether they are post- or pre-income; they both occur within a relatively brief time period, and they recur continually in the ERE. Although the consumption and the productive demands are aggregated to set the market rate of interest, a point of great importance for the productive system is revealed if we separate these demands analytically. The diagram in Figure 51 depicts the establishment of the rate of interest on the time market. The vertical axis is the rate of interest; the horizontal axis is gold ounces. The SS curve is the supply-of-savings schedule, determined by individual time preferences. The CC curve is the schedule of consumers’ loan demands for present goods,

484 Production: The Rate of Interest and Its Determination 419 consisting of the aggregate net demand (post-income) at the various hypothetical rates of interest. The DD curve is the total demand for present goods by suppliers of future goods, and it CC consists of the plus a curve that is not shown—the curve demand for present goods by the owners of original productive CC and the DD curves are factors, i.e., land and labor. Both the determined by individual time preferences. The equilibrium rate of interest will be set by the market at the point of inter- SS . DD curves—point E section of the and E determines two important re- The point of intersection at sultants: the rate of interest, which is established at 0A , and the total supply of savings AE. A vital matter for the productive sys- tem, however, is the position of the CC CC is curve: the larger at any given rate of interest, the larger the amount of total sav- ings that will be competed for and drawn away from production into consumers’ loans. In our diagram, the total savings going BE . into investment in production is The relative strength of productive and consumption demand for present goods in the society depends on the config- urations of the time-preference schedules of the various indi- viduals on the market. We have seen that the productive demand for present goods tends to be inelastic with respect to interest rates; on the other hand, the consumers’ loan curve will probably display greater elasticity. It follows that, on the demand side, changes in time preferences will display them- selves mostly in the consumption demand schedule. On the supply side, of course, a rise in time preferences will lead to a shift of the SS curve to the left, with less being saved and invested at each rate of interest. The effects of time-preference changes on the rate of interest and the structure of production will be discussed further below. It is clear that the gross savings that maintain the production structure are the “productive” savings, i.e., those that go into productive investment, and that these exclude the “consump- tion” savings that go into consumer lending. From the point of view of the production system, we may regard borrowing by a

485 Power and Market with Man, Economy, and State 420 consumer as dissaving, for this is the amount by which a person’s , as contrasted to sav- consumption expenditures exceed his income ings, the amount by which a person’s income exceeds his con- sumption. In that case, the savings loaned are canceled out, so to speak, by the dissavings of the consumption borrowers. The consumers’ and producers’ subdivisions of the time market are a good illustration of how the rate of interest is equalized over the market. The connection between the returns on investment and money loans to consumers is not an obvious one. But it is clear from our discussion that both are parts of one time market. It should also be clear that there can be no long- run deviation of the rate of interest on the consumption loan market from the rate of interest return on productive invest- ment. Both are aspects of one time market. If the rate of inter- est on consumers’ loans, for example, were higher than the rate of interest return from investment, savings would shift from buying future goods in the form of factors to the more remu- nerative purchase of I.O.U.’s. This shift would cause the price of future factors to fall, i.e., the interest rate in investment to rise; and the rate of interest on consumers’ loans to fall, as a result of the competition of more savings in the consumer loan arena. The everyday arbitrage of the market, then, will tend to equalize the rate of interest in both parts of the market. Thus, the rate of interest will tend to be equalized for all areas of the economy, as it were in three dimensions—“horizontally” in every process of production, “vertically” at every stage of pro- duction, and “in depth,” in the consumer loan market as well as in the production structure. 7. The Myth of the Importance of the Producers’ Loan Market We have completed our analysis of the determination of the pure rate of interest as it would be in the evenly rotating econ- omy—a rate that the market tends to approach in the real world. We have shown how it is determined by time preferences on the time market and have seen the various components of

486 Production: The Rate of Interest and Its Determination 421 that time market. This statement will undoubtedly be extremely puzzling to many readers. Where is the producers’ loan market? This market is always the one that is stressed by writers, often to the exclusion of anything else. In fact, “rate of interest” gen- erally refers to money loans, including loans to consumers and producers, but particularly stressing the latter, which is usually quantitatively greater and more significant for production. The rate of interest of money loans to the would-be producer is sup- posed to be the significant rate of interest. In fact, the fashion- able neoclassical doctrine holds that the producers’ loan market determines the rate of interest and that this determination takes is the supply of savings entering SS place as in Figure 52, where DD is the demand for these loans by produc- the loan market, and ers or entrepreneurs. Their intersection allegedly determines the rate of interest. It will be noticed that this sort of approach completely over- looks the gross savings of the producers and, even more, the demand for present goods by owners of the original factors . Instead of being fundamentally suppliers of present goods, capitalists are por- trayed as demanders of present goods. What determines the SS

487 Power and Market with 422 Man, Economy, and State DD and schedules, according to this neoclassical doctrine? The SS curve is admittedly determined by time preferences; the DD curve, on the other hand, is supposed to be determined by the “marginal efficiency of capital,” i.e., by the expected rate of return on the investment. This approach misses the point very badly because it looks at the economy with the superficial eye of an average business- man. The businessman borrows on a producers’ loan market from individual savers, and he judges how much to borrow on the basis of his expected rate of “profit,” or rate of return. The writers assume that he has available a shelf of investment proj- ects, some of which would pay him, say 8 percent, some 7 per- and that at each hypothetical inter- cent, some 3 percent, etc., est rate he will borrow in order to invest in those projects where his return will be as high or higher. In other words, if the interest rate is 8 percent, he will borrow to invest in those proj- ects that will yield him over 8 percent; if the rate is 4 percent, he will invest in many more projects—those that will yield him over 4 percent, etc. In that way, the demand curve for savings, for each individual, and still more for the aggregate on the mar- ket, will slope rightward as demand curves usually do, as the rate of interest falls. The intersection sets the market rate of inter- est. Superficially, this approach might seem plausible. It usually happens that a businessman foresees such varying rates of return on different investments, that he borrows on the market from different individual savers, and that he is popularly consid- ered the “capitalist” or entrepreneur, while the lenders are sim- DD curve in ply savers. This lends plausibility to terming the Figure 52, the demand by capitalists or entrepreneurs for money (present goods). And it seems to avoid mysterious com- plexities and to focus neatly and simply on the rate of interest for producers’ loans—the loans from savers to businessmen—in which they and most writers on economics are interested. It is this rate of interest that is generally discussed at great length by economists.

488 423 Production: The Rate of Interest and Its Determination Although popular, this approach is wrong through and through, as will be revealed in the course of this analysis. In the DD curve a lit- first place, let us consider the construction of this tle more closely. What is the basis for the alleged shelf of avail- able projects, each with different rates of return? Why does a par- ticular investment yield any net monetary return at all? The usual answer is that each dose of new investment has a “marginal value productivity,” such as 10 percent, 9 percent, 4 percent, etc., that naturally the most productive investments will be made first and that therefore, as savings increase, further investments will be less and less value-productive. This provides the basis for the alleged “businessman’s demand curve,” which slopes to the right as savings increase and the interest rate falls. The cardinal error -pro- value here is an old one in economics—the attribution of ductivity to monetary investment. There is no question that investment increases the physical productivity of the productive process, as well as the productivity per man hour. Indeed, that is precisely why investment and the consequent lengthening of the periods of production take place at all. But what has this to do with value-productivity or with the monetary return on investment, especially in the long run of the ERE? Suppose, for example, that a certain quantity of physical fac- tors (and we shall set aside the question of how this quantity can be measured) produces 10 units of a certain product per period at a selling price of two gold ounces per unit. Now let us postu- late that investment is made in higher-order capital goods to such an extent that productivity multiplies fivefold and that the same original factors can now produce 50 units per period. The selling price of the larger supply of product will be less; let us assume that it will be cut in half to one ounce per unit. The gross revenue per period is increased from 20 to 50 ounces. Does this mean that value-productivity has increased two and a half times, just as physical productivity increased fivefold? Cer- tainly not! For, as we have seen, producers benefit, not from the gross revenue received, but from the price spread between their selling price and their aggregate factor prices. The increase in

489 with Power and Market 424 Man, Economy, and State physical productivity will certainly increase revenue in the short run, but this refers to the profit-and-loss situations of the real tendency will be nothing of long-run world of uncertainty. The the sort. The long-run tendency, eventuating in the ERE, is toward an equalization of price spreads. How can there be any permanent benefit when the cumulative factor prices paid by this producer increase from, say, 18 ounces to 47 ounces? This is precisely what will happen on the market, as competitors vie to invest in these profitable situations. The price spread, i.e., the , will again be 5 percent. interest rate Thus the productivity of production processes has no basic relation to the rate of return on business investment. This rate of return depends on the price spreads between stages, and these price spreads will tend to be equal. The size of the price spread, i.e., the size of the interest rate, is determined, as we have seen at length, by the time-preference schedules of all the individuals in the economy. In sum, the neoclassical doctrine maintains that the interest rate, by which is largely meant the producers’ loan market, is co-determined by time preference (which determines the sup- ply of individual savings) and by marginal (value) productivity of investment (which determines the demand for savings by busi- nessmen), which in turn is determined by the rates of return that can be achieved in investments. But we have seen that these very rates of return are, in fact, the rate of interest and that their size is determined by time preferences. The neoclassicists are partly right in only one respect—that the rate of interest in the producers’ loan market is dependent on the rates of return on investment. They hardly realize the extent of this dependence, rates of return however. It is clear that these , which will be equal- ized into one uniform rate, constitute the significant rate of inter- 27, 28 . est in the production structure 27 For brilliant dissections of various forms of the “productivity” the- ory of interest (the neoclassical view that investment earns an interest return because capital goods are value -productive), see the following

490 425 Production: The Rate of Interest and Its Determination Discarding the neoclassical analysis, we may ask: What, then, is the role of the productive loan market and of the rate of in- terest set therein? This role is one of complete and utter dependence on the rate of interest as determined above, and manifesting itself, as we have seen, in the rate of investment return, on the one hand, and in the consumers’ loan market, on the other. These latter two markets are the independent and important subdivisions of the general time market, with the for- mer being the important market for the production system. In this picture, the producers’ loan market has a purely sub- sidiary and dependent role. In fact, from the point of view of fundamental analysis, there need not be any producers’ loan market at all. To examine this conclusion, let us consider a state of business affairs without a producers’ loan market. What is needed to bring this about? Individuals save, consuming less these savings in the than their income. They then directly invest production structure, the incentive for investment being the rate of interest return—the price spread—on the investment. This rate is determined, along with the rate on the consumers’ loan market, by the various components of the time market that articles by Frank A. Fetter: “The Roundabout Process of the Interest Theory,” Quarterly Journal of Economics, 1902, pp. 163–80, where Böhm- Bawerk’s highly unfortunate lapse into a productivity theory of interest is refuted; “Interest Theories Old and New,” pp. 68–92, which presents an extensive development of time-preference theory, coupled with a cri- tique of Irving Fisher’s concessions to the productivity doctrine; also see “Capitalization Versus Productivity, Rejoinder,” American Economic 1914, pp. 856–59, and “Davenport’s Competitive Economics,” Review, Journal of Political Economy, 1914, pp. 555–62. Fetter’s only mistake in interest theory was to deny Fisher’s assertion that time preference (or, as Fisher called it, “impatience”) is a universal and necessary fact of human action. For a demonstration of this important truth, see Mises, Human Action , pp. 480 ff. 28 On Keynes’ failure to perceive this point, see p. 371 of this chapter, note 5 above.

491 Power and Market with Man, Economy, and State 426 we have portrayed above. There is, in that case, no producers’ loan market. There are no loans from a saving group to another group of investors. And it is clear that the rate of interest in the production structure still exists; it is determined by factors that have nothing to do with the usual discussion by economists of the producers’ loan market. 8. The Joint-Stock Company It is clear that, far from being the centrally important ele- ment, the producers’ loan market is of minor importance, and it is easy to postulate a going productive system with no such mar- ket at all. But, some may reply, this may be all very well for a primitive economy where every firm is owned by just one capitalist-investor, who invests his own savings. What happens in our modern complex economy, where savings and investment , are processes engaged in by different groups of are separated people—the former by scattered individuals, the latter by rela- tively few directors of firms? Let us, therefore, now consider a second possible situation. Up to this point we have not treated in detail the question whether each factor or business was owned by one person or jointly by many persons. Now let us jointly owned by many consider an economy in which factors are people, as largely happens in the modern world, and we shall see what difference this makes in our analyses. Before studying the effect of such jointly owned companies on the producers’ loan market, we must digress to analyze the owned firm, nature of these companies themselves. In a jointly instead of each individual capitalist’s making his own invest- ments and making all his own investment and production deci- sions, various individuals pool their money capital in one organ- business firm ization, or , and jointly make decisions on the investment of their joint savings. The firm then purchases the land, labor, and capital-goods factors, and later sells the product to consumers or to lower-order capitalists. Thus, the firm is the product joint owner of the factor services and particularly of the

492 427 Production: The Rate of Interest and Its Determination as it is produced and becomes ready for sale. The firm is the product-owner until the product is sold for money. The indi- viduals who contributed their saved capital to the firm are the a joint owners, successively, of: ( ) the initial money capital—the c ) the services of the factors, ( pooled savings, ( b ) the product of the factors, and ( d ) the money obtained from the sale of the product. In the evenly rotating economy, their ownership of assets follows this same step-by-step pattern, period after period, without change. In a jointly owned firm, in actual prac- tice, the variety of productive assets owned by the firm is large. Any one firm is usually engaged in various production processes, each one involving a different period of time, and is likely to be engaged in different stages of each process at any one particular time. A firm is likely to be producing so that its output is continuous and so that it makes sales of new units of the product every day. It is obvious, then, that if the firm keeps continually in busi- ness, its operations at any one time will be a mixture of invest- ment and sale of product. Its assets at any one time will be a mixture of cash about to be invested, factors just bought, hardly begun products, and money just received from the sale of products. The result is that, to the superficial, it looks as if the firm is an automatically continuing thing and as if the pro- duction is somehow timeless and instantaneous, ensuing imme- diately after the factor input. Actually, of course, this idea is completely unfounded. There is no automatic continuity of investment and production. Pro- duction is continued because the owners are continually making decisions to proceed; if they did not think it profitable to do so, they could and do at any point alter, curtail, or totally cease time from operations and investments. And production takes initial investment to final product. In the light of our discussion, we may classify the types of as- sets owned by any firm (whether jointly or individually owned) as follows:

493 Power and Market with Man, Economy, and State 428 A. Money Productive Assets B. Melange of factors, such as land and capital goods, embodying future services (this will be analyzed below); various stages of product; the completed product On this entire package of assets, a monetary evaluation is placed by the market. How this is done will be examined in detail later. At this point, let us revert to the simple case of a one-shot in- vestment, an investment in factors on one date, and the sale of the resulting product a year later. This is the assumption involved in our original analysis of the production structure; and it will be seen below that the same analysis can be applied to the more complex case of a melange of assets at different stages of production and even to cases where one firm engages in several different production processes and produces different goods. Let us consider a group of individuals pooling their saved money capital to the extent of 100 ounces, purchasing fac- tors with the 100 gold ounces, obtaining a product, and selling the product for 105 ounces a year later. The rate of interest in this society is 5 percent per annum, and the rate of interest return on this investment conforms with this condition. The On what principle do the individual owners question now arises: It will almost always mutually apportion their shares of the assets? be the case that every individual is vitally interested in knowing his share of the joint assets, and consequently firms are estab- lished in such a way that the principle of apportionment is known to all the owners. At first one might be inclined to say that this is simply a case of bargaining, as in the case of the product jointly owned by all the owners of the factors. But the former situation does not apply here. For in the case discussed above, there was no prin- ciple whereby any man’s share of ownership could be distin- guished from that of anyone else. A whole group of people worked, contributed their land, etc., to the production process, and there was no way except simple bargaining by which the

494 429 Production: The Rate of Interest and Its Determination income from the sale of the product could be apportioned among them. Here, each individual is contributing a certain amount of money capital to begin with. Therefore, the propor- tions are naturally established from the outset. Let us say that the 100 ounces of capital are contributed by five men as follows: A . . . . . . . . . . . . . . . . . . . . 40 oz. B . . . . . . . . . . . . . . . . . . . . 20 oz. C . . . . . . . . . . . . . . . . . . . . 20 oz. D . . . . . . . . . . . . . . . . . . . . 15 oz. E . . . . . . . . . . . . . . . . . . . . 5 oz. In other words, A contributes 40 percent of the capital, B 20 percent, C 20 percent, D 15 percent, E 5 percent. Each indi- vidual owner of the firm then owns the same percentage of all the assets that he contributed in the beginning. This holds true at each step of the way, and finally for the money obtained from the sale of the product. The 105 ounces earned from the sale will be either reinvested in or “disinvested” from the process. At any rate, the ownership of these 105 ounces will be distributed in the same percentages as the capital invested. This natural structure of a firm is essentially the structure of . In the joint-stock company, each investor- a joint-stock company —a certification of ownership in propor- share owner receives a tion to the amount he has invested in the total capital of the company. Thus, if A, B, . . . E above form a company, they may issue 100 shares, each share representing a value, or an asset, of one ounce. A will receive 40 shares; B, 20 shares; C, 20 shares, etc. After the sale of the product, each share will be worth 5 per- cent more than its original, or par , value. Suppose that after the sale, or indeed at any time before the wishes to invest in this company. Sup- sale, another person, F , pose that he wishes to invest 30 ounces of gold. In that case, the investment of money savings in the company increases from 100 (if before the sale) or 105 (if after the sale) by 30 ounces. Thirty new shares will be issued and turned over to F, and the capital value of the firm increases by 30 ounces. In the vast

495 Power and Market with Man, Economy, and State 430 majority of cases where reinvestment of monetary revenue is going on continuously, at any point in time the capital value of a firm’s assets will be the appraised value of all the productive assets, including cash, land, capital goods, and finished prod- ucts. The capital value of the firm is increased at any given time by new investment and is maintained by the reinvestments of the owners after the finished product is sold. The shares of capital are generally known as stock ; the total value of capital stock is the amount originally paid in on the par formation of the company. From that point on, the total capital value of assets changes as income is earned, or, in the world of uncertainty, as losses are suffered, and as capital is reinvested or withdrawn from the company. The total value of capital stock changes accordingly, and the value of each share will differ from the original value accordingly. How will the group of owners decide on the affairs of the company? Those decisions that must be made jointly will be made by some sort of voting arrangement. The natural voting arrangement, which one would expect to be used, is to have one vote per share of voting stock, with a majority of the votes deciding. This is precisely the arrangement used in the joint- corporation stock company and its modern form, the . Of course, some joint-stock company arrangements differ from this, according to the desires of the owners. Partnerships can be worked out between two or more people on various principles. Usually, however, if one partner receives more than his proportionate share of invested capital, it is because he is contributing more of his labor or his land to the enterprise and gets paid accordingly. As we shall see, the rate paid to the labor of the “working partner” will be approximately equal to what he could earn in labor elsewhere, and the same is true for pay- ment to the land or any other originally owned factor con- tributed by a partner. Since partnerships are almost always lim- ited to a few, the relationships are more or less informal and need not have the formal patterns of the joint-stock company.

496 431 Production: The Rate of Interest and Its Determination However, partnerships will tend to work quite similarly. They provide more room for idiosyncratic arrangements. Thus, one partner may receive more than his share of capital because he is loved and revered by the others; this is really in the nature of a gift to him from the rest of the partners. Joint-stock compa- nies hew more closely to a formal principle. The great advantage of the joint-stock company is that it provides a more ready channel for new investments of saved capital. We have seen how easy it is for new capital to be attracted through the issuance of new shares. It is also easier for any owner to withdraw his capital from the firm. This greater ease of withdrawal vastly increases the temptation to invest in the company. Later on we shall explore the pricing of stock shares in the real world of uncertainty. In this real world, there is room for great differences of opinion concerning the appraised value of a firm’s assets, and therefore concerning the monetary appraised value of each share of the firm’s stock. In the evenly rotating economy, however, all appraisals of monetary value will agree—the principles of such appraisal will be exam- ined below—and therefore the appraised value of the shares of stock will be agreed upon by all and will remain constant. While the share market of joint-stock companies provides a ready channel for accumulating savings, the share market is . The savings or dissavings of strictly dependent on the price spreads capitalists are determined by time preferences, and the latter establish the price spread in the economy. The value of capital invested in the enterprise, i.e., its productive assets, will be the sum of future earnings from the capital discounted by the rate of interest. If the price spreads are 5 percent, the rate of interest return yielded on the share market (the ratio of earnings per share to the market price of the share) will tend to equal the rate of interest as determined elsewhere on the time market—in this case, 5 percent. We still have a situation in which capitalists supply their own saved capital, which is used to purchase factors in expec- tation of a net monetary return. The only complications that

497 with Power and Market Man, Economy, and State 432 develop from joint-stock companies or corporations are that many capitalists contribute and own the firm’s assets jointly and that the price of a certain quantum of ownership will be regu- lated by the market so that the rate of interest yield will be the same for each individual share of stock as it is for the enterprise as a whole. If the whole firm buys factors for a total price of 100 and sells the product a year later for 105, for a 5-percent return, 1 / of the shares of ownership of this firm will sell for then, say, 5 an aggregate price of 20 and earn an annual net return of one ounce. Thus, the rates of interest for the partial shares of capi- tal will all tend to be equal to the rate of interest earned on the 29 entire capital. Majority rule in the joint-stock companies, with respect to total shares owned, does not mean that the minority rights of owners are overridden. In the first place, the entire pooling of resources and the basis on which it is worked out are voluntary for all parties concerned. Secondly, all the stockholders, or own- ers, have one single interest in common—an increase in their monetary return and assets, although they may, of course, differ concerning the means to achieve this goal. Thirdly, the mem- bers of the minority may sell their stock and withdraw from the company if they so desire. 29 The shares of stock, or the units of property rights, have the characteristic of fungibility; one unit is exactly the same as another. . . . We have a mathematical division of the one set of rights. This fungible quality makes pos- sible organized commodity and security markets or exchanges. . . . With these fungible units of . . . property rights we have a possible acceleration of changes of own- ership and in membership of the groups. . . . If a course of market dealings arises, the unit of property has a swift cash conversion value. Its owner may readily resume the cash power to command the uses of wealth. (Hastings Lyon, Corporations and their Financing [Boston: D.C. Heath, 1938], p. 11) Thus, shares of property as well as total property have become readily marketable.

498 Production: The Rate of Interest and Its Determination 433 Actually, the partners may arrange their voting rights and ownership rights in any way they please, and there have been many variations of such arrangements. One such form of group ownership, in which each owner has one vote regardless of the number of shares he owns, has absurdly but effectively arro- gated to itself the name of “co-operative.” It is obvious that partnerships, joint-stock companies, and corporations are all 30 co-operative institutions. eminently Many people believe that economic analysis, while applica- ble to individually owned firms, does not hold true for the modern economy of joint-stock companies. Nothing could be further from the truth. The introduction of corporations has not fundamentally changed our analysis of the interest rate or the savings-investment process. What of the separation of “management” from ownership in a corporation? It is certainly true that, in a joint-stock firm, the owners hire managerial labor to supervise their workers, whereas individual owners generally perform their own managerial labor. A manager is just as much a hired laborer as any other worker. The presi- dent of a company, just like the ditch digger, is hired by the owners; and, like the ditch digger, he expends labor in the pro- duction process. The price of managerial labor is determined in the same way as that of other labor, as will be seen below. On the market, the income to an independent owner will also include the going wage for that type of managerial labor, which joint-stock owners, of course, will not receive. Thus, we see that, far from rendering economic analysis obsolete, the modern world of the corporation aids analysis by separating and simplifying functions in production—specifically, the managerial function. 30 The literature on the so-called “co-operative movement” is of remarkably poor quality. The best source is Co-operatives in the Petroleum Industry , K.E. Ettinger, ed. (New York: Petroleum Industry Research Foundation, 1947), especially pt. I, Ludwig von Mises, “Observations on the Co-operative Movement.”

499 with Power and Market 434 Man, Economy, and State In addition to the capital-supplying function, the corporate capitalists also assume the function: the crucial entrepreneurial directing element in guiding the processes of production to- ward meeting the desires of the consumers. In the real world of uncertainty, it takes sound judgment to decide how the market is operating, so that present investment will lead to future prof- its, and not future losses. We shall deal further with the nature of profit and loss, but suffice it to say here that the active entre- preneurial element in the real world is due to the presence of uncertainty. We have been discussing the determination of the pure rate of interest, the rate of interest as it always tends to be and as it will be in the certain world of the ERE. In the ERE, where all techniques, market demands and supplies, etc., for the future are known, the investment function becomes purely pas- sive and waiting. There might still be a supervisory or manage- rial labor function, but this can be analyzed under prices of labor factors. But there will no longer be an entrepreneurial function because future events are known. Some have maintained, finally, that joint-stock companies make for a separation of savings and investment. Stockholders save, and the managers do the investing. This is completely fal- hired agents of the stockholders and lacious. The managers are subject to the latters’ dictation. Any individual stockholder not satisfied with the decisions of the majority of owners can dis- pose of his ownership share. As a result, it is effectively the stock- 31 holders who invest the funds. stockholders who save and the Some people maintain that since most stockholders are not “interested” in the affairs of their company, they do not effec- tively control the firm, but permit control to pass into the hands of the hired managers. Yet surely a stockholder’s interest is a matter of his own preference and is under his own control. Pre- ferring his lack of interest, he permits the managers to continue their present course; the fundamental control, however, is still 31 See Mises, Human Action , pp. 301–05, 703–05.

500 Production: The Rate of Interest and Its Determination 435 32 his, and he has absolute control over his agents. A typical view asserts: The maximizing of dividend income for stockholders as a group is not an objective that is necessarily unique or paramount. Instead, management officials will seek to improve the long-run earnings and com- petitive position of the firm and their own prestige as 33 managers. But to “improve the long-run earnings” is identical with maxi- mizing stockholders’ income, and what else can develop the “prestige” of managers? Other theorists lapse into the sheer mysticism of considering the “corporation”—a conceptual name which we give to an institution owned by real individu- 34 als—as “really” existing and acting by itself. 9. Joint-Stock Companies and the Producers’ Loan Market We are now ready to embark on an analysis of the effect of joint-stock companies on the producers’ loan market. Let us take the aforementioned firm with a total capital stock and capital value of 130 ounces and owned by six stockholders. The firm earns a net income of 5 percent per year for its own- ers, and this is the interest rate earned by all the firms in the economy. We have already seen how the firm expanded its capital by . 30 ounces through the sale of new capital stock to F Let us see what happens when a productive loan is made. Suppose that the 32 The proxy fights of recent years simply give dramatic evidence of this control. 33 Edgar M. Hoover, “Some Institutional Factors in Business Deci- sions,” American Economic Review, Papers and Proceedings, May, 1954, p. 203. 34 For example, see Gerhard Colm, “The Corporation and the Corpo- ration Income Tax in the American Economy,” American Economic Review, Papers and Proceedings, May, 1954, p. 488.

501 Power and Market with Man, Economy, and State 436 firm borrows 20 ounces from the producers’ loan market for a five-year period. What has happened? The firm has exchanged a future good—a promise to pay money in the future—for pres- ent money. The present money has been supplied by a saver, G. It is clear that G has done the saving and is the capitalist in this transaction, while the joint stockholders A–F are here supply- ing future goods; and further, it is the stockholders who invest the new capital in the production system. On the surface, this seems to be a positive case of the separation of savings and investment. However, let us look at the transaction further. G has sup- plied new capital, worth 20 ounces, to the firm, for a five-year period. The owners A–F take this new capital and invest it in future goods, i.e., factors of production. In other words, to the extent of 20 ounces, A–F are intermediary investors of the sav- ings of the creditors. What will the rate of interest on this loan be? It is obvious that this rate of interest in the ERE, will be equal to 5 percent, i.e., it will be purely dependent on the rate of interest return that prevails in the price spreads of the pro- duction structure. The reason for this should be clear. We have already seen how the interest rate is determined in the produc- tion structure; we have assumed it to be 5 percent everywhere. Now, suppose that the firm offers to pay G 3 percent on the loan. Clearly, G will not lend the firm 20 ounces for a 3-percent return when he could get 5 percent as a stockholder either in the same firm or in any other firm. On the other hand, the firm is in no position to pay G any more than 5 percent, since its net return on the investment will be only 5 percent. If the maxi- mum that the firm can pay in interest is 5 percent, and the min- imum that the creditor can accept is 5 percent, it is obvious that the transaction will take place at 5 percent. It is clear that, in essence, G, the creditor on the prospective loan market, is no different from F, the man who has invested in stock. Both have saved money instead of spending it on con- sumption, and both wish to sell their saved capital in exchange for future goods and to earn interest. The time-preference

502 Production: The Rate of Interest and Its Determination 437 schedules of both F and G, as well as of everyone else, are aggregated on the time market to arrive at the rate of interest; both F and G are net savers at the market rate. The interest rate, then, is determined by the various time-preference sched- ules, and the final rate is set by the saving schedules, on the one hand, and by the demand-for-present-goods schedules, on the other. The demand schedules consist (and consist only) of the productive demand by laborers and landowners and the con- sumption demand by borrowing consumers. F and G are both net savers, interested in investing their capital for the highest return. There is no essential difference between F’s method of the differ- investing his capital and G’s method of investing his; ence between investing in stock and lending money to firms is mainly a technical one. The separation between saving and investment that occurs in the latter case is completely unimportant. The interest return on investment, as set by total savings and total demands by owners of factors, completely determines the rate of interest on the producers’ loan market as well as the rate of earning on stock. The producers’ loan market is totally unimportant from the point of view of fundamental analysis; it is even useless to try to construct demand and supply schedules for this mar- 35 ket, since its price is determined elsewhere. Whether saved via stocks or via loans is capital is channeled into investments unimportant. The only difference is in the legal technicalities. 35 As Frank Fetter brilliantly stated: Contract [interest] is based on and tends to conform to economic interest [i.e., the “natural interest” price differ- ential between stages]. . . . It is economic interest that we seek to explain logically through the economic nature of the goods. Contract interest is a secondary problem—a business and legal problem—as to who shall have the benefit of the income arising with the possession of the goods. It is closely connected with the question of own- ership. (Fetter, “Recent Discussions of the Capital Con- cept,” pp. 24–25)

503 Power and Market with Man, Economy, and State 438 Indeed, even the legal difference between the creditor and the owner is a negligible one. G’s loan has increased the capital value of the assets in the firm from 130 to 150. The invested 150 pays 5 percent, or 7.5 ounces per year. Let us examine the situation and see who the actual owners of this capital are (see Figure 53). In this diagram, the left-hand rectangle represents assets at any one point in time. We see in the right-hand rectangle that 130 ounces of these assets is represented by owners’ capital, and 20 by liabilities—i.e., by I.O.U.’s due to creditors. But what does this “representation” mean? It means that if, for example, the firm were to liquidate and go out of business, 20 ounces of its assets would be used to pay off the creditors, and 130 would go to the legal owners. It means, further, that of the seven and a half ounces paid out as net earnings per year, six and a half ounces go to the legal owners and one ounce to the creditors, each being 5 percent of their saving. In fact, each group gets 5 percent on its investment , for are not the creditors just as much investors as the

504 Production: The Rate of Interest and Its Determination 439 stockholders? In fact, are not the creditors the owners of 20 ounces’ worth of the firm’s assets, and do they not own the pro rata earnings of those 20 ounces? What functions of ownership not have as compared to the stockholders? Even do the creditors from the legal point of view, the creditors on the get first claim assets of a corporation, and they get paid before the stockhold- ers. They are therefore definitely owners of these assets. It might be stated that since they are not shareholders, they do not vote on the decisions of the corporation, but there are many nonvoting situations in which joint-stock companies issue shares, the holders of which do not vote on company affairs, even though they receive their prorata value of the earnings. We must conclude that economically and even in basic law, there is no difference between shareholders and productive creditors; both are equally suppliers of capital, both receive interest return as determined on the general time market, both own their proportionate share of the company’s assets. The differences between the two are only technical and semantic. It is true that our discussion has so far applied only to the evenly rotating economy, but we shall see that the real world of uncertainty and entrepreneurship, while complicat- 36 ing matters, does not change the essentials of our analysis. In recent writings there has been a growing acknowledgment of the essential identity between shareholders and creditors, in contrast to the old tradition that postulated a sharp cleavage be- tween them. But it is curious that the new literature interprets the identity in precisely the wrong way: instead of treating the creditors like shareholder-owners, it treats the shareholders like creditors. In other words, the correct approach is to consider creditors as actually part owners of the firm; but the new litera- ture treats stockholders as merely creditors of the firm, in keep- ing with the new tradition of picturing the hired managers as its 36 “The creditor is always a virtual partner of the debtor or a virtual owner of the pledged and mortgaged property.” Mises, Human Action , p. 536. Also see Fetter, “Recent Discussions of the Capital Concept,” p. 432.

505 Power and Market with Man, Economy, and State 440 real controllers and owners. Managers are depicted as somehow owning the firm and paying out interest to creditors, as well as dividends to stockholders, just as any factor payment is made— as a grudging cost of production. In reality, the managers are only the hired agents of the stockholders, and it is the latter who decide how much of their earnings to reinvest in the firm and how much to “take out of the firm” in the form of “dividends.” The commonly made distinction between “dividends” and “retained earnings” is not a useful one for the purposes of eco- nomic analysis. Retained earnings are not necessarily rein- vested; they may be held out of investment in a cash balance and later paid out as dividends. Dividends, on the other hand, are not necessarily spent on consumption; they may be invested in some other firm. Therefore, this distinction is a misleading one. Earnings are either reinvested or they are not; and all corporate earnings constitute earnings of the individual owners. Savings may be channeled through intermediaries before entering the actual producers’ loan (or the consumers’ loan) a productive investment is one of the tasks of market. Finding entrepreneurs, and it is often far more convenient for all con- cerned when the individual, instead of making up his mind him- self on the proper channels of investment, lends or invests his money in other institutions specially set up to be experts in investment. These institutions may serve as channels, gathering in the small savings of isolated individuals, whose investments by themselves are too small to be worth the cost of finding a market for them. The institutions then invest the funds knowl- edgeably in larger lump sums. A typical example is the invest- , which sells its own stock to individuals and then uses ment trust this capital to buy stock of other companies. In the ERE, the interest that will be earned from individuals’ savings via inter- mediaries will equal the interest earned from direct investments minus the cost of the intermediary’s service, this price to be determined on the market just like other prices. Thus, if the interest rate throughout the market is 5 percent, and the cost of intermediary service is 1 percent, then, in the ERE, those who

506 441 Production: The Rate of Interest and Its Determination channel their savings via the convenient intermediary method will receive a 4-percent interest return on the investment of their savings. We have thus seen the unimportance of the producers’ loan market as an independent determining factor in the establish- ment of the market rate of interest or in the productive system. In many cases it is convenient to designate by different terms the rate of interest on contractual loan markets and the rate of interest in the form of earnings on investments as a result of contractual rate of price spreads. The former we may call the interest (where the interest is fixed at the time of making the contract), and the latter the natural rate of interest (i.e., the inter- est comes “naturally” via investments in production processes, rather than being officially included in an exchange contract). The two interest rates will, of course, coincide in the ERE. Throughout our analysis we have been making one underly- ing assumption that might be modified: that individuals will always try to obtain the highest interest return. It is on this basis that we have traced the arbitrage actions and eventual unifor- mities of the ERE. We have assumed that each investor will try to earn as much as he can from his investment. This might not always be true, and critics of economics have never tired of reproaching economists for neglecting other than monetary ends. Economics does not neglect such ends, however. In fact, praxeological analysis explicitly includes them. As we have repeatedly pointed out, each individual attempts to maximize his psychic income, and this will translate itself into maximizing income only if other psychic ends are neutral. The his monetary ease with which economics can accommodate nonmonetary ends may readily be seen. Suppose that the interest rate in the society is 5 percent. Suppose, however, that there is a line of production that is distasteful to a large number of people, including investors. In a society, for example, where the making of arms is held in disfavor, simple arbitrage would not work to equate returns in the armament industry with those in other

507 Power and Market with 442 Man, Economy, and State industries. We are not here referring to the displeasure of con- sumers of arms, which would, of course, reflect itself in a low- ered demand for the product. We are referring to the particular displeasure of producers, specifically investors. Because of this psychic dislike, investors will require a higher return in the armament industry than in other industries. It is possible, for example, that they might require an interest return of 10 per- cent in the armament industry, even though the general rate of interest is 5 percent. What factors, then, will have to pay for this increased discount? We are not overly anticipating the results of our subsequent analysis if we state that the owners of nonspecific factors, i.e., those factors which can be employed elsewhere (or, strictly, the services of which can thus be employed) will certainly not accept a lower monetary return in the armament industry than in the other in dustries. In the ERE, their prices as deter- mined in this industry will, then, be the same as in the other industries. In fact, they might be even higher, if the owners share the investors’ specific antipathy toward engaging in the armament industry. The burden of the lower prices at each stage of production, then, falls on the factors in purely specific must be devoted to this industry if the industry, those which they are to be in the production system at all. In the long run of the ERE, these will not be capital goods, since capital goods always need to be reproduced, and the equivalent resources can gradually or rapidly leave the industry, depending in each case on the durability of the capital good and the length of the process of its production. The specific factor may be labor, but this is not empirically likely, since labor is almost always a non- specific factor that may shift to several occupations. It is there- fore likely to be specific land factors that bear the brunt of the lower return. The opposite will occur in the case of an industry that most investors specifically are very eager to engage in for one reason or another. In that case, they will accept a lower interest return in this production process than in others. The force of competi- tion on the market will, once again, keep nonspecific factors at

508 Production: The Rate of Interest and Its Determination 443 the same price from industry to industry, although the price might be lower if the factor-owners were also particularly eager to work in this industry. The higher prices at the various stages are therefore reaped by the owners of specific factors, generally land factors. The rate of interest, then, always tends toward equality throughout its various submarkets and in its various forms. In the ERE, the rates will be uniformly equal throughout. This conclusion must be modified, however, to state that the rates of interest will differ in accordance with a “psychic” component, either positive or negative, depending on whether there is an acute dislike or liking among investors for a particular produc- 37 tion process. We may say that, in the case of a particular lik- ing, the investors are “consuming” the enjoyment of investing in the particular process and paying the price of a lower return; in the case of a particular dislike, they are charging more for a particular disutility. It must be emphasized, however, that these particu- differences in return do not occur if merely one person larly likes or dislikes a certain field, but only if there is a signif- icant aggregate of strong preferences in one direction or another. This type of consumption, positive or negative, is intertwined in the production process and occurs directly with production, and thus differs from ordinary consumption, which occurs at the end of the production process. 10. Forces Affecting Time Preferences Praxeology can never furnish an ultimate explanation for a man’s time preferences. These are psychologically determined by each person and must therefore be taken, in the final analy- sis, as data by economists. However, praxeological analysis can ceteris paribus supply some truths about time preferences, using 37 Similar psychic components may occur in the consumers’ loan mar- ket—for example, if there is general strong liking or dislike for a certain borrower.

509 Power and Market with Man, Economy, and State 444 assumptions. Thus, as we have seen above, each person has a time-preference schedule relating to his money stock. A lower money stock will cause a higher time-preference rate for any unit of money remaining in his possession, until finally his time- preference rate will rise to infinity when the money stock—or rather, the money for consumption—is low enough. Here, one element, a man’s money stock, is varied and his value scale is otherwise assumed to remain constant. Hence, we can in this way gauge the effects of a change in one determinant, the money stock. money stock that is relevant to his time Actually, it is not his preferences, but the real value of his money stock. In the ERE, of course, where the purchasing power of the money unit Ceteris paribus remains unchanged, the two are identical. , an increase in his real income—real additions to his money stock— will lower the time-preference rate on his schedule. Of course, historically, there is no reason why his time-preference schedule should remain unchanged. It is important to know, however, that, given an unchanged schedule, his relevant time-preference rate will fall. There are other elements that enter into the determination of the time-preference schedules. Suppose, for example, that people were certain that the world would end on a definite date in the near future. What would happen to time preferences and to the rate of interest? Men would then stop providing for future needs and stop investing in all processes of production longer than the shortest. Future goods would become almost valueless compared to present goods, time preferences for pres- ent goods would zoom, and the pure interest rate would rise almost to infinity. On the other hand, if people all became immortal and healthy as a result of the discovery of some new drug, time preferences would tend to be very much lower, there would be a great increase in investment, and the pure rate of interest would fall sharply.

510 445 Production: The Rate of Interest and Its Determination 11. The Time Structure of Interest Rates It is clear that the natural interest rates are highly flexible; they tend toward uniformity and are easily changed as entre- preneurial expectations change. In the real world the prices of the various factors and intermediate products, as well as of the final products, are subject to continual fluctuation, as are the prices of stock and the interest return on them. It is also clear that the interest rate on short-term loans is easily changed with changed conditions. As the natural interest rate changes, the new loans for short periods can easily conform to the change. long-term A difficulty seems to arise, however, in the case of producers’ loans. Here is an apparently clear-cut rigid element in the system, and one which can conform to the natural rate of interest in investments only after a great lag. After all, a 20-year loan is contracted at an original interest rate that remains fixed for the duration; is this not a fixed element that cannot conform to changing conditions and valuations? This superficial view is incorrect. Long-term I.O.U.’s can also be bought and sold in a market. Most of these long-term debts are called bonds , and they are traded in a flourishing and flexible bond market. The fixed rate of interest at the beginning is unimportant. Thus, a 100- ounce long-term loan is contracted at 5-percent fixed interest, or five ounces per year. If the general interest rate rises, people will tend to sell their bonds, which have been yielding them only 5 percent, and invest their money elsewhere—eith