THE ANALYSIS OF PRODUCTION ACTIVITIES—the actions that 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 applicable 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 economy and are the indispensable keys to the analysis of the complex 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 individual. Since all action deals with units of supply of a good, we may refer to these subjective estimates as marginal utility and marginal cost, the marginal signifying action in steps.

(2) Each person acts in the present instant, on the basis of present value scales, to obtain anticipated end results in the future. Each person acts, therefore, to arrive at a certain satisfactory state in the future. Each has a temporal horizon of future dates toward which his actions are directed. He uses present given means, according to his technological ideas, to attain his ends in the future.

(3) Every person prefers and will attempt to achieve the satisfaction 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 allocated first to its most highly valued uses, then to its next most highly valued use, etc. The definition of a good is that it consists of an interchangeable supply of one or more units. Therefore, every unit will always be valued equally with every other. If a unit of a stock is given up or disposed of, the least highly valued 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 utility of addition of a unit to the stock equals the utility of a unit in its next most highly valued use, i.e., the most highly valued of the not yet satisfied ends. This provides us with the law of marginal 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 constant, 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 individuals in the market.

Analysis of the activities of production in a monetary market economy is a highly complex matter. An explanation of these 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 construction of the evenly rotating economy.

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. Technological ideas change, and factors are used in different ways. Both types of change have differing effects on prices. Time preferences change, with certain effects on interest and capital formation. 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 of affairs in which it is evenly rotating, i.e., in which the same 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 have two successive states of affairs: (a) the period of transition to an unchanging, evenly rotating economy, and (b) the unchanging round of the evenly rotating economy itself. This latter stage is the state of final equilibrium. It is to be distinguished from the market equilibrium prices that are set each day by the interaction of supply and demand. The final equilibrium state is one which the economy is always tending to approach. If our data—values, technology, and resources—remained constant, the economy would move toward the final equilibrium position and remain there. In actual life, however, the data are always changing, and therefore, before arriving at a final equilibrium 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 ethical merit to the equilibrium position. It is a concept for scientific explanation of human activity.

The reader might ask why such an “unrealistic” concept as final equilibrium is permissible, when we have already presented and will present grave strictures against the use of various 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 infinitely 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 is always moving, the final position of rest, at which, on the basis 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 legitimate and realistic importance.

We must always remember, however, that while a final equilibrium is the goal toward which the economy is moving at any particular time, changes in the data alter this position and therefore shift the direction of movement. Therefore, there is nothing in a dynamic world that is ethically better about a final equilibrium position. As a matter of fact, since wants are unsatisfied (otherwise 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 actually be, the result of market activity, and not the condition of 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 be the condition for any legitimate activity on the market. There 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 equations, which portray mutual relationships between two or more “functions.” Of themselves, of course, such mathematical procedures are unimportant, 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 formulating the laws among these variables and in formulating theoretical 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 assumed hypothetically and later approximately verified by referring to precise observable regularities, in praxeology we know the causal force at work. This causal force is human action, motivated, purposeful behavior, directed at certain ends. The 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 history. The only “natural laws” (if we may use such an old-fashioned but perfectly legitimate label for such constant regularities) in human action are qualitative rather than quantitative. They are, for example, precisely the laws educed in praxeology and economics—the fact of action, the use of means to achieve ends, time preference, diminishing marginal utility, etc.1

Mathematical equations, then, are appropriate and useful where there are constant quantitative relations among unmotivated variables. They are singularly inappropriate in praxeology and economics. In the latter fields, verbal, logical analysis of action and its processes through time is the appropriate method. It is not surprising that the main efforts of the “mathematical 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 the first place, it cannot describe the path by which the economy approaches the final equilibrium position. This task can be performed 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 unchanging, 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 auxiliary tool in aiding us in the analysis of real action. Since mathematics is least badly accommodated to a static state, mathematical 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 rotating economy describe only a static situation, outside of time.2 They differ drastically from the mathematical equations of physics, which describe a process through time; it is precisely through this description of constant, quantitative relations in the motion of elements that mathematics renders its great service in natural science. How different is economics, where mathematics, at best, can only inadequately describe a timeless end result!3

The use of the mathematical concept of “function” is particularly inappropriate in a science of human action. On the one hand, action itself is not a function of anything, since “function” implies definite, unique, mechanical regularity and determination. On the other hand, the mathematics of simultaneous 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 economists, 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 older concept of cause and effect.4

The “weakness” displayed here is not that of Böhm-Bawerk, but of those, like Professor Stigler, who attempt vainly and fallaciously to construct economics on the model of mathematical physics, specifically, of classical mechanics.5

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 demanded 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 unnecessary. Money is demanded and held only because it gives greater assurance of finding a market and because of the uncertainties 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 system—there would be no point in his keeping a cash balance of money. It would be invested so that money would be returned

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 conceive consistently of its establishment. But the idea of the evenly rotating economy is indispensable in analyzing the real economy; through hypothesizing a world where all change has worked itself out, we can analyze the directions of actual change.

• 1[PUBLISHER’S NOTE: Page numbers cited in parentheses within the text refer to the present edition.] Another difference is one we have already discussed: that mathematics, particularly the calculus, rests in large part on assumptions of infinitely 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.
• 2The mathematical economists, or “econometricians,” have been trying 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.
• 3For a brilliant critique of the use of mathematics in economics, see Mises, Human Action, pp. 251, 347–54, 697–99, 706–11. Also see Mises, “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 Painlevé, “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 Action and the neglected work, J.E. Cairnes, The Character and Logical Method of Political Economy (2nd ed.; London: Macmillan & Co., 1888). Also see Marian Bowley, Nassau Senior and Classical Economics (New York: 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 development 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)
• 4George J. Stigler, Production and Distribution Theories (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, see T.W. Hutchison, A Review of Economic Doctrines, 1870–1929 (Oxford: The Clarendon Press, 1953), pp. 147–48, and the interesting article by Emil Kauder, “Intellectual and Political Roots of the Older Austrian School,” Zeitschrift für Nationalökonomie XVII, 4 (1958), 412 ff. 5Stigler appends a footnote to the above paragraph which is meant as the coup de grace to Böhm-Bawerk: “Böhm-Bawerk
• 5Stigler 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 master. “Training” in mathematics is no more necessary to the realization of 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 greatness 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.

Crucial to understanding the process of production is the question of the specificity of factors, a problem we touched on in 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 factors 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 one purely nonspecific factor is inconceivable if we properly consider “suitability in production” in value terms rather than in technological terms.6 In fact, if we analyze the concept, we find that there is no sense in saying that a factor is “equally suitable” in purely technological terms, since there is no way of comparing the physical quantities of one product with those of another. If X can help to produce three units of A or two units of B, there is no way by which we can compare these units. Only the valuation of consumers establishes a hierarchy of valued goods, their interaction setting the prices of the consumers’ goods. (Relatively) nonspecific factors, then, are allocated to those products that the consumers 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 production, and the nonspecific factor (of varying degrees of convertibility), which can be used in more than one production process.

Now let us for a time consider a world where every good is produced only by several specific factors. In this world, a world that is conceivable, though highly unlikely, every person, every piece of land, every capital good, would necessarily be irrevocably 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. Certainly, the consumers would still have to allocate their scarce 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 various consumers’ goods. There would still, in the sphere of production of exchangeable goods, be one allocation that every man would make: how much time to devote to labor and how much to leisure. But there would be no problem of which field to labor in, no problem of what to do with any piece of land, no problem 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 see two typical consumers’ goods, A and B. Each, depicted as a solid rectangle at the bottom of the diagram, is produced by cooperating factors of the next higher rank, designated P1, or the first order of producers’ goods. The capital goods of the first rank are, in turn, produced with the help of co-operating factors, 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 purely specific, since no good is used at different stages of the 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 concluding 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, transformed into lower and lower orders of capital goods, until consumers’ goods are reached.

Now that we have traced the direction of productive effort, we must trace the direction of monetary income. This is a reverse 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 income. 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 stage that brings about the final product. In that stage, numerous factors, all now assumed to be specific, co-operate in producing the consumers’ good. There are three types of such factors: labor, original nature, and produced capital goods.7 Let us assume that on a certain day, consumers purchase a certain quantity of a good X for, say, 100 ounces of gold. Given the quantity of the good sold, the price of the total quantity is equal to the (gross) income obtained from the sale of the good. How will these 100 ounces be allocated to the producing factors?

In the first place, we must make an assumption about the ownership of the consumers’ good just before it is sold. It is obvious that this owner or these owners will be the immediate recipients 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 the final ownership of the product (before it is sold to the consumer): (a) all the owners of these factors jointly own the final 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 consumer. 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 term “product-owner” suffices for designating the owner of the capital assets, whatever the alternative adopted. Product-owners are also “entrepreneurs,” since they assume the major entrepreneurial burden of adjusting to uncertain future conditions. 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.

• 6The literature in economics hason been immeasurably confused by writers on production theory who deal with problems in terms of technology 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.
• 7We must hasten to add that this does not signify adoption of the old classical fallacy that treated each of these groups of factors as homogeneous. 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 various income returns and of the relation of time to production.

Let us first consider the case of joint ownership by the owners of all the final co-operating factors.8 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 owners 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 factor-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.

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 also products, are themselves jointly 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 capital goods had obtained the following:

Capital good A: 30 ounces
Capital good B: 30 ounces
Capital good C: 20 ounces

The income to each capital good will then be owned by five factor-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 allocated 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 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 accruing to the capital-goods owners is included in the shaded portion 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, followed by a similar upward arrow at the top of the diagram, the top line designating the money ultimately received by the owners of the various factors. The width of the top line (100 ounces) must be equal to the width of the bottom line (100 ounces), 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 second-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 capital good has yet been produced and only labor and nature remain. The result is that the 100 ounces are all eventually allocated 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 products, at whatever stage, are owned jointly by the owners of their factors, it is clear that first work is done on the highest stage. Owners of land and of labor invest their land and labor to produce 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 that stage to produce the lower-order good, etc. Finally, the lowest stage is reached, and the final factors co-operate to produce the consumers’ good. The consumers’ good is then sold to consumers.9

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 accrues.10

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 without 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 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 fluctuates 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 monetary cash balance, he may purchase goods by reducing the balance. 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 assumptions, may be a specific factor, but his money is usable in 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 demand.11 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 strictures on the market process. For even in this impossible case, the individual is no worse off than he would have been in isolation 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 enormous 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 isolation 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 use or threat of violence.12

Our example of the “worst possible case” enables us to analyze 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 exchangeable goods.” The two must be kept conceptually distinct. Freedom is meaningfully definable only as absence of interpersonal 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 constantly 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 certainly 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 poverty. That a person is “free to starve” is therefore not a condemnation 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.

• 8It must be understood that “factors of production” include every service that advances the product toward the stage of consumption. Thus, such services as “marketing costs,” advertising, etc., are just as legitimately productive services as any other factors. The fallacy in the spurious distinction between “production costs” and “selling costs” has been definitely demonstrated by Mises, Human Action, p. 319.
• 9On the structure of production, see Wieser, Social Economics, pp. 47ff.
• 10In practice, one or more persons can be the owners of any of the factors. 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.
• 11Actually, this case cannot occur, since labor, as we shall see below, is always a nonspecific factor.
• 12It is therefore our contention that the term “consumers’ sovereignty” 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.

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 forgone because of the decision. When a means M must be distributed among ends E1, E2, and E3, with E1 ranked highest on 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 E1 and E2, and must forgo E3, E3 is the marginal cost of his decision. If he errs in his decision, and arrives at E3 instead of E2, then ex post—in retrospect—he is seen to have suffered 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-ants.13 Secondly, it is clear that, since such factors as land and the produced capital goods have only one use, namely, the production of this product (by virtue of being purely specific), they involve no cost 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 may be, is costless, except for rare cases of direct consumption by the producer or in cases of anticipation of a price increase in the near future. This sale is costless from the proper point of view—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 the decision. At present, there is no alternative to the sale of the good at the market price, and therefore the sale is costless.14

It is evident, therefore, that once the product has been made, “cost” has no influence on the price of the product. Past 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 them to remain idle.15 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 or whether or not to employ his labor on the product. The monetary return is ranked on his subjective value scale along with the costs of forgoing leisure, and his decision is made on the quantity of labor he will put forth in production. The height of costs on individual value scales, then, is one of the determinants of the quantity, the stock, that will be produced. This stock, of course, later plays a role in the determination of market price, since stock is evaluated by consumers according to the law of diminishing 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 factors 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 utilities, setting the prices of consumers’ goods; the stock is produced 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 utilities forgone) of engaging in the production. In the former case, the utility valuations are generally (though by no means always) the ones made by consumers; in the latter case, they are made by producers. But it is clear that the determinants of price are only the subjective utilities of individuals in valuing given conditions and alternatives. There are no “objective” or “real” costs that determine, or are co-ordinate in determining, price.16

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 intertwined, element: present goods are being forgone in exchange for an expectation of return in the future. 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 production, and its analysis must pervade any theory of production.

When the owners of the factors embark on a process of production 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 order to invest their labor and land in a process of production, 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 processes of production. Present consumption is given up in anticipation of future consumption. Since we have seen that the universal law of time preference holds that any given satisfaction will be preferred earlier than later, an equivalent satisfaction will be preferred as early as possible. Present consumption of a good will be given up only in anticipation of a greater future consumption, the degree of the premium being dependent on time preferences. This restriction of present consumption is saving. (See the discussion in chapter 1.)

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 consumers and the 100 ounces is received by the joint owners. It is impossible, however, for us to say what this saving or investment was in monetary terms.

• 13Cf. 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.
• 14As Thirlby says, “Cost is ephemeral. The cost involved in a particular 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 retrospective.” (Jevons, Theory of Political Economy, p. 164)
• 15There 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.
• 16It is unfortunate that these truths, substantially set forth by the “Austrian School of economics” (which included some Englishmen and Americans) 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 Marshall’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 previous centuries. He 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 treatment 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 methods of the natural sciences. Emil Kauder, “The Retarded Acceptance of the Marginal Utility Theory,” Quarterly Journal of Economics, November, 1953, pp. 564–75.

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 production process, which, after a certain time, produces a consumers’ good to be sold to consumers for money. Now let us consider a situation in which the owners of the factors do not own the final 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 individual or a group of individuals acting jointly can then, at 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 restriction of consumption, instead of being done by the owners of land and labor, has been done by the capitalists. The capitalists originally saved, say, 95 ounces of gold which they could have then spent on consumers’ goods. They refrained from doing so, however, and, instead, advanced the money to the original owners of the factors. They paid the latter for their services while they were working, thus advancing them money before the product was actually produced and sold to the consumers. The capitalists, therefore, made an essential contribution to production. They relieved the owners of the original factors from the necessity of sacrificing present goods and waiting for future goods. Instead, the capitalists have supplied present goods from their own savings (i.e., money with which to buy present goods) to the owners of the original factors. In return for this supply of present goods, the latter contribute their productive 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 capitalist or group of capitalists owns all the stages of any good’s production, 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 ultimately 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, however, 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 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 factors have the money already for which they otherwise would have had to save and wait (and bear uncertainty), while the capitalist 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 future goods. The capital 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 capital 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 consumed. 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 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 managerial 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 analysis—namely, that all producers’ goods and services are only hired, never bought outright. This is a convenient assumption that will be maintained long after the assumption of specific factors is dropped. We here assume that the pure capitalists never purchase as a whole a factor that in itself could yield several units of service. They can only hire the services of factors per unit of time. This situation is directly analogous to the conditions described in chapter 4, section 7 above, in which consumers bought or “rented” the unit services of goods rather than the goods as a whole. In a free economy, of course, this hiring or renting must always occur in the case of labor services. The laborer, being a free man, cannot be bought; i.e., he cannot 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, but his services can be bought over a period of time; i.e., he can be rented or hired.

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, 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 “entrepreneurs” who buy labor and land factors in expectation of a future monetary return from the final product. They are entrepreneurs, however, only in the actual economy of uncertainty. In an evenly rotating economy, where all the market actions are repeated in an endless round and there is therefore no uncertainty, 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 certain, the capitalists are still providing present goods to the owners of 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 two for 100 ounces when it had become a present good. In other 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 resulting premium of a given good at present over the present prospect of its future acquisition.

In the monetary economy, since money enters into all transactions, 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 assumed to be purely specific to a particular line of production. When the capitalists have saved money (“money capital”), however, they are at liberty to purchase factor services in any line of production. Money, the general medium of exchange, is precisely nonspecific. If, for example, the saver sees that he can invest 95 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 investment 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 capital will, in the ERE, be the same in every line of production. If capitalists can earn 3 percent per annum in one production process and 5 percent per annum in another, they will cease investing in the former and invest more in the latter until the rates of return are uniform. In the ERE, there is no entrepreneurial uncertainty, and the rate of net return is the pure exchange ratio between present and future goods. This rate of return is the rate of interest. This pure rate of interest will be uniform for all periods of time and for all lines of production and will remain constant in the ERE.17

Suppose that at some time the rates of interest earned are not uniform as between several lines of production. If capitalists 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 simplicity 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 producing “similar” products. Since money is the general medium of exchange and can be invested in all products, this close competition extends throughout the length and breadth of the production structure.

A fuller discussion of the determination of the rate of interest will take place in chapter 6 below. But one thing should here be evident. The classical writers erred grievously in their discussion of the income-earning process in production. They believed that wages were the “reward” of labor, rents the “reward” 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 we have seen and shall see further below, capital goods are not 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 analysis, that no income accrues to the owners of capital goods as such.18

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 capitalists do not earn income from their possession of capital goods or because capital goods generate any sort of monetary income. The capitalists earn income in their capacity as purchasers of future goods in exchange for supplying present goods to owners of factors. It is this time element, the result of the various individuals’ time preferences, and not the alleged independent productivity of capital goods, from which the interest rate and interest income arise.

The capitalists earn their interest income, therefore, by supplying the services of present goods to owners of factors in advance of the fruits of their production, acquiring their products by this purchase, and selling the products at the later date when they become present goods. Thus, capitalists supply present goods in exchange for future goods (the capital goods), hold the future goods, and have work done on them until they become present 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 system. It is the “social rate of time preference.” It is the “price of time” on the market as the resultant of all the individual valuations 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 expectation of future goods as against present goods.

• 17The term “pure rate of interest” corresponds to Mises’ term “originary rate of interest.” See Mises, Human Action, passim.
• 18Here 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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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, interest income will be earned at the same uniform rate by capitalists 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 the capital-goods structure, treated as if it were in one composite 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 shall expand the analysis to include the case of many stages in the production process, and we shall defend this type of temporal 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 services and not whole goods can be acquired. In the case of 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 capitalist product-owners hire or rent rather than own any of the productive factors outright. In our example above, the 95 ounces went to all the factor-owners jointly. By what principles can we determine how the joint income is allocated to the various individual factor services? If all the factors are purely specific, we can resort to what is usually called the theory of bargaining. We are in a very analogous situation to the two-person barter of chapter 2. For what we have is not relatively determinate 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 consumers. 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 factors 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 bargaining 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 economic analysis into tragedy for the economy. Whatever agreement is arrived at by the various individuals will be beneficial to every one of them; otherwise, he would not have so agreed.27

at least 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 evident that the owner of every labor factor has some minimum selling price, a price below which he will not work. In our case, where we are assuming (as we shall see, quite unrealistically) that every 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 nonspecific factor, so that the theory of bargaining could never apply to labor incomes.28

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 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 must be used are 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) individuals owned these two parts, i.e., two different individuals produced 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 bargaining. 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 several different ways.29

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 indeterminacy become.30

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 (barring discoveries of new, fertile lands).

• 27Little 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, 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.
• 28Contrast the discussion in most textbooks, where bargaining occupies an important place in explanation of market pricing only in the discussion of labor incomes.
• 29See Mises, Human Action, p. 336.
• 30Any zone of indeterminacy in pricing must consist of the coincidence of an absolutely vertical supply curve with an absolutely vertical market demand curve for the good or service, so that the equilibrium price 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.