Chapter 4: How To Get Milk

Economists understand very little about how technological progress occurs.   —  Alan Greenspan, “Testimony of Chairman Alan Greenspan”

Before we leave the topic of the problems and blessings of roundaboutness of production and the structure of production, it will be very useful to see a natural, concrete example of it in action. It then will become easier to understand the unnatural cases involving malinvestments and the skyscraper curse.

Making production processes more roundabout results in greater production in terms of the quantity produced and a lower cost on a per-unit basis. Entrepreneurs would not want to make production processes more roundabout unless they thought they would create more profits as a result. More roundabout production takes more time, more steps, and a more extensive division of labor. It also uses new technology.

Entrepreneurs do make mistakes, of course, but the only systematic errors they make are when they are fooled into rearranging production because of artificially low interest rates and easy credit conditions. When the central bank lowers its target interest rates it also makes credit conditions easier in that banks will make a larger volume of loans, which means they weaken their lending standards in order to facilitate the larger volume of loans.

A good example of a very direct production process, in contrast to a more roundabout one, is a farmer who goes to the barn, milks a cow, and then returns to the house and feeds the milk to his family.

An example of a more roundabout, although still very direct, production process comes from my childhood. We lived on the edge of a small town. Just beyond our house were fields and barns. Dairy cattle would feed on the grass in the fields. Later they would return to the barns to be milked. The milk would then be transported a short distance  —  a couple miles  —  in a small tanker truck to one of three small dairies in my hometown. There the milk would be processed and packaged. Early the next morning a dairy man in a white suit would arrive at our house and place several quart-size glass bottles of milk in an insulated dairy box outside of our back door and pick up any empty bottles we had placed there. If we wanted an ice cream sundae, we had to go to the dairy during retail hours.

By the time I graduated from high school the entire system had changed. The small dairy farms had been largely replaced with larger farms. The small four-wheel tanker trucks had been replaced by large eighteen-wheel tankers. An eighteen-wheel tanker truck brought the raw milk from the farms to the dairy factory about thirty miles from our house, and a different eighteen-wheel refrigerated truck brought cartons of milk and ice cream as well as boxes of butter to the supermarket. All three of the small hometown dairies eventually went out of business. They were replaced by much larger, factory-size dairies many miles from our home. Instead of having the milk bottles delivered directly to our house, we now purchased dairy products at the local supermarket, an institution that was also a relatively new phenomenon.

The dairy factory system is a much more roundabout production process. It takes more time. The milk travels a round-trip journey of more than sixty miles instead of the less-than-four-mile journey in the old days. There is a greater amount of capital as well as advanced technology involved and there is also far less labor per unit of milk. The overall cost of milk is lower, and with competition between large dairy wholesalers and supermarkets, so is the price.

In order to attain a more roundabout production process there are several requirements. It requires entrepreneurs with a vision of the most profitable action among all possible actions. It requires investment in more capital goods and new technology. Of course, all of this rearranging of production is going to take a great deal of time and even more time for it to be profitable.

Therefore, the entrepreneurs need to have access to savings. They need to have either their own savings or someone else’s savings on a long-term basis in order to proceed. Hence there must be more overall savings in an economy in order to achieve more roundabout production and all the benefits it entails. Savers must have lower time preferences and be willing to delay some consumption in the present. Savers will be rewarded with interest income, with which they will be able to make a greater number of purchases in the future and at lower prices because of the increase in production of goods. The whole process is regulated by the rate of interest, the price system, and the system of profit and loss.

This process is sometimes referred to as creating economies of scale. But notice that while there are economies of scale in this example, everything about the production process changed. The most successful approach was not preordained or known in times past. The entire recipe or technology of production has changed. All the capital goods  —  including the milking machines, the trucks, and the machinery inside the dairies  —  are different. Notice further that the change in the dairy industry is going to induce changes in other industries, including technology and investment in the mechanical milking machines industry. All of this requires a careful synchronization process, which is obviously beyond the scope of central planning. The process is driven by the rate of interest. So we will now see what happens when the interest rate is misleading and results in an economic bust and, in severe cases, the skyscraper curse.