7. From an Evenly Rotating Economy to the Real World

In an evenly rotating economy, the problem of resource allocation would be easily solved. Knowledge of future preferences, resources, and techniques of production would be the result of a world without change. Equipped with this knowledge, market participants would be able to devote resources to their most satisfying lines of use without friction and inconsistent planning. Units of factors of production would be priced equal to their discounted marginal value product, thereby permitting investor-producers to earn only an interest return. Units of factors would be repeatedly employed in the same fashion as in the past, since to change particular usages would require the creation of a lower marginal value product, an inferior result that could be anticipated in advance and obviated. The known money values of future products would indicate the money values of resources to be used in their creation.

However, everyone knows that the real world is not a world of mere constants and perfect predictability. There is really no assurance about tomorrow. The tastes and value scales of individuals do not remain constant, and neither can anyone assume that the nature and amount of available resources will remain the same. And with time comes continuous revision in the recipes and techniques of production. Thus in the real world there is no simple and automatic solution to the task of resource allocation. Because of the ever-present factor of uncertainty, no actor “knows” the future; each can only attempt to forecast it in terms of his own understanding of the potentiality of the present.

Nevertheless, the concept of the ERE is useful in explaining and understanding the real world of change. In the midst of continuous change, the market is relentlessly in pursuit of a general equilibrium in which all productive factors are being applied to their most desired uses and all profits and losses have disappeared. In other words, the tendency of the real market is always moving toward an evenly rotating economy. It is the factor of change that prevents that economy from ever being reached. With the conditions and data of the market being subject to constant change, revisions and adjustments in plans and actions are continually necessitated.

The concept of an ERE helps one to imagine a world in which changes in tastes, resources, and technology have ceased. More importantly, it yields an understanding of the direction that the market is continually taking as errors emanating from the imperfect knowledge of the future give rise to revised plans and actions on the part of market participants. For example, when producers underestimate the demand for a particular good, the resulting higher price of the good attracts more resources to that use and away from less important uses. As more attention is given to the production of this good, its unit price falls and the unit price of its resources rises, gradually eliminating the opportunity to profit form its production.

This is a process of adjusting to facts of the market that were not knowable in advance. Through this adjusting process, the market continually strives to reach the state of the ERE; the problem is that this quest is constantly interrupted and sidetracked as a result of subsequent change and its complement, the need for additional adjustment. It should be clear that the imaginary ERE is not being held up as some kind of ideal economy. Its purpose is only to help explain the workings of the real market economy. The contrast between the real world and the ERE is described by Rothbard:

The difference in the dynamic, real world is this. None of these future values or events is known; all must be estimated, guessed at, by the capitalists. They must advance present money in a speculation upon the unknown future in the expectation that the future product will be sold at a remunerative price. In the real world, then, quality of judgment and accuracy of forecast play an enormous role in the incomes acquired by capitalists. As a result of the arbitrage of the entrepreneurs, the tendency is always toward the ERE; in consequence of ever-changing reality, changes in value scales and resources, the ERE never arrives.1

This whole matter of the constant changeability of market conditions is the essence of the concept of uncertainty, as distinguished earlier from the concept of quantifiable risk. The key to this distinction is that the interrelationship of events and factors in the competitive market is so complex that it precludes the precise calculation of probability of the success or failure of any given entrepreneurial decision. Market conditions at any instant are comparatively unique; they do not lend themselves to the gathering of extensive empirical data that can be said to relate to homogeneous circumstances and events. Accurate anticipations of consumer preferences, competitor actions, technological change, and resource availabilities are far more difficult to make than typical actuarial predictions.

Actuarial predictions deal with matters that have an extensive history, are subject to detailed classification, and occurred under conditions that can be expected to remain for the most part unchanged for the time being. Businessmen, however, do not have the fortune of operating under many of these repetitive sequences of highly categorized events. As Knight has said the problem stems from the inability to accumulate sufficient empirical data relating to particular classes of subjects and events. As Hayek has put it, “In the social sciences we have to deal with... phenomena which are not made up of sufficiently large numbers of similar events to enable us to ascertain the probabilities of their occurrence.2

All of this is not to say that businessmen have absolutely no sense of what future developments are likely to be. They do make judgments and predictions about the future. But the point is that these anticipations are speculative and not mathematically precise. It is not that there are no indications concerning the future; it is that there is grossly incomplete knowledge of future developments. The following statements by Knight are pertinent:

It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little. This is as true of business as of other spheres of activity. The essence of the situation is action according to opinion, of greater or less foundation and value, neither entire ignorance nor complete and perfect information, but partial knowledge.3

Entrepreneurial Profits and Losses

Profit theory has often explained the emergence of money profits in the market economy either as a reward for taking risks or as the natural income earned by capital (as opposed to the rents of land and wages of labor) in the classical sense. Both of these analyses are incorrect. In the competitive market, all business activity is risky in the sense of being uncertain; yet not every business venture is monetarily profitable. A businessman who makes too many mistakes is not automatically rewarded with profits simply because he undertook ventures of a risky nature. Profits cannot be called simply a reward for risk-taking. The classical thesis that profits are the return peculiar to the category of capital or capital goods is an empty explanation because it fails to show just why something extra should arise from the usage of capital and not from the usage of the other factors of land and labor. At times this theory borders on a sort of normal interest theory, but it lacks the principle of time-preference and is mistaken in tying interest only to capital goods. As has been shown, the phenomenon of interest is present in all matters involving the exchange of present goods for future goods.

Profits which are nonexistent in the evenly rotating economy are received by those entrepreneur-producers who most correctly anticipate the wishes of the consumers. Profits arise when productive factors are bought for prices lower than the prices for which their products are sold. In a world of uncertainty, the producers have to judge what the marginal value product will be for units of productive factors. Those who are able to discern discrepancies between current resource prices and the future prices of their products generate money revenues in excess of money costs by capitalizing on such opportunities. In such cases the resources can be said to have been underpriced. The ultimate prices of consumer goods are determined by the subjective valuations placed by consumers on the goods offered for sale. Thus the crucial task of the entrepreneur-producer in purchasing various units of resources is to anticipate as correctly as possible the future preferences of consumers. Using such anticipations, he is able to impute an anticipated marginal value product to the available factors of production.

Profits result if others have failed to value the particular factor units as highly and if it turns out that the entrepreneur-producer was reasonably correct in his anticipations. On the other hand, losses result whenever he acquires resources at amounts greater than the money value of the products generated from such resources. In these cases the resources can be said to be overpriced for the purposes to which they were put. Since there is no certainty about the future, there is room in the market economy for entrepreneurial losses as well as profits. Profits, then, do arise in connection with risk-taking but only when the anticipations turn out to be correct.

A theory of profits should also include a corollary explanation of losses. The principal determinant of business success is the foresight and alertness of those in charge of directing the business. Mises has explained the source of money profits in the following way:

The ultimate source from which entrepreneurial profit and loss are derived is the uncertainty of the future constellation of demand and supply.

If all entrepreneurs were to anticipate correctly the future state of the market, there would be neither profits nor losses. The prices of all the factors of production would already today be fully adjusted to tomorrow’s prices of products. In buying the factors of production the entrepreneur would have to expend (with due allowance for the difference between the prices of present goods and future goods) no less an amount than the buyers will pay him later for the product. An entrepreneur can make a profit only if he anticipates future conditions more correctly than other entrepreneurs. Then he buys the complementary factors of production at prices the sum of which, including allowance for the time difference, is smaller than the price at which he sells the product.4

It should be realized that the phenomenon of entrepreneurial profits and losses continues to occur only because there are persistent changes in market conditions. This is what was meant when it was earlier stated that the concept of the evenly rotating economy provides an understanding of the goal toward which the market continuously moves but never reaches. If new changes in market data were not to constantly occur, the prices of all complementary resources would be finally set so that total money costs would equal total money revenues and there would be nothing left for profits and losses. There is an inherent tendency for profits and losses to disappear as entrepreneurs make adjustments in their plans, moving into profitable lines and away from unprofitable ones. It is the recurrence of change and discovery in market conditions that precludes the permanent and complete elimination of profits and losses.

Consumer Valuations and Productive Resources

It has already been shown that the subjective valuations of consumers are the principal determinant in establishing prices of consumer goods. And the vital connection between the prices of consumer goods and the prices of factors of production was demonstrated in describing the conditions of the evenly rotating economy. In the ERE the prices of resources are derived from the money value of the product created. This essential relationship between the prices of final and intermediate goods and services is no less applicable in the dynamic market economy. Just as in the ERE, entrepreneurs bid for units of resources in the real market in light of their expected marginal value product. Prices of consumer goods are not set by simply adding up the money costs of production. The value scales of consumers determine the prices of produced consumer goods, and it is these expected prices of consumer goods that provide the basis for entrepreneurial bidding for units of scarce resources that are utilized in the generation of consumer goods. The process is the same as it would be in the ERE, except that in the real world product value cannot be imputed to the means of production with certainty.

The entrepreneur-producer’s failure to see that the prices of productive resources arise from the expected price of his product occurs because he sees his costs as being externally determined and simply given. His problem, as he see it, is to place available resources in productive uses that will yield revenues sufficiently in excess of these costs. But if the broader view that the economist takes is considered, one realizes that the prices of resources, or costs, stem from widespread bidding by countless participants since most factors can be employed in a wide variety of productive uses. Underlying all of this bidding are the anticipated marginal value products as envisioned by the various producers. For a highly nonspecific factor of production, the unit price that any given producer pays reflects the expected marginal value product of that factor in alternative uses, the culmination of bidding on the part of innumerable and diverse firms. The acceptance of a “given” price by the individual entrepreneur-producer actually contributes another bid to the market process.

The derivation of prices of highly specialized factors from the expected value of their product is even more obvious. The price of this type of resource is actually far more sensitive to changes in the price of its product than is the price of a highly versatile resource to changes in the price of any particular product for which it is being used because the economic fate of the versatile factor is not so dependent upon how well any particular product fares economically. The gradations of its value in alternative uses entail much narrower gaps than does a specific resource whose value in some other use by definition approaches zero. One only needs to consider the predicament of the owner of cigarette machines if the demand for cigarettes were to significantly diminish or increase to grasp the relationship between product prices and the prices of specific resources.

The producer who sells his product to other producers rather than the ultimate consumer does not escape the influence of consumer valuations on the price of his product. The producer who purchases his product to be used further in the production process or to be sold to other producers or ultimate consumers will see the product in terms of what he in turn can sell the good or its product for. The influence of consumer valuations is pervasive regardless of the number of stages through which the resources pass before their culmination in the final consumer good. At some final level, producers who sell directly to consumers must directly impute dollar values expressive of consumer preferences to the resources and services purchased. It is this front line of producers who set the imputation of consumer prices to resource prices in motion, and this imputative relationship permeates every prior stage of the production process. No seller of producer goods and services can long stay in a particular line of business if the ultimate consumer good into whose production his product or service enters has grown unpopular, regardless of how many stages or levels removed from the final product his contribution is.

Sellers of producer goods and services may well be able to concern themselves only with the expected prices to be paid by their own customers, and not trouble themselves with the prices that will eventually be paid by customers. Yet it cannot be ignored long that these immediate prices mirror over time the anticipated final prices, and this fact becomes more apparent the further one moves along the production process toward product completion. The closer to completion the intermediate goods become, the more specific they are and the closer the tie between them and the ultimate consumer good. For example, iron is more convertible than iron tubes, and iron tubes are more convertible than iron machine parts. In a modern economy the advent of intricate capital goods creates a serious issue of convertibility in a market environment of changing conditions. Less advanced times were characterized by far more flexible, though less productive, means of production. Mises has explained this dominant role of the consumers in the economic process of the market economy:

The consumers determine ultimately not only the prices of the consumers’ goods, but no less the prices of all factors of production. They determine the income of every member of the market economy.... The competition between the entrepreneurs reflects the prices of consumers’ goods in the formation of the factors of production.... It makes effective the subsumed decisions of the consumers as to what purpose the non-specific factors should be used for and to what extent the specific factors of production should be used.5

Of course, in the midst of the uncertainty and extremely long channels of production that characterize the modern market economy, there is plenty of room for error in pricing based on expected consumer preferences and product prices. As noted earlier, those who make too many mistakes are penalized by financial loss, and those who are more correct in their anticipations reap financial profits. Changes in market conditions are particularly harsh for the owners of capital goods that are not easily convertible to other uses. The owner of cigarette machines could be ruined if there were a widespread fall in the demand for cigarettes.

At any given moment capital goods are appraised exclusively from the point of view of their future usefulness. This potential usefulness is not merely a matter of technological usefulness but embraces the monetary significance of the item’s anticipated product. Thus a relatively new machine can be rendered obsolete and virtually worthless as a result of changes in market data. The entrepreneur does not appraise his complex of productive factors from the standpoint of how much he expended for them in the past. As Jevons said, “In commerce bygones are forever bygones.... Industry is essentially prospective, not retrospective.” This is the essential meaning of the concept of “sunk costs.” Mises cogently makes the same point: “Errors committed in the past in the production of capital goods available today do not burden the buyer; their incidence falls entirely on the seller. In this sense the entrepreneur who proceeds to buy against money capital goods for future production crosses out the past.”6

It can then be seen that nonspecific resources like raw iron and labor can be used to produce a specialized machine whose product is no longer important to the consuming public. This means that the money value of the machine would bear no relationship to the money costs of the versatile inputs whose usefulness has been dissipated in the conversion process. In retrospect, it would have been better had the versatile resource units been devoted to more desirable conversions. But such mistakes are likely to occur in the absence of perfect knowledge of the future.

The Consequences of the Past

Although all action is oriented to the future, one must not overlook the influence of the past on production. The fact that changes in market conditions render an inconvertible capital is necessarily economically feasible to abandon the inferior good and shift to the superior one. One is certainly justified in saying that in retrospect committing resources to a form that eventually becomes inferior is economically wasteful. The entry of the asset on the owner’s books would show this economic loss. It may be, however, that the inferior machine can still be used in competition with the superior one. Whether the inferior machine should remain in use or be abandoned for the more modern one depends on how well the latter performs.

The decision hinges on the net revenues that can be expected from each alternative from the present moment on. The additional cost of implementing the technologically superior machine may be too great to warrant the shift. The inferior machine is already in existence and its original cost is thus no longer relevant. On the other hand, the cost of the superior machine is still relevant because no decision on it has been made and no money has been committed for its acquisition. If the net revenues expected from continued use of the inferior machine are greater than that expected from alternative uses (including scrapping), then this continued use is economical.

The complaint that things would be better if the inferior machine had never been provided serves no purpose now. The task is to make the best of things as they now exist. This is what Mises means when he says, “History and the past have their say.”7

The influence of the past has the same application to the question of advantageous and disadvantageous locations of inconvertible capital goods. Changes in market conditions can result in a plant’s location becoming less desirable than some other place of operation, but costs of relocating can prohibit a shift in spite of the desirability of the new location.

Unrestricted and Restricted Markets

The economic analysis in this book deals primarily with a market economy in which there exist comparatively few artificial restrictions on the economic activities of its members. It is this relatively unhampered market that tends to direct resources so that, as Mises says, “No want more urgently felt should remain unsatisfied because the means suitable for its attainment were employed--wasted--for the attainment of a want less urgently felt.” The importance of the subjective valuations of producers and consumers has been emphasized already. The unhampered market recognizes the wants of every individual, regardless of his function as a buyer or seller. (Actually, each able person performs both roles in the market economy.)

The significant point here is that although the wants of the consumers are preeminent regarding the goods and services offered for sale in the market, the ultimate decision to choose between the monetary reward of the market and the advantages of other pursuits is left up to each individual. Employees and investors act on the basis of nonmonetary as well as monetary factors. The sovereignty of the consumers is not unlimited.

It should be clear, however, that artificial restrictions that are granted to some producers and denied to others can be and have been superimposed on the otherwise unhampered market. As a result, restrictions like monopoly rights, patents, and copyrights emerge on the market as economic factors in the same way that other resources gain economic significance. The process of monetary calculation results in the association of economic value with each factor to the extent of its expected contribution to money revenues, which means that market prices can exist for such restrictive factors as transferable franchises, patents, and copyrights. The pricing of such restrictive factors is thus no different from the pricing of resource factors that are not artificially created.8

The Social Role of Profits

The objective of entrepreneurial activity in the market economy is to capitalize on opportunities to invest in factors of production at costs that are adequately lower than the revenues subsequently generated by productive activities. Those who are able to achieve this objective successfully receive money profits. The important result of profitable business operations is that resources are thereby diverted away from less desirable uses into uses that better suit the wishes of consumers. Profits, then, serve a vital social purpose. In a changing world there is always an opportunity to improve the way things are done. Improvements may take the form of more satisfying products and services or more efficient ways of generating presently preferred products and services.

So long as the ways of doing things are not frozen and people are not barred from pursuing improvements, profits will always occur and be a necessary part of the market economy. Only in the imaginary and static economy of the ERE are all opportunities for improvement in resource utilization exhausted. It is clear that changes in either preferences, resources, or technology call for rearrangements in the employment of available resources.

The emergence of discrepancies between product prices and the prices of the complementary factors of production signals to market participants that adjustments are in order. Profitable discrepancies attract increased assignment of resources to those particular lines of application; this extension is accompanied by higher unit prices of resources used and lower unit prices of those particular products. Over time the price discrepancies are eliminated in those particular lines; profits for those businesses disappear, at least until new discrepancies are discovered or created.

The superior foresight of the successful entrepreneur-producer does not benefit him permanently because others follow his example and lower his profits.9 If the difference between total money costs and total money revenues goes the opposite way and financial losses instead of profits are the result, adjustments are made in the other direction. Relevant factors of production are reshuffled into other employments until losses in the original lines of business are terminated and profit prospects restored. The occurrence of financial losses shows that resources would be better used elsewhere, that they have been put to uses that are inferior to alternative lines of employment as represented by their prevailing market prices.

It is the ceaseless search on the part of entrepreneurs for profitable opportunities that leads to the allocation of scarce resources to their most desirable productive usages. Along the way, they wipe out the discrepancies between resource values and product values and thereby remove market inconsistencies. Discrepancies between factor and product money values simultaneously expose existing misallocations of resources and promote corrective action in providing profit opportunities. It is thus important to realize, as Kirzner has pointed out, that “the entrepreneurial search for profits implies a search for situations where resources are misallocated.“10 The crucial role of the entrepreneur, hence of profits, in the market economy is of utmost significance.

For it is impossible to eliminate the entrepreneur from the picture of the market economy. The various complementary factors of production cannot come together spontaneously. They need to be combined by the purposive efforts of men aiming at certain ends and motivated by the urge to improve their state of satisfaction. In eliminating the entrepreneur one eliminates the driving force of the whole market system.11

Although there would be neither entrepreneurs nor entrepreneurial profits in an ERE, it has been shown that there would exist an interest income for the producers who invest present money for future money. In the real world of change and profits, the time-preference principle is no less operative. This means that conceptually there can be recognized the phenomenon of interest in the market economy. However, because of the factor of uncertainty, each investment of present money is faced with the possibility of failure and loss. Consequently, the so-called rate of interest actually constitutes a combination of time and uncertainty factors that are intertwined to give a single rate. The distinction can be made only conceptually as the factor of uncertainty surrounds every instance of investment. The perception of varying degrees of uncertainty accounts for the structure of varying so-called rates of interest.

At the outset of this overview of the Austrian analysis of the market economy, it was stressed that in an economy of exchange, advanced and developed through specialization and the division of labor, two absolutely essential requirements must be satisfied. The first was the need for a common basis for calculating the relative merits of alternative resource employments. Calculations in kind were seen to be insufficient for the rational allocation of scarce resource in an advanced economy. This requirement calls for some medium through which the preferences of the members of the society, its consumers, could be expressed to and discerned by the employers of the productive resources. The second was the need for a means by which the decisions and actions of scattered and separate actors can be coordinated. It was concluded that both of these requirements are met by the use of a common means of exchange and its counterpart, money prices. Economic calculation, predicated upon a system of market prices, emerges as the indispensable means of effective resource employment.

It can now be seen that through the economic calculations of entrepreneur-producers, there is a rational process of factor utilization. These calculations are developed with the guidance of past market prices and money results and through projected market prices and monetary results relating to various resources and final products. The advent of change in market conditions is reflected in certain price changes that signal for different courses of action to be taken to enhance the effectiveness of resource employment. Without the system of money prices and the ability to calculate expected results of various actions in terms that afford comparisons, there would be no way rationally to plan production activities on a scale characteristic of an advanced economy.

Efficient resource utilization necessitates some means by which prospective alternative lines of use can be related as well as possible to each prospective result of product. Although it is tenuous and imprecise, monetary calculation provides this means. And although erroneous calculations can be made because of poor judgment, resulting in the misallocation of resources, they can be quickly rectified by the financial loss revealed in retrospective calculation.

It bears repeating that monetary calculation is not concerned with the measurement of value. The task of resource allocation can be accomplished if calculations afford guidance to the relative importance of various uses and products. Monetary profits and losses indicate the more desirable and the less desirable applications of units of scarce resources. Although it is prospective monetary calculation that is primary, retrospective calculations of profit and loss are important both instructionally and in guiding decisions about capital maintenance and capital consumption. The concepts of capital and income, profit and loss, revenues and costs, provide the rational basis for resource allocations in the market economy. The allocation process is thereby purposive and not haphazard.

An Introduction to Austrian Economics

Entrepreneurial Profits and Losses

Consumer Valuations and Productive Resources

The Consequences of the Past

Unrestricted and Restricted Markets

The Social Role of Profits

Suggested Readings