The Next Generation of Austrian Economics: Essays in Honor of Joseph T. Salerno

Modern* economic theory tends to treat production, the process of generating valued consumption in a market, as a function carried out within firms and so out of reach for the general market (Coase 1937). Firms are seen as “black box” generators of output from inputs in accordance with a calculable and formalized “production function,” and both inputs and outputs are exchanged at competitive money prices in market transactions. The market, consequently, is seen as simply a means for efficiently allocating resources through the price mechanism. The development and production of the specific goods and services that are directly valued by consumers is considered of much lesser import.

In contrast, Austrians emphasize the causal processes in the economy and therefore pay much attention to production — the way value is created through consumer wants satisfaction — and capital theory — how factors are utilized to support production. Austrians recognize that the specialized market process consists of and is dependent on an intricate structure of productive resources. This structure supports roundabout production processes that exploit productivity-enhancing uses of non-permanent intermediate (produced) goods. Such an advanced production apparatus is dependent on the specific uses of capital goods that facilitate taking factors of production through stages aimed at eventually satisfying consumer wants.

This distinctly Austrian perspective on the market as a process of production is the subject for this chapter, with specific emphasis on how changes to the economy’s production apparatus or capital structure are brought about. The aim is to elaborate on the implications of the market’s capital and production structure and thereby illustrate a specific theoretical problem that is conspicuously missing in the Austrian analysis. I draft a solution to this problem by addressing potential remedies made available by market actors exercising productive entrepreneurship. In this sense, the essay elucidates a realm for entrepreneurship within production and capital theory.

Production and Capital Structure

Capital goods can be defined as “the produced goods that must be combined still further with other factors in order to provide the consumers’ good” (Rothbard 2004 [1962], p. 299). These intermediate or “produced” goods that can only indirectly satisfy consumer wants are “a necessary way station to increased consumption” (Rothbard 2004 [1962], p. 966; emphasis in original). Seen as a whole, they compose “an intricate, delicate, interweaving structure of capital goods” (Rothbard 2004 [1962], p. 967; Lachmann 1978 [1956]), a production structure that in its current length and form is configured to satisfy wants already anticipated by entrepreneurs.

A production structure is composed of specific capital goods, themselves a combination of other capital goods and original factors. It is assembled and configured in a specific way for a specific purpose (Lachmann 1978 [1956]) and operated by specialized labor. Production is temporally dependent since it must be carried out in time. Carrying out a production process with already existing, supporting capital goods takes time, as does the production of the capital goods used in the process. The existent production structure was brought together and configured in the past, and is used and operated in the present to produce consumers’ goods available in the future.

Time, therefore, is both a limitation and a factor of production: due to its irreversibility, it “puts the future services of certain resources beyond our reach in the present and so makes it impossible to anticipate their use” (Hayek 1941, p. 52). In other words, we cannot conceive of specialized production without capital. Even acknowledging that there is a capital structure supporting production in multiple stages ultimately appears insufficient for us to fully understand the production process. For this reason, a theory of production is of limited use without a capital theory that also includes action and so explains the structure’s dynamic: how and why the production structure has taken a certain shape and how and why the structure changes over time. As we will see, the Austrian conception of production subject to the heterogeneous structure of productive capital indicates a problem related to the structure of tasks in an economy’s production apparatus. This problem does not exist for Robinson Crusoe but is potentially crippling in a specialized market, and it requires entrepreneurship and integration to be solved.

Roundabout Production Without Existing Capital

Imagine that a person P, in a world without existent capital, decides to manufacture a product A with the intention of making it available for consumers in the open market. To the extent the production process requires (or is more productive with) capital, these capital goods must first be produced. Regardless of the complexity of the specific production process, the only possible way of realizing production of A is to first produce the necessary intermediate goods such as tools and machinery, and then, at a later time and using the intermediate goods, produce A. To make this happen, P therefore accumulates the resources necessary, gets busy creating the means to carry out the production process, and then produces the end product.

Due to P’s productive endeavor to establish the necessary structure for their envisioned production process, the world now has capital. This capital gives P a competitive advantage in the market by creating a unique production capability (Barney 1995; 1991), which increases in the overall valuable output in the economy. The direct effect of the “advancing capital structure increases the marginal productivity of labor” without requiring an increase in “the labor energy expended” (Rothbard 2004 [1962], p. 578). The capital created is essentially an extension of and therefore facilitates more productive uses of labor. In this sense, the investment creating “non-permanent resources enables us [the market] to maintain production permanently at a higher level than would be possible without them” (Hayek 1941, p. 54, emphasis in original). Overall, P’s endeavor has brought about a situation where the original factors — land and labor — are used more efficiently toward satisfying consumer wants than was the case before. Production has become more roundabout.

The value of this better use of original factors is measured by the subjective valuations of consumers who benefit from this production. As Austrians have known since Menger (2007 [1871]), the market value of the capital produced is derived from consumer benefits. This means the value cannot be established until consumer valuation of the end product has been revealed through market action (purchases of the product). The market value of the produced capital — the indirect means to satisfy consumer wants — is equal to their contribution to the value consumers ultimately place in the consumption good produced (Mises 1951 [1936]; Rothbard 1987).

The temporal sequence of actions within the production process is then exactly the opposite of how its value is derived. Production begins with the extraction of the highest-order goods from their natural state and the production of intermediate or capital goods, and continues through the stages to eventually produce the lowest-order good offered to consumers. Upon consumers’ decision to purchase the lowest-order good at a certain price, the market value of capital goods is established by imputation “upstream” through the higher orders to the highest order and original factors (Menger 2007 [1871]). There can be no capital that is not preceded by production, and there can be no specialized, roundabout production without the existence of capital.

Roundabout Production In the Specialized Market

Let us now turn to analyzing a specialized market economy with existing advanced production structures, as does e.g. Rothbard (2004 [1962]) and Coase (1937). We assume a market with highly specialized production with a capital structure that is well configured to satisfy consumer wants. As capital is heterogeneous, by which is meant that it “is not an amorphous mass but possesses a definite structure [and] is organised in a definite way” (Hayek 1941, p. 6), the capital structure entails both productivity gains and high costs of adjustment. As the market data change, the existing capital structure will be misaligned to real consumer wants. In this sense, the specialized market place is very fragile to (unanticipated) changes.

This problem is partly recognized in the Austrian business cycle theory, but it is scarcely elaborated. Rather, it is acknowledged that the realignment process of the market’s capital structure, from the anticipated and prepared-for market situation to the new and revealed situation, takes time. This is undoubtedly true, and this process is carried out by entrepreneurs (broadly defined), who are “eager to earn profits, appear as bidders at an auction, as it were, in which the owners of the factors of production put up for sale land, capital goods, and labor” (Mises 1998 [1949], p. 335). Time-consuming and costly realignment follows (cf. Williamson 1985, pp. 21–22).

Yet this problem does not arise only when the market process is affected by abrupt and/or unanticipated exogenous change such as the expansion of credit by banks and the subsequent distortion of market prices. In fact, any reconfiguration, elaboration, or expansion of the capital structure, whether as a reaction to changing consumer preferences or as a means toward increased productivity and economic growth, is subject to what we can describe as a “specialization deadlock”: production structure based inertia to which both market actions and actors are subject.

A specialized market consists of production processes that encompass many stages and where the stages are carried out separately by specialized labor operating specialized capital structures configured to facilitate this particular (and perhaps similar) stage. While there may be several uses for specialized capital, each of the uses tends to be highly specific and the capital goods are therefore very limitedly substitutable in the market. To the degree capital traded in the market has undergone a particular transformation by being irreversibly combined into a non-decomposable unique (or uniquely aligned) capital good, there is no existent market for the produced means of production. New capital goods exist in a non-salable state to the degree their uses have no or very limited substitutability and lack obvious substitute uses. Whether or not a market for specialized capital goods emerges depends on the competitive discovery process (Hayek 1978) as entrepreneurs imitate and attempt to surpass the original entrepreneur’s successful production achievement (Bylund forthcoming; 2011).

While the uniqueness of particular capital goods in specialized production may severely limit their markets (both in terms of demand and supply), this may not constitute more than a temporary problem. The problem emerges as specialized capital is utilized in roundabout production processes under intensive division of labor. Assuming a market with entrepreneurs alert to and ready to adjust errors and misalignment through arbitrage (Kirzner 1973), and therefore an equilibrating market process, the market should soon approach stasis.

Entrepreneurs, eager for profit, will bid for capital and labor factors that they perceive to be undervalued or in otherwise suboptimal use. Provided entrepreneurs do not commit more errors than successful adjustments, and provided consumer preferences do not frequently, radically, and unexpectedly change, a market without innovation has limited opportunity for growth and productivity increase. In fact, even allowing for innovation of capital goods, which can be usefully thought of as finding new productive combinations of land factors and existing capital (Schumpeter 1934 [1911]), will not facilitate economic growth through productivity increases unless there is also a corresponding intensification in the division of labor. As Mises (1998[1949], p. 164) notes,

The division of labor splits the various processes of production into minute tasks, many of which can be performed by mechanical devices. It is this fact that made the use of machinery possible and brought about the amazing improvements in technical methods of production. Mechanization is the fruit of the division of labor, its most beneficial achievement, not its motive and fountain spring.

The truthfulness of the temporally dependent order in Mises’s claim can easily be shown, as we shall see in the next section.

The Specialization Deadlock

Consider the specialized market in the previous section. Assuming the market is minimally regulated and therefore without artificial barriers of entry, we can assume with Rothbard (2004 [1962], p. 369, fig. 41) that the rate of interest income for capitalist investments in each production stage will be approximately the same. Entrepreneurial arbitrage will see to it that this holds true within one production process as well as across parallel, competing processes. Alert entrepreneurs will discover and correct through arbitrage any “errors” revealed by above-normal returns in any process or stage. Profitable (successful) undertakings tend to be imitated and loss-generating (unsuccessful) are abandoned by entrepreneurs eager to earn profits, which suggests an equilibrating process consisting of continuous adjustment through correction (Shane 2003). This, in turn, suggests that markets are effectively created for specific capital goods utilized in production processes as entrepreneurs set out to imitate and emulate processes that earn profits (Stigler 1951; Bylund 2015). The economy in this sense functions as a continuous “discovery process” where competition for profit is the driving force toward better alignment between the totality of the production structure and consumer wants (Hayek 1978).

Along the lines of this reasoning one can develop a theory of strategic management based on the resources used within the firm, as has been done by Barney (1986; 1991) and others. The incentive of any firm (or rather, its owners and management) is here to strive for including and utilizing as rare and unsubstitutable resources as possible that are still valuable in production. The rarer and less substitutable (and imitable) the resources, the longer a firm can stay ahead of its competition and earn above-normal profits — competitors are simply unable to emulate the capital recipe of success. But it should be noted that while this competitive advantage may last for some time due to the unavailability of necessary resources for competitors, it will eventually be undermined by the discovery of better processes or alternative implementations of the same process.

The reason for this is that capital goods are produced and non-permanent. Even in situations where a certain capital good cannot be imitated or emulated (however unlikely this scenario is), it must be reproduced when it is used up or expired. The serviceability of capital can be extended through investments in maintenance, upkeep, and repairs. Still, capital is ultimately consumed during the production process, which means the owner of a unique capital good used in profitable production must at some point invest to extend its productive life. In a specialized market economy, any such reproduction must to some degree depend on the availability of market for materials, parts, etc., — the higher-order goods used in production of the capital good. It is therefore an impossibility that a certain resource combination — a particular capital good — is non-reproducible over time.

But even so, as Mises shows in the quote above, capital is ultimately dependent on division of labor preceding its development and use. Only through the splitting of tasks can capital goods be (1) innovated and (2) utilized in new processes. The former holds true simply because new specializations (that is, a more intensive division of labor) are necessary in order to produce a new type of capital good, at the very least in the tasks of combining factors or configuring an existing capital good. The latter is illustrated by Mises’s example of mechanization of the minute tasks that are made into separate tasks only through the splitting of existing, more broadly defined, tasks.

Consider a production process in our previously assumed specialized market that is dedicated to the production of bread. It consists of the following division of labor: a farmer produces wheat, a miller produces flour, and a baker produces and sells the bread. Each stage uses capital: the farmer uses a plow in the spring and sickle in the late summer, the miller uses milling stones, and the baker uses an oven. One can imagine making this process more roundabout through the innovation of new capital goods to support either of the stages, e.g. a tractor for the farmer or a blender for the baker (Böhm-Bawerk 1959 [1889]). But no such capital can be made available for the farmer or baker without an innovative entrepreneur figuring out the full production process for that specific capital good. This amounts to a much greater undertaking than the error-correction type of arbitrage provided by Kirznerian entrepreneurs (Kirzner 1973; 2009).

An alternative is to make the bread-producing process itself more roundabout through the insertion of more narrowly specialized labor: splitting a task into several (Smith 1976 [1776]; Bylund forthcoming). The splitting of a task is different from simply “adding” labor power. The farmer can “hire” labor workers to carry out the same tasks as he is already carrying out, which increases output through increasing the volume of labor being used in the process. As these workers need to be paid — and likely monitored (Alchian and Demsetz 1972; Williamson 1993) — it is not obvious that this is a profitable investment for the farmer. Where an increase in the number of workers leads to diminishing returns, the farmer is likely to make a loss on invested funds.

The alternative is to engage in intensifying the division of labor, which, as suggested in the Mises quote above, entails taking an existing task and dividing it into a number of more narrowly defined tasks. In the case of the bread production process, this amounts to replacing one of the existing stages with several new and separate tasks in the same way a hypothetical original production process was split from self-sufficiency toward specializations in farming, milling, and baking.

Where a market stage already consists of easily separable tasks, such as the plowing, sowing, watering, and harvesting of farming, specialization may not be more than a minor change. For instance, a farmer having hired labor workers may assign specific tasks to different workers and thereby simplify specialization. This must be preceded by increased density of labor factors (Durkheim 1933 [1892]) and can be facilitated by coordination through centralized ownership (Stigler 1951). As this type of “marginal” or incremental specialization can be rather easily brought about, it may not constitute an economic problem of production. In fact, such productivity-increasing measures should be easily discernible for the actors themselves: we know that “work performed under the division of labor is more productive than isolated work and that man’s reason is capable of recognizing this truth” (Mises 1998 [1949], p. 144; emphasis added). This is not a division of labor as much as it is a rational (re)allocation of labor input across already existing chores. But this means it also cannot constitute a problem for competing farmers, who as (or even more) easily can institute this type of division of labor by imitation or emulation. So we may, for the sake of simplicity, assume that such comparatively simple opportunities have already been exploited. Indeed, we can think of the inefficient use of laborers on the farm as an “error” to be corrected by the alert farmer.

This leaves the type of disruptive specializing that suggests a new production sub-process to replace a commonplace and standardized task carried out by market actors. We can now begin to discern the problem, since all the “low-hanging fruits” in terms of productivity-increasing allocative measures are easily exploitable and so should tend to already be exploited. What remains is the unintuitive or highly coordinative task-splitting that requires foresight, investment, and perhaps development of new types of capital goods to be realized. Add to this situation how within-stage (horizontal) competition should tend to standardize the procedures used and therefore effectively produce market standards around best practices. This is the process through which markets are created, which was explained by Stigler (1951). While the market may not reach a general equilibrium, it can easily be seen how its competitive process brings about standardizing at the production possibilities frontier. At this point, further specializing should seem unattainable if at all advantageous — much like splitting the task of “driving a taxi” into the more specialized tasks of driving straight, driving around corners, and going in reverse.

Further advances in productivity requires the adoption of a more intensive division of labor — the further splitting of existent tasks — and the use of (new) capital to replace labor with automatic execution of newly identified and separated “minute tasks.” The market, in other words, finds a state of rest in the sense of a highly restricting inertia — if not impossibility — of adopting further productivity-increasing measures. Specialization cannot go further through incremental adoption of better utilizations of labor. Whether or not market actors have exhausted all opportunities for further incremental improvements to production processes, the market is in a specialization deadlock.

Breaking Free From the Specialization Deadlock

So far we have considered production in the market: while not all actions necessarily take place independently and under the price mechanism, we noted how markets are generated as new production structures are imitated by competitors (Stigler 1951; Bylund 2011; forthcoming). For all tasks carried out in an economy’s production apparatus, therefore, there is semi-standardization within the limits of substitutability where the price mechanism is applicable. In other words, there is a tendency toward standardization of best practices through competition as improvements are all but universally implemented through profit-induced imitation in the open market.

So far we have not made any assumptions about who brings about or profits from the adjustments made in the market. The reason for this is that opportunities for incremental changes to the production structure are neither difficult to discover nor to implement or observe /imitate. This suggests the function of adjustment can be carried out by most or all market actors and without much foresight, coordination or investment. Indeed, the farmer who hires labor workers and assigns different responsibilities to them is engaging in (a weak form of) specialization and division of labor, but in such a mundane fashion that it is of little analytical importance. These tasks were already carried out — they may even have been identified as separate such — and the increased density due to increased volume of available labor facilitated an “obvious” opportunity for “specializing.” Rather than each labor worker switching between the same or similar tasks, each worker could save time and energy by streamlining their work and so focusing on a single or only a few tasks serially divided among them (Smith 1976 [1776]). This type of improvement in productivity is, indeed, within the limits of man’s capability of reason. In fact, we might expect the common worker, knowledgeable of the production process as well as the “particular circumstances of time and place” (Hayek 1945, p. 521), to identify and act to implement such productivity-increasing measures.

But this only augments our perception that the specialization deadlock is an economic problem. It should furthermore be an increasing problem as a market becomes more intensely specialized, since specializing increases heterogeneity and therefore lowers the overall density of workers carrying out similar tasks in the market place. As opportunities for specializing are exploited, taking specialization even further may necessitate much less obvious changes — and coordination. So far in our discussion, we have not included more than minimal coordination in the market place, primarily through the price mechanism and simple agreements.

Consider the case of the tractor noted above. In order to provide a tractor in this market, actors need to break free from the specialization deadlock. This is a problem of innovation, coordination, and capital investment, since it includes the insertion of a new productive sub-process to produce a higher-order good (the tractor) to be used in farming. This sub-process requires its own division of labor to carry out tasks specific to tractor production. In this case, this is a novel process the tasks of which may not have been more than limitedly known. But this need not be the case: we can easily imagine splitting the existing tasks into several independent subtasks. The solution is however found to be the same: innovation, coordination, and capital investment are necessary for the implementation and thus realization of the new tasks and thereby the more roundabout production structure.

It is not within the scope of this chapter’s discussion to specify the exact nature of implementing such improvements to the production structure. This has been done elsewhere (Bylund 2011; 2015; forthcoming), so it should therefore be sufficient to point out that this is the role of the innovative and imaginative entrepreneur. But it should also be noted that there can be no blueprint for the implementation (realization) of such novel production processes that introduce a radically intensified division of labor since their functioning is strictly unknowable — detailed information about the intricate workings of a previously unseen sub-process is revealed only through its implementation process. For this reason, the entrepreneur can only guide the project and must rely on the decentralized problem-solving or proxy-entrepreneurship of employed workers (Foss, Foss and Klein 2007). This appears to require an integrated production structure, which is commonly referred to as a firm.

Implications for Economic Theory

What has been drafted above suggests that production theory is incomplete without both capital theory and entrepreneurship. This may appear obvious to Austrians, but the entrepreneurship aspect appears often missing or lacking in discussions on capital theory. Rothbard’s discussion on production theory in Man, Economy and State can serve as an illustrative example.

Rothbard here provides a groundbreaking discussion on production theory, but his discussion on the effect of saving on the economy’s production stages is severely lacking. Increased saving, states Rothbard, shifts “investment further up the ladder to the higher-order production stages.” And further: “Simple investigation will reveal that the only way that so much investment can be shifted from the lower to the higher stages … is to increase the number of productive stages in the economy, i.e. to lengthen the structure of production” (Rothbard 2004 [1962], p. 519, emphasis in original). Perhaps this is a necessary conclusion, but as we have seen in this chapter, increasing the number of production stages implies the splitting of tasks and, essentially, breaking free from the specialization deadlock of the existent capital structure. We can hardly assume that this process is automatic or immediate (and it is of course unlikely that Rothbard would rely on such an assumption).

But even if we allow this process to be time-consuming, any production process must already encompass a full-length process with stages covering the production distance from virgin land to consumer. A more roundabout production process does not add stages to the “top,” but must split a stage into several or insert a new sub-process in-between or to assist existing stages. This has implications for the income accruing to factors and capitalists involved in each stage, since a “local” intensification of the division of labor by splitting one stage into many necessarily disrupts production.

Rothbard seems to assume a preexisting market for each production stage, which suggests standardization and substitutability throughout the market and thus somewhat accurately determined market prices. From the perspective of Rothbard’s discussion, it may not be limiting but useful to rely on analytical aggregates and talk of “readjustment.” But “readjusting” the production structure to new levels of saving is a much messier process than the type of arbitrage-like allocative adjustment we discuss above — and much messier than is shown in Rothbard’s analysis. Changes to the length of the production structure means the structure is disrupted by an imaginative entrepreneur, which has implications throughout the “intricate, delicate, interweaving structure of capital goods” (Rothbard 2004 [1962], p. 967). It is insufficient and potentially misleading to assume changes in the savings rate reallocates “capital” within the production process (and therefore across the production apparatus’ existing stages). More realistically, productive investments can fundamentally change production processes by splitting or inserting stages, and this can bring about important changes to the economy’s capital structure.

It is furthermore insufficient to treat the entrepreneur as simply the discoverer of price discrepancies who then acts to shift factors from one production process to another to better account for their “real” value (Rothbard 2004 [1962], p. 511; cf. Kirzner 1973; Sautet 2000). As Rothbard (2004 [1962], pp. 858–59) puts it:

to view entrepreneurship as simply the founding of new firms is completely invalid. Entrepreneurship is not just the founding of new firms, it is not merely innovation; it is adjustment: adjustment to the uncertain, changing conditions of the future. This adjustment takes place, perforce, all the time and is not exhausted in any single act of investment.

But as we saw above, while adjustment takes place “all the time” it can and does take place within the limits of the existing division of labor intensity; “adjustment” is unable to deal with the specialization deadlock and therefore excludes disruptive innovation. In other words, it does not include “breaking free” from the deadlock through revolutionizing the production structure, which necessitates realizing an innovative splitting of tasks — which in turn requires integration (a firm) (Bylund 2015). Entrepreneurial adjustment ensues upon and as a consequence of disruption, but it is limited to corrections given the existing production or capital structure and incremental improvements to it.

In this sense, we have drafted a scope for entrepreneurship with the help of capital and production theory that both confirms and challenges Rothbard’s analysis. It confirms Rothbard’s focus on adjustments, which are carried out “all the time” through the market’s competitive discovery process and “is not exhausted in any single act of investment.” This can potentially be seen as a “Kirznerian” type of entrepreneurship (Kirzner 1973; 1979; 1999; 2009). Yet Rothbard, by not including the type of disruptive entrepreneurship that can be found in e.g. Schumpeter (1934 [1911]), sees no significance in organization or its function in the market. He therefore does not recognize the causal relationship between the division of labor and the creation of capital that Mises notes and that we here found to suggest a solution to the interlocking compatibilities of the production structure that we refer to as the “specialization deadlock.”

In fact, it appears Rothbard in Man, Economy and State fails to recognize the great importance of the division of labor for production and capital theory as well as for the evolution of society. This chapter attempts to show, in line with Mises’s view (Mises 1998 [1949]; Salerno 1990) as well as Rothbard’s later and more astute understanding (Rothbard 1991), how the importance of the division of labor hardly can be exaggerated, but that it in fact can be used to explain the process of capital creation.

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• *Per Bylund is John F. Baugh Center Research Professor in the Department of Entrepreneurship at Baylor University in Waco, Texas. I had the great pleasure and privilege of being a summer research fellow in 2009 and 2010, and a postdoctoral research fellow in 2012. This chapter is an extension of the theoretical perspective developed in my dissertation at the University of Missouri, which was originally developed while a summer fellow at the Mises Institute and with the help and encouragement of Professor Salerno.