3. Entrepreneurship and Income
a. Costs to the Firm
We have seen the basis on which the prices of the factors of production and the interest rate are determined.
Looked at from the point of view of an individual entrepreneur, payments to factors are money costs.
It is clear that we cannot simply rest on the old classical law that prices of products
tend in the long run to be equal to their costs of production.
Costs are not fixed by some invisible hand, but are determined precisely by the total
force of entrepreneurial demand for factors of production.
Basically, as Boehm-Bawerk and the Austrians pointed out, costs conform to prices and not vice versa.
Confusion may arise because, looked at from the point of view of the individual firm rather than of the economist,
it appears as if costs, at least in the sense of the prices of factors, are somehow given and beyond one's control.
Hence, when the economist considers only the single firm, as in recent years, he goes completely
astray by ignoring the generality of economic interrelations.
To analyze means-ends relations logically, as economics does, requires taking all relations
into account.
Failure to do so, either by treating the single firm only, or by treating unreal holistic
aggregates, or by taking refuge in the irrelevant mathematics of the Lausanne General Equilibrium
School is equivalent to abandoning economics.
If a firm can command a selling price that will more than cover its costs, it remains
in business.
If not, it will have to leave.
The illusion of externally determined costs is prevalent because, as we shall presently
see, most factors can be employed in a wide variety of firms, if not industries.
If we take the broader view of the economist, however, the various costs, that is, prices
of factors, determined by their various DMVPs in alternative uses, are ultimately determined
solely by consumers' demand for all uses.
It must not be forgotten, furthermore, that changes in demand and selling price will change
the prices and incomes of specialized factors in the same direction.
The cost curves, so fashionable in current economics, assume fixed factor prices, thereby
by ignoring their variability even for the single firm.
It might be noted that in this work there is none of that plethora and tangle of cost
curves which fill the horizon of almost every recent neo-classical work in economics.
Many beginning students come away with the impression that economics consists of an indigestible
A simple brew of cost curves to be memorized by rote and drawn neatly on the blackboard.
This omission has been deliberate, since it is our contention that the cost curves are
at best redundant, thus violating the simplicity principle of Occam's razor and, at worst,
misleading and erroneous.
As an explanation of the pricing of factors and the allocation of output, it is obvious
Notice that cost curves add nothing new to discussion in terms of marginal productivity.
At best, the two are reversible.
This can be clearly seen in such texts as E.T.
Weiler's The Economic System and George J. Stigler's Theory of Price.
But in addition, the shift brings with it many grave deficiencies and errors.
This is revealed in the very passage in which Stigler explains the reasons for his switch
from a perfunctory discussion of productivity to a lengthy treatment of cost curves.
The law of variable proportions has now been explored sufficiently to permit a transition
to the cost curves of the individual firm.
The fundamentally new element in the discussion will, of course, be the introduction of prices
of the Productive Services.
The transition is made here only for the case of competition.
That is, the prices of the productive services are constant because the firm does not buy
enough of any service to affect its price.
But by introducing given prices of productive services, the contemporary theorist really
abandons any attempt to explain these prices.
This is one of the cardinal errors of the currently fashionable theory of the firm.
It is highly superficial.
One of the aspects of this superficiality is the assumption that prices of productive
services are given without any attempt to explain them.
To furnish an explanation, marginal productivity analysis is necessary.
Marginal productivity analysis and the profit motive are sufficient to explain the profit
The Market Prices of Commodities and Factors on the Basis of Given Stocks and Speculative Demands and Given Consumer Valuations
The immediate run is important, since it provides an explanation of the actual market prices of all goods at any time.
The other important concept is that of the final price, or the long-run equilibrium price, that is, the price that would be established in the ERE.
This is important because it reveals the direction in which the immediate run market prices tend to move.
It also permits the analytic isolation of interest as compared to profit and loss in entrepreneurial incomes.
In the ERE, all factors will receive their discounted marginal value product, and interest will be pure time preference.
The interesting phases, then, are the immediate run and the long run, yet cost curve analysis deals almost exclusively with a hybrid intermediate phase known as the short run.
In this short run, costs are sharply divided into two categories, fixed, which must be incurred regardless of the amount produced, and variable, which vary with output.
This whole construction is a highly artificial one. There is no actual fixity of costs. Any alleged fixity depends purely on the length of time involved.
In fact, suppose that production is zero. The cost curve theorists would have us believe that even at zero output, there are fixed costs that must be incurred, rent of land, payment of management, etc.
However, it is clear that if data are frozen, as they should be in such an analysis, and the entrepreneurs expect a situation of zero output to continue indefinitely, these fixed costs would become variable and disappear very quickly, the rent contract for land would be terminated and management fired as the firm closed its doors.
There are no fixed costs.
Rather, there are different degrees of variability for different productive factors.
Some factors are best used in a certain quantity over a certain range of output,
while others yield best results over other ranges of output.
The result is not a dichotomy into fixed and variable costs, but a condition of many degrees of variability for the various factors.
Lionel Robbins points out that the length of a period of productive activity depends upon the expectations of entrepreneurs concerning the permanence of a change and the technical obstacles to a change.
Change.
Even if none of these difficulties existed, it is hard to see why the short run should
be picked out for detailed analysis when it is merely one way station or rather a series
of way stations between the important periods of time, the immediate run and the long run.
Analytically, the cost curve approach is at best of little interest.
With these caveats, let us now turn to an analysis of the costs of the firm.
Let us consider what will happen to costs at alternate hypothetical levels of output.
There are two elements that determine the behavior of average costs, that is, total
costs per unit output.
A. There are physical costs, the amounts of factors that must be purchased in order to
to Obtain a Certain Physical Quantity of Output
These are the obverse of physical productivity,
the amounts of the physical product that can be produced
with various amounts of factors.
This is a technological problem.
Here the question is not marginal productivity,
where one factor is varied while others remain constant in quantity.
Here we concentrate on the scale of output when all factors are permitted to vary.
Where all factors and the product are completely divisible,
a proportionate increase in the quantities of all the factors
must lead to an equally proportionate increase in physical output.
This may be called the law of constant returns to scale.
B. The second determinant of average costs is factor prices.
Pure competition theorists assume that these prices remain unchanged with a changing scale of output.
But this is impossible.
As any firm's scale of output increases, it necessarily bids factors of production away from other firms,
raising their prices in the process.
And this is particularly true for labor and land factors, which cannot be increased in supply via new production.
The increase in factor prices as output increases, combined with constant physical costs, raises the average money cost per unit output.
We may therefore conclude that if factors and product were perfectly divisible, average cost
would always be increasing. In the productive world, perfect divisibility does not always or
even usually obtain. Units of factors and of output are indivisible, that is, they are not
Purely divisible into very small units. First, the product may be indivisible. Thus, suppose that three units of factor A plus two units of factor B may combine to produce one refrigerator.
Now, it may be true that 6a plus 4b will produce two refrigerators according to our law of
returns to scale.
But it is also true that 4a plus 3b will not produce one and a fraction refrigerators.
There are bound to be gaps where an increased supply of factors will not lead to an increased
In the areas of the gaps, average costs increase rapidly, since new factors are being hired with no product forthcoming.
Then, when expenditures on factors are increased sufficiently to produce more of the product,
There is a precipitate decline in average cost compared to the situation during the gap.
As a result, no businessman will knowingly invest in the area of the gaps.
To invest more without yielding a product is sheer waste.
And so, businessmen will invest only in the trough points outside the gap areas.
For example, suppose that a thousand gold ounces invested in factors yield 100 units of product,
and that 1100 ounces yield 101 units. All the points in the gap between 1000 and 1100
will yield no more than 100 units. The excess of investment over 1000
1,000 and under 1,100 ounces is clearly sheer waste, and no businessman will invest within the gap.
Instead, investments will be made at such trough points for average cost as 1,000 and 1,100.
Secondly, and more important, the productive factors may be indivisible. Because of this
In this indivisibility it is not possible simply to double or have the quantities of input of every one of the productive services simultaneously.
Each factor has its own technological unit size.
As a result, almost all business decisions take place in zones in which many factors have to remain constant,
While others, the more divisible ones, may vary, and these relative divisibilities and
indivisibilities are due not to variations in periods of time, but to the technological
size of the various units.
In any productive operation there will be many varieties of indivisibility.
Professor Stigler presents the example of a railroad track, a factor capable of handling
up to 200 trains a day.
The track is most efficiently utilized when train runs total precisely 200 a day.
This is the technologically ideal output and may be the one for which the track was designed.
Now what happens when output is below 200?
The railroad's output is only 100 per day. The divisible factors of production will then be cut in half by the owners of the railroad.
Thus, if engineers are divisible, the railroad will hire half as many engineers, or hire its engineers for half their usual number of hours.
But, and this is the critical point here, the railroad cannot cut the track in half,
and operate on half a track.
The technological unit of track being what it is, the number of tracks has to remain
at one.
Conversely, when output increases to 200 again, other productive services may be doubled,
But the quantity of track remains the same.
We are not discussing the fact that the railroad could, of course, cut down or increase the
mileage of its track by including less or more geographic area in its service.
The example assumes a given geographic area in which the railroad operates.
What happens should output increase to 250 trains a day, a 25% increase over the planned
quantity.
Divisible services such as engineers may be increased by one-fourth, but the track must
either remain at one and be overutilized, or be increased to two.
If it is increased, the tracks will again be underutilized at 250, because the ideal
output from the point of view of utilizing the tracks is now 400.
When an important indivisible factor is becoming less and less underutilized, the tendency
will be for increasing returns, for decreasing average costs as output increases.
When an important indivisible factor is becoming more and more overutilized, there is a tendency
for increasing average costs.
In some spheres of production, indivisibilities may be such that full utilization of one indivisible
factor requires full utilization of all.
In that case, all the indivisible factors move together and can be lumped together for
our purposes.
They become the equivalent of one indivisible factor, such as the railroad track.
In such cases, again, average costs will first decline with an increase in output, as the
increased output remedies an underutilization of the lumped indivisible factors.
After the technologically most efficient point is reached, however, costs will increase,
given the indivisible factors.
The tendency for costs to decline will, in addition, be offset by the rise in factor
prices caused by the increase in output.
In the overwhelming majority of cases, however, each factor will differ from the others in
in size and degree of divisibility.
As a consequence, any size or combination chosen might utilize one indivisible factor
most efficiently, but at the expense of not utilizing some other indivisible factor at
peak efficiency.
Suppose we consider a hypothetical schedule of average money cost at each alternative
output.
When we start at a very low level of output, all the indivisible factors will be underutilized.
Then as we expand production, average costs will decrease unless offset by the price rise
for those divisible factors needed to expand production.
As soon as one of the indivisible factors is fully utilized and becomes overworked,
Average costs will rise sharply.
Later, a tendency toward decreasing costs sets in again as another underutilized factor
becomes more fully utilized.
The result is an alternating series of decreases and increases in average costs as output increases.
Eventually, a point will be reached at which more indivisible factors will be overutilized
then underutilized, and from then on the general trend of average cost as output increases
will be upward.
Before that point, the trend will be downward.
Mingling with these influences from the technological side of costs are the continuing rises in
factor prices, which also become more important as output increases.
In sum, as Mises states, other things being equal, the more the production of a certain
article increases, the more factors of production must be withdrawn from other employments in
which they would have been used for the production of other articles.
Hence, other things being equal, average production costs increase with the increase in the quantity
produced.
But this general law is by sections superseded by the phenomenon that not all factors of
production are perfectly divisible, and that as far as they can be divided, they are not
divisible in such a way that full utilization of one of them results in full utilization
of the other imperfectly divisible factors.
Some indivisible factors, such as the railroad track, can be available in only one particular
size.
Other indivisible factors, such as machinery, can be built in various sizes.
Cannot a small factory then use small-scale machinery, which will be just as efficient
as large-scale machinery in a larger factory?
And would this not eliminate indivisibilities and result in constant costs?
No. For here too one particular size will probably be most efficient. Below the most
efficient size, operating the machine will be more costly. Thus, as Stigler says, fitting
together of the parts of a 10-horsepower motor does not require ten times the labor necessary
to fit those of a one-horsepower motor. Similarly, a truck requires one driver, whether it has
as a half-ton or two-ton capacity.
It is also true that an oversized machine will be more costly than the optimum, but
this will be no limitation on the size of the firm, for a large firm can simply use
several smaller, optimum-sized machines instead of one huge machine.
Labor is usually treated as a perfectly divisible factor, as one that varies directly with the
and the size of the output.
But this is not true.
As we have seen, the truck driver is not divisible into fractions.
Further, management tends to be an indivisible production factor.
So also, salesmen, advertising, cost of borrowing, research expenditures, and even insurance
for actuarial risk.
There are certain basic costs in borrowing which simply arise from investigating, paperwork,
etc. These will tend to be proportionately smaller the larger the size, another indivisibility,
with returns increasing over a certain area. Also, the broader the coverage, the lower
insurance premiums will be. It is particularly important not to limit possible efficiencies
Efficiencies from large-scale production to narrow technological factors such as the size
of the plant.
There are also $efficiencies derived from the organization of a firm owning several
plants, for example, management utilization, specialization, efficiency of large-scale
purchasing and selling, research expenditures, etc.
And there are the well-known gains from the increase in the division of labor with larger
outputs.
The benefits from the division of labor may be considered indivisible.
They arise from the specialized machines that must first be used with a larger product,
and similarly from the increased labor skills of specialists.
Here too, however, there is a point beyond which no further specialization is possible,
Management has usually been stressed as particularly subject to overutilization.
Even more important is the factor of ultimate decision-making ability, which cannot be enlarged
to the extent that management can.
What any given firm's size and output will be is therefore subject to a host of conflicting
The Task of the Businessman and Not of the Economist
Furthermore, the cost curve diagrams, so simple and smooth in the textbooks, misinterpret real conditions.
We have seen that there are a whole host of determinants which tend at any point toward increasing and toward decreasing costs.
It is, of course, true that an entrepreneur will seek to produce at the point of maximum profit, that is, of maximum net returns over costs.
But the factors that influence his decision are too numerous and their interactions too complex to be captured in cost curve diagrams.
It is clear to almost everyone that the optimum size of a firm in some industries is larger than in others.
The economic optimum for a steel plant is larger than the optimum barbershop.
In industries where large-scale firms have demonstrated the most efficiency, however,
many people have worried a great deal about an alleged tendency for decreasing costs to continue permanently
and therefore for monopoly to result from ever larger firms.
It should be obvious, however, that there is no infinite tendency for ever larger size.
This is clear from the very fact that every firm at any time always has a finite size
and that therefore an economic limit must have been imposed upon it from some direction.
Furthermore, we have seen that the general rule of operating in a zone of diminishing
marginal productivity for each factor, as well as the tendency for product prices to
decline and factor prices to increase as output increases, establishes limits on the size
of each firm.
And as a neglected point, we shall see that ultimate limits are set on the relative size
by the necessity for markets to exist in every factor in order to make it possible for the firm to calculate its profits and losses.
Money costs will equal opportunity costs to the businessman only when he plans an investment in factors.
To the extent that his money costs are sunk in any production process, they are committed
irrevocably, and any future plans must consider them as irretrievably spent.
Plans are relevant not only in the ERE, but also to all decisions on maintenance or replacement,
as well as additions to capital goods when they wear out or fall into disrepair.
The businessman's market supply will depend on his present opportunity cost, not his past
money cost.
For the businessman sells his goods at any price that will more than cover any further
costs that must be incurred in selling them.
As capital goods move toward final output in any stage of the production structure,
More and more investment has been sunk into the process, therefore the marginal cost of
further production, roughly the opportunity cost, becomes ever lower as the product moves
toward final output and sale.
When for example some costs are not fixed but irrevocable from the point of view of
further short-run production, they are not included in the businessman's estimated costs
of Such Further Production.
As we have seen, the sale of immediate stock completely ready for sale is virtually costless,
since there are no further costs for its production in the immediate run.
It is costless only if no rise in the price of the good is foreseen for the near future.
If it is, then there will arise the opportunity cost of forgoing a higher price.
Hence, if there is no hope of a higher price, the businessman will sell, however low the
price, adjusting for the costs of selling minus the costs of continued storage.
In the ERE, of course, all costs and investments will be adjusted, and irrevocably incurred
Average costs will present no problem. In the ERE, average money costs for all firms will equal the price of the product minus pure interest return to the capitalist entrepreneurs, and also, as we shall see, minus the return to the discounted marginal productivity of the owner, a factor which does not enter into the firm's money costs.
B. Business Income.
The net incomes in the economy accrue to labor in wages, to landowners in ground rents, both
wages and ground rents being rents, that is, unit prices of productive factors, to capitalists
in interest, all of which continue in the ERE, and profits and losses to entrepreneurs,
which do not.
Land rents are capitalized in the capital value of land, which therefore earns the interest
rate in the ERE.
But what of the owners?
Are their incomes exhausted by the category of entrepreneurial profit and loss, which
we studied in Chapter 8, or will they continue to earn income beyond interest in the ERE?
So far we have seen that owners of businesses perform an entrepreneurial function, the function
of uncertainty bearing in an ever-changing world.
Owners are also capitalists who advance present funds to labor and land factors and earn interest.
They may also be their own managers.
In that case, they earn an implicit wage of management since they are performing work
Work which could also be performed by employees.
We have seen that, catallactically, labor is the personal energy of non-owners in production,
and that this factor receives wages.
When the owner does laboring work himself, then he too earns an implicit wage.
This wage, of course, continues also in the ERE.
But is there a function which owning businessmen perform and would still perform in the ERE
beyond the advancing of capital or possible managerial work?
The answer is that they do execute another function for which they cannot hire other
factors.
It goes beyond the simple capital advancing function and it still continues in the ERE.
For want of a better term, it may be called the decision-making function, or the ownership
function.
Hired managers may successfully direct production or choose production processes, but the ultimate
responsibility and control of production rests inevitably with the owner, with the businessman
whose property the product is until it is sold.
It is the owners who make the decision concerning how much capital to invest and in what particular
processes, and particularly it is the owners who must choose the managers.
The ultimate decisions concerning the use of their property and the choice of the men
to manage it must therefore be made by the owners and by no one else.
It is a function necessary to production, and one that continues in the ERE, since even
in the ERE there are skills needed to hire proper managers and invest in the most efficient
processes, and even though these skills remain constant, the efficiency with which they are
performed will differ from one firm to another, and differing returns will be received accordingly.
In one of those extremely fertile but neglected hints of his, Boehm-Bawerk wrote,
The decision-making factor is necessarily specific to each firm. We cannot call what it earns a wage because it can never be hired, and thus it does not earn an implicit wage. We may therefore call the income of this factor the rent of decision-making ability.
It is clear that this rent will be equal to the factors DMVP, the amount which it specifically contributes to the firm's revenue.
Since this ability differs from one owner to the next, the rents will differ accordingly.
This difference accounts for the phenomenon of high-cost and low-cost firms in any industry,
and indicates that differences in efficiency among firms are not solely functions of ephemeral uncertainty, but would persist even in the ERE.
Granting that the supramarginal, that is, the lower-cost firms in an industry are earning rents of decision-making ability for their owners,
What of the marginal firms in the industry, the high-cost firms just barely in business?
Are their owners earning rents of decision-making ability?
Many economists have believed that these marginal firms earn no such income, just as they have
believed that the marginal land earns zero rent.
We have seen, however, that the marginal land earns some rent, even if close to zero.
Similarly, the marginal firm earns some rent of decision-making ability.
We can never say quantitatively how much it will be, only that it will be less than the
corresponding decision rents of the supra-marginal firms.
The belief that marginal firms earn no decision rents whatever seems to stem from two errors.
One, the assumption of mathematical continuity so that successive points blend together.
And two, the assumption that rent is basically differential and therefore that the most inferior
working land or firm must earn zero to establish the differential.
We have seen, however, that rents are absolute, the earnings and marginal value products of
factors.
There is no necessity, therefore, for the poorest factor to earn zero, as we can see
when we realize that wages are a subdivision of rents, and that there is clearly no one
making a zero wage.
And so, neither does the marginal firm earn a decision rent of zero.
Not the decision rent earned by the marginal firm must be positive and not zero becomes
evident if we consider a firm whose decision rent is only zero.
Its owner would then be performing certain functions, making and bearing responsibility
for ultimate decisions about his property and choosing the top managers, and yet receiving
No Return, and this in the E.R.E., where it cannot be simply the unforeseen result of
entrepreneurial mistakes.
But there will be no reason for the owner to continue performing these functions without
a return.
He will not continue to earn what is psychically a negative return, for while he remained in
In business, he would continue to expand energy and ownership while receiving nothing in return.
To sum up, the income accruing to a business owner in a changing economy will be a composite
of four elements.
a.
Interest on capital invested, uniform in the ERE.
b.
Ages of Management when Owner is Self-Employed, set according to DMVP
C. Rents of Ownership Decision, set according to DMVP
A, B and C, all remaining in the ERE
Disappearing in the ERE
D. Entrepreneurial Profit or Loss
We have so far been dealing almost exclusively with capitalist entrepreneurs.
Since the entrepreneur is the actor in relation to natural uncertainty, the capital investor, who hires and makes advances to other factors, plays a peculiarly important entrepreneurial role.
Making decisions concerning how much and where to invest, he is the driving force of the modern economy.
and Economy, laborers are also entrepreneurs in the sense of predicting demand in the markets
for labor and choosing to enter certain markets accordingly.
Someone who emigrates from one country to another in expectation of a higher wage is,
in this sense, an entrepreneur and may obtain a monetary profit or loss from his move.
One important distinction between capitalist entrepreneurs and laborer entrepreneurs is
that only the former may suffer negative incomes in production.
Even if a laborer emigrates to a nation where pay turns out to be lower than expected, he
absorbs only a differential, or opportunity, loss from what he might have earned elsewhere.
But he still earns a positive wage in production.
Even in the unlikely event of a labor surplus vis-à-vis land, the laborer earns zero,
and not negative, wages.
But the capitalist entrepreneur, the man who hires the other factors, can and does incur
actual monetary losses from his entrepreneurial effort.
C. Personal Consumer Service
A particularly important category of laborer entrepreneurs is that of the sellers of personal
services to consumers.
These laborers are generally capitalists as well.
The sellers of such services—doctors, lawyers, concert artists, servants, etc.—are self-employed
Businessmen, who, in addition to interest on whatever capital they have invested, earn
an implicit managerial wage for their labor.
Since the scope of their business property and decisions is relatively negligible compared
to their labor services, we may neglect their decision rents here.
It is a managerial wage, even though the only employee may be the owner himself.
It may seem strange to classify a domestic servant as self-employed, but actually he
is no different from a doctor or a lawyer to the extent that the latter sells his services
to consumers rather than to capitalists.
Thus, they earn a peculiar type of income, a business return consisting almost exclusively
of labor income.
We may call this type of work direct labor, since it is labor that serves directly as
a consumer's good, rather than hired as a factor of production.
And since it is a consumer's good, this labor service is priced directly on the market.
The determination of the prices of these goods will be similar on the demand side to that
of any consumer's good.
Employers evaluate marginal units of the service on their value scales and decide how much,
if any, to purchase.
There is a difference, however, on the supply side.
The sale of the product, once produced, is costless to the entrepreneur.
He has no alternative use for it.
The case of personal service, however, is different.
In the first place, leisure is a definite alternative to work.
In the second place, as a result of the connexity of the labor market, the worker can shift
to a higher-paying occupation further up on the structure of production, if his income
in this occupation is unsatisfactory.
The seller of the service, or the direct laborer, earns, as do all factors, his DMVP to the
consumer.
D. He will allocate his labor to whatever branch, whether high or low in the structure of production, where his DMVP will be the highest, and where, as a consequence, his wage rate will be the greatest.
The principles of allocation, then, between direct labor and indirect labor in production, are the same as those among the various branches of indirect productive use.
D. Market Calculation and Implicit Earnings. We have seen that a musician or a doctor earns
wages without being an employee. The wages of each are implicit in the income that he receives,
even though they are received directly from the consumers. In the real world, each function
is not necessarily performed by a different person. The same person can be a landowner and a worker.
Similarly, a particular firm, or rather its owner or owners, may own land and participate
in the production of capital goods. The owner may also manage his own firm. In practice,
the different sources of income can be separated only by referring to these incomes as determined
and by prices on the market.
For example, suppose that a man owns a firm which invests its capital, owns its own ground
land and produces a capital good, and that he manages the plant himself.
He receives a net income over a year's period of 1,000 gold ounces.
How can he estimate the different sources of his income?
is that he had invested 5,000 gold ounces in the business.
He looks around at the economy and finds that what he can pretty well call the ruling rate
of interest toward which the economy is tending is 5%.
He then concludes that 250 gold ounces of his net income was implicit interest.
Next, he estimates approximately what he would have received in wages of management if he
He had gone to work for a competing firm, rather than engaging in this business.
Suppose he estimates that this would have been 500 gold ounces.
He then looks to his ground land.
What could he have received for the land if he had rented it out instead of using it
himself in the business?
Let us say that he could have received 400 ounces in rental income for the land.
Now our owner received a net money income as landowner, capitalist, laborer, entrepreneur
of 1,000 gold ounces for the year.
He then estimates what his costs were in money terms.
These costs are not his explicit money expenses, which have already been deducted to find his
His net income, but his implicit expenses, that is, his opportunities foregone by engaging
in the business.
Adding up these costs, he finds that they total 250 gold ounces in interest, 500 gold
ounces in wages, 400 gold ounces in rent, for a total of 1150 gold ounces total opportunity
costs.
Thus, the entrepreneur suffered a loss of 150 ounces over the period.
If his opportunity costs had been less than 1,000, he would have gained an entrepreneurial
profit.
It is true that such estimates are not precise.
The estimates of what he would have received can never be wholly accurate.
But this tool of ex-post calculation is an indispensable one.
It is the only way by which a man can guide his ex ante decisions, his future actions.
By means of this calculation, he may realize that he is suffering a loss in this business.
If the loss continues much longer, he will be impelled to shift his various resources
to other lines of production.
It is only by means of such estimates that an owner of more than one type of factor in
A very important aspect of such estimates of implicit incomes has been overlooked.
There can be no implicit estimates without an explicit market.
When an entrepreneur receives income, in other words, he receives a complex of various functional
incomes.
To isolate them, by calculation, there must be in existence an external market to which
the entrepreneur can refer.
This is an extremely important point, for, as we shall soon see in detail, this furnishes
is a most important limitation on the relative potential size of a single firm on the market.
For example, suppose we return for a moment to our old hypothetical example in which each
firm is owned jointly by all its factor owners.
In that case, there is no separation at all between workers, landowners, capitalists,
and entrepreneurs.
There would be no way, then, of separating the wage incomes received from the interest
or rent incomes or profits received.
And now we finally arrive at the reason why the economy cannot consist completely of such
firms called producers cooperatives.
Another reason why an economy of producers cooperatives could not calculate is that every
Every original factor would be tied indissolubly to a specific line of production.
There can be no calculation where all factors are purely specific.
For without an external market for wage rates, rents and interest, there would be no rational
way for entrepreneurs to allocate factors in accordance with the wishes of the consumers.
No one would know where he could allocate his land or his labour to provide the maximum
monetary gains.
No entrepreneur would know how to arrange factors in their most value-productive combinations
to earn the greatest profit.
There could be no efficiency in production because the requisite knowledge would be lacking.
The productive system would be in complete chaos.
And everyone, whether in his capacity as consumer or as producer, would be injured thereby.
It is clear that a world of producer's cooperatives would break down for any economy but the most
primitive, because it could not calculate, and therefore could not arrange productive
factors to meet the desires of the consumers, and hence earn the highest incomes for the
producers.
E. Vertical Integration and the Size of the Firm
In the free economy there is an explicit time market, labor market, and land rent market.
It is clear that while chaos would ensue from a world of producers' cooperatives, other
critical points even before that would, as it were, introduce little bits of chaos into
to the Productive System.
Thus, suppose that workers are separated from capitalists, but that all capitalists own
their own ground land.
Further, suppose that for one reason or another, no capitalist will be able to rent out his
land to some other firm.
In that case, land and a particular capital and production process are indissolubly wedded
to each other.
There would be no rational way to allocate land in production, since it would have no
explicit price anywhere.
Since producers would suffer heavy losses, the free market would never establish such
a situation.
For the free market always tends to conduct affairs so that entrepreneurs make the greatest
profit through serving the consumer best and most efficiently.
Since absence of calculation creates grave inefficiencies in the system, it also causes
heavy losses.
Such a situation, absence of calculation, would therefore never be established on a
free market, particularly after an advanced economy has already developed calculation
and a market.
If this is true for such cases as a world of producers' cooperatives and the absence
of a Rent Market, it also holds true on a smaller scale for vertical integration and
the size of a firm.
Vertical integration occurs when a firm produces not only at one stage of production, but over
two or more stages.
For example, a firm becomes so large that it buys labor, land and capital goods of the
The fifth order then works on these capital goods producing other capital goods of the
fourth order.
In another plant it then works on the fourth order capital goods until they become third
order capital goods.
It then sells the third order product.
Vertical integration of course lengthens the production period for any firm.
is it lengthens the time before the firm can recoup its investment in the production process.
The interest return then covers the time for two or more stages rather than one.
Vertical integration, we might note, tends to reduce the demand for money to turn over
at various stages and thereby to lower the purchasing power of the monetary unit.
There is a more important question involved, however.
This is the role of implicit earnings and calculation in a vertically integrated firm.
The firm, say, buys labor and land factors at both the fifth and the fourth stages.
It also makes the fourth stage capital goods itself and uses them in another plant to make
a lower stage good.
Does such a firm employ calculation within itself, and if so, how?
Yes, the firm assumes that it sells itself the fourth-rank capital good.
It separates its net income as a producer of fourth-rank capital from its role as producer
of third-rank capital.
It calculates the net income for each separate division of its enterprise, and allocates
It's resources according to the profit or loss made in each division.
It is able to make such an internal calculation only because it can refer to an existing explicit
market price for the fourth stage capital good.
In other words, a firm can accurately estimate the profit or loss it makes in a stage of
of its enterprise, only by finding out the implicit price of its internal product, and
it can do this only if an external market price for that product is established elsewhere.
To illustrate, suppose that a firm is vertically integrated over two stages, with each stage
covering one year's time.
The general rate of interest in the economy tends towards 5% per annum.
This particular firm, say the Jones Manufacturing Company, a vertically integrated firm, buys
factors at the 5th rank for 100 ounces and original factors at the 4th rank for 15 ounces.
It sells the final product at 140 ounces.
It seems that it has made a handsome entrepreneurial profit on its operations, but can it find
out which stage or stages is making this profitable showing?
If there is an external market for the product of the stage that the firm has vertically
integrated, stage 4, the Jones Company is able to calculate the profitability of specific
stages of its operations.
Suppose, for example, that the price of the fourth-order capital good on the external
market is 103 ounces.
The Jones Company then estimates its implicit price for this intermediate product at what
it would have brought on the market if it had been sold there.
This price will be about 103 ounces.
The implicit price or opportunity cost of selling to oneself might be less than the existing
market price, since the entry of the Jones Company on the market might have lowered the
price of the good, say to 102 ounces.
There would be no way at all, however, to estimate the implicit price if there were
no external market and external price.
Assuming that the price is estimated at 103, then the total amount of money spent by Jones'
lower order plant on factors is 15, explicit on original factors, plus 103, implicit on
capital goods, for a total of 118.
Now the Jones Company can calculate the profits or losses made at each stage of its operations.
The higher stage bought factors for 100 ounces and sold them at 103 ounces.
It made a 3% return on its investment.
The lower stage bought its factors for 118 ounces and sold the product for 140 ounces,
Making a 29% Return
It is obvious that instead of enjoying a general profitability, the Jones Company suffered a
2% entrepreneurial loss on its earlier stage and gained a 24% profit on its later stage.
Knowing this, it will shift resources from the higher to the lower stage in accordance
in accordance with their respective profitabilities, and therefore in accordance with the desires of consumers.
Perhaps it will abandon its higher stage altogether, buying the capital good from an external firm and concentrating its resources in the more profitable lower stage.
On the other hand, suppose that there is no external market,
is that the Jones Company is the only producer of the intermediate good.
In that case, it would have no way of knowing which stage was being conducted profitably
and which not.
It would therefore have no way of knowing how to allocate factors to the various stages.
There would be no way for it to estimate any implicit price or opportunity cost for the
capital good at that particular stage.
Any estimate would be completely arbitrary and have no meaningful relation to economic conditions.
In short, if there were no market for a product and all of its exchanges were internal, there
would be no way for a firm or for anyone else to determine a price for the good.
A firm can estimate an implicit price when an external market exists, but when a market
is absent, the good can have no price, whether implicit or explicit.
Any figure could be only an arbitrary symbol.
Not being able to calculate a price, the firm could not rationally allocate factors and
resources from one stage to another.
Since the free market always tends to establish the most efficient and profitable type of
of Production, whether for type of good, method of production, allocation of factors, or size of firm, we must conclude that complete vertical integration for a capital good product can never be established on the free market above the primitive level.
For every capital good, there must be a definite market in which firms buy and sell that good.
It is obvious that this economic law sets a definite maximum to the relative size of any particular firm on the free market.
Because of this law, firms cannot merge or cartelize for complete vertical integration of stages or products.
Because of this law, there can never be one big cartel over the whole economy,
or mergers until one big firm owns all the productive assets in the economy.
The force of this law multiplies as the area of the economy increases and as
islands of non-calculable chaos swell to the proportions of masses and continents.
As the area of incalculability increases, the degrees of irrationality, misallocation, loss,
Costs, impoverishment, etc. become greater.
Under one owner or one cartel for the whole productive system, there would be no possible
areas of calculation at all, and therefore complete economic chaos would prevail.
Capital goods are stressed here because they are the product for which the calculability
problem becomes important.
Consumers goods per se are no problem, since there are always many consumers buying goods,
and therefore consumers goods will always have a market.
Economic calculation becomes ever more important as the market economy develops and progresses,
as the stages and the complexities of type and variety of capital goods increase.
However more important for the maintenance of an advanced economy, then, is the preservation
of markets for all the capital and other producers' goods.
Our analysis serves to expand the famous discussion of the possibility of economic calculation
under socialism, launched by Professor Ludwig von Mises over 40 years ago.
Mises, who has had the last as well as the first word in this debate, has demonstrated
irrefutably that a socialist economic system cannot calculate, since it lacks a market,
and hence lacks prices for producers and especially for capital goods.
It is remarkable that so many anti-socialist writers have never become aware of this critical
point.
Now we see that, paradoxically, the reason why a socialist economy cannot calculate is
not specifically because it is socialist.
Socialism is that system in which the state forcibly seizes control of all the means of
production in the economy.
The reason for the impossibility of calculation under socialism is that one agent owns or
or directs the use of all the resources in the economy.
It should be clear that it does not make any difference whether that one agent is the state
or one private individual or private cartel.
Whichever occurs, there is no possibility of calculation anywhere in the production
structure since production processes would be only internal and without markets.
There could be no calculation, and therefore complete economic irrationality and chaos
would prevail, whether the single owner is the state or private persons.
The difference between the state and the private case is that our economic law debars people
from ever establishing such a system in a free market society.
Far lesser evils prevent entrepreneurs from establishing even islands of incalculability,
let alone infinitely compounding such errors by eliminating calculability altogether.
But the state does not and cannot follow such guides of profit and loss.
Its officials are not held back by fear of losses from setting up all-embracing cartels
The State is free to embark upon socialism without considering such matters.
While there is therefore no possibility of a one-firm economy or even a one-firm vertically
integrated product, there is much danger in an attempt at socialism by the State.
A further discussion of the state and state intervention will be found in Chapter 12 of this book.
A curious legend has become quite popular among the writers on the socialist side of the debate over economic calculation.
This runs as follows.
Mises, in his original article, asserted theoretically that there could be no economic calculation under socialism.
and Socialism. Barone proved mathematically that this is false and that calculation is possible. Hayek and Robbins conceded the validity of this proof but then asserted that calculation would not be practical.
The inference is that the argument of Mises has been disposed of, and that all socialism
needs is a few practical devices, perhaps calculating machines or economic advisors,
to permit calculation and the counting of the equations.
This legend is almost completely wrong from start to finish.
In the first place, the dichotomy between theoretical and practical is a false one.
In economics, all arguments are theoretical, and since economics discusses the real world,
these theoretical arguments are, by their nature, practical ones as well.
The false dichotomy disposed of, the true nature of the Barone proof, becomes apparent.
It is not so much theoretical as irrelevant.
The proof by listing of mathematical equations is no proof at all.
It applies at best only to the evenly rotating economy.
Obviously, our whole discussion of the calculation problem applies to the real world and to it
only.
There can be no calculation problem in the ERE because no calculation there is necessary.
Obviously, there is no need to calculate profits and losses when all future data are known
from the beginning and where there are no profits and losses. In the ERE, the best allocation of
resources proceeds automatically. For Barone to demonstrate that the calculation difficulty does
not exist in the ERE is not a solution, it is simply a mathematical belaboring of the obvious.
Far from being refuted, Mises had already disposed of this argument in his original article.
Further, Barone's article was written in 1908, 12 years before Mises.
A careful perusal of Mises' original article, in fact, reveals that he there disposed of almost all the alleged solutions,
Part of the confusion stems from an unfortunate position taken by two followers of Mises in
this debate, Hayek and Robbins.
They argued that a socialist government could not calculate because it simply could not
not compute the millions of equations that would be necessary.
This left them open to the obvious retort that now, with high-speed computers available
to the government, this practical objection is no longer relevant.
In reality, the job of rational calculation has nothing to do with computing equations.
Nobody has to worry about equations in real life except mathematical economists.