WEBVTT NOTE 9.03. Entrepreneurship and Income 1 00:00:00.000 --> 00:00:05.000 3. Entrepreneurship and Income 2 00:00:05.000 --> 00:00:09.000 a. Costs to the Firm 3 00:00:09.000 --> 00:00:17.000 We have seen the basis on which the prices of the factors of production and the interest rate are determined. 4 00:00:17.000 --> 00:00:25.000 Looked at from the point of view of an individual entrepreneur, payments to factors are money costs. 5 00:00:25.000 --> 00:00:32.000 It is clear that we cannot simply rest on the old classical law that prices of products 6 00:00:32.000 --> 00:00:37.440 tend in the long run to be equal to their costs of production. 7 00:00:37.440 --> 00:00:43.940 Costs are not fixed by some invisible hand, but are determined precisely by the total 8 00:00:43.940 --> 00:00:48.920 force of entrepreneurial demand for factors of production. 9 00:00:48.920 --> 00:00:57.920 Basically, as Boehm-Bawerk and the Austrians pointed out, costs conform to prices and not vice versa. 10 00:00:57.920 --> 00:01:05.920 Confusion may arise because, looked at from the point of view of the individual firm rather than of the economist, 11 00:01:05.920 --> 00:01:15.920 it appears as if costs, at least in the sense of the prices of factors, are somehow given and beyond one's control. 12 00:01:15.920 --> 00:01:23.920 Hence, when the economist considers only the single firm, as in recent years, he goes completely 13 00:01:23.920 --> 00:01:29.680 astray by ignoring the generality of economic interrelations. 14 00:01:29.680 --> 00:01:37.880 To analyze means-ends relations logically, as economics does, requires taking all relations 15 00:01:37.880 --> 00:01:39.360 into account. 16 00:01:39.360 --> 00:01:46.400 Failure to do so, either by treating the single firm only, or by treating unreal holistic 17 00:01:46.400 --> 00:01:53.880 aggregates, or by taking refuge in the irrelevant mathematics of the Lausanne General Equilibrium 18 00:01:53.880 --> 00:01:58.440 School is equivalent to abandoning economics. 19 00:01:58.440 --> 00:02:04.600 If a firm can command a selling price that will more than cover its costs, it remains 20 00:02:04.600 --> 00:02:05.960 in business. 21 00:02:05.960 --> 00:02:08.460 If not, it will have to leave. 22 00:02:08.460 --> 00:02:15.200 The illusion of externally determined costs is prevalent because, as we shall presently 23 00:02:15.200 --> 00:02:22.620 see, most factors can be employed in a wide variety of firms, if not industries. 24 00:02:22.620 --> 00:02:29.460 If we take the broader view of the economist, however, the various costs, that is, prices 25 00:02:29.460 --> 00:02:37.940 of factors, determined by their various DMVPs in alternative uses, are ultimately determined 26 00:02:37.940 --> 00:02:42.740 solely by consumers' demand for all uses. 27 00:02:42.740 --> 00:02:49.020 It must not be forgotten, furthermore, that changes in demand and selling price will change 28 00:02:49.020 --> 00:02:55.040 the prices and incomes of specialized factors in the same direction. 29 00:02:55.040 --> 00:03:02.520 The cost curves, so fashionable in current economics, assume fixed factor prices, thereby 30 00:03:02.520 --> 00:03:08.100 by ignoring their variability even for the single firm. 31 00:03:08.100 --> 00:03:13.880 It might be noted that in this work there is none of that plethora and tangle of cost 32 00:03:13.880 --> 00:03:21.400 curves which fill the horizon of almost every recent neo-classical work in economics. 33 00:03:21.400 --> 00:03:27.180 Many beginning students come away with the impression that economics consists of an indigestible 34 00:03:27.180 --> 00:03:35.220 A simple brew of cost curves to be memorized by rote and drawn neatly on the blackboard. 35 00:03:35.220 --> 00:03:40.540 This omission has been deliberate, since it is our contention that the cost curves are 36 00:03:40.540 --> 00:03:47.980 at best redundant, thus violating the simplicity principle of Occam's razor and, at worst, 37 00:03:47.980 --> 00:03:50.500 misleading and erroneous. 38 00:03:50.500 --> 00:03:56.620 As an explanation of the pricing of factors and the allocation of output, it is obvious 39 00:03:56.620 --> 00:04:02.860 Notice that cost curves add nothing new to discussion in terms of marginal productivity. 40 00:04:02.860 --> 00:04:05.540 At best, the two are reversible. 41 00:04:05.540 --> 00:04:09.180 This can be clearly seen in such texts as E.T. 42 00:04:09.180 --> 00:04:14.940 Weiler's The Economic System and George J. Stigler's Theory of Price. 43 00:04:14.940 --> 00:04:20.600 But in addition, the shift brings with it many grave deficiencies and errors. 44 00:04:20.600 --> 00:04:26.720 This is revealed in the very passage in which Stigler explains the reasons for his switch 45 00:04:26.720 --> 00:04:33.760 from a perfunctory discussion of productivity to a lengthy treatment of cost curves. 46 00:04:33.760 --> 00:04:40.160 The law of variable proportions has now been explored sufficiently to permit a transition 47 00:04:40.160 --> 00:04:43.940 to the cost curves of the individual firm. 48 00:04:43.940 --> 00:04:49.960 The fundamentally new element in the discussion will, of course, be the introduction of prices 49 00:04:49.960 --> 00:04:52.280 of the Productive Services. 50 00:04:52.280 --> 00:04:57.160 The transition is made here only for the case of competition. 51 00:04:57.160 --> 00:05:03.240 That is, the prices of the productive services are constant because the firm does not buy 52 00:05:03.240 --> 00:05:08.140 enough of any service to affect its price. 53 00:05:08.140 --> 00:05:14.760 But by introducing given prices of productive services, the contemporary theorist really 54 00:05:14.760 --> 00:05:18.900 abandons any attempt to explain these prices. 55 00:05:18.900 --> 00:05:24.220 This is one of the cardinal errors of the currently fashionable theory of the firm. 56 00:05:24.220 --> 00:05:26.220 It is highly superficial. 57 00:05:26.220 --> 00:05:31.600 One of the aspects of this superficiality is the assumption that prices of productive 58 00:05:31.600 --> 00:05:36.320 services are given without any attempt to explain them. 59 00:05:36.320 --> 00:05:43.480 To furnish an explanation, marginal productivity analysis is necessary. 60 00:05:43.480 --> 00:05:48.880 Marginal productivity analysis and the profit motive are sufficient to explain the profit 61 00:05:48.880 --> 00:05:55.880 The Market Prices of Commodities and Factors on the Basis of Given Stocks and Speculative Demands and Given Consumer Valuations 62 00:06:18.880 --> 00:06:28.880 The immediate run is important, since it provides an explanation of the actual market prices of all goods at any time. 63 00:06:28.880 --> 00:06:40.880 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. 64 00:06:40.880 --> 00:06:48.680 This is important because it reveals the direction in which the immediate run market prices tend to move. 65 00:06:48.680 --> 00:06:57.880 It also permits the analytic isolation of interest as compared to profit and loss in entrepreneurial incomes. 66 00:06:57.880 --> 00:07:07.880 In the ERE, all factors will receive their discounted marginal value product, and interest will be pure time preference. 67 00:07:07.880 --> 00:07:25.880 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. 68 00:07:25.880 --> 00:07:39.880 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. 69 00:07:39.880 --> 00:07:52.880 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. 70 00:07:52.880 --> 00:08:09.880 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. 71 00:08:09.880 --> 00:08:37.880 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. 72 00:08:37.880 --> 00:08:40.880 There are no fixed costs. 73 00:08:40.880 --> 00:08:47.880 Rather, there are different degrees of variability for different productive factors. 74 00:08:47.880 --> 00:08:53.880 Some factors are best used in a certain quantity over a certain range of output, 75 00:08:53.880 --> 00:08:57.880 while others yield best results over other ranges of output. 76 00:08:57.880 --> 00:09:09.880 The result is not a dichotomy into fixed and variable costs, but a condition of many degrees of variability for the various factors. 77 00:09:09.880 --> 00:09:25.880 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. 78 00:09:25.880 --> 00:09:26.880 Change. 79 00:09:26.880 --> 00:09:32.640 Even if none of these difficulties existed, it is hard to see why the short run should 80 00:09:32.640 --> 00:09:39.920 be picked out for detailed analysis when it is merely one way station or rather a series 81 00:09:39.920 --> 00:09:48.600 of way stations between the important periods of time, the immediate run and the long run. 82 00:09:48.600 --> 00:09:54.600 Analytically, the cost curve approach is at best of little interest. 83 00:09:54.600 --> 00:10:00.380 With these caveats, let us now turn to an analysis of the costs of the firm. 84 00:10:00.380 --> 00:10:07.240 Let us consider what will happen to costs at alternate hypothetical levels of output. 85 00:10:07.240 --> 00:10:13.500 There are two elements that determine the behavior of average costs, that is, total 86 00:10:13.500 --> 00:10:16.160 costs per unit output. 87 00:10:16.160 --> 00:10:22.960 A. There are physical costs, the amounts of factors that must be purchased in order to 88 00:10:22.960 --> 00:10:26.960 to Obtain a Certain Physical Quantity of Output 89 00:10:26.960 --> 00:10:30.960 These are the obverse of physical productivity, 90 00:10:30.960 --> 00:10:34.960 the amounts of the physical product that can be produced 91 00:10:34.960 --> 00:10:37.960 with various amounts of factors. 92 00:10:37.960 --> 00:10:40.960 This is a technological problem. 93 00:10:40.960 --> 00:10:44.960 Here the question is not marginal productivity, 94 00:10:44.960 --> 00:10:49.960 where one factor is varied while others remain constant in quantity. 95 00:10:49.960 --> 00:10:56.960 Here we concentrate on the scale of output when all factors are permitted to vary. 96 00:10:56.960 --> 00:11:01.960 Where all factors and the product are completely divisible, 97 00:11:01.960 --> 00:11:06.960 a proportionate increase in the quantities of all the factors 98 00:11:06.960 --> 00:11:12.960 must lead to an equally proportionate increase in physical output. 99 00:11:12.960 --> 00:11:17.960 This may be called the law of constant returns to scale. 100 00:11:17.960 --> 00:11:23.560 B. The second determinant of average costs is factor prices. 101 00:11:23.560 --> 00:11:31.960 Pure competition theorists assume that these prices remain unchanged with a changing scale of output. 102 00:11:31.960 --> 00:11:33.960 But this is impossible. 103 00:11:33.960 --> 00:11:42.360 As any firm's scale of output increases, it necessarily bids factors of production away from other firms, 104 00:11:42.360 --> 00:11:45.360 raising their prices in the process. 105 00:11:45.360 --> 00:11:54.360 And this is particularly true for labor and land factors, which cannot be increased in supply via new production. 106 00:11:54.360 --> 00:12:06.360 The increase in factor prices as output increases, combined with constant physical costs, raises the average money cost per unit output. 107 00:12:06.360 --> 00:12:14.520 We may therefore conclude that if factors and product were perfectly divisible, average cost 108 00:12:14.520 --> 00:12:22.120 would always be increasing. In the productive world, perfect divisibility does not always or 109 00:12:22.120 --> 00:12:30.280 even usually obtain. Units of factors and of output are indivisible, that is, they are not 110 00:12:30.280 --> 00:12:47.280 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. 111 00:12:47.280 --> 00:12:55.780 Now, it may be true that 6a plus 4b will produce two refrigerators according to our law of 112 00:12:55.780 --> 00:12:57.880 returns to scale. 113 00:12:57.880 --> 00:13:07.040 But it is also true that 4a plus 3b will not produce one and a fraction refrigerators. 114 00:13:07.040 --> 00:13:14.160 There are bound to be gaps where an increased supply of factors will not lead to an increased 115 00:13:14.160 --> 00:13:30.160 In the areas of the gaps, average costs increase rapidly, since new factors are being hired with no product forthcoming. 116 00:13:30.160 --> 00:13:37.160 Then, when expenditures on factors are increased sufficiently to produce more of the product, 117 00:13:37.160 --> 00:13:44.660 There is a precipitate decline in average cost compared to the situation during the gap. 118 00:13:44.660 --> 00:13:51.160 As a result, no businessman will knowingly invest in the area of the gaps. 119 00:13:51.160 --> 00:13:56.160 To invest more without yielding a product is sheer waste. 120 00:13:56.160 --> 00:14:03.160 And so, businessmen will invest only in the trough points outside the gap areas. 121 00:14:03.160 --> 00:14:11.720 For example, suppose that a thousand gold ounces invested in factors yield 100 units of product, 122 00:14:11.720 --> 00:14:22.120 and that 1100 ounces yield 101 units. All the points in the gap between 1000 and 1100 123 00:14:22.120 --> 00:14:29.000 will yield no more than 100 units. The excess of investment over 1000 124 00:14:29.000 --> 00:14:37.640 1,000 and under 1,100 ounces is clearly sheer waste, and no businessman will invest within the gap. 125 00:14:37.640 --> 00:14:46.600 Instead, investments will be made at such trough points for average cost as 1,000 and 1,100. 126 00:14:47.720 --> 00:14:55.080 Secondly, and more important, the productive factors may be indivisible. Because of this 127 00:14:55.080 --> 00:15:06.080 In this indivisibility it is not possible simply to double or have the quantities of input of every one of the productive services simultaneously. 128 00:15:06.080 --> 00:15:11.080 Each factor has its own technological unit size. 129 00:15:11.080 --> 00:15:20.080 As a result, almost all business decisions take place in zones in which many factors have to remain constant, 130 00:15:20.080 --> 00:15:26.880 While others, the more divisible ones, may vary, and these relative divisibilities and 131 00:15:26.880 --> 00:15:34.280 indivisibilities are due not to variations in periods of time, but to the technological 132 00:15:34.280 --> 00:15:37.080 size of the various units. 133 00:15:37.080 --> 00:15:43.720 In any productive operation there will be many varieties of indivisibility. 134 00:15:43.720 --> 00:15:50.020 Professor Stigler presents the example of a railroad track, a factor capable of handling 135 00:15:50.020 --> 00:15:53.040 up to 200 trains a day. 136 00:15:53.040 --> 00:16:00.960 The track is most efficiently utilized when train runs total precisely 200 a day. 137 00:16:00.960 --> 00:16:08.120 This is the technologically ideal output and may be the one for which the track was designed. 138 00:16:08.120 --> 00:16:12.800 Now what happens when output is below 200? 139 00:16:12.800 --> 00:16:22.800 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. 140 00:16:22.800 --> 00:16:33.800 Thus, if engineers are divisible, the railroad will hire half as many engineers, or hire its engineers for half their usual number of hours. 141 00:16:33.800 --> 00:16:41.280 But, and this is the critical point here, the railroad cannot cut the track in half, 142 00:16:41.280 --> 00:16:44.160 and operate on half a track. 143 00:16:44.160 --> 00:16:51.320 The technological unit of track being what it is, the number of tracks has to remain 144 00:16:51.320 --> 00:16:52.800 at one. 145 00:16:52.800 --> 00:17:00.440 Conversely, when output increases to 200 again, other productive services may be doubled, 146 00:17:00.440 --> 00:17:04.500 But the quantity of track remains the same. 147 00:17:04.500 --> 00:17:10.580 We are not discussing the fact that the railroad could, of course, cut down or increase the 148 00:17:10.580 --> 00:17:17.440 mileage of its track by including less or more geographic area in its service. 149 00:17:17.440 --> 00:17:24.460 The example assumes a given geographic area in which the railroad operates. 150 00:17:24.460 --> 00:17:32.380 What happens should output increase to 250 trains a day, a 25% increase over the planned 151 00:17:32.380 --> 00:17:33.780 quantity. 152 00:17:33.780 --> 00:17:40.340 Divisible services such as engineers may be increased by one-fourth, but the track must 153 00:17:40.340 --> 00:17:47.560 either remain at one and be overutilized, or be increased to two. 154 00:17:47.560 --> 00:17:55.080 If it is increased, the tracks will again be underutilized at 250, because the ideal 155 00:17:55.080 --> 00:18:01.460 output from the point of view of utilizing the tracks is now 400. 156 00:18:01.460 --> 00:18:08.800 When an important indivisible factor is becoming less and less underutilized, the tendency 157 00:18:08.800 --> 00:18:17.280 will be for increasing returns, for decreasing average costs as output increases. 158 00:18:17.280 --> 00:18:24.700 When an important indivisible factor is becoming more and more overutilized, there is a tendency 159 00:18:24.700 --> 00:18:28.680 for increasing average costs. 160 00:18:28.680 --> 00:18:36.760 In some spheres of production, indivisibilities may be such that full utilization of one indivisible 161 00:18:36.760 --> 00:18:41.240 factor requires full utilization of all. 162 00:18:41.240 --> 00:18:48.040 In that case, all the indivisible factors move together and can be lumped together for 163 00:18:48.040 --> 00:18:49.440 our purposes. 164 00:18:49.440 --> 00:18:56.360 They become the equivalent of one indivisible factor, such as the railroad track. 165 00:18:56.360 --> 00:19:03.840 In such cases, again, average costs will first decline with an increase in output, as the 166 00:19:03.840 --> 00:19:10.820 increased output remedies an underutilization of the lumped indivisible factors. 167 00:19:10.820 --> 00:19:17.620 After the technologically most efficient point is reached, however, costs will increase, 168 00:19:17.620 --> 00:19:20.040 given the indivisible factors. 169 00:19:20.040 --> 00:19:26.920 The tendency for costs to decline will, in addition, be offset by the rise in factor 170 00:19:26.920 --> 00:19:31.440 prices caused by the increase in output. 171 00:19:31.440 --> 00:19:37.900 In the overwhelming majority of cases, however, each factor will differ from the others in 172 00:19:37.900 --> 00:19:41.420 in size and degree of divisibility. 173 00:19:41.420 --> 00:19:48.520 As a consequence, any size or combination chosen might utilize one indivisible factor 174 00:19:48.520 --> 00:19:56.300 most efficiently, but at the expense of not utilizing some other indivisible factor at 175 00:19:56.300 --> 00:19:58.220 peak efficiency. 176 00:19:58.220 --> 00:20:04.780 Suppose we consider a hypothetical schedule of average money cost at each alternative 177 00:20:04.780 --> 00:20:05.860 output. 178 00:20:05.860 --> 00:20:13.700 When we start at a very low level of output, all the indivisible factors will be underutilized. 179 00:20:13.700 --> 00:20:22.220 Then as we expand production, average costs will decrease unless offset by the price rise 180 00:20:22.220 --> 00:20:27.180 for those divisible factors needed to expand production. 181 00:20:27.180 --> 00:20:34.100 As soon as one of the indivisible factors is fully utilized and becomes overworked, 182 00:20:34.100 --> 00:20:36.700 Average costs will rise sharply. 183 00:20:36.700 --> 00:20:43.940 Later, a tendency toward decreasing costs sets in again as another underutilized factor 184 00:20:43.940 --> 00:20:46.900 becomes more fully utilized. 185 00:20:46.900 --> 00:20:56.060 The result is an alternating series of decreases and increases in average costs as output increases. 186 00:20:56.060 --> 00:21:03.220 Eventually, a point will be reached at which more indivisible factors will be overutilized 187 00:21:03.220 --> 00:21:11.180 then underutilized, and from then on the general trend of average cost as output increases 188 00:21:11.180 --> 00:21:12.820 will be upward. 189 00:21:12.820 --> 00:21:16.940 Before that point, the trend will be downward. 190 00:21:16.940 --> 00:21:23.560 Mingling with these influences from the technological side of costs are the continuing rises in 191 00:21:23.560 --> 00:21:29.980 factor prices, which also become more important as output increases. 192 00:21:29.980 --> 00:21:36.080 In sum, as Mises states, other things being equal, the more the production of a certain 193 00:21:36.080 --> 00:21:43.580 article increases, the more factors of production must be withdrawn from other employments in 194 00:21:43.580 --> 00:21:48.060 which they would have been used for the production of other articles. 195 00:21:48.060 --> 00:21:56.100 Hence, other things being equal, average production costs increase with the increase in the quantity 196 00:21:56.100 --> 00:21:57.280 produced. 197 00:21:57.280 --> 00:22:04.460 But this general law is by sections superseded by the phenomenon that not all factors of 198 00:22:04.460 --> 00:22:11.420 production are perfectly divisible, and that as far as they can be divided, they are not 199 00:22:11.420 --> 00:22:18.800 divisible in such a way that full utilization of one of them results in full utilization 200 00:22:18.800 --> 00:22:23.460 of the other imperfectly divisible factors. 201 00:22:23.460 --> 00:22:30.140 Some indivisible factors, such as the railroad track, can be available in only one particular 202 00:22:30.140 --> 00:22:31.460 size. 203 00:22:31.460 --> 00:22:37.420 Other indivisible factors, such as machinery, can be built in various sizes. 204 00:22:37.420 --> 00:22:43.620 Cannot a small factory then use small-scale machinery, which will be just as efficient 205 00:22:43.620 --> 00:22:47.320 as large-scale machinery in a larger factory? 206 00:22:47.320 --> 00:22:52.820 And would this not eliminate indivisibilities and result in constant costs? 207 00:22:52.820 --> 00:23:00.060 No. For here too one particular size will probably be most efficient. Below the most 208 00:23:00.060 --> 00:23:07.220 efficient size, operating the machine will be more costly. Thus, as Stigler says, fitting 209 00:23:07.220 --> 00:23:14.820 together of the parts of a 10-horsepower motor does not require ten times the labor necessary 210 00:23:14.820 --> 00:23:22.740 to fit those of a one-horsepower motor. Similarly, a truck requires one driver, whether it has 211 00:23:22.740 --> 00:23:26.740 as a half-ton or two-ton capacity. 212 00:23:26.740 --> 00:23:32.580 It is also true that an oversized machine will be more costly than the optimum, but 213 00:23:32.580 --> 00:23:38.840 this will be no limitation on the size of the firm, for a large firm can simply use 214 00:23:38.840 --> 00:23:45.580 several smaller, optimum-sized machines instead of one huge machine. 215 00:23:45.580 --> 00:23:52.500 Labor is usually treated as a perfectly divisible factor, as one that varies directly with the 216 00:23:52.500 --> 00:23:54.400 and the size of the output. 217 00:23:54.400 --> 00:23:56.120 But this is not true. 218 00:23:56.120 --> 00:24:01.200 As we have seen, the truck driver is not divisible into fractions. 219 00:24:01.200 --> 00:24:06.180 Further, management tends to be an indivisible production factor. 220 00:24:06.180 --> 00:24:13.560 So also, salesmen, advertising, cost of borrowing, research expenditures, and even insurance 221 00:24:13.560 --> 00:24:15.860 for actuarial risk. 222 00:24:15.860 --> 00:24:23.640 There are certain basic costs in borrowing which simply arise from investigating, paperwork, 223 00:24:23.640 --> 00:24:32.000 etc. These will tend to be proportionately smaller the larger the size, another indivisibility, 224 00:24:32.000 --> 00:24:38.460 with returns increasing over a certain area. Also, the broader the coverage, the lower 225 00:24:38.460 --> 00:24:45.600 insurance premiums will be. It is particularly important not to limit possible efficiencies 226 00:24:45.600 --> 00:24:52.080 Efficiencies from large-scale production to narrow technological factors such as the size 227 00:24:52.080 --> 00:24:53.560 of the plant. 228 00:24:53.560 --> 00:24:59.480 There are also $efficiencies derived from the organization of a firm owning several 229 00:24:59.480 --> 00:25:05.920 plants, for example, management utilization, specialization, efficiency of large-scale 230 00:25:05.920 --> 00:25:11.520 purchasing and selling, research expenditures, etc. 231 00:25:11.520 --> 00:25:16.800 And there are the well-known gains from the increase in the division of labor with larger 232 00:25:16.800 --> 00:25:18.200 outputs. 233 00:25:18.200 --> 00:25:23.200 The benefits from the division of labor may be considered indivisible. 234 00:25:23.200 --> 00:25:29.760 They arise from the specialized machines that must first be used with a larger product, 235 00:25:29.760 --> 00:25:34.480 and similarly from the increased labor skills of specialists. 236 00:25:34.480 --> 00:25:40.880 Here too, however, there is a point beyond which no further specialization is possible, 237 00:25:40.880 --> 00:25:51.920 Management has usually been stressed as particularly subject to overutilization. 238 00:25:51.920 --> 00:25:58.680 Even more important is the factor of ultimate decision-making ability, which cannot be enlarged 239 00:25:58.680 --> 00:26:01.920 to the extent that management can. 240 00:26:01.920 --> 00:26:08.880 What any given firm's size and output will be is therefore subject to a host of conflicting 241 00:26:38.880 --> 00:26:42.880 The Task of the Businessman and Not of the Economist 242 00:26:42.880 --> 00:26:51.880 Furthermore, the cost curve diagrams, so simple and smooth in the textbooks, misinterpret real conditions. 243 00:26:51.880 --> 00:27:01.880 We have seen that there are a whole host of determinants which tend at any point toward increasing and toward decreasing costs. 244 00:27:01.880 --> 00:27:13.480 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. 245 00:27:13.480 --> 00:27:24.680 But the factors that influence his decision are too numerous and their interactions too complex to be captured in cost curve diagrams. 246 00:27:24.680 --> 00:27:32.680 It is clear to almost everyone that the optimum size of a firm in some industries is larger than in others. 247 00:27:32.680 --> 00:27:38.680 The economic optimum for a steel plant is larger than the optimum barbershop. 248 00:27:38.680 --> 00:27:44.680 In industries where large-scale firms have demonstrated the most efficiency, however, 249 00:27:44.680 --> 00:27:53.680 many people have worried a great deal about an alleged tendency for decreasing costs to continue permanently 250 00:27:53.680 --> 00:27:59.680 and therefore for monopoly to result from ever larger firms. 251 00:27:59.680 --> 00:28:06.680 It should be obvious, however, that there is no infinite tendency for ever larger size. 252 00:28:06.680 --> 00:28:14.680 This is clear from the very fact that every firm at any time always has a finite size 253 00:28:14.680 --> 00:28:21.680 and that therefore an economic limit must have been imposed upon it from some direction. 254 00:28:21.680 --> 00:28:27.100 Furthermore, we have seen that the general rule of operating in a zone of diminishing 255 00:28:27.100 --> 00:28:33.760 marginal productivity for each factor, as well as the tendency for product prices to 256 00:28:33.760 --> 00:28:41.000 decline and factor prices to increase as output increases, establishes limits on the size 257 00:28:41.000 --> 00:28:42.760 of each firm. 258 00:28:42.760 --> 00:28:48.560 And as a neglected point, we shall see that ultimate limits are set on the relative size 259 00:28:48.560 --> 00:29:00.560 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. 260 00:29:00.560 --> 00:29:09.560 Money costs will equal opportunity costs to the businessman only when he plans an investment in factors. 261 00:29:09.560 --> 00:29:16.880 To the extent that his money costs are sunk in any production process, they are committed 262 00:29:16.880 --> 00:29:24.320 irrevocably, and any future plans must consider them as irretrievably spent. 263 00:29:24.320 --> 00:29:32.060 Plans are relevant not only in the ERE, but also to all decisions on maintenance or replacement, 264 00:29:32.060 --> 00:29:39.000 as well as additions to capital goods when they wear out or fall into disrepair. 265 00:29:39.000 --> 00:29:47.200 The businessman's market supply will depend on his present opportunity cost, not his past 266 00:29:47.200 --> 00:29:48.840 money cost. 267 00:29:48.840 --> 00:29:54.640 For the businessman sells his goods at any price that will more than cover any further 268 00:29:54.640 --> 00:29:58.720 costs that must be incurred in selling them. 269 00:29:58.720 --> 00:30:05.120 As capital goods move toward final output in any stage of the production structure, 270 00:30:05.120 --> 00:30:11.480 More and more investment has been sunk into the process, therefore the marginal cost of 271 00:30:11.480 --> 00:30:18.200 further production, roughly the opportunity cost, becomes ever lower as the product moves 272 00:30:18.200 --> 00:30:21.240 toward final output and sale. 273 00:30:21.240 --> 00:30:27.480 When for example some costs are not fixed but irrevocable from the point of view of 274 00:30:27.480 --> 00:30:33.880 further short-run production, they are not included in the businessman's estimated costs 275 00:30:33.880 --> 00:30:36.560 of Such Further Production. 276 00:30:36.560 --> 00:30:44.400 As we have seen, the sale of immediate stock completely ready for sale is virtually costless, 277 00:30:44.400 --> 00:30:50.800 since there are no further costs for its production in the immediate run. 278 00:30:50.800 --> 00:30:57.860 It is costless only if no rise in the price of the good is foreseen for the near future. 279 00:30:57.860 --> 00:31:03.860 If it is, then there will arise the opportunity cost of forgoing a higher price. 280 00:31:03.860 --> 00:31:11.140 Hence, if there is no hope of a higher price, the businessman will sell, however low the 281 00:31:11.140 --> 00:31:17.860 price, adjusting for the costs of selling minus the costs of continued storage. 282 00:31:17.860 --> 00:31:25.000 In the ERE, of course, all costs and investments will be adjusted, and irrevocably incurred 283 00:31:25.000 --> 00:31:53.000 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. 284 00:31:53.000 --> 00:31:56.280 B. Business Income. 285 00:31:56.280 --> 00:32:04.120 The net incomes in the economy accrue to labor in wages, to landowners in ground rents, both 286 00:32:04.120 --> 00:32:12.600 wages and ground rents being rents, that is, unit prices of productive factors, to capitalists 287 00:32:12.600 --> 00:32:20.360 in interest, all of which continue in the ERE, and profits and losses to entrepreneurs, 288 00:32:20.360 --> 00:32:22.160 which do not. 289 00:32:22.160 --> 00:32:28.120 Land rents are capitalized in the capital value of land, which therefore earns the interest 290 00:32:28.120 --> 00:32:30.680 rate in the ERE. 291 00:32:30.680 --> 00:32:32.420 But what of the owners? 292 00:32:32.420 --> 00:32:38.360 Are their incomes exhausted by the category of entrepreneurial profit and loss, which 293 00:32:38.360 --> 00:32:46.960 we studied in Chapter 8, or will they continue to earn income beyond interest in the ERE? 294 00:32:46.960 --> 00:32:53.620 So far we have seen that owners of businesses perform an entrepreneurial function, the function 295 00:32:53.620 --> 00:32:57.920 of uncertainty bearing in an ever-changing world. 296 00:32:57.920 --> 00:33:05.220 Owners are also capitalists who advance present funds to labor and land factors and earn interest. 297 00:33:05.220 --> 00:33:07.980 They may also be their own managers. 298 00:33:07.980 --> 00:33:13.800 In that case, they earn an implicit wage of management since they are performing work 299 00:33:13.800 --> 00:33:17.660 Work which could also be performed by employees. 300 00:33:17.660 --> 00:33:24.880 We have seen that, catallactically, labor is the personal energy of non-owners in production, 301 00:33:24.880 --> 00:33:27.960 and that this factor receives wages. 302 00:33:27.960 --> 00:33:34.500 When the owner does laboring work himself, then he too earns an implicit wage. 303 00:33:34.500 --> 00:33:39.800 This wage, of course, continues also in the ERE. 304 00:33:39.800 --> 00:33:47.200 But is there a function which owning businessmen perform and would still perform in the ERE 305 00:33:47.200 --> 00:33:52.680 beyond the advancing of capital or possible managerial work? 306 00:33:52.680 --> 00:33:58.680 The answer is that they do execute another function for which they cannot hire other 307 00:33:58.680 --> 00:34:00.080 factors. 308 00:34:00.080 --> 00:34:07.220 It goes beyond the simple capital advancing function and it still continues in the ERE. 309 00:34:07.220 --> 00:34:13.360 For want of a better term, it may be called the decision-making function, or the ownership 310 00:34:13.360 --> 00:34:15.160 function. 311 00:34:15.160 --> 00:34:21.580 Hired managers may successfully direct production or choose production processes, but the ultimate 312 00:34:21.580 --> 00:34:29.360 responsibility and control of production rests inevitably with the owner, with the businessman 313 00:34:29.360 --> 00:34:33.600 whose property the product is until it is sold. 314 00:34:33.600 --> 00:34:40.560 It is the owners who make the decision concerning how much capital to invest and in what particular 315 00:34:40.560 --> 00:34:46.860 processes, and particularly it is the owners who must choose the managers. 316 00:34:46.860 --> 00:34:52.080 The ultimate decisions concerning the use of their property and the choice of the men 317 00:34:52.080 --> 00:34:58.380 to manage it must therefore be made by the owners and by no one else. 318 00:34:58.380 --> 00:35:05.100 It is a function necessary to production, and one that continues in the ERE, since even 319 00:35:05.100 --> 00:35:12.380 in the ERE there are skills needed to hire proper managers and invest in the most efficient 320 00:35:12.380 --> 00:35:18.440 processes, and even though these skills remain constant, the efficiency with which they are 321 00:35:18.440 --> 00:35:26.880 performed will differ from one firm to another, and differing returns will be received accordingly. 322 00:35:26.880 --> 00:35:32.680 In one of those extremely fertile but neglected hints of his, Boehm-Bawerk wrote, 323 00:35:56.880 --> 00:36:19.880 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. 324 00:36:19.880 --> 00:36:29.880 It is clear that this rent will be equal to the factors DMVP, the amount which it specifically contributes to the firm's revenue. 325 00:36:29.880 --> 00:36:35.880 Since this ability differs from one owner to the next, the rents will differ accordingly. 326 00:36:35.880 --> 00:36:43.880 This difference accounts for the phenomenon of high-cost and low-cost firms in any industry, 327 00:36:43.880 --> 00:36:55.880 and indicates that differences in efficiency among firms are not solely functions of ephemeral uncertainty, but would persist even in the ERE. 328 00:36:55.880 --> 00:37:06.880 Granting that the supramarginal, that is, the lower-cost firms in an industry are earning rents of decision-making ability for their owners, 329 00:37:06.880 --> 00:37:14.920 What of the marginal firms in the industry, the high-cost firms just barely in business? 330 00:37:14.920 --> 00:37:19.400 Are their owners earning rents of decision-making ability? 331 00:37:19.400 --> 00:37:25.640 Many economists have believed that these marginal firms earn no such income, just as they have 332 00:37:25.640 --> 00:37:29.900 believed that the marginal land earns zero rent. 333 00:37:29.900 --> 00:37:37.820 We have seen, however, that the marginal land earns some rent, even if close to zero. 334 00:37:37.820 --> 00:37:44.500 Similarly, the marginal firm earns some rent of decision-making ability. 335 00:37:44.500 --> 00:37:50.860 We can never say quantitatively how much it will be, only that it will be less than the 336 00:37:50.860 --> 00:37:56.600 corresponding decision rents of the supra-marginal firms. 337 00:37:56.600 --> 00:38:03.800 The belief that marginal firms earn no decision rents whatever seems to stem from two errors. 338 00:38:03.800 --> 00:38:11.500 One, the assumption of mathematical continuity so that successive points blend together. 339 00:38:11.500 --> 00:38:18.600 And two, the assumption that rent is basically differential and therefore that the most inferior 340 00:38:18.600 --> 00:38:25.000 working land or firm must earn zero to establish the differential. 341 00:38:25.000 --> 00:38:32.140 We have seen, however, that rents are absolute, the earnings and marginal value products of 342 00:38:32.140 --> 00:38:33.140 factors. 343 00:38:33.140 --> 00:38:39.140 There is no necessity, therefore, for the poorest factor to earn zero, as we can see 344 00:38:39.140 --> 00:38:45.800 when we realize that wages are a subdivision of rents, and that there is clearly no one 345 00:38:45.800 --> 00:38:48.200 making a zero wage. 346 00:38:48.200 --> 00:38:54.840 And so, neither does the marginal firm earn a decision rent of zero. 347 00:38:54.840 --> 00:39:01.600 Not the decision rent earned by the marginal firm must be positive and not zero becomes 348 00:39:01.600 --> 00:39:07.160 evident if we consider a firm whose decision rent is only zero. 349 00:39:07.160 --> 00:39:12.880 Its owner would then be performing certain functions, making and bearing responsibility 350 00:39:12.880 --> 00:39:19.600 for ultimate decisions about his property and choosing the top managers, and yet receiving 351 00:39:19.600 --> 00:39:27.200 No Return, and this in the E.R.E., where it cannot be simply the unforeseen result of 352 00:39:27.200 --> 00:39:29.800 entrepreneurial mistakes. 353 00:39:29.800 --> 00:39:35.060 But there will be no reason for the owner to continue performing these functions without 354 00:39:35.060 --> 00:39:36.140 a return. 355 00:39:36.140 --> 00:39:43.260 He will not continue to earn what is psychically a negative return, for while he remained in 356 00:39:43.260 --> 00:39:51.560 In business, he would continue to expand energy and ownership while receiving nothing in return. 357 00:39:51.560 --> 00:39:58.780 To sum up, the income accruing to a business owner in a changing economy will be a composite 358 00:39:58.780 --> 00:40:00.860 of four elements. 359 00:40:00.860 --> 00:40:02.220 a. 360 00:40:02.220 --> 00:40:07.060 Interest on capital invested, uniform in the ERE. 361 00:40:07.060 --> 00:40:08.060 b. 362 00:40:08.060 --> 00:40:15.060 Ages of Management when Owner is Self-Employed, set according to DMVP 363 00:40:15.060 --> 00:40:21.060 C. Rents of Ownership Decision, set according to DMVP 364 00:40:21.060 --> 00:40:27.060 A, B and C, all remaining in the ERE 365 00:40:27.060 --> 00:40:29.060 Disappearing in the ERE 366 00:40:29.060 --> 00:40:34.060 D. Entrepreneurial Profit or Loss 367 00:40:34.060 --> 00:40:40.060 We have so far been dealing almost exclusively with capitalist entrepreneurs. 368 00:40:40.060 --> 00:40:55.060 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. 369 00:40:55.060 --> 00:41:03.060 Making decisions concerning how much and where to invest, he is the driving force of the modern economy. 370 00:41:03.060 --> 00:41:09.960 and Economy, laborers are also entrepreneurs in the sense of predicting demand in the markets 371 00:41:09.960 --> 00:41:14.980 for labor and choosing to enter certain markets accordingly. 372 00:41:14.980 --> 00:41:20.940 Someone who emigrates from one country to another in expectation of a higher wage is, 373 00:41:20.940 --> 00:41:28.340 in this sense, an entrepreneur and may obtain a monetary profit or loss from his move. 374 00:41:28.340 --> 00:41:34.940 One important distinction between capitalist entrepreneurs and laborer entrepreneurs is 375 00:41:34.940 --> 00:41:40.760 that only the former may suffer negative incomes in production. 376 00:41:40.760 --> 00:41:46.600 Even if a laborer emigrates to a nation where pay turns out to be lower than expected, he 377 00:41:46.600 --> 00:41:54.120 absorbs only a differential, or opportunity, loss from what he might have earned elsewhere. 378 00:41:54.120 --> 00:41:58.400 But he still earns a positive wage in production. 379 00:41:58.400 --> 00:42:05.640 Even in the unlikely event of a labor surplus vis-à-vis land, the laborer earns zero, 380 00:42:05.640 --> 00:42:08.200 and not negative, wages. 381 00:42:08.200 --> 00:42:15.080 But the capitalist entrepreneur, the man who hires the other factors, can and does incur 382 00:42:15.080 --> 00:42:21.080 actual monetary losses from his entrepreneurial effort. 383 00:42:21.080 --> 00:42:25.080 C. Personal Consumer Service 384 00:42:25.080 --> 00:42:31.760 A particularly important category of laborer entrepreneurs is that of the sellers of personal 385 00:42:31.760 --> 00:42:34.420 services to consumers. 386 00:42:34.420 --> 00:42:38.360 These laborers are generally capitalists as well. 387 00:42:38.360 --> 00:42:45.960 The sellers of such services—doctors, lawyers, concert artists, servants, etc.—are self-employed 388 00:42:45.960 --> 00:42:52.040 Businessmen, who, in addition to interest on whatever capital they have invested, earn 389 00:42:52.040 --> 00:42:56.720 an implicit managerial wage for their labor. 390 00:42:56.720 --> 00:43:02.160 Since the scope of their business property and decisions is relatively negligible compared 391 00:43:02.160 --> 00:43:07.260 to their labor services, we may neglect their decision rents here. 392 00:43:07.260 --> 00:43:14.000 It is a managerial wage, even though the only employee may be the owner himself. 393 00:43:14.000 --> 00:43:20.120 It may seem strange to classify a domestic servant as self-employed, but actually he 394 00:43:20.120 --> 00:43:26.160 is no different from a doctor or a lawyer to the extent that the latter sells his services 395 00:43:26.160 --> 00:43:30.000 to consumers rather than to capitalists. 396 00:43:30.000 --> 00:43:38.500 Thus, they earn a peculiar type of income, a business return consisting almost exclusively 397 00:43:38.500 --> 00:43:40.760 of labor income. 398 00:43:40.760 --> 00:43:47.260 We may call this type of work direct labor, since it is labor that serves directly as 399 00:43:47.260 --> 00:43:52.820 a consumer's good, rather than hired as a factor of production. 400 00:43:52.820 --> 00:43:59.980 And since it is a consumer's good, this labor service is priced directly on the market. 401 00:43:59.980 --> 00:44:05.940 The determination of the prices of these goods will be similar on the demand side to that 402 00:44:05.940 --> 00:44:08.720 of any consumer's good. 403 00:44:08.720 --> 00:44:15.160 Employers evaluate marginal units of the service on their value scales and decide how much, 404 00:44:15.160 --> 00:44:17.000 if any, to purchase. 405 00:44:17.000 --> 00:44:20.700 There is a difference, however, on the supply side. 406 00:44:20.700 --> 00:44:26.440 The sale of the product, once produced, is costless to the entrepreneur. 407 00:44:26.440 --> 00:44:29.400 He has no alternative use for it. 408 00:44:29.400 --> 00:44:33.440 The case of personal service, however, is different. 409 00:44:33.440 --> 00:44:38.040 In the first place, leisure is a definite alternative to work. 410 00:44:38.040 --> 00:44:44.360 In the second place, as a result of the connexity of the labor market, the worker can shift 411 00:44:44.360 --> 00:44:50.640 to a higher-paying occupation further up on the structure of production, if his income 412 00:44:50.640 --> 00:44:54.440 in this occupation is unsatisfactory. 413 00:44:54.440 --> 00:45:02.740 The seller of the service, or the direct laborer, earns, as do all factors, his DMVP to the 414 00:45:02.740 --> 00:45:03.820 consumer. 415 00:45:03.820 --> 00:45:18.820 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. 416 00:45:18.820 --> 00:45:31.820 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. 417 00:45:31.820 --> 00:45:40.780 D. Market Calculation and Implicit Earnings. We have seen that a musician or a doctor earns 418 00:45:40.780 --> 00:45:48.860 wages without being an employee. The wages of each are implicit in the income that he receives, 419 00:45:48.860 --> 00:45:56.220 even though they are received directly from the consumers. In the real world, each function 420 00:45:56.220 --> 00:46:04.140 is not necessarily performed by a different person. The same person can be a landowner and a worker. 421 00:46:04.140 --> 00:46:11.420 Similarly, a particular firm, or rather its owner or owners, may own land and participate 422 00:46:11.420 --> 00:46:18.460 in the production of capital goods. The owner may also manage his own firm. In practice, 423 00:46:18.460 --> 00:46:26.140 the different sources of income can be separated only by referring to these incomes as determined 424 00:46:26.140 --> 00:46:28.860 and by prices on the market. 425 00:46:28.860 --> 00:46:35.820 For example, suppose that a man owns a firm which invests its capital, owns its own ground 426 00:46:35.820 --> 00:46:42.580 land and produces a capital good, and that he manages the plant himself. 427 00:46:42.580 --> 00:46:48.400 He receives a net income over a year's period of 1,000 gold ounces. 428 00:46:48.400 --> 00:46:53.340 How can he estimate the different sources of his income? 429 00:46:53.340 --> 00:46:57.860 is that he had invested 5,000 gold ounces in the business. 430 00:46:57.860 --> 00:47:03.300 He looks around at the economy and finds that what he can pretty well call the ruling rate 431 00:47:03.300 --> 00:47:08.780 of interest toward which the economy is tending is 5%. 432 00:47:08.780 --> 00:47:15.980 He then concludes that 250 gold ounces of his net income was implicit interest. 433 00:47:15.980 --> 00:47:22.300 Next, he estimates approximately what he would have received in wages of management if he 434 00:47:22.300 --> 00:47:27.940 He had gone to work for a competing firm, rather than engaging in this business. 435 00:47:27.940 --> 00:47:33.020 Suppose he estimates that this would have been 500 gold ounces. 436 00:47:33.020 --> 00:47:35.660 He then looks to his ground land. 437 00:47:35.660 --> 00:47:40.780 What could he have received for the land if he had rented it out instead of using it 438 00:47:40.780 --> 00:47:43.060 himself in the business? 439 00:47:43.060 --> 00:47:49.540 Let us say that he could have received 400 ounces in rental income for the land. 440 00:47:49.540 --> 00:47:57.220 Now our owner received a net money income as landowner, capitalist, laborer, entrepreneur 441 00:47:57.220 --> 00:48:01.020 of 1,000 gold ounces for the year. 442 00:48:01.020 --> 00:48:05.820 He then estimates what his costs were in money terms. 443 00:48:05.820 --> 00:48:12.500 These costs are not his explicit money expenses, which have already been deducted to find his 444 00:48:12.500 --> 00:48:20.340 His net income, but his implicit expenses, that is, his opportunities foregone by engaging 445 00:48:20.340 --> 00:48:22.220 in the business. 446 00:48:22.220 --> 00:48:29.980 Adding up these costs, he finds that they total 250 gold ounces in interest, 500 gold 447 00:48:29.980 --> 00:48:40.020 ounces in wages, 400 gold ounces in rent, for a total of 1150 gold ounces total opportunity 448 00:48:40.020 --> 00:48:41.020 costs. 449 00:48:41.020 --> 00:48:48.320 Thus, the entrepreneur suffered a loss of 150 ounces over the period. 450 00:48:48.320 --> 00:48:54.660 If his opportunity costs had been less than 1,000, he would have gained an entrepreneurial 451 00:48:54.660 --> 00:48:56.340 profit. 452 00:48:56.340 --> 00:48:59.980 It is true that such estimates are not precise. 453 00:48:59.980 --> 00:49:05.580 The estimates of what he would have received can never be wholly accurate. 454 00:49:05.580 --> 00:49:10.800 But this tool of ex-post calculation is an indispensable one. 455 00:49:10.800 --> 00:49:18.700 It is the only way by which a man can guide his ex ante decisions, his future actions. 456 00:49:18.700 --> 00:49:24.960 By means of this calculation, he may realize that he is suffering a loss in this business. 457 00:49:24.960 --> 00:49:30.660 If the loss continues much longer, he will be impelled to shift his various resources 458 00:49:30.660 --> 00:49:33.100 to other lines of production. 459 00:49:33.100 --> 00:49:39.280 It is only by means of such estimates that an owner of more than one type of factor in 460 00:49:39.280 --> 00:49:57.240 A very important aspect of such estimates of implicit incomes has been overlooked. 461 00:49:57.240 --> 00:50:04.140 There can be no implicit estimates without an explicit market. 462 00:50:04.140 --> 00:50:11.300 When an entrepreneur receives income, in other words, he receives a complex of various functional 463 00:50:11.300 --> 00:50:12.780 incomes. 464 00:50:12.780 --> 00:50:19.840 To isolate them, by calculation, there must be in existence an external market to which 465 00:50:19.840 --> 00:50:23.300 the entrepreneur can refer. 466 00:50:23.300 --> 00:50:29.700 This is an extremely important point, for, as we shall soon see in detail, this furnishes 467 00:50:29.700 --> 00:50:38.400 is a most important limitation on the relative potential size of a single firm on the market. 468 00:50:38.400 --> 00:50:44.920 For example, suppose we return for a moment to our old hypothetical example in which each 469 00:50:44.920 --> 00:50:49.700 firm is owned jointly by all its factor owners. 470 00:50:49.700 --> 00:50:56.060 In that case, there is no separation at all between workers, landowners, capitalists, 471 00:50:56.060 --> 00:50:57.680 and entrepreneurs. 472 00:50:57.680 --> 00:51:03.840 There would be no way, then, of separating the wage incomes received from the interest 473 00:51:03.840 --> 00:51:07.120 or rent incomes or profits received. 474 00:51:07.120 --> 00:51:14.040 And now we finally arrive at the reason why the economy cannot consist completely of such 475 00:51:14.040 --> 00:51:18.740 firms called producers cooperatives. 476 00:51:18.740 --> 00:51:24.760 Another reason why an economy of producers cooperatives could not calculate is that every 477 00:51:24.760 --> 00:51:31.840 Every original factor would be tied indissolubly to a specific line of production. 478 00:51:31.840 --> 00:51:38.280 There can be no calculation where all factors are purely specific. 479 00:51:38.280 --> 00:51:45.000 For without an external market for wage rates, rents and interest, there would be no rational 480 00:51:45.000 --> 00:51:51.640 way for entrepreneurs to allocate factors in accordance with the wishes of the consumers. 481 00:51:51.640 --> 00:51:57.560 No one would know where he could allocate his land or his labour to provide the maximum 482 00:51:57.560 --> 00:51:59.400 monetary gains. 483 00:51:59.400 --> 00:52:05.760 No entrepreneur would know how to arrange factors in their most value-productive combinations 484 00:52:05.760 --> 00:52:08.080 to earn the greatest profit. 485 00:52:08.080 --> 00:52:14.880 There could be no efficiency in production because the requisite knowledge would be lacking. 486 00:52:14.880 --> 00:52:18.840 The productive system would be in complete chaos. 487 00:52:18.840 --> 00:52:26.400 And everyone, whether in his capacity as consumer or as producer, would be injured thereby. 488 00:52:26.400 --> 00:52:33.160 It is clear that a world of producer's cooperatives would break down for any economy but the most 489 00:52:33.160 --> 00:52:39.180 primitive, because it could not calculate, and therefore could not arrange productive 490 00:52:39.180 --> 00:52:46.440 factors to meet the desires of the consumers, and hence earn the highest incomes for the 491 00:52:46.440 --> 00:52:47.440 producers. 492 00:52:47.440 --> 00:52:53.800 E. Vertical Integration and the Size of the Firm 493 00:52:53.800 --> 00:53:02.000 In the free economy there is an explicit time market, labor market, and land rent market. 494 00:53:02.000 --> 00:53:08.280 It is clear that while chaos would ensue from a world of producers' cooperatives, other 495 00:53:08.280 --> 00:53:15.560 critical points even before that would, as it were, introduce little bits of chaos into 496 00:53:15.560 --> 00:53:17.560 to the Productive System. 497 00:53:17.560 --> 00:53:24.240 Thus, suppose that workers are separated from capitalists, but that all capitalists own 498 00:53:24.240 --> 00:53:26.440 their own ground land. 499 00:53:26.440 --> 00:53:32.640 Further, suppose that for one reason or another, no capitalist will be able to rent out his 500 00:53:32.640 --> 00:53:35.600 land to some other firm. 501 00:53:35.600 --> 00:53:43.080 In that case, land and a particular capital and production process are indissolubly wedded 502 00:53:43.080 --> 00:53:44.500 to each other. 503 00:53:44.500 --> 00:53:50.100 There would be no rational way to allocate land in production, since it would have no 504 00:53:50.100 --> 00:53:53.300 explicit price anywhere. 505 00:53:53.300 --> 00:53:59.020 Since producers would suffer heavy losses, the free market would never establish such 506 00:53:59.020 --> 00:54:00.940 a situation. 507 00:54:00.940 --> 00:54:07.100 For the free market always tends to conduct affairs so that entrepreneurs make the greatest 508 00:54:07.100 --> 00:54:12.600 profit through serving the consumer best and most efficiently. 509 00:54:12.600 --> 00:54:18.960 Since absence of calculation creates grave inefficiencies in the system, it also causes 510 00:54:18.960 --> 00:54:20.840 heavy losses. 511 00:54:20.840 --> 00:54:26.760 Such a situation, absence of calculation, would therefore never be established on a 512 00:54:26.760 --> 00:54:33.600 free market, particularly after an advanced economy has already developed calculation 513 00:54:33.600 --> 00:54:36.080 and a market. 514 00:54:36.080 --> 00:54:42.400 If this is true for such cases as a world of producers' cooperatives and the absence 515 00:54:42.400 --> 00:54:49.320 of a Rent Market, it also holds true on a smaller scale for vertical integration and 516 00:54:49.320 --> 00:54:51.800 the size of a firm. 517 00:54:51.800 --> 00:54:58.800 Vertical integration occurs when a firm produces not only at one stage of production, but over 518 00:54:58.800 --> 00:55:01.540 two or more stages. 519 00:55:01.540 --> 00:55:08.440 For example, a firm becomes so large that it buys labor, land and capital goods of the 520 00:55:08.440 --> 00:55:15.040 The fifth order then works on these capital goods producing other capital goods of the 521 00:55:15.040 --> 00:55:16.660 fourth order. 522 00:55:16.660 --> 00:55:23.000 In another plant it then works on the fourth order capital goods until they become third 523 00:55:23.000 --> 00:55:25.200 order capital goods. 524 00:55:25.200 --> 00:55:29.960 It then sells the third order product. 525 00:55:29.960 --> 00:55:35.780 Vertical integration of course lengthens the production period for any firm. 526 00:55:35.780 --> 00:55:43.620 is it lengthens the time before the firm can recoup its investment in the production process. 527 00:55:43.620 --> 00:55:51.260 The interest return then covers the time for two or more stages rather than one. 528 00:55:51.260 --> 00:55:57.300 Vertical integration, we might note, tends to reduce the demand for money to turn over 529 00:55:57.300 --> 00:56:04.660 at various stages and thereby to lower the purchasing power of the monetary unit. 530 00:56:04.660 --> 00:56:08.420 There is a more important question involved, however. 531 00:56:08.420 --> 00:56:15.980 This is the role of implicit earnings and calculation in a vertically integrated firm. 532 00:56:15.980 --> 00:56:23.340 The firm, say, buys labor and land factors at both the fifth and the fourth stages. 533 00:56:23.340 --> 00:56:30.500 It also makes the fourth stage capital goods itself and uses them in another plant to make 534 00:56:30.500 --> 00:56:33.620 a lower stage good. 535 00:56:33.620 --> 00:56:40.420 Does such a firm employ calculation within itself, and if so, how? 536 00:56:40.420 --> 00:56:47.540 Yes, the firm assumes that it sells itself the fourth-rank capital good. 537 00:56:47.540 --> 00:56:54.520 It separates its net income as a producer of fourth-rank capital from its role as producer 538 00:56:54.520 --> 00:56:56.940 of third-rank capital. 539 00:56:56.940 --> 00:57:03.300 It calculates the net income for each separate division of its enterprise, and allocates 540 00:57:03.300 --> 00:57:09.060 It's resources according to the profit or loss made in each division. 541 00:57:09.060 --> 00:57:17.540 It is able to make such an internal calculation only because it can refer to an existing explicit 542 00:57:17.540 --> 00:57:22.120 market price for the fourth stage capital good. 543 00:57:22.120 --> 00:57:29.020 In other words, a firm can accurately estimate the profit or loss it makes in a stage of 544 00:57:29.020 --> 00:57:36.380 of its enterprise, only by finding out the implicit price of its internal product, and 545 00:57:36.380 --> 00:57:44.980 it can do this only if an external market price for that product is established elsewhere. 546 00:57:44.980 --> 00:57:51.600 To illustrate, suppose that a firm is vertically integrated over two stages, with each stage 547 00:57:51.600 --> 00:57:54.140 covering one year's time. 548 00:57:54.140 --> 00:58:00.460 The general rate of interest in the economy tends towards 5% per annum. 549 00:58:00.460 --> 00:58:07.760 This particular firm, say the Jones Manufacturing Company, a vertically integrated firm, buys 550 00:58:07.760 --> 00:58:17.040 factors at the 5th rank for 100 ounces and original factors at the 4th rank for 15 ounces. 551 00:58:17.040 --> 00:58:21.420 It sells the final product at 140 ounces. 552 00:58:21.420 --> 00:58:28.260 It seems that it has made a handsome entrepreneurial profit on its operations, but can it find 553 00:58:28.260 --> 00:58:33.880 out which stage or stages is making this profitable showing? 554 00:58:33.880 --> 00:58:39.580 If there is an external market for the product of the stage that the firm has vertically 555 00:58:39.580 --> 00:58:47.180 integrated, stage 4, the Jones Company is able to calculate the profitability of specific 556 00:58:47.180 --> 00:58:50.120 stages of its operations. 557 00:58:50.120 --> 00:58:55.440 Suppose, for example, that the price of the fourth-order capital good on the external 558 00:58:55.440 --> 00:58:58.840 market is 103 ounces. 559 00:58:58.840 --> 00:59:05.500 The Jones Company then estimates its implicit price for this intermediate product at what 560 00:59:05.500 --> 00:59:10.540 it would have brought on the market if it had been sold there. 561 00:59:10.540 --> 00:59:14.720 This price will be about 103 ounces. 562 00:59:14.720 --> 00:59:22.120 The implicit price or opportunity cost of selling to oneself might be less than the existing 563 00:59:22.120 --> 00:59:28.200 market price, since the entry of the Jones Company on the market might have lowered the 564 00:59:28.200 --> 00:59:32.680 price of the good, say to 102 ounces. 565 00:59:32.680 --> 00:59:38.840 There would be no way at all, however, to estimate the implicit price if there were 566 00:59:38.840 --> 00:59:43.920 no external market and external price. 567 00:59:43.920 --> 00:59:51.240 Assuming that the price is estimated at 103, then the total amount of money spent by Jones' 568 00:59:51.240 --> 01:00:01.840 lower order plant on factors is 15, explicit on original factors, plus 103, implicit on 569 01:00:01.840 --> 01:00:07.340 capital goods, for a total of 118. 570 01:00:07.340 --> 01:00:15.300 Now the Jones Company can calculate the profits or losses made at each stage of its operations. 571 01:00:15.300 --> 01:00:23.020 The higher stage bought factors for 100 ounces and sold them at 103 ounces. 572 01:00:23.020 --> 01:00:27.220 It made a 3% return on its investment. 573 01:00:27.220 --> 01:00:36.100 The lower stage bought its factors for 118 ounces and sold the product for 140 ounces, 574 01:00:36.100 --> 01:00:39.220 Making a 29% Return 575 01:00:39.220 --> 01:00:46.100 It is obvious that instead of enjoying a general profitability, the Jones Company suffered a 576 01:00:46.100 --> 01:00:55.580 2% entrepreneurial loss on its earlier stage and gained a 24% profit on its later stage. 577 01:00:55.580 --> 01:01:01.580 Knowing this, it will shift resources from the higher to the lower stage in accordance 578 01:01:01.580 --> 01:01:08.580 in accordance with their respective profitabilities, and therefore in accordance with the desires of consumers. 579 01:01:08.580 --> 01:01:21.580 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. 580 01:01:21.580 --> 01:01:26.580 On the other hand, suppose that there is no external market, 581 01:01:26.580 --> 01:01:32.380 is that the Jones Company is the only producer of the intermediate good. 582 01:01:32.380 --> 01:01:38.180 In that case, it would have no way of knowing which stage was being conducted profitably 583 01:01:38.180 --> 01:01:39.740 and which not. 584 01:01:39.740 --> 01:01:45.840 It would therefore have no way of knowing how to allocate factors to the various stages. 585 01:01:45.840 --> 01:01:52.260 There would be no way for it to estimate any implicit price or opportunity cost for the 586 01:01:52.260 --> 01:01:55.880 capital good at that particular stage. 587 01:01:55.880 --> 01:02:03.780 Any estimate would be completely arbitrary and have no meaningful relation to economic conditions. 588 01:02:03.780 --> 01:02:10.480 In short, if there were no market for a product and all of its exchanges were internal, there 589 01:02:10.480 --> 01:02:17.660 would be no way for a firm or for anyone else to determine a price for the good. 590 01:02:17.660 --> 01:02:25.120 A firm can estimate an implicit price when an external market exists, but when a market 591 01:02:25.120 --> 01:02:31.560 is absent, the good can have no price, whether implicit or explicit. 592 01:02:31.560 --> 01:02:35.640 Any figure could be only an arbitrary symbol. 593 01:02:35.640 --> 01:02:42.040 Not being able to calculate a price, the firm could not rationally allocate factors and 594 01:02:42.040 --> 01:02:46.000 resources from one stage to another. 595 01:02:46.000 --> 01:02:51.800 Since the free market always tends to establish the most efficient and profitable type of 596 01:02:51.800 --> 01:03:12.800 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. 597 01:03:12.800 --> 01:03:20.800 For every capital good, there must be a definite market in which firms buy and sell that good. 598 01:03:20.800 --> 01:03:30.800 It is obvious that this economic law sets a definite maximum to the relative size of any particular firm on the free market. 599 01:03:30.800 --> 01:03:40.800 Because of this law, firms cannot merge or cartelize for complete vertical integration of stages or products. 600 01:03:40.800 --> 01:03:47.800 Because of this law, there can never be one big cartel over the whole economy, 601 01:03:47.800 --> 01:03:55.200 or mergers until one big firm owns all the productive assets in the economy. 602 01:03:55.200 --> 01:04:02.000 The force of this law multiplies as the area of the economy increases and as 603 01:04:02.000 --> 01:04:08.720 islands of non-calculable chaos swell to the proportions of masses and continents. 604 01:04:08.720 --> 01:04:17.360 As the area of incalculability increases, the degrees of irrationality, misallocation, loss, 605 01:04:17.360 --> 01:04:21.760 Costs, impoverishment, etc. become greater. 606 01:04:21.760 --> 01:04:29.160 Under one owner or one cartel for the whole productive system, there would be no possible 607 01:04:29.160 --> 01:04:37.440 areas of calculation at all, and therefore complete economic chaos would prevail. 608 01:04:37.440 --> 01:04:42.240 Capital goods are stressed here because they are the product for which the calculability 609 01:04:42.240 --> 01:04:45.640 problem becomes important. 610 01:04:45.640 --> 01:04:52.680 Consumers goods per se are no problem, since there are always many consumers buying goods, 611 01:04:52.680 --> 01:04:58.280 and therefore consumers goods will always have a market. 612 01:04:58.280 --> 01:05:05.200 Economic calculation becomes ever more important as the market economy develops and progresses, 613 01:05:05.200 --> 01:05:12.500 as the stages and the complexities of type and variety of capital goods increase. 614 01:05:12.500 --> 01:05:18.020 However more important for the maintenance of an advanced economy, then, is the preservation 615 01:05:18.020 --> 01:05:24.180 of markets for all the capital and other producers' goods. 616 01:05:24.180 --> 01:05:31.180 Our analysis serves to expand the famous discussion of the possibility of economic calculation 617 01:05:31.180 --> 01:05:37.380 under socialism, launched by Professor Ludwig von Mises over 40 years ago. 618 01:05:37.380 --> 01:05:43.540 Mises, who has had the last as well as the first word in this debate, has demonstrated 619 01:05:43.540 --> 01:05:51.180 irrefutably that a socialist economic system cannot calculate, since it lacks a market, 620 01:05:51.180 --> 01:05:57.380 and hence lacks prices for producers and especially for capital goods. 621 01:05:57.380 --> 01:06:03.180 It is remarkable that so many anti-socialist writers have never become aware of this critical 622 01:06:03.180 --> 01:06:04.820 point. 623 01:06:04.820 --> 01:06:12.020 Now we see that, paradoxically, the reason why a socialist economy cannot calculate is 624 01:06:12.020 --> 01:06:16.720 not specifically because it is socialist. 625 01:06:16.720 --> 01:06:22.620 Socialism is that system in which the state forcibly seizes control of all the means of 626 01:06:22.620 --> 01:06:25.300 production in the economy. 627 01:06:25.300 --> 01:06:33.160 The reason for the impossibility of calculation under socialism is that one agent owns or 628 01:06:33.160 --> 01:06:38.620 or directs the use of all the resources in the economy. 629 01:06:38.620 --> 01:06:44.760 It should be clear that it does not make any difference whether that one agent is the state 630 01:06:44.760 --> 01:06:49.160 or one private individual or private cartel. 631 01:06:49.160 --> 01:06:55.600 Whichever occurs, there is no possibility of calculation anywhere in the production 632 01:06:55.600 --> 01:07:02.840 structure since production processes would be only internal and without markets. 633 01:07:02.840 --> 01:07:09.720 There could be no calculation, and therefore complete economic irrationality and chaos 634 01:07:09.720 --> 01:07:16.520 would prevail, whether the single owner is the state or private persons. 635 01:07:16.520 --> 01:07:23.340 The difference between the state and the private case is that our economic law debars people 636 01:07:23.340 --> 01:07:28.780 from ever establishing such a system in a free market society. 637 01:07:28.780 --> 01:07:35.900 Far lesser evils prevent entrepreneurs from establishing even islands of incalculability, 638 01:07:35.900 --> 01:07:43.580 let alone infinitely compounding such errors by eliminating calculability altogether. 639 01:07:43.580 --> 01:07:49.860 But the state does not and cannot follow such guides of profit and loss. 640 01:07:49.860 --> 01:07:56.500 Its officials are not held back by fear of losses from setting up all-embracing cartels 641 01:07:56.500 --> 01:08:07.320 The State is free to embark upon socialism without considering such matters. 642 01:08:07.320 --> 01:08:14.200 While there is therefore no possibility of a one-firm economy or even a one-firm vertically 643 01:08:14.200 --> 01:08:21.360 integrated product, there is much danger in an attempt at socialism by the State. 644 01:08:21.360 --> 01:08:28.360 A further discussion of the state and state intervention will be found in Chapter 12 of this book. 645 01:08:28.360 --> 01:08:37.360 A curious legend has become quite popular among the writers on the socialist side of the debate over economic calculation. 646 01:08:37.360 --> 01:08:39.360 This runs as follows. 647 01:08:39.360 --> 01:08:48.360 Mises, in his original article, asserted theoretically that there could be no economic calculation under socialism. 648 01:08:48.360 --> 01:09:04.360 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. 649 01:09:04.360 --> 01:09:10.220 The inference is that the argument of Mises has been disposed of, and that all socialism 650 01:09:10.220 --> 01:09:17.520 needs is a few practical devices, perhaps calculating machines or economic advisors, 651 01:09:17.520 --> 01:09:22.840 to permit calculation and the counting of the equations. 652 01:09:22.840 --> 01:09:27.480 This legend is almost completely wrong from start to finish. 653 01:09:27.480 --> 01:09:33.800 In the first place, the dichotomy between theoretical and practical is a false one. 654 01:09:33.800 --> 01:09:40.840 In economics, all arguments are theoretical, and since economics discusses the real world, 655 01:09:40.840 --> 01:09:47.220 these theoretical arguments are, by their nature, practical ones as well. 656 01:09:47.220 --> 01:09:54.220 The false dichotomy disposed of, the true nature of the Barone proof, becomes apparent. 657 01:09:54.220 --> 01:09:58.160 It is not so much theoretical as irrelevant. 658 01:09:58.160 --> 01:10:03.240 The proof by listing of mathematical equations is no proof at all. 659 01:10:03.240 --> 01:10:07.960 It applies at best only to the evenly rotating economy. 660 01:10:07.960 --> 01:10:15.320 Obviously, our whole discussion of the calculation problem applies to the real world and to it 661 01:10:15.320 --> 01:10:16.880 only. 662 01:10:16.880 --> 01:10:25.160 There can be no calculation problem in the ERE because no calculation there is necessary. 663 01:10:25.160 --> 01:10:32.120 Obviously, there is no need to calculate profits and losses when all future data are known 664 01:10:32.120 --> 01:10:40.920 from the beginning and where there are no profits and losses. In the ERE, the best allocation of 665 01:10:40.920 --> 01:10:48.120 resources proceeds automatically. For Barone to demonstrate that the calculation difficulty does 666 01:10:48.120 --> 01:10:55.480 not exist in the ERE is not a solution, it is simply a mathematical belaboring of the obvious. 667 01:10:55.480 --> 01:11:03.480 Far from being refuted, Mises had already disposed of this argument in his original article. 668 01:11:03.480 --> 01:11:10.480 Further, Barone's article was written in 1908, 12 years before Mises. 669 01:11:10.480 --> 01:11:19.480 A careful perusal of Mises' original article, in fact, reveals that he there disposed of almost all the alleged solutions, 670 01:11:19.480 --> 01:11:38.680 Part of the confusion stems from an unfortunate position taken by two followers of Mises in 671 01:11:38.680 --> 01:11:42.080 this debate, Hayek and Robbins. 672 01:11:42.080 --> 01:11:47.480 They argued that a socialist government could not calculate because it simply could not 673 01:11:47.480 --> 01:11:52.480 not compute the millions of equations that would be necessary. 674 01:11:52.480 --> 01:11:58.460 This left them open to the obvious retort that now, with high-speed computers available 675 01:11:58.460 --> 01:12:03.360 to the government, this practical objection is no longer relevant. 676 01:12:03.360 --> 01:12:10.400 In reality, the job of rational calculation has nothing to do with computing equations. 677 01:12:10.400 --> 01:12:16.600 Nobody has to worry about equations in real life except mathematical economists.