Friday, March 23, 2012

From an Evenly Rotating Economy to the Real World

An Introduction to Austrian Economics

Thomas C. Taylor

From an Evenly Rotating Economy to the Real World

In an evenly rotating economy, the problem of resource allocation would be easily solved. Knowledge of future preferences, resources, and techniques of production would be the result of a world without change. Equipped with this knowledge, market participants would be able to devote resources to their most satisfying lines of use without friction and inconsistent planning. Units of factors of production would be priced equal to their discounted marginal value product, thereby permitting investor-producers to earn only an interest return. Units of factors would be repeatedly employed in the same fashion as in the past, since to change particular usages would require the creation of a lower marginal value product, an inferior result that could be anticipated in advance and obviated. The known money values of future products would indicate the money values of resources to be used in their creation.
However, everyone knows that the real world is not a world of mere constants and perfect predictability. There is really no assurance about tomorrow. The tastes and value scales of individuals do not remain constant, and neither can anyone assume that the nature and amount of available resources will remain the same. And with time comes continuous revision in the recipes and techniques of production. Thus in the real world there is no simple and automatic solution to the task of resource allocation. Because of the ever-present factor of uncertainty, no actor "knows" the future; each can only attempt to forecast it in terms of his own understanding of the potentiality of the present.
Nevertheless, the concept of the ERE is useful in explaining and understanding the real world of change. In the midst of continuous change, the market is relentlessly in pursuit of a general equilibrium in which all productive factors are being applied to their most desired uses and all profits and losses have disappeared. In other words, the tendency of the real market is always moving toward an evenly rotating economy. It is the factor of change that prevents that economy from ever being reached. With the conditions and data of the market being subject to constant change, revisions and adjustments in plans and actions are continually necessitated.
The concept of an ERE helps one to imagine a world in which changes in tastes, resources, and technology have ceased. More importantly, it yields an understanding of the direction that the market is continually taking as errors emanating from the imperfect knowledge of the future give rise to revised plans and actions on the part of market participants. For example, when producers underestimate the demand for a particular good, the resulting higher price of the good attracts more resources to that use and away from less important uses. As more attention is given to the production of this good, its unit price falls and the unit price of its resources rises, gradually eliminating the opportunity to profit form its production.
This is a process of adjusting to facts of the market that were not knowable in advance. Through this adjusting process, the market continually strives to reach the state of the ERE; the problem is that this quest is constantly interrupted and sidetracked as a result of subsequent change and its complement, the need for additional adjustment. It should be clear that the imaginary ERE is not being held up as some kind of ideal economy. Its purpose is only to help explain the workings of the real market economy. The contrast between the real world and the ERE is described by Rothbard:
The difference in the dynamic, real world is this. None of these future values or events is known; all must be estimated, guessed at, by the capitalists. They must advance present money in a speculation upon the unknown future in the expectation that the future product will be sold at a remunerative price. In the real world, then, quality of judgment and accuracy of forecast play an enormous role in the incomes acquired by capitalists. As a result of the arbitrage of the entrepreneurs, the tendency is always toward the ERE; in consequence of ever-changing reality, changes in value scales and resources, the ERE never arrives. [1]
This whole matter of the constant changeability of market conditions is the essence of the concept of uncertainty, as distinguished earlier from the concept of quantifiable risk. The key to this distinction is that the interrelationship of events and factors in the competitive market is so complex that it precludes the precise calculation of probability of the success or failure of any given entrepreneurial decision. Market conditions at any instant are comparatively unique; they do not lend themselves to the gathering of extensive empirical data that can be said to relate to homogeneous circumstances and events. Accurate anticipations of consumer preferences, competitor actions, technological change, and resource availabilities are far more difficult to make than typical actuarial predictions.
Actuarial predictions deal with matters that have an extensive history, are subject to detailed classification, and occurred under conditions that can be expected to remain for the most part unchanged for the time being. Businessmen, however, do not have the fortune of operating under many of these repetitive sequences of highly categorized events. As Knight has said the problem stems from the inability to accumulate sufficient empirical data relating to particular classes of subjects and events. As Hayek has put it, "In the social sciences we have to deal with... phenomena which are not made up of sufficiently large numbers of similar events to enable us to ascertain the probabilities of their occurrence. [2]
All of this is not to say that businessmen have absolutely no sense of what future developments are likely to be. They do make judgments and predictions about the future. But the point is that these anticipations are speculative and not mathematically precise. It is not that there are no indications concerning the future; it is that there is grossly incomplete knowledge of future developments. The following statements by Knight are pertinent:
It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little. This is as true of business as of other spheres of activity. The essence of the situation is action according to opinion, of greater or less foundation and value, neither entire ignorance nor complete and perfect information, but partial knowledge. [3]

Entrepreneurial Profits and Losses

Profit theory has often explained the emergence of money profits in the market economy either as a reward for taking risks or as the natural income earned by capital (as opposed to the rents of land and wages of labor) in the classical sense. Both of these analyses are incorrect. In the competitive market, all business activity is risky in the sense of being uncertain; yet not every business venture is monetarily profitable. A businessman who makes too many mistakes is not automatically rewarded with profits simply because he undertook ventures of a risky nature. Profits cannot be called simply a reward for risk-taking. The classical thesis that profits are the return peculiar to the category of capital or capital goods is an empty explanation because it fails to show just why something extra should arise from the usage of capital and not from the usage of the other factors of land and labor. At times this theory borders on a sort of normal interest theory, but it lacks the principle of time-preference and is mistaken in tying interest only to capital goods. As has been shown, the phenomenon of interest is present in all matters involving the exchange of present goods for future goods.
Profits which are nonexistent in the evenly rotating economy are received by those entrepreneur-producers who most correctly anticipate the wishes of the consumers. Profits arise when productive factors are bought for prices lower than the prices for which their products are sold. In a world of uncertainty, the producers have to judge what the marginal value product will be for units of productive factors. Those who are able to discern discrepancies between current resource prices and the future prices of their products generate money revenues in excess of money costs by capitalizing on such opportunities. In such cases the resources can be said to have been underpriced. The ultimate prices of consumer goods are determined by the subjective valuations placed by consumers on the goods offered for sale. Thus the crucial task of the entrepreneur-producer in purchasing various units of resources is to anticipate as correctly as possible the future preferences of consumers. Using such anticipations, he is able to impute an anticipated marginal value product to the available factors of production.
Profits result if others have failed to value the particular factor units as highly and if it turns out that the entrepreneur-producer was reasonably correct in his anticipations. On the other hand, losses result whenever he acquires resources at amounts greater than the money value of the products generated from such resources. In these cases the resources can be said to be overpriced for the purposes to which they were put. Since there is no certainty about the future, there is room in the market economy for entrepreneurial losses as well as profits. Profits, then, do arise in connection with risk-taking but only when the anticipations turn out to be correct.
A theory of profits should also include a corollary explanation of losses. The principal determinant of business success is the foresight and alertness of those in charge of directing the business. Mises has explained the source of money profits in the following way:
The ultimate source from which entrepreneurial profit and loss are derived is the uncertainty of the future constellation of demand and supply.
If all entrepreneurs were to anticipate correctly the future state of the market, there would be neither profits nor losses. The prices of all the factors of production would already today be fully adjusted to tomorrow's prices of products. In buying the factors of production the entrepreneur would have to expend (with due allowance for the difference between the prices of present goods and future goods) no less an amount than the buyers will pay him later for the product. An entrepreneur can make a profit only if he anticipates future conditions more correctly than other entrepreneurs. Then he buys the complementary factors of production at prices the sum of which, including allowance for the time difference, is smaller than the price at which he sells the product. [4]
It should be realized that the phenomenon of entrepreneurial profits and losses continues to occur only because there are persistent changes in market conditions. This is what was meant when it was earlier stated that the concept of the evenly rotating economy provides an understanding of the goal toward which the market continuously moves but never reaches. If new changes in market data were not to constantly occur, the prices of all complementary resources would be finally set so that total money costs would equal total money revenues and there would be nothing left for profits and losses. There is an inherent tendency for profits and losses to disappear as entrepreneurs make adjustments in their plans, moving into profitable lines and away from unprofitable ones. It is the recurrence of change and discovery in market conditions that precludes the permanent and complete elimination of profits and losses.

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