Wednesday, March 21, 2012

Production in an Evenly Rotating Economy

An Introduction to Austrian Economics

Thomas C. Taylor

Production in an Evenly Rotating Economy

We must now explain how scarce resources are allocated in the production of various consumer goods in the market economy. The generation of consumer goods, as will be shown, is a complex process in which the production of numerous goods used to make other goods, often called capital goods, plays an essential role. Production requires the creation of capital goods to be used in further production as well as the final goods designed to please the consumer. One can readily observe that in our economy the decisively preponderant form of economic activity is the production of intermediate or capital goods as opposed to final consumption goods. Nature does not bestow an abundance of goods on man in immediately consumable forms. With the exception of the air (and this exception is not everywhere applicable), there is hardly any good that nature supplies that cannot be made far more useful through the application of some productive effort. The question is not whether there should be production, but to what ends should production be directed so that the most desirable goods and services are produced.

Resource Pricing in an Evenly Rotating Economy (ERE)

In order for the owners of productive factors to be willing to contribute resources to the productive process of the market, there must be some means by which they can share in the output arising from production. Their participation is achieved through the price system. Particular units of productive factors are exchanged for specific quantities of money through supply-and-demand forces in the same way that consumer goods are bought and sold. However, there is one crucial difference between the pricing of consumer goods and productive factors: Consumer goods are evaluated directly by consumers as ends or ultimate sources of satisfaction, but consumers do not evaluate the resources used to generate the final goods. It should be clear that effective allocation of scarce resources requires a system in which specific employments are considered in terms of the relative importance of alternative results. If certain ends or consumer goods are more important than others, then resources versatile enough to serve a variety of ends should be directed to the creation of the most important ones. An explanation of the pricing of units of resources will show how this goal is accomplished.
The concept of an imaginary economy devoid of change in technology, resources, and tastes, an economy in which the same steps of production and consumption are repeated over and over, is useful in understanding the nature of the pricing of resource units in the real world of continuous change. Rothbard has called such an economy an evenly rotating economy, or ERE. In the ERE, each producer, given his predicament of owning some resources and bidding for units of particular resources, would be able to impute to a given resource unit the money value of its contribution to the final product because he would know in advance the monetary result of particular production decisions. He would not encounter the uncertainty arising from changing economic conditions. Past results would exactly predict future results.
The unit price of each type of resource would equal the discounted value of its marginal contribution to product value. (The discount relates to a margin reflecting time preference or interest, a matter to be discussed below.) This price would apply to the resource in all of its various lines of employment to the extent that the resource owners were indifferent to the nonmonetary factors relating to the different lines. The resource could not earn more in one line than in another because resource owners would have shifted their factor to the more remunerative lines. This shift would have driven the factor price down in the attractive employments and caused the price to rise in those abandoned lines. Prices of homogeneous factors would become equal in all employments.
This uniform price would be equated to the resource's marginal value product, which would thus be the same in all lines of employment. Producers would not tolerate any discrepancy between a factor's price and its contribution to product value. If a resource had been receiving a price lower than its marginal value product, producers would have increased the use of the resource in these outputs so that its unit price would be bid upward but not in excess of its contribution to productive value. Conversely, if a resource unit had been paid a price higher than its marginal value product, employment of the resource would have fallen off in those lines at least until the price ceased to exceed the factor's contribution to product revenues. The price of a durable factor would be derived from and equal to the summation of the marginal value products of its specific service units to be used over time. Durable resources, then, could be purchased or rented in the ERE according to the value imputed to the service units to be derived.
Thus in the evenly rotating economy the price of each product would (except for the interest factor) equal the summation of the marginal value products of its complementary factors of production. For each producer, total money revenues (excluding interest) would equal total money costs. Adjustments leading up to the ERE would have eliminated all instances of profit and loss. The continuous stability and certainty of an evenly rotating economy would preclude the need for further adjustments or changes in resource allocation. Each factor would be allocated to various uses so that its marginal product contribution would be the same in each use. With perfect knowledge about the future, producers would make no mistakes about imputing product values to resource values. What is of extreme importance here is that the influence is from product price back to factor price, and not the other way around. Means derive their importance from the ends or results they effect. Here lies the key to effective resource utilization. Yet, the erroneous notion that factor costs determine product prices has widespread acceptance.
Only those factor units whose marginal effect on product value could be isolatable and hence determinable would be subject to the competitive forces that would set resource prices equal to discounted marginal value product. This means that determinate pricing would require the existence of versatile, relatively nonspecific factors whose multiple uses set the competitive process in motion as producers bid for the factors' employment in various lines of production. A price emerges on the market for a particular resource because producers compete for its employment in alternative uses. If products were produced by strictly specific resources, then the market could establish only cumulative prices for each combinational group of resource factors, and each price would represent the monetary value of the common product. Prices are determinate for absolutely specific resources in those situations in which the production process uses no more than one specific resource. As a result of the bidding of competitive producers, such prices of specific resources equal the residual difference between the final product price and the sum of the prices of the nonspecific factors.
Cumulative residual prices will prevail on the market in connection with those processes in which more than one specific resource is required. In such cases, the amount singly paid to each specific factor is established only through the process of bargaining among the separate owners of the specific factors. Prices of particular factors emerge only when producers compete for their use in alternative lines of production or when there is only one specific resource in each productive process, thereby imputing marginal value to the particular factor's units.
It is important to realize that the imputation of value to factors of production on the part of producers is done only on an incremental or marginal basis. In hiring or purchasing productive services, the producer always makes his decision in terms of the added advantage of the additional factor. This does not mean that he deals with infinitesimal increments. For example, his marginal unit may be fifty additional employees or four new machines, but he thinks in terms of his particular situation and bids for services in light of their expected marginal contribution. Rothbard has effectively dealt with this point:
It is, then, clearly impossible to impute absolute "productivity" to any productive factor or class of factors. In the absolute sense, it is meaningless to try to impute productivity to any factor, since all the factors are necessary to the product. We can discuss productivity only in marginal terms, in terms of the productive contribution of a single unit of a factor, given the existence of the other factors.This is precisely what entrepreneurs do on the market, adding and subtracting units of factors in an attempt to achieve the most profitable course of action. [1]
Just as the farmer's five sacks of grain were allocated to the most urgent uses first, so are the units of a productive factor. As additional units of any factor are employed in a given process or throughout the economy, the marginal value product declines. The decline in the marginal value product is enhanced as a result of the law of diminishing returns, which holds that in the employment of any variable factor to a fixed factor, marginal physical productivity begins to fall at a certain point. This means that, given the supply of a particular factor, the price per unit of that factor will be set equal to the marginal value product related to the last unit of supply. As each of the farmer's sacks of grain carried the same value equal to the value of the marginal use--feeding pet parrots--each unit of a particular factor is priced in the ERE equal to the marginal value product, which is the money value that would be sacrificed if one unit of the factor were lost.
This process of resource pricing would apply to factor service units, whether purchased on a limited scale through renting or on a greater scale through the purchase of whole factors. In the ERE, all factor service units would receive their marginal value product, and there would exist no reason for their being shifted to other lines of employment once this condition was reached. Each particular factor would have one unit price throughout the market. In each specific use the resource would be employed to the extent that its marginal value product was equal to its price, competitively established throughout its market. The demand curve for each factor in each particular use depicts its declining marginal value product; like the demand curve for consumers' goods, it would be downward-sloping to the right.
The supply curve for each productive resource in each line of use would be upward-sloping to the right, reflecting the fact that resource units, possessing a versatility of productiveness in alternative uses, would be shifted away from the given use to other uses at lower prices and would be attracted to the given use from alternative lines of employment at higher prices. The curve would probably be flatter for factors of labor than for land and capital goods factors because of the relatively greater degree of nonspecificity and flexibility in the nature of the labor resources.

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