Resource Supply, Entrepreneurial Activity, and Subjective Valuation

An Introduction to Austrian Economics

Thomas C. Taylor

Resource Supply, Entrepreneurial Activity,
and Subjective Valuation

The theory of subjective value must not be overlooked in the discussion of factor supply curves. The owners of the units of factor service will subjectively determine the various quantities of service units that they are willing to offer to producers for each possible price per service unit in each particular use of the factor. They will weigh subjectively the monetary and nonmonetary results of committing the various possible quantities of service units to production. For example, the laborer will consider the value of leisure as well as other nonmonetary factors like working conditions in reaching his decision about employment. Those lines of work associated with significantly favorable nonmonetary characteristics would attract a greater number of workers than those characterized by noticeably unfavorable working conditions. Higher wage rates or prices than otherwise necessary would be paid those working in the generally disliked jobs; conversely, lower wages than otherwise required would be paid to those employed in the generally favored jobs.

These results are consistent with the principle of declining marginal value product for each particular use. Greater quantities of factors employed would tap decreasing marginal value products; lesser quantities would relate to higher marginal value products. Market supply curves for each factor in each particular use would show the summation of individual supply curves. The intersection of the market demand-and-supply curves would show the establishment of the equilibrium price for each factor in each particular line of employment, and this price would represent the marginal value product of a factor unit in that particular use. Such would be the endlessly prevailing price structure for units of productive resources in the evenly rotating economy.

In hiring or purchasing factors of production, the producer, like all other market participants, is acting on his own subjective value judgments. [2] His willingness to invest specific amounts of money or commit himself to the investment of amounts of money obtained from others, who likewise act on personal valuations, reflects his decision that taking other actions instead would contribute less satisfaction to him than pursuing his business plan. His subjective evaluation of expected "money costs" and other forms of sacrifice, i.e., forgone alternative satisfaction, or in Buchanan's terms, his "choice-influencing" costs, is lower than the subjective value expected to be realized from the action chosen.

The Efficiency of Resource Allocation in an ERE

In an advanced economy the time between the inception of virtually every consumer good and its fruition is exceedingly long. In order to obtain goods that they desire and can consume, people are able to resort ultimately to only two types of productive resources, themselves and nature. Because either the goods that come from nature are not completely accessible to humans, or the resources of nature are not always usable in their natural state, humans inject their own efforts into the natural process. This productive effort transforms and combines the gifts of nature into more satisfactory goods. All such production must take place through time; thus, the fundamental and ultimate requirements for production are nature, man, and time.

Humans can combine their own efforts with the gifts of nature to produce consumable goods either directly or indirectly. Using the direct approach, a person applies his energies to a natural resource for immediate satisfaction, as in obtaining a drink of water from a stream. It was owing to the great contribution of Bohm-Bawerk that economic analysis recognized that production cannot occur without the passing of time, a recognition that was especially pertinent in connection with the indirect approach to production. [3] Under this second method, production first yields intermediate goods that are not consumable but rather are used to assist in further production efforts. These intermediate goods, known as producers' goods or capital goods, include tools, equipment, buildings, and all other produced means of production. An example of this indirect method, which Bohm-Bawerk called "roundabout production," is obtaining water to drink from the stream with a log hollowed out to make a bucket. The bucket could be used to make the acquisition of water easier by reducing the number of trips to the stream.

The advantage of roundabout or indirect production is not confined to making it easier to acquire goods that already exist in consumable form, such as water. A far greater advantage is its capacity to produce consumer goods that otherwise could never be made available. All modern conveniences such as cars, communications devices, refrigerators, eyeglasses, and countless others would be nonexistent were their production not preceded by the creation of tools and equipment. In an advanced economy, units of these capital goods are a significant part of the factors being purchased for production purposes. In the ERE, each particular type would be priced per service unit at an amount equal to its discounted marginal value product. The price of the whole capital good would equal the capitalization of its future marginal value products.

Time Preference and Interest

Because of the time-consuming element of production, the price paid each factor unit in the ERE is its discounted marginal value product and not its full marginal value product. The principle of time-preference, which holds that people prefer present goods to future goods, underlies the requirement that future marginal value products be discounted to their present values. People who save some of their purchasing power and invest in productive undertakings thereby forgo the enjoyment of consumption goods that purchasing power could have obtained. They exchange present goods for future goods. When they purchase units of productive factors in the expectation of generating future purchasing power, i.e., future goods, they provide the former owners of these resources with a means to acquire present goods. However, since they prefer present goods over future goods, future goods are valued less in the present than are present goods, and it is this lesser value that is presently imputed to the marginal value product of each productive factor. This is why in an ERE producers would earn an interest income, the difference between the money value of consumer goods and the money value of productive resources purchased at earlier points in time.

In an advanced economy in which extensive use of roundabout production processes is prominent, the interest factor is of utmost importance. Here rests the kernel of Bohm-Bawerk's devastating reply to Marx's exploitation theory, which maintained that capitalist-producers exploited the working class by paying them less than the value of their products. Marx was right in citing the emergence of a surplus value, but he was wrong in overlooking that rather than being a matter of exploitation, this discrepancy was partly the result of a natural and unavoidable phenomenon: interest.

In an ERE, the interest rate would be the same throughout the economy and in every productive stage because if interest rates were higher in certain industries or stages than in others, producers would shift to the more remunerative lines so that the differences would disappear as the result of competitive forces. In those industries or stages that producers abandon, the demand for productive resources falls, thereby reducing the prices of units of factors. This raises the discrepancy between marginal value product and money costs; hence the interest rate in those lines is increased. On the other hand, in those industries that attract additional investment, interest rates fall as a result of higher resource prices and the lower selling prices of finished goods.

This process of shifting investment would go on until the interest rate in every line of production became the same, at which point an evenly rotating economy would be reached. The higher the rate of interest, the more production efforts will be directed toward the production of consumer goods and the less saving available for more time-consuming production of future goods. A lower rate of interest indicates a lower discounting of future goods to present goods and is concomitant with greater savings and the opportunity to adopt more time-consuming processes of production.

Even Bohm-Bawerk, who played such a vital role in developing interest theory, committed the common error of attributing the interest factor to the productivity of capital goods. But interest can be explained completely by the principle of time-preference and does not arise only in connection with the employment of capital goods. The productivity of capital goods is already taken into consideration in determining which marginal value products should be discounted for the time period expected to elapse before the future goods become present goods. And this applies to all factors of production, not just capital goods. Mises says:

The contribution of the complementary factors of production to the result of the process is the reason for their being considered as valuable; it explains the prices paid for them and is fully taken into account in the determination of these prices. No residuum is left that is not accounted for and could explain interest. [4]

Interest is not a return peculiarly characteristic of the use of capital goods, as has often been contended. The classical association of interest only with capital goods is not tenable because interest permeates all economic activity in which present goods are furnished in exchange for future goods. Thus interest arises in consumer loans as well as producer loans. The phenomenon of interest operates as well in the price paid for land and labor whose benefits or proceeds are to be received in the future. In fact, if it were not for the element of time-preference, the prices of parcels of land would be infinite.

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