Thursday, February 28, 2013

Land Prices, Wages and Interest Rates

We have so far examined what determines the value of the services of land and its price on the assumption that the number of workers and the amount of investable funds are given. In reality neither is ever given; both are subject to constant change.
We shall examine the effects of changes in the supply of and the demand for capital and labor later on. Here, only a few preliminary remarks.
If the supply price of labor, i.e. the wage demands, declines, more workers can be employed, as explained earlier. Given a certain amount of land, each worker will then have less land to work on. The law of diminishing returns works in the opposite direction. The productivity, i.e. the labor-replacing capacity of the land, becomes greater. The rent from land increases.
If the supply price of capital, i.e. interest, declines, the cost of production declines. But the cost reductions vary according to the length of the production detours. With short production detours costs decline to a lesser degree than they do with long production detours, because capital costs enter into the former less than into the latter. Now the use of land means a long, in fact an infinitely long, production detour. If somebody borrows money to buy land, he has to pay interest on this money in eternity in order to profit from the land's equally eternal and not amortizable benefits.
For this reason a lowering of interest rates must mean a very substantial reduction in the cost of the use of land. This reduction in costs will result in sub-marginal land becoming marginal. This land will now yield a revenue even though its technical productivity has not risen. All land prices will go up until the—now lower—interest on the—now higher—prices is again equal to the rent.

Common Sense Economics

Wednesday, February 27, 2013

Differential Rents and Differential Prices

Land is not homogeneous, as we have assumed so far. It differs in quality. One of the chief qualitative differences of land rendering comparable services in other respects is the result of differences in distance from production and consumption centers.
Suppose the last additional unit of what we could call standard land, cultivated by 1,000 workers, increases the productivity of those thousand workers by the product of five workers. There may exist other land of which the last unit, added to an equal area, increases the productivity of the same number of workers by the product of three, two or one worker. There may even exist land of such poor quality that additional amounts do not increase the product at all—marginal land.
Except for this last-mentioned case, entrepreneurs will be prepared to pay money for all land, but obviously less than for standard land. Their bids for various sorts of land will vary according to the work-replacing capacity of the land. Land of which additional quantities add nothing to the productivity of a given number of workers is worthless and generally free, i.e. it is nobody's property.
The classical economists explained all the advantages accruing to the owner of land—they called them rent or ground rent—by the fact that good land yields more than bad land. In a certain sense all ground rent is indeed differential rent. But in this sense all wages, too, are differential rents. They are the difference between what is paid to a worker of high and to a worker of low or zero productivity. But the differential rent theory does not explain the laws according to which land of a given quality cultivated by a given number of workers is to be valued. Nor does this theory explain the point at which land becomes marginal.
The expression rent, and more particularly ground rent, for all the benefits land yields to its owners is none the less still in current use.
Obviously land of very different quality is used simultaneously, but as land of lower quality yields less vast acreages of it are equivalent to small areas of good land.
Differential rents and differential prices caused by quality differences should not be confused with the rents and prices of homogeneous land of a certain quality worked by a given number of workers.

Homogeneous land of a certain quality yields its owner a revenue which corresponds to the additional productivity of the last unit of such land taken into use. The benefit of the higher productivity of preceding units accrues to the workers in the form of wages.
Land of inferior quality yields less revenue according to its lower productivity. Compared with the rent of such inferior land the rent of the better land is indeed a differential rent.
Rent from good land can never be higher than rent from inferior land offered at correspondingly lower prices. Scarcity of land is a relative concept. With correspondingly higher demand inferior or more distant land is taken into use. The “frontier” moves further out.

Common Sense Economics

Tuesday, February 26, 2013

The Price of Land

In the real world entrepreneurs do not buy the services of land as they do the services of workers. They either rent or buy the land as a carrier of services. It is the usefulness of the services which determines the rent as well as the purchase price of land. The rent for a certain period, say one year, is equal to the value of all the services the land renders during the year. The latter, too, are called rent. But what are the principles which determine the price of land to be bought? One would expect the price of land to be equivalent to the sum of the prices of all the services it renders. But the following has to be considered.
In so far as the services of land are perpetual, the price of land would obviously have to be infinitely high, were it not for the fact that the purchase price is paid in money and that money if lent as credit also yields a perpetual service, namely the interest the lender goes on receiving. Thus the price of land must stabilize at the point where the interest on the purchase price is equal to the price of the service the land renders during a certain period. In other words the price of land is, in principle, the price of its service capitalized at the long-term interest rate for credits. If the service is worth $5 a year, and the interest rate is 3 per cent, then the price of the land is $166, for 5/x = 3/100, therefore x=500/3=166.
If the services of the land—of a coal field for instance—are not perpetual but last only, say, 10 years, the calculation is somewhat more complicated. In this case it is not possible to compare the rent with the interest payments because only the latter are perpetual. One has to compare the present utility of the money on the one hand and that of the annual services of the land on the other. The money is, of course, worth its face value. But if a unit of land annually yields $5 for 10 years, it is worth not 5 x 10, or $50, but less. Since present money yields interest as of today, whereas the annuities yield interest only as of their payment, the annuities can only be valued at a so-called discount. At an interest rate of 3 per cent, land yielding $5 during 10 years and nothing thereafter would be worth about $43.
It may be asked: why is the price of land equal to the capitalization of the services it yields, whereas machines sell at production cost? The answer is that machines can never cost more than their production costs, for their number can be increased at will by payment of these costs. Nor can the productivity advantages of a machine ever be greater than the interest on the cost price calculated for the lifetime of the machine. If the advantages were greater than this amount of interest ever new machines would be constructed. Land, on the other hand, is produced by nature once and for all. It is scarce and cannot be increased by work. Its services are fixed and are not influenced either by production costs or rates of interest. But since in the long run money lent as credit and money invested in land must offer the same yield, the price of land must stabilize at a level where the interest on the purchase price equals the price of the services. Changes in the interest rate must, therefore, entail inverse changes in the price of land. A falling interest rate raises land prices and vice versa.

Common Sense Economics

Monday, February 25, 2013

The Price of the Services of Land

There remains, of course, the question of the pricing of land. Its price will obviously depend on the services land offers to entrepreneurs, including in particular agricultural entrepreneurs, i.e. farmers—just as in a slave society the price of a slave would depend on his services. In a society of free men, of course, only the services have a price and not the man who renders them.
Land, just as capital, is useful to the entrepreneur because it replaces work. This seems paradoxical at first sight, for in raising a crop land does not merely replace labor but is indispensable. It can never be replaced even by the greatest number of workmen. But the absolute absence of land is a limiting case that can be neglected for analytical purposes.
Given a certain area of land and certain amounts of labor, every addition of land for cultivation will increase the productivity of the existing workers and thus replace workers, just as every additional worker will increase the productivity of the existing land and thus replace land.
However, here too we meet the law of diminishing returns, as in the case of the productivity of capital discussed above (p. 40). The productivity of a given number of workers cultivating land of a given quality will increase with the addition of more and more acres, though in a decreasing degree.
Entrepreneurs will obviously be prepared to bid for the service of every additional unit of land an amount as high as the wages of the workers that the addition of this unit can replace. Given a certain supply curve of land services the price of the service is herewith determined.
Land serves not only production but consumption too. A nation's most important durable consumer good is its housing stock. Houses cannot be built on air—they have to be built on land. The value of urban landed property depends on how much of their income consumers are willing to spend for living in certain districts. In essence the problems involved are the same as those we have been discussing earlier in connection with the choice between the consumption of apples and pears.

Common Sense Economics

Sunday, February 24, 2013

Is Land a Third Production Factor?

It is customary to speak of land and of the products of nature as a third factor of production besides labor and capital. It is equally customary to assume that land and its services can generally be rented for “rent”—as capital is borrowed for interest.
This approach is unrealistic and leads to analytical difficulties. It cannot be denied that land, such as coal and oil fields, is often rented for use or exploitation. Machines, too, are sometimes rented. However, it is far more general for entrepreneurs to buy and not to rent the land where they intend to build their plant, just as they buy their machines rather than hire them.
If we treat land in principle as being rented rather than bought, then we neglect in our analysis the fact that land has to be carried through time just as other capital goods, that it takes credits to do so and that, therefore, an entrepreneur buying land with borrowed money thereby influences interest rates.
Entrepreneurs themselves make no distinction of principle between buying labor, machines or land. Their calculations distinguish only between two totally different kinds of costs: on the one hand the annually recurring interest they pay for the money they borrow, and on the other hand the prices they pay, once only, for labor, capital goods or land bought with the borrowed money. There is for an entrepreneur no difference between a machine in his plant and the land of the site of his plant, just as there is no difference of principle between labor and machines. Machines are labor of previous production periods. Nor can in many cases the land component be distinguished in practice from the labor component.
We shall thus treat land as a sort of capital good, provided by nature rather than by man. We shall consider only two factors of production: first labor, including land as a carrier of services, for which the entrepreneur has to pay a price; and second money capital or credit, for which he has to pay interest.

Common Sense Economics

Saturday, February 23, 2013

Production with Land

In addition to labor and capital there is allegedly a third factor of production—land. The production factor labor is always used in conjunction with or on the production factor land. Only the combination of labor and land—plus capital which draws production into detours—leads to the production of goods.
Land is needed in agriculture because we can sow and reap harvests only on land. Land is also necessary for every other production. The workers have to work somewhere. They cannot work in the clouds.
Economics is usually concerned only with agricultural land or urban landed property. But coal or oil fields are also land. There is no difference of principle between land yielding wheat and land yielding coal, or a river used for navigation or water power. We shall treat as land every part of the surface of our earth that yields space and natural resources, such as coal, minerals and so on. The sea, too, can be considered land in this sense.
Land was formerly defined as the eternal and indestructible basis of all production. This is too narrow and even a wrong definition. If the soil is not conserved, it gets exhausted as do oil wells and coal mines.
As a site for production and consumption land indeed renders eternal services. Its utility to man can, however, vary within wide limits. It can increase, for instance, by the introduction of new means of communication.
The utility of land is identical with the utility of all services rendered by it. If these services are limited, in time the value of land is generally considered as the sum of all these services. In so far as the services are eternal, land is valued as the carrier of recurring annual yields. As we shall presently see, the price of land is equal to the money value of these annuities, capitalized at the prevailing interest rate

Common Sense Economics

Friday, February 22, 2013

Production Factors are Remunerated according to their Marginal Utility

It is sometimes said that the distribution of the proceeds of production takes place according to the contribution of the factors of production to the total product. Labor receives what is to be imputed to labor; the capitalist receives what is to be imputed to capital. But this is an antiquated and over-simplified way of expression. In reality, the worker, equipped with a certain amount of capital, produces a certain amount of goods—no doubt more than he would have produced without capital equipment. But once labor is so equipped, it is impossible to find out how much of the product is to be imputed to labor and how much to capital. The product is just the result of productive labor. The only thing which can be discovered is how much the product has increased by the addition of the last unit of capital. We can calculate the so-called marginal productivity of capital.
The marginal productivity of capital determines not only the amount of capital used at a given supply of capital; it also determines what part of the total product is branched off and accrues to the capitalists in the form of interest payments. This part is by no means equivalent to the total amount by which production has increased owing to the use of capital. It is less because in accordance with the law of diminishing returns the marginal productivity of capital is less than its intra-marginal productivity. The benefits of the intra-marginal productivity of capital accrue to the workers in the form of higher wages. They cannot be distinguished from the productivity of labor as such.

Common Sense Economics

Thursday, February 21, 2013

The Law of Diminishing Marginal Returns

This is due to the so-called law of diminishing marginal returns, with which we have to get acquainted now. It is a technical law. It is concerned with the technical productivity of one factor of production used in combination with another.
The law states that, given a certain amount of one factor—labor for instance—the addition of every further unit of the other factor—e.g. capital—increases the productivity of the first factor, but in a decreasing degree. The validity of this law will readily be understood if we consider that an amount of capital applied to labor, for instance in the form of a hammer, is likely to raise the productivity of labor much more than the same amount of capital used for the last refinement of a capitalistic process. This law of diminishing returns, or better diminishing marginal returns, means that the entrepreneurs will be able to pay less interest for every additional amount of capital.
We can now establish how much capital will be used in our stationary economy. Just as on every other market, the quantities borrowed and lent on the credit markets are determined by the intersection point of the demand and the supply curves. Capital will be saved and employed in production up to the point where the higher interest demanded for additional credits can no longer be paid by the entrepreneurs because the additional amounts of capital no longer increase productivity to a corresponding degree. The lending price for capital, the interest rate, is determined by the marginal supply of and the marginal demand for credits.
It should be noted in this connection that the question of combination of capital and labor is not identical with the question of the optimum size of the plant. Nor should either question be confused with the question of the optimum combination of so-called fixed and variable capital. These questions will be treated later on. They do not exist in a stationary economy, where we must assume that adjustments to the optimum size of plants and to the optimum combination of fixed and variable capital have already taken place.

Common Sense Economics

Wednesday, February 20, 2013

Production by Labor and Capital

Goods are not in the real world produced by labor alone. Capital is another factor of production. We have described above the nature and significance of capital. Production can require more or less capital. Even in the most primitive circumstances some capital is needed for the survival of the workers during the production period. Modern production, with its very roundabout methods, needs much more capital. As production detours lengthen—say double—a double amount of capital must be in the hands of entrepreneurs. In a modern economy work is directed into roundabout methods of production by entrepreneurs, who borrow money in the form of credits from banks or in various forms from other money owners and spend that money on capital goods. If entrepreneurs should wish to double the length of the production detours, they would need to borrow a double amount of investable funds. The length of production detours depends, therefore, on the supply of and demand for investable funds.
Investable funds are directly or indirectly supplied by people who save money instead of spending it on consumption. How large is the supply of investable funds by savers? In a stationary economy, where changes are excluded by definition, we have to ask: how large is the total stock of savings? We do not ask how large is any addition to the stock by new saving. New savings are not necessary to uphold the status quo of production detours. The money received from the sale of finished products enables the entrepreneurs always again to acquire the capital goods or semi-finished products they need.
The amount of saving offered is, like every supply in a free economy, a function of the price, i.e. the interest rate. The question of how the supply curve for savings runs in general is controversial. Some people deny that the supply curve runs in the usual way upward to the right, which would indicate that more is saved and more savings offered at a higher interest rate. These authors assume that the curve runs vertically, meaning that the amount of savings is independent of the interest rate. This may or may not be the case. The important point here is that the curve never runs horizontally, i.e. that the supply is never unlimited.
Note that we are here dealing with the question of how much will be saved out of a given income. The further question, how changes in income call forth changes in savings, will be treated later when dealing with the changing economy. The latter question should never detract attention from the former.
What, on the other hand, will be the shape and level of the demand curve for credits, i.e. how much capital will be demanded at the various interest rates? In other words, how much interest will the entrepreneurs be prepared to pay for various amounts of capital?
Capital increases the productivity of the labor used in production. Suppose the length of detours of x years of a production in which y dollars are simultaneously invested is increased by 10 per cent of x years. They then obviously need simultaneously 110 per cent of y credits. Suppose that by such an increase of length the annual product increases by an amount equivalent to the output of three workers. Then, obviously, the entrepreneurs would be prepared to pay for the additional credit necessary an interest sum pro anno corresponding to the wages of three workers. If the next extension of production detours would again increase the product by the same amount, the entrepreneurs would again be prepared to pay interest corresponding to the wages of three workers. The demand curve would run horizontally. For every additional new quantity of capital the same interest would be offered.
But in reality every additional quantity of capital is less valuable than the former. Therefore the demand curve for credits does not run horizontally but downward to the right. So if the supply of capital increases, the interest rate must decline.

Common Sense Economics

Tuesday, February 19, 2013

Production Exchange: Production by Labor Alone

If goods were produced by labor alone there would be no problems of capitalist methods of production or of income distribution among groups of different factors of production, particularly between labor and capitalists. There would be only the problem of what and how much is produced. This problem depends, of course, on what the factors of production wish to consume, or better on how they wish to distribute their income on the purchase of various goods. But this is a problem of consumption with which we shall deal later.
Here we have only to state how much, in terms of work-hours, will be produced. The question is easily answered according to what we have already explained above. If labor were the only factor of production, work would be put into production up to the point where the money received for the work is no longer considered equivalent to the sacrifice of leisure. Money is valued here, we must remember, not for its own utility but for the utility of the goods that can be bought with it on the market according to the prevailing prices. Thus more work will be done, and production will increase either when higher rewards are offered for work—for instance, when the productivity of labor has risen—or when the workers are prepared to accept lower wages. We shall discuss this later in more detail. Here we shall but briefly anticipate: in a simple diagram like that of Figure 1 or 4 higher wage offers would mean an upward shift in the demand curve for labor, whereas willingness to work for less money would be expressed by a downward shift in the labor supply curve. It will readily be seen that both movements would result in an increase of the volume of production.
Hourly wages, i.e. the remuneration per work-hour, will—in case of a downward shift of the labor supply curve—remain unchanged so long as the demand curve for labor is horizontal. But as soon as other factors contribute to production, the demand curve for labor (for reasons to be discussed later) will run down to the right, indicating that entrepreneurs are prepared to employ additional labor only at lower wages. In this case—we shall return to it later—a lowering of the labor supply curve leads to a fall in wages. At the same time, as we shall see, the income accruing to other factors of production increases. The individual worker receives a smaller share of the community's whole cake. But the whole cake has grown because more bakers are at work, which in turn is due to the fact that the individual bakers are content with smaller slices of cake. The total amount of cake received by all the bakers now employed, however, and even their share of it, will have become larger.
We are thus led to the important conclusion that, given an unchanged demand situation, a reduction in the individual worker's share in the result of production is accompanied by an increase of the total product, whereas an increase in his share would entail a reduction of the total product—except under quite unrealistic assumptions concerning the elasticity of demand for labor and the elasticity of supply of other production factors.
We shall see again and again the working of this peculiar law, according to which changes in the remuneration of one factor of production lead to opposite changes in the volume of the total product.
We shall examine later on, in Part III, whether changes in wages can in certain special conditions influence the aggregate demand for goods, and whether, for instance, wage increases need not have the expected production-curtailing effects. Notwithstanding the possibility of influencing the volume of production by influencing demand, the fundamental fact remains that wage increases curtail production. This is a fact often overlooked nowadays by those who overrate the possible secondary effects of wage changes.
There is in a money economy a certain difficulty not existing in a pure barter economy: an increased product cannot be exchanged through the medium of the same amount of money unless the price level declines. We shall, for the time being, evade this difficulty by assuming that enough new money is always introduced into the system to prevent a decline in the price level. The price stability so ensured does not, however, imply wage stability. If labor becomes more modest in its wage demands, the wage level falls relative to the price level. The difference between the amount of money spent on wages and the amount of money received from sales accrues to other factors of production as income.

Common Sense Economics

Monday, February 18, 2013

Production Exchange and Consumption Exchange

We began our economic analysis with the examination of the extremely simplified model of an economy of one isolated worker-producer. Here one single exchange act took place. The worker supplied his work to nature against products and nature demanded his work for them. We have since introduced three important features into this simple world: the entrepreneur, money and the time element.
Through their introduction the single-exchange economy is essentially changed. It becomes a two-exchange economy. Here exchange for production and for consumption are separated into two acts. The worker supplies his work no longer to nature for her products, but to the entrepreneur who demands the work against money. In a second exchange, some time later, the entrepreneur supplies the finished product to the worker who demands it against money. Money thereby serves as a sort of general representative of utility. Both the workers and the entrepreneurs value money according to the utility of the goods and services it buys on the market at current prices.
The separation of the production exchange from the consumption exchange does not, however, change the fundamental fact that in a stationary economy production and consumption are always equal. During every production period all factors of production together consume what they produce, or rather what they have produced in the past production period. And during every period the factors of production produce what they consume, or rather what they are going to consume in the subsequent period.

Common Sense Economics

Sunday, February 17, 2013

What is a Stationary Economy?

This whole first part of our exposition is concerned with the working of a stationary economy. It may be useful to say a few words here on the meaning of this term, in order that the reader may follow the subsequent discussions.
When we speak of a stationary economy, we do not mean an economy in which production and consumption come to a stop. In a stationary economy production and consumption always repeat themselves in the same manner because there are no forces at work which could change them. It is an economy whose course is always exactly repeated. Such an economy does not exist in reality. But it is important to examine how such a fictitious economy would work, so as to be better able to analyze the effects of changes in important data.
The stationary economy is also often referred to as an economy in equilibrium, meaning an economy which has adjusted itself to all past and is not exposed to any further changes.

Common Sense Economics

Saturday, February 16, 2013

Amount of Capital and Roundabout Ways of Production

Increase in production is not the only thing which causes the quantity of goods simultaneously present in an economy, the capital of the economy, to increase.
Capital can also increase when production methods become more capitalistic, more roundabout. We can illustrate our argument by returning to our comparison of the flow of goods over time with the flow of water in a river bed. If the river bed becomes wider it can contain more water than before. But the same happens also if the length of two successive river beds increases. The two streams will then overlap, as it were; the first will still be flowing when the second emerges. More water will be present simultaneously. In the same way, the goods simultaneously present in an economy must increase if production takes more time. Figure 10 illustrates this. If production takes twice as long as before, the goods previously ready for consumption at the end of Period I will now not be consumed until the end of Period II, and will therefore still be present in the economy during Period II when a new production process has already started.
The classical roundabout method of production is production by machines: a worker no longer works by hand or with a few tools, but with the help of a machine.
When a worker changes over to machine production, a new factor of production appears to have been introduced. This, however, is not the case. In the first place the machine itself consists of labor—in so far as it does not consist of raw material, which we disregard for the moment. In the second place, the machine does not really transform the worker's work. What happens is that his present work is added to the work already incorporated in the machine.
The labor incorporated in the machine differs, however, from the labor added in the current production period in that it is work done long before the current period, and that its result is normally not consumed during the immediately following production period but in a later one. On the average, the machine remains in the production process much longer. It is consumed only over long periods. During these periods the labor incorporated in the machines, together with the labor added in running the machines, goes over into the finished goods. Even if the worker can thus produce more quickly with the help of the machine than he could without it the entire production process lasts much longer. It starts not with the current work of the worker using the machine but with the production of the machine itself, and it ends not with the goods completed currently with the help of the machine but with the last goods which the machine is still able to turn out. Only when the machine ceases to be usable at all has the last of the original labor incorporated in it gone over into finished products. This is why production with more capital, with a strengthened—or, as is sometimes said, a deepened—capital structure, takes more time.

FIG. 10
How does an economy change from a less into a more capitalistic one; how does its capital structure deepen? If all the money the entrepreneurs borrow is spent by their workers on consumer goods there is, on our assumptions about their replacement needs, obviously no possibility for entrepreneurs to buy machines. But suppose the workers, or other factors of production who would in the ordinary course of events spend their income on consumption, decide to save and to put the savings at the disposal of the entrepreneurs: then the entrepreneurs would be able to buy capital goods with the money otherwise spent on consumption.
Once the economy has changed over to roundabout methods of production, no further additional saving is needed for their maintenance. The capital structure is deepened once and for all. For the finished goods into which the capital goods are ultimately converted are sold against money. And with this money the entrepreneurs are again able to repay their debts to the capitalists, who can then lend it to them again without recourse to new savings. Figure 11 shows this flow of money.
Needless to say, different goods require production detours of entirely different lengths. Productions taking detours of quite different lengths are therefore always present in an economy. The production detour of domestic help is very short. For the building of houses and skyscrapers the production detour is very long. But if the capital structure is deepened, every production detour lengthens, although not in the same proportion. The new vacuum cleaner used by domestic help, too, means a longer production detour.

FIG. 11
The deepening of the capital structure, the lengthening of production detours, lead to increased production not by the employment of more workers but by an increase in the productivity of the single worker. Work spent on building and then on using a machine yields technically higher results than work applied immediately to the production of the end product. It is more productive.
But the reason for this increased productivity is not that the services of a machine are essentially different from those of a worker. If the machines really performed different work, if they were a different factor of production, it would be impossible for the price of machines to coincide in the long run, as it does, with their cost price. They would sell at a premium. The reason for the increased productivity is that the results of the work embedded in the machine need be available for consumption only after a longer period, that production—or consumption—is allowed to take more time. This “being allowed to take more time” is really the second factor of production, capital—if labor is considered the first.
The entrepreneur who works with machines can repay the money he borrowed from capitalists for the purpose of production only after the amortization of the machines. Per unit of product he thus needs more credits than before the extension of production detours (cf. Figures 10 and 11). For the right to use credits, and thereby to be allowed to take more time—and not for the individual capital good—he has to pay a certain compensation calculated in percentage of the amount of the credits and according to their duration. It is called interest.

Common Sense Economics

Friday, February 15, 2013

Amount of Capital Dependent on Volume of Production?

We must sharply distinguish between the question: is the volume of production dependent upon capital accumulation; and the reverse question: is the amount of capital dependent on the volume of production? The latter question is, of course, to be answered in the affirmative. If more is produced, other things being equal, there is an increase in the amount of capital, i.e. in the amount of goods simultaneously present in the economy—or, better, of goods which reach the future from the present. Such an increase in capital is often spoken of as an increase in the width of the capital structure—just as a river bed becomes wider when the inflow of water increases.
The flow of goods over time has indeed often been compared with the flow of water in a river. It is a useful comparison, and we shall use it to explain many problems in connection with capital.

Common Sense Economics

Thursday, February 14, 2013

Expansion of Production Dependent on Capital Accumulation?

Capital is needed to keep the workers alive during the production period. We are therefore faced with the question: to what extent does any increase in employment actually depend upon an increase in capital? We shall deal with this question later in detail. Here we merely wish to make a brief remark on the so-called wage fund theory, which is the classics' answer to this question. This theory assumed that more workers could only be employed if a store of means of subsistence had been accumulated previously by production and abstinence.
This problem—like so many others in economics—is not a real one. The present does not live at all on a store of goods accumulated in the past. The present lives as a rule on goods that flow uninterruptedly from past production into present consumption; stores of goods are neither necessary nor would they be sufficient to enable new workers to be employed. Nor is an increase of production in the past a necessary condition for an increase of the labor force in the present.
What enables an increased labor force to be employed and production to expand is the fact that the entrepreneur obtains money with which to pay new workers. This money may be borrowed from other people who have not consumed all the goods which they were entitled to receive, but have saved some of their income. But even if there are no new savings, employment and production can increase. It is not at all necessary to think of such a thing as a fixed wage fund, as the wage fund theory in its monetary form supposes. The necessary capital can be supplied through savings in other capital needs, or money can simply be created by money-issuing banks, as we shall see in Part III when discussing inflation. Finally, increased employment may not require more capital at all if there is a proportionate fall in wages.
We shall discuss the supply of capital later in detail. Here it suffices to state that neither monetary nor real scarcities need prevent an increase in employment. In whatever way the money with which to pay new workers is made available, its expenditure for labor by the entrepreneurs enforces a redistribution of past products in such a way that the new workers can survive during the current production period.

Common Sense Economics

Wednesday, February 13, 2013

The Time Element

Production does not go on in a timeless world. The product is not ready for consumption at the same moment as labor is expended on it. Production takes time.
From this elementary technical fact it follows that the workers cannot consume the products of present labor, but only those of previous labor. In a money economy, the money which the workers receive from their entrepreneurs in wages and spend for their living during any given production period does not buy the products of this same period but those of an earlier period. And by the sale of these products of an earlier period the entrepreneurs receive back the money spent in that earlier period.
All this is unimportant in a stationary economy, where by definition outlays and production do not change from one period to another. But in the real world there are constant changes. Only a model clearly showing the time sequence of events is useful in analysis. It would not be necessary to stress this point were it not for the fact that, under the influence of Keynes' General Theory of Employment, Interest and Money, the tendency to use so-called circular analysis, which neglects the time element, has been strengthened.
Circular analysis presupposes that the current income of workers is spent on their current output. This would mean that current production in turn is influenced by current spending. But in reality current spending meets the products of past production which can no longer be influenced by current spending. On the other hand, the fact that a changed demand meets an as yet unchanged supply does lead to price increases and declines and to many other important changes. Only the so-called sequence analysis, as developed especially by Swedish economists, can give a satisfactory picture of these changes. For the analysis of equilibrium situations, for which they are meant in the first place, circular analyses remain permissible but dangerous because they serve very often, consciously or unconsciously, to analyze changes from one equilibrium situation to the other.
As production takes time, and we cannot therefore live from hand to mouth, a certain amount of goods in various stages of production must always be simultaneously present in the economy. Goods ready for consumption are, in the first place, essential for production by enabling the workers to survive during the production period; the other goods, as we shall see later, are essential by enabling the workers to be more productive. We shall call the total stock of these goods the capital of the community, and the individual goods capital goods.
The capital of the community is owned by people commonly called capitalists. For the time being we shall take the ownership situation as historically given. Later we shall inquire into the reasons for capital accumulation and changes in ownership.
In a money economy capitalists do not as a rule actually own the stock of capital goods. They own money and lend it to entrepreneurs, who use the money to pay their workers—who in turn use it to buy goods of a past production period.
As production goes on, new, half finished and finished goods accumulate in the hands of the entrepreneurs. Juridically these goods belong to the entrepreneurs, but economically they belong to the money capitalists because the money used for the production is owned by them. The entrepreneurs are, as it were, the trustees of the money capitalists.

FIG. 9
When the entrepreneurs of the past period sell their products to the workers of the present period, the money they receive enables them to repay their loans and thus to free themselves from their debts to the capitalists.
Figure 9 shows how the money borrowed by an entrepreneur in the current production period is used by his workers to buy the goods produced in a past period, thereby enabling past debts to be repaid.

Common Sense Economics

Tuesday, February 12, 2013


Entrepreneur A can obviously exchange his apples with entrepreneur B, who produces pears, only if he himself needs pears for himself or his workers. If A should prefer butter, he cannot exchange his apples with B because B has produced no butter. Butter may have been produced by C. But if B owns something which is gladly taken by others in exchange for their products, then A can sell his apples to B against this medium and use it in an exchange with C for butter. Nowadays money, mainly paper money, serves as such a medium that is gladly taken by all members of the community in exchange for their products. Money is, therefore, the general medium of exchange.
The chief function of money is to enlarge the number of people between whom exchanges can take place. It is an enlarger of exchange possibilities. It enables any one member of the community to dispose of his goods to any other member, regardless of whether the latter produces anything the first wants; the money received enables him to get the equivalent in goods he wants from a third person.
We have seen above (p. 14) how division of labor increases the productivity of the work done. Division of labor in its turn depends upon the possibility to exchange. Even if B can produce pears at lower cost, this is of no benefit to A so long as B is not prepared to take A's apples in exchange for his pears. It follows that the introduction of money as an enlarger of exchange possibilities must result in increased division of labor and thus in higher output. Since higher output as a rule increases the amount of hours worked, the introduction of money raises living standards in two ways.
Money works not only as an enlarger of exchange possibilities, but also as an exchange act saver. Before the introduction of money apples wandered from entrepreneur A to entrepreneur B, who delivered them to his workers, while pears wandered from B to A, who delivered them to his workers—four exchange acts. Now the workers no longer receive the finished goods from their own entrepreneur, who is eliminated as a middleman between them and other entrepreneurs. With the money received from his entrepreneur each worker buys directly from other entrepreneurs—two exchange acts are eliminated.
Figure 8 shows, in very simplified form, the circulation of money in the case of apple production by worker A and pear production by worker B.
Besides being an enlarger of exchange possibilities and an exchange act saver, money has many other important functions. We shall here mention only one of them—that of an indicator of profits, as we can call it.
As we have already seen, there are no profits of the national economy as a whole. In a money economy this is even more obvious than in a barter economy. The same amount of money the entrepreneurs spend on the factors of production—the workers—comes back to them in exchange for their products. Taken as a whole, money received can neither exceed nor be short of money spent—at least so long as the flow of money is not interrupted. This latter assumption applies, by definition, to a stationary economy.
On the other hand, money is clearly the medium in which the private profits of individuals materialize. If an entrepreneur—as described earlier—can manage by his special knowledge and skill to produce 80 pears in one work-hour, instead of 50 as other entrepreneurs do, he spends 371/2 per cent less for the production of the same number of pears. The difference will show up as a stock of money not needed for the payment of wages and available for other expenditure. This is the kind of profit we have discussed above; the entrepreneur pays his workers less than the full yield of their work because this yield would be smaller if they worked in another enterprise.
Money is, however, also the indicator of another kind of private profit. It can happen that an entrepreneur makes a profit not, so to speak, at the expense of his workers but at the expense of other entrepreneurs. Entrepreneur A may receive more for his products than corresponds to his input, whereas entrepreneur B receives less. This can obviously not happen in the long run because no entrepreneur will continue spending money on production that he knows he will not get back. But in the short run it might turn out, owing perhaps to a change in tastes, that the consumer-workers spend more money on apples and less on pears than anticipated. The result will be that at the end of the production period the distribution of money among the entrepreneurs will be different from what it was at the beginning. A's stock of money will have grown by the amount that B's has become smaller.
We may, in this connection, add a remark on balance sheets and income statements. These show only the relative prosperity of individual economic subjects, i.e. the extent to which the income and wealth of some entrepreneurs have changed in relation to those of others. They give no information on the absolute wealth of the community because they do not indicate what can be bought with the money amounts shown. A scarcity of goods may lead to fancy prices and hence to higher incomes and capital appreciation for some entrepreneurs. This does not mean that the community's real income or wealth has increased. A community will, on the other hand, have become richer if two-horse carriages have been replaced by 100-horse-power automobiles produced with the same labor effort. But such things cannot be gathered from balance sheets. Simple addition of the balance sheets or income statements of all the members of a community does not, therefore, tell us anything about its real product or income. This should be remembered in appraising some of the usual national income calculations.

Common Sense Economics

Monday, February 11, 2013

The Entrepreneur

We now take a further step toward reality by introducing the most important person within the framework of a free economy: the entrepreneur.
His functions are manifold; we note only the most important at this point:
(1) The entrepreneur is a sort of exchange center. He intercedes in all the exchange activities which we have described so far in our simplified models.
In our isolated single-producer economic model, the worker exchanged his work-hours with nature against the proceeds of his work, the finished products. In the case of a two-producer economy these goods were then exchanged, at least partly, between the workers. A schematic view of this exchange is pictured in Figure 5.
In the real world the workers generally do not exchange their services directly with nature or with other workers. The entrepreneurs intercede in both exchange activities. Our model of an economy of two producers becomes one of an economy of two workers and two entrepreneurs, as schematized in Figures 6a and 6b. In Figure 6a the workers first exchange directly with nature. Entrepreneur A then receives the products of the work of worker A and exchanges them with entrepreneur B for the products of worker B. Entrepreneur B delivers products of worker A to worker B in payment for worker B's products, whereas entrepreneur A delivers products of worker B to worker A in payment for worker A's products. In Figure 6b the entrepreneurs have also taken over the workers' exchange with nature. The workers deliver to the entrepreneurs not their products but their work, and it is the entrepreneurs who exchange the workers' work with nature.

Each worker, as before, receives for his work the products of the other worker. (Neither model is, as yet, complicated by the existence of money; we are still in a barter economy.)
(2) The entrepreneur is furthermore the beneficiary of production cost differentials. We have assumed above (p. 12) that workers, for various reasons, produce with varying degrees of productivity. To produce the same amount of goods some need a greater, some a smaller, number of work-hours: or, what comes to the same thing, some produce greater and some smaller amounts of goods in the same time. In the real world the greater productivity of the work done is not generally due to some special quality of the worker, but of the enterprise in which he works. It is therefore not the worker but the entrepreneur who reaps the benefits of the higher productivity.

FIG. 7
Let Figure 7 represent the hourly output of two workers. Suppose worker A produces 50 pears an hour while worker B produces 80 pears in the same time. Rectangle I then represents worker A's output per hour, that is 50 pears. Rectangle I and rectangle II together represent worker B's output per hour, that is 80 pears. If it were the difference in the workers' efficiency which leads to the differential of 30 pears, the wage of worker A would have to be 50 pears, and that of worker B 80 pears.
But if not worker B but the enterprise B in which he works is responsible for the higher output per hour, the owner of this enterprise, entrepreneur B, has no reason to pay his workers more than they would produce and receive if they were working in an enterprise of lower productivity—say in enterprise A, where 50 pears are produced in an hour. The surplus hourly production of 30 pears, represented in our graph by rectangle II, entrepreneur B will keep as a reward for the greater productivity of his enterprise. All workers receive a uniform wage of 50 pears, regardless of the productivity of the enterprise by which they are employed. This is what actually happens in reality. Uniform wage rates are, in principle, paid for the same work.
(3) We have defined profits as income that accrues to some individuals because others do not receive the whole output of their work in special circumstances of a temporary nature. The entrepreneur who keeps as income for himself the additional output of his workers which is due to the higher productivity, not of the workers but of his enterprise, is the profit-maker par excellence.
(4) The entrepreneur, however, is also the profit destroyer par excellence. If entrepreneur A sees that entrepreneur B can produce pears at lower cost than he can, he will try—and in the long run he will generally succeed in the attempt—to imitate his competitor's methods of production. As a result entrepreneur A, too, will be able to produce 80 pears an hour. The output curve of enterprise A in Figure 7 will rise to the level of enterprise B. Entrepreneur A, too, will make a profit.
This, however, will not be the end of the story. Under the assumption of free competition A, as well as B, will begin to bid up wages so as to attract workers because any increase in production would enlarge their total profits. The competition for workers will clearly go on until profits are swallowed up by wage increases. Workers will then receive not 50 pears an hour but their whole output, 80 pears an hour. The whole hourly product of labor (rectangle I plus rectangle II) will be paid out as wages. This situation will change only if and when some entrepreneurs succeed in raising the productivity of their enterprises once more.
In a stationary economy, a theoretical model of an economy which goes on each day as it did before, by definition productivity does not change. There can, therefore, be no entrepreneurial profits.

Common Sense Economics

Sunday, February 10, 2013

Exchange and Profits

Exchange increases output through division of labor. We defined profit above (p. 6) as a surplus of output over input. We showed that in the case of the single producer an increase in output can never be considered a profit, because his entire output of goods is always the exact result of his input of labor, regardless of the size of the output per unit of input.
We are now dealing, however, with more than one producer, so that the problem of the distribution of the output between them arises. The term profit could now have two meanings: (a) it could mean a surplus accruing to the whole two-man community of producers, a profit for their national economy, so to speak; (b) it could also mean a surplus accruing to one of the producers by an altered distribution of output, a private advantage for one individual producer over the other.
An increase in output as such cannot be considered a profit for the entire national economy, just as an increase in output cannot be considered a profit in the case of a single producer. The economy, as a whole, is nothing but the sum of all individual producers. It does not make any difference whether the increase in output is due to greater productivity of individual producers or to exchange and division of labor. Therefore exchange, too, cannot lead to a profit for the national economy as a whole.
But how about the increases in the income of the individual producer-consumers resulting from a changed distribution of output among them? Such increases do exist, but not all of them are profits. If an individual producer-consumer's share of the total product rises because his own output increases, this cannot be called a profit—at least not if we are to distinguish profits clearly from other forms of income earned by the factors of production. Profit is only that form of income which accrues to one individual because another individual fails to receive, in certain special circumstances, the entire output to which the “demand curve of nature” entitles him, according to his productivity.
Profit is a slice of somebody else's output. We shall often come back to the question of how such profits arise and how they disappear, because this is of fundamental importance for many other problems. We shall see that profits are children of change and uncertainty and that they are temporary in character. Here we only wish to stress that exchange, as such, does not lead to private profits.
It is true that in our example producer A obtains more pears through exchange with B than he could have produced himself at the same expenditure of work-hours. But this only means that his output per unit of input, his productivity, has increased, even though only indirectly. Nothing accrues to him to which he would not be entitled by his work. And nothing is withheld from B, who retains more apples than if he had not entered into exchange with A.
It is furthermore true that A receives more pears for his apples than would be needed to make the exchange worthwhile to him. But this, too, is not profit. It is an advantage comparable to the advantage that accrues to the isolated producer to whom nature yields a greater return for his intramarginal working hours than would have been necessary to overcome his tendency to do nothing. Such an advantage in exchange does not mean that one receives more than one gives. It means only that one receives more than the minimum necessary to make the exchange possible.

Common Sense Economics

Saturday, February 9, 2013

Exchange of Goods

So long as both A and B produce at the same cost, each sacrificing the same number of working hours for the same quantity of the same product, no exchange takes place between A and B no matter how different their individual relative valuations of apples and pears may be. Production simply follows the demand and consumption of the individual producers. But if the production costs of A and B differ, exchange will take place as soon as they are no longer isolated from each other but able to exchange goods.

FIG. 4
As an isolated producer, A could produce 5 pears only by exchanging 15 apples with nature, since his production costs for pears are those shown by curve S2 in Figure 4 (1 pear for 3 apples). It would obviously be advantageous for him to produce no pears at all but only apples, and to exchange some of the latter for pears with B, whose production costs for pears are those shown by curve S3 (1 pear for 1/3 apple). So-called division of labor would be the result. No one any longer produces everything. Labor is divided according to what is to be produced. It should be noted that in our example both A and B produce apples at the same cost. What differs is the production cost of pears in terms of apples. It is the difference in the relative production cost of apples and pears which makes exchange advantageous.
How could an exchange of products between A and B be made under the cost condition described? We see that A produces 1 pear in the time it takes him to produce 3 apples, and that B produces 3 pears in the time it takes him to produce 1 apple. The most advantageous exchange for A would be to receive 3 of B's pears in exchange for each of his own apples; and the most advantageous exchange for B would be to receive 3 of A's apples in exchange for each of his own pears. Both exchanges are possible, but in either case only one of the producers would gain; by an exchange at any level in between both producers could gain.
If A gives less than 3 apples for each pear he receives, he gains by the exchange, for his production costs are such that he must sacrifice 3 apples for every pear he produces. On the other hand, if B receives more than 1 apple for every 3 pears, he also gains by the exchange, for in his own orchard he must sacrifice 1 apple for every 3 pears he produces. The range within which exchange is advantageous for both producer A and producer B is therefore between 1/3 and 3 apples per pear, or between 3 and 1/3 pears per apple.
The actual exchange rate of apples for pears at which the deal will go through depends, in our two-producer economy in which there are no competing parties in the market, upon the respective bargaining ability of A and B. All that can be stated with certainty is that the rate is bound to be within definite limits, and even that is contingent upon a rational behavior of both producers—meaning that both try to maximize the advantages to be obtained.
Let us assume that the price of pears expressed in apples will be somewhere between the two extremes, say 1 apple for 1 pear. How many apples and pears will A and B produce and eventually consume? According to Figure 4 producer A obtained his 5 pears by sacrificing 15 apples. The possibility of exchange with B, whose production cost of pears in terms of apple production time is lower, makes it advantageous for A to obtain his 5 pears by exchange with B rather than to produce them himself. He will produce only apples—50 as before. Of these he exchanges 5 for 5 of B's pears. Besides his 5 pears he will now have 45 apples, instead of 35 as before. He is better off by 10 apples.
Producer B got his 28 pears, according to Figure 4, by sacrificing just over 9 apples. He now exchanges 5 of his pears for 5 apples. He has 23 pears and 46 apples, instead of 28 pears and 41 apples. He, too, gains by the exchange because he could have produced the additional 5 apples himself only by sacrificing 15 pears—instead of 5 as he now does.
Some effects of exchange become immediately evident:
(1) Producer A now produces only apples and gets all his pears through exchange with B; division of labor is complete as far as he is concerned. Producer B still produces 41 apples himself, even though his productivity is much greater for pears than for apples. The reason is that A offers him no more apples at a price of 1:1. Owing to his lower average productivity A is too poor to buy more pears from B.
(2) The division of labor resulting from differences of productivity in turn increases differences and degree of productivity by specialization of production and work.
(3) The living standard of both A and B has risen. This is due to the fact that each producer's own more expensive production has been replaced by the other's cheaper production. In the same way international trade raises the living standard when expensive domestic production is replaced by less expensive foreign production. More expensive production of all goods, on the other hand, does not lead to increased exchange of goods either in internal or in foreign trade, but merely causes a fall in the living standard.
(4) The reward for the work done by both A and B has risen as a result of exchange. The labor demand curve (cf. Figure 1) moves up. Ceteris paribus the number of work-hours will be greater. Thus exchange increases the total output not only through increased productivity due to division of labor, but also through an increase in the amount of work done, due to its higher remuneration.

Common Sense Economics

Friday, February 8, 2013

Differences in Production Costs

We can now take another small step towards reality. It is most unlikely that production costs will be the same for two or more producers. Differences in the ability to produce various goods may be the result of tradition (a man learns the art of producing apples from his father), or of natural conditions (apples grow better on his land than pears). But whatever the reasons, the fact remains that the cost of production of goods in terms of work-hours normally is different for different people.
Figure 2 has shown us what a single producer would produce and consume at various production cost levels, given a certain demand curve, i.e. a certain judgment of the comparative utilities of apples and pears. Suppose now that A can produce pears only at higher cost, i.e. by more work, than B. A may, for instance, be working under conditions represented by the supply curve S2 in Figure 2 (1 pear can be produced by sacrificing 3 apples), while B may be working under the conditions of supply curve S3 (1 pear can be produced by sacrificing 1/3 apple). If the demand curve for A and B were that of our original single producer (D), producer A would now do as the single producer did when faced with supply conditions S2, i.e. produce 10 pears and 20 apples; at the same time producer B would do as the single producer did when faced with supply conditions S3, i.e. produce 23 pears and 42 apples.
But the demand curves of A and B differ from those of our single producer; the demand curves now are as Da and Db in Figure 3. To demonstrate what will happen, we have only to amalgamate Figures 2 and 3 in Figure 4, which shows: Producer A, with demand conditions Da and supply conditions S2, produces 5 pears. To do so he must sacrifice 15 of the original total of 50 apples, leaving him with 35 apples. Producer B, with demand conditions Db and supply conditions S3, produces 28 pears at a sacrifice of just over 9 apples, leaving him with nearly 41 apples. A thus produces only 1 pear for every 7 apples—a result of his being both a man with a weaker taste for pears and a poorer producer of them. B produces just over 7 pears for every 10 apples, the result of both greater liking for pears and greater proficiency in their production.

Common Sense Economics