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The Structure of Capital

Mises Daily: Thursday, January 25, 2001 by

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After I wrote "Boom and Bust," several readers asked for further explanation of the concept that capital has a structure. These requests prompt me to offer the following:

Gene CallahanAustrian economic theory differs markedly from the mainstream in the importance it places on the structure of capital. The Neoclassical and Keynesian theories tend to treat capital as a homogenous lump or pool. This blob of capital somehow maintains itself, in addition to excreting little "capital blobettes" that yield a return to the capitalists. This concept allows mathematical economists to "sum up" the amount of capital and treat the "total capital of an economy" as a single number to be fed into mathematical equations.

Austrians consider this approach illusory, as it simply eliminates from consideration the most important features of capital. Mises says capital "is a product of reasoning, and its place is in the human mind. It is a mode of looking at the problems of acting, a method of appraising them from the point of view of a definite plan." (HA, XVIII.7) In a similar vein, Israel Kirzner points out, in An Essay on Capital, that something is a capital good because it is a way station in someone's plan to produce a consumer good. Capital goods, seen as the myriad elements of different individuals' plans, cannot be viewed as a single "thing." These plans change over time, creating brand new capital goods and rendering other items that once were capital goods useless. The plans interact with each other, some of them complementing each other and mutually aiding in their fulfillment, others contradicting each other and resulting in one or another plan being thwarted.

Only in a socialist economy where one central board directs all production does the concept of the economy's total capital make sense. However, as Mises demonstrated, the lack of real prices in the socialist economy eliminates any potential way to quantify this collection of capital.

The Austrian concept of capital envisions not a great blob, but complex orders of goods interlocked in complementary structures. It was the founder of the Austrian School, Carl Menger, who first began the explication of the capital structure. He termed goods that directly relieve some dissatisfaction, such as water or food, goods of the first order. They are also referred to as consumer goods. Goods whose value comes from their aid in producing goods of the first order, such as plows and aqueducts, are called goods of a higher order, or producer goods. A higher-order good used to directly produce a consumer good, such as an oven used to bake bread, is a second-order good. The components used to build the oven are third-order goods, and so on.

Note that this distinction does not exist in the goods themselves, but in human thought and planning! If I collect ovens as objects of art, then they are, for me, consumer goods. On the other hand, if I own a grocery store, then the food items I stock are, for me, producer goods. As Ludwig Lachmann put it in Capital and Its Structure:

The generic concept of capital... has no measurable counterpart among material objects; it reflects the entrepreneurial appraisal of such objects. Beer barrels and blast-furnaces, harbour installations and hotel-room furniture are capital not by virtue of their physical properties but by virtue of their economic functions.

The capital structure of the economy might be likened to a coral reef, where all of the corals are still living. (In a real coral reef the bulk of the reef is composed of coral skeletons.) Each coral is connected to several others. The corals below any particular animal are the higher order goods that went into its production. Those alongside it are complementary goods that help it to create the next layer of goods. And the corals above it are that next layer of goods it helps to produce.

The entire structure rests on the sandy sea bottom -- land. Land, taken in the economic sense to include all of the fruits of nature, is the foundation of all production. At the very least, we need a place to stand or sit -- and our bodies! -- in order to produce something. The nature-given factors of production are the base from which our reef grows. At the very top of the reef, waving in the currents of human desire, are the consumer goods.

Extending our metaphor, we could say that the intensity of the changes in these currents determines how deeply they affect the reef. Minor changes, such as consumers shifting from buying one doll one Christmas to buying another the next, mostly affect the top layers. The doll factory may have to retool to produce the new design, but they will still need plastic, cardboard boxes, steel for their molds, assembly-line workers, and so on. Major changes in the currents will cause changes deep in the structure of the reef. When consumers changed their preference for personal transportation from horses to cars, capital structures throughout the economy were destroyed, created, and reconfigured. The need for hay production dropped while that for oil production rose. Blacksmiths lost jobs while factory workers were hired. Capital changed hands from those who stayed too long with now obsolete production to those who correctly anticipated the demand for new production.

Ultimately, it is the currents of consumer wishes that determine the entire structure of the reef. This is what Mises refers to as "consumer sovereignty." Entrepreneurs re-align the structure of the reef in their ceaseless quest for profits. They succeed only in that the new alignment better matches the desires of the consumers than did the previous one. Some have objected to the notion of consumer sovereignty, saying that what should be emphasized is personal sovereignty. The producers, they say, are sovereign every bit as much as the consumers. This misses the point. "Producer" and "consumer" are roles. Certainly, a business owner is free to use his business for personal satisfaction instead of the satisfaction of the consumers. However, to the very extent that he is doing so, he is acting as a consumer himself.

Some economists, such as Alfred Marshall, criticized Menger's conception of goods arrayed in various orders as vague and unhelpful, since one good can be in several different orders. Measured along different paths, a single coral may be one, two, three and four layers away from the top at the same time. This corresponds to Marshall's example of a train carrying passengers and various producer goods as being of four orders at once.

This apparent difficulty vanishes in the light of the truth that something is a capital good not because of its intrinsic properties, but because of its role in someone's plan to create a consumer good. Consider oil, for instance. Since the dawn of man, vast pools of oil had been sitting right where we drill it from today. However, nobody considered this oil a capital good, or, indeed, a good at all. The physical properties of the oil did not change, but one day it became a valuable capital good. It was now a part of people's plans for improving human satisfaction.

Once we view capital goods as elements of a plan, we have no problem conceiving that the same good may play a different role in the plans of different people. If I use my car to take a Sunday drive, it is a consumer good for me. To a traveling salesman, using the same make of car for sales calls, the car is a second-order good. The same model car, used to ferry plans for the construction of a factory back and forth across town, may be many orders of goods away from a final consumer good. The capital nature of a good is not something in the good itself, but is the role the good plays in the plans of acting man.

This is not to say that the physical properties of a good are unimportant to their economic character. If oil didn't have the right chemical properties to be used as a fuel, it would not have become a part of anyone's plans, except, perhaps, by mistake. But the determining factor in whether something is a capital good or not is a plan.

We can see this clearly when contemplating mistakes. For instance, some people believe rhinoceros horns have medicinal properties. We might doubt this, and study might prove we are correct in our doubts. But as long as people believe the horns are efficacious, the tools used to process the horns will be capital goods, and will fetch a market price that depends on the value assigned to the horns. The moment the last person stopped believing the horns had beneficial properties, the tools would cease being capital goods and would lose all their value, unless they had alternate uses.

The Austrian concept of capital gives lie to the idea that the market economy is wasteful because it doesn't make use of "idle capital goods." The items in question are, in fact, things that have ceased to be capital goods! The cost of maintaining and employing them has come to exceed the return they offer, so they are no longer a part of anyone's plan to produce a consumer good. To put them back into production is to waste resources, as they require complementary goods that would be better used elsewhere.

For example, a steel company might have some plants sitting idle because they have become, in the owner's judgment, obsolete. In order to bring these plants back on line, workers would have to be hired, iron and coke purchased, buildings and driveways maintained, electricity and water used, and so on. These are just some of the complementary goods needed to operate the plant.

All of these items are only economic goods because they are scarce. There are alternate uses for each of them. By bidding various prices for consumer goods, consumers communicate the importance of these goods in satisfying their needs to entrepreneurs. Evaluating the prices of the factors of production needed to create these goods against the prices it is estimated consumers will pay for the final products allows entrepreneurs to adjust the factors of production to consumer needs. If the output of the steel plant does not exceed the cost of the complementary goods needed to operate it, then consumers do not value this use of these resources as much as they do an alternate use. This fact is communicated to the owner of the steel company by the fact that others are willing to bid more than he is for the use of these resources.

Another complaint leveled against the free market is that it does not abandon older, 'inefficient" methods of production fast enough. (The foes of the market economy have seldom worried about the consistency of their methods of attack.) But a new plant can only be judged more efficient than an older one if the returns it offers on capital are higher. This is precisely the point when a profit-seeking entrepreneur will abandon his old plant and build a new one. New plants and machinery do not drop from the sky cost-free. To build new equipment, resources must be bid away from other productive activities. The entrepreneur determines if this is worthwhile by estimating whether he will make a profit by bidding more for these resources than their current users are doing.

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Gene Callahan, who writes frequently for Mises.org, is working on a book called Economics for Real People. See his Archive or send him MAIL