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1. Entrepreneurial Profit and Loss

Having developed in the previous chapters our basic analysis of the market economy, we now proceed to discuss more dynamic and specific applications, as well as the consequences of intervention in the market.

     In the evenly rotating economy, there are only two ultimate categories of producers’ prices and incomes: interest (uniform throughout the economy), and “wages”—the prices of the services of various labor factors. In a changing economy, however, wage rates and the interest rate are not the only elements that can change. Another category of both positive and negative income appears: entrepreneurial profit and loss. We shall concentrate on the capitalist-entrepreneurs, economically the more important type of entrepreneur. These are the men who invest in “capital” (land and/or capital goods) used in the productive process. Their function is as we have described: the advance of money to owners of factors and the consequent use of the goods until the more nearly present product is later sold. We have worked out the laws of the ERE in detail: factor prices will equal DMVP, every factor will be allocated to its most value-productive uses, capital values will equal the sums of the DMVPs, the interest rate will be uniform and governed solely by time preferences, etc.

     The difference in the dynamic, real world is this. None of these future values or events is known; all must be estimated, guessed at, by the capitalists. They must advance present money in a speculation upon the unknown future in the expectation that the future product will be sold at a remunerative price. In the real world, then, quality of judgment and accuracy of fore­cast play an enormous role in the incomes acquired by capital­ists. As a result of the arbitrage of the entrepreneurs, the tend­ency is always toward the ERE; in consequence of ever-changing reality, changes in value scales and resources, the ERE never arrives.

     The capitalist-entrepreneur buys factors or factor services in the present; his product must be sold in the future. He is always on the alert, then, for discrepancies, for areas where he can earn more than the going rate of interest. Suppose the interest rate is 5 percent; Jones can buy a certain combination of factors for 100 ounces; he believes that he can use this agglomeration to sell a product after two years for 120 ounces. His expected future re­turn is 10 percent per annum. If his expectations are fulfilled, then he will obtain a 10-percent annual return instead of 5 percent. The differ­ence between the general interest rate and his actual return is his money profit (from now on to be called simply “profit,” un­less there is a specific distinction between money profit and psychic profit). In this case, his money profit is 10 ounces for two years, or an extra 5 percent per annum.

     What gave rise to this realized profit, this ex post profit fulfill­ing the producer’s ex ante expectations? The fact that the fac­tors of production in this process were underpriced and under­capitalized—underpriced in so far as their unit services were bought, undercapitalized in so far as the factors were bought as wholes. In either case, the general expectations of the market erred by underestimating the future rents (MVPs) of the factors. This particular entrepreneur saw better than his fellows, how­ever, and acted on this insight. He reaped the reward of his superior foresight in the form of a profit. His action, his recog­nition of the general undervaluation of productive factors, re­sults in the eventual elimination of profits, or rather in the tend­ency toward their elimination. By extending production in this particular process, he increases the demand for these factors and raises their prices. This result will be accentuated by the entry of competitors into the same area, attracted by the 10-percent rate of return. Not only will the rise in demand raise the prices of the factors, but the increase in output will lower the price of the product. The result will be a tendency for a fall in the rate of return back to the pure interest rate.

     What function has the entrepreneur performed? In his quest for profits he saw that certain factors were underpriced vis-à-vis their potential value products. By recognizing the discrepancy and doing something about it, he shifted factors of production (obviously nonspecific factors) from other productive processes to this one. He detected that the factors’ prices did not adequately reflect their potential DMVPs; by bidding for, and hiring, these factors, he was able to allocate them from production of lower DMVP to production of higher DMVP. He has served the con­sumers better by anticipating where the factors are more valu­able. For the greater value of the factors is due solely to their being more highly demanded by the consumers, i.e., being bet­ter able to satisfy the desires of the consumers. That is the mean­ing of a greater discounted marginal value product.

     It is clear that there is no sense whatever in talking of a going rate of profit. There is no such rate beyond the ephemeral and momentary. For any realized profit tends to disappear be­cause of the entrepreneurial actions it generates. The basic rate, then, is the rate of interest, which does not disappear. If we start with a dynamic economy, and if we postulate given value scales and given original factors and technical knowledge throughout, the result will be a wiping out of profits to reach an ERE with a pure interest rate. Continual changes in tastes and resources, however, constantly shift the final equilibrium goal and estab­lish a new goal toward which entrepreneurial action is directed—and again the final tendency in the ERE will be the dis­appearance of profits. For the ERE means the disappearance of uncertainty, and profit is the outgrowth of uncertainty.

     A grave error is made by a host of writers and economists in considering only profits in the economy. Almost no account is taken of losses. The economy should not be characterized as a “profit economy,” but as a “profit and loss economy.”[1]

     A loss occurs when an entrepreneur has made a poor estimate of his future selling prices and revenues. He bought factors, say, for 1,000 ounces, developed them into a product, and then sold it for 900 ounces. He erred in not realizing that the factors were overpriced and overcapitalized on the market in relation to their discounted marginal value products, i.e., to the prices of his out­put.

     Every entrepreneur, therefore, invests in a process because he expects to make a profit, i.e., because he believes that the mar­ket has underpriced and undercapitalized the factors in relation to their future rents. If his belief is justified, he makes a profit. If his belief is unjustified, and the market, for example, has really overpriced the factors, he will suffer losses.

     The nature of loss has to be carefully defined. Suppose an en­trepreneur, the market rate of interest being 5 percent, buys factors at 1,000 and sells their product for 1,020 one year later. Has he suffered a “loss” or made a “profit”? At first, it might seem that he has not taken a loss. After all, he gained back the principal plus an extra 20 ounces, for a 2-percent net return or gain. However, closer inspection reveals that he could have made a 5-percent net re­turn anywhere on his capital, since this is the going interest re­turn. He could have made it, say, investing in any other enter­prise or in lending money to consumer-borrowers. In this ven­ture he did not even earn the interest gain. The “cost” of his investment, therefore, was not simply his expenses on factors—1,000—but also his forgone opportunity of earning interest at 5 percent, i.e., an additional 50. He therefore suffered a loss of 30 ounces.

     The absurdity of the concept of “rate of profit” is even more evident if we attempt to postulate a rate of loss. Obviously, no meaningful use can be made of “rate of loss”; entrepreneurs will be very quick to leave the losing investment and take their cap­ital elsewhere. With entrepreneurs leaving the line of production, the prices of the factors there will drop and the price of the product will rise (with reduced supply), until the net return in that branch of production will be the same as in every branch, and this return will be the uniform interest rate of the ERE. It is clear, therefore, that the process of equalization of rate of return throughout the economy, one that results in a uniform rate of interest, is the very same process that brings about the abolition of profits and losses in the ERE. A real economy, in other words, where line A yields a net return of 10 percent to some entrepreneur, and line B yields 2 percent, while other lines yield 5 percent, is one in which the rate of interest is 5 percent, A makes a pure profit of 5 percent, and B suffers a pure loss of 3 percent. A correctly estimated that the market had underpriced his factors in relation to their true DMVPs; B had incorrectly guessed that the market had underpriced (or, at the very least, correctly priced) his factors, but found to his sorrow that they had been overpriced in rela­tion to the uses that he made of the factors. In the ERE, where all future values are known and there is therefore no under­pricing or overpricing, there are no entrepreneurial profits or losses; there is only a pure interest rate.

     In the real world, profits and losses are almost always inter­twined with interest returns. Our separation of them is concep­tually valid and very important, but cannot be made easily and quantitatively in practice.

     Let us sum up the essence of an evenly rotating economy. It is this: all factors of production are allocated to the areas where their discounted marginal value products are the greatest. These are determined by consumer demand schedules. In the modern world of specialization and division of labor, it is almost always the consumers alone who decide, and this in effect excludes the capitalists, who rarely consume more than a negligible amount of their own products. It is the consumers, then, given the “nat­ural” facts of stocks of resources (particularly labor and land fac­tors), who make the decisions for the economic system. The con­sumers, through their buying and abstention from buying, de­cide how much of what will be produced, at the same time de­termining the incomes of all the participating factors. And every man is a consumer.

     One obvious exception to this “rule” occurs when either cap­italists or laborers have strong preferences or dislikes for a par­ticular line of production. The equilibrium rate of return in the ERE for a strongly disliked line will be considerably higher than the uniform rate, and the equilibrium rate of return for a strongly liked line will be lower. These preferences, however, have to be strong enough to affect the investment or productive actions of a considerable number of potential investors or laborers in or­der to register as a change in the rate of return.

     Do profits have a social function? Many critics point to the ERE, where there are no profits (or losses) and then attack en­trepreneurs earning profits in the real world as if they were do­ing something mischievous or at best unnecessary. Are not profits an index of something wrong, of some maladjustment in the economy? The answer is: Yes, profits are an index of maladjust­ment, but in a sense precisely opposed to that usually meant. As we have seen above, profits are an index that maladjustments are being met and combatted by the profit-making entrepreneurs. These maladjustments are the inevitable concomitants of the real world of change. A man earns profits only if he has, by superior foresight and judgment, uncovered a maladjustment—specifically an undervaluation of certain factors by the market. By stepping into this situation and gaining the profit, he calls everyone’s at­tention to that maladjustment and sets forces into motion that eventually eliminate it. If we must condemn anyone, it should not be the profit-making entrepreneur, but the one that has suf­fered losses. For losses are a sign that he has added further to a maladjustment, through allocating factors where they were over­valued as compared to the consumers’ desire for their product. On the other hand, the profit-maker is allocating factors where they had been undervalued as compared to the consumers’ de­sires. The greater a man’s profit has been, the more praiseworthy his role, for then the greater is the maladjustment that he alone has uncovered and is combatting. The greater a man’s losses, the more blameworthy he is, for the greater has been his contribu­tion to maladjustment.[2]

     Of course, we should not be too hard on the bumbling loser. He receives his penalty in the form of losses. These losses drive him from his poor role in production. If he is a consistent loser wherever he enters the production process, he is driven out of the entrepreneurial role altogether. He returns to the job of wage earner. In fact, the market tends to reward its efficient en­trepreneurs and penalize its inefficient ones proportionately. In this way, consistently provident entrepreneurs see their capital and resources growing, while consistently imprudent ones find their resources dwindling. The former play a larger and larger role in the production process; the latter are forced to abandon entrepreneurship altogether. There is no inevitably self-rein­forcing tendency about this process, however. If a formerly good entrepreneur should suddenly made a bad mistake, he will suffer losses proportionately; if a formerly poor entrepreneur makes a good forecast, he will make proportionate gains. The market is no respecter of past laurels, however large. Moreover, the size of a man’s investment is no guarantee whatever of a large profit or against grievous losses. Capital does not “beget” profit. Only wise entrepreneurial decisions do that. A man investing in an unsound venture can lose 10,000 ounces of gold as surely as a man engaging in a sound venture can profit on an investment of 50 ounces.[3]

     Beyond the market process of penalization, we cannot con­demn the unfortunate capitalist who suffers losses. He was a man who voluntarily assumed the risks of entrepreneurship and suffered from his poor judgment by incurring losses proportionate to his error. Outside critics have no right to condemn him further. As Mises says:

Nobody has the right to take offense at the errors made by the entrepreneurs in the conduct of affairs and to stress the point that people would have been better supplied if the entrepreneurs had been more skillful and prescient. If the grumbler knew better, why did he not himself fill the gap and seize the opportunity to earn profits? It is easy indeed to display foresight after the event.[4]

2. The Effect of Net Investment

     Having considered the ERE and its relation to specific en­trepreneurial profit and loss, let us now turn to the problem: When will there be aggregate profits or losses in the economy? This is connected with the question: What is the effect of a change in the level of aggregate saving or investment in the econ­omy?

     Let us begin with an economy in the equilibrium depicted in chapters 5 and 6. Production occurs in processes up to six years in total length; total gross income is 418 gold ounces, gross savings-investment is 318 ounces, total consumption 100 ounces, net savings-investment is zero. Of the 100 ounces of income, 83 ounces of net income are earned by land and labor owners, 17 ounces by capital owners. The production structure remains constant because the natural rates of interest coincide, and the resulting price spreads conform to the aggregate of individual time-preference schedules in the economy. As Hayek states:

Whether the structure of production remains the same depends entirely upon whether entrepreneurs find it profitable to reinvest the usual proportion of the return from the sale of the product in turning out intermediate goods of the same sort. Whether this is profitable, again, depends upon the prices obtained for the product of this particular stage of production on the one hand and on the prices paid for the original means of production and for the intermediate products taken from the preceding stage of production on the other. The continuance of the existing degree of capitalistic organization depends, accordingly, on the prices paid and obtained for the product of each stage of production, and these prices are, therefore, a very real and important factor in determining the direction of produc­tion.[5]

     What happens if, in a certain period, there are now net savings as a result of a lowering of time-preference schedules? Suppose, for example, that consumption decreases from 100 to 80 and that the saved 20 ounces enter the time market. Gross savings have increased by 20 ounces. During the transition period, net saving has changed from zero to 20; after the new level of saving has been reached, however, there will be a new equilibrium with gross savings equalling 338 and net savings equalling zero. To the super­ficial, it might seem that all is lost. Has not consumption de­creased from 100 to 80 ounces? What, then, will happen to the whole complex of productive activities that rest on final consump­tion sales? Will this not lead to a disastrous depression for all firms? And how can a reduced consumption profitably support an increased volume of expenditures on producers’ goods? The latter has aptly been termed by Hayek the “paradox of saving,” i.e., that saving is the necessary and sufficient condition for in­creased production, and yet that such investment seems to con­tain within itself the seeds of financial disaster for the investors.[6]

     If we observe the diagram in Figure 40 above, it is clear that the volume of money incomes to Capitalists1 will be drastically re­duced. Capitalists1 will receive a total of 80 instead of 100 ounces. The amount that they have to apportion to original factors and to Capitalists2 is therefore also considerably decreased. Thus, from the side of final consumers’ spending, an impetus toward declining money incomes and prices is sent along the production structure. In the meanwhile, however, another force has concur­rently come into play. The 20 ounces have not been lost to the system. They are in the process of being invested in the economy, their owners ranging throughout the economy looking for max­imum interest returns on their investment. The new savings have changed the ratio of gross investment to consumption from 318:100 to 338:80. A “narrower” consumption base must sup­port a larger amount of producers’ spending. How can this happen, especially since the lower-rank capitalists must also receive a lower aggregate income? The answer is: in only one way—by shifting investment further up the ladder to the higher-order production stages. Simple investigation will reveal that the only way that so much investment can be shifted from the lower to the higher stages, while preserving uniform (lowered) interest differentials (cumulative price spreads) at each stage, is to in­crease the number of productive stages in the economy, i.e., to lengthen the structure of production. The impact of net saving on the economy, i.e., of increased total savings, is to lengthen and narrow the structure of production, and this procedure is viable and self-supporting, since it preserves essential price spreads from stage to stage. The diagram in Figure 60 illustrates the impact of net saving.

     In this diagram we see the narrowing and the lengthening of the structure of production. The heavy line AA outlines the original structure. The bottom rectangle—consumption—is­ narrowed with the addition of new savings. As we go up in stepwise fashion—the steps in these diagrams accounting for the interest spreads[7]—the new production structure BB (the shaded area) becomes relatively less and less narrow compared to the original structure, until it becomes wider in the upper registers, and finally adds new and higher stages.

     The reader will notice that the steps (differentials between stages) in the new production structure BB are considerably nar­rower than the ones in AA. This is not an accident. If the steps in BB were of the same width as in AA, there would be no lengthening of the structure, and total investment would diminish instead of increase. But what is the significance of the narrowing steps in the structure? On the assumptions on which we have drawn the diagram, it is equivalent to a lowering of the interest spreads, i.e., a lowering of the natural rate of interest. But we have seen above that the consequence of lower time-preference rates in the society is precisely a lowering of the rate of interest. Thus, lowered time preferences mean an increased proportion of savings-investment to consumption and lead to smaller price spreads and an equivalent lowering of the rate of interest.

     The lowering of interest spreads may be portrayed by another diagram, as in Figure 61.

     In this diagram, cumulative prices are plotted against stages of production, and the further right we go, the lower the stage of production, until consumption is reached. AA is the original curve with the topmost dot representing the highest cumulative price—the one for the final product consumed. The dots next to the left are the lower cumulative prices of the higher stages, and the differences between the dots represent the interest spread and therefore the rate of interest return from stage to stage. BB is the curve applicable to the new situation, after saving has increased. Consumption has declined; hence the rightmost dot in B is lower than the one in A, and the arrow depicts the change. The point next to the left on the BB curve is, of course, lower than the rightmost dot, but lower by a smaller amount than the corresponding dot in AA, because the lower interest rate signifies a smaller spread between the cumulative prices of the two stages. The next dot to the left, having the same rate of interest return, will be on approximately the same slope. Therefore, since the BB curve is flatter than the AA curve—because of the lower in­terest spread—it crosses the AA curve and from that point left­ward, i.e., in the higher productive stages, its prices are higher than A’s. Arrows depict this change as well.

     In Figure 60 we saw the effect of additional saving, i.e., positive net savings, on the structure of production and on the rate of interest. Here we see that the change in the rate of interest lessens the spreads of cumulative prices, so that aggregate consumption is lower, the immediate next higher stages are less and less lower, until the lines cross, and the prices in the higher stages are higher than before. Let us consider the price changes in the various stages and the processes by which they occur. In the lower stages, prices fall because of the lower consumer demand and the resulting shift of investment capital from the stages nearest consumption. In the higher stages, on the other hand, demand for factors increases under the impact of the new savings and the shift in investment from the lower levels. The increased investment expenditure in the higher levels raises the prices of the factors in these stages. It is as if the impact of lower consumer demand tends to die out in the higher stages and is more and more counteracted by the increase and shift in investment funds.

     The process of readjustment to lower price spreads caused by increased gross saving has been lucidly described by Hayek. As he states:

The final effect will be that, through the fall of prices in the later stages of production and the rise of prices in the earlier stages of production, price margins between the different stages of production will have decreased all round.[8]

     The changes in cumulative prices in the various sectors will lead to changes in the prices of the particular goods that enter into the cumulation of factors. These factors are, of course, the capital goods, land, and labor factors, and are ultimately reducible to the latter two, since capital goods are produced (and re­produced) factors. It is clear that lower aggregate demand in the lower stages will cause the prices of the various factors there to decline. The specific factors will have to bear the brunt of the decline, since they have nowhere else to go. The nonspecific fac­tors, on the other hand, can and do go elsewhere—to the earlier stages, where the monetary demand for factors has increased.

     The pricing of capital goods is ultimately unimportant in this connection, because it is reducible to the prices of land, labor, and time, and because the slopes of the curves, the interest spread, indicate the mode of pricing of the capital goods. The ultimately important factors, then, are land, labor, and time. The time ele­ment has been extensively considered and accounts for the inter­est spread. It is the land and labor elements that constitute the fundamental resources being shifted or remaining in production. Some land is specific and some nonspecific; some can be used in several alternative types of productive processes; some can be used in only one type. Labor, on the other hand, is almost always nonspecific; very rare indeed is the person who could conceivably perform only one type of task.[9] Of course, there are different degrees of nonspecificity for any factor, and the less specific ones will be more readily shifted from one stage or product to another.

     Those factors which are specific to only one particular stage and process will therefore fall in price in the later stages and rise in the earlier stages. What of the nonspecific factors, which include all labor factors? These will tend to shift from the later to the earlier stages. At first, there will be a difference in the price of each nonspecific factor; it will be lower in the lower stages and higher in the higher stages. In equilibrium, however, as we have seen time and again, there must be a uniform price for any factor throughout the economy. The lower demand in the lower stages, and the consequent lower price, coupled with the higher demand and higher price in the higher stages, causes the shift of the factor from later to earlier stages. The shift ceases when the price of the factor is again uniform throughout.

     We have seen the impact of new saving, i.e., a shift from con­sumption to investment, on the prices of goods at various levels. What, however, is the aggregate impact of a change to a higher level of gross savings on the prices of factors? Here we reach a paradoxical situation. Net income is the total amount of money that ultimately goes to factors: land, labor, and time. In any equi­librium situation, net saving is zero by definition (since net sav­ing means a change in the level of gross saving over the previ­ous period of time), and net income equals consumption and consumption alone. If we look again at Figure 41 above, we see that the total income for original factors and interest can come only from net, rather than gross, income. Let us consider the new ERE after the change has taken place to a higher level of saving (ignoring for a moment the relevant conditions during the period of change). Gross savings = gross investment has increased from 318 to 338. But consumption has declined from 100 to 80, and it is consumption that provides the net income in the equi­librium situation. Net income is, as it were, the “fund” out of which money prices and incomes are paid to original factors. And this fund has declined.

     The recipients of the net income fund are the original factors (labor and land) and interest on time. We know that the interest rate declines; this is a corollary of the increased saving and in­vestment in the productive system, caused by lowered time pref­erence. However, the absolute amount of interest income is gross investment multiplied by the rate of interest. Gross investment has increased, so that it is impossible for economic analysis to determine whether interest income has fallen, increased, or re­mained the same. Any of these alternatives is a possibility.

     What happens to total original-factor income is also indeter­minate. Two forces are pulling different ways in a progressing economy (an economy with increasing gross investment). On the one hand, the total net income money fund is falling; on the other hand, if the interest decline is large enough, it is possible that the fall in interest income will outstrip the fall in total net income, so that total factor income actually increases. For this to occur is possible but empirically highly unlikely.

     The one certain prospect is that total net income for factors and interest will fall. If the total original-factor income falls, then, since we have implicitly been assuming a given supply of original factors, the prices of these factors, as well as the interest rate, will “in general” also decline.

     That the general trend of original-factor incomes and prices may well be downward is a startling conclusion, for it is difficult to conceive of a progressing economy as one in which factor prices, such as wage rates and ground rents, steadily decline. What in­terests us, however, is not the course of money incomes and prices of factors, but of real incomes and prices, i.e., the “goods-income” accruing to factors. If money wage rates or wage incomes fall, and the supply of consumers’ goods increases such that the prices of these goods fall even more, the result is a rise in “real” wage rates and “real incomes” to factors. That this is precisely what does happen solves the paradox that a progressing economy ex­periences falling wages and rents. There may be a fall in money terms (although not in all conceivable cases); but there will always be a rise in real terms.

     The rise in real rates and incomes is due to the increase in the marginal physical productivity of factors that always results from an increase in saving and investment.[10] The increased productivity of the longer production processes leads to a greater physical supply of capital goods, and, most important, of consumers’ goods, with a consequent fall in the prices of consumers’ goods. As a result, even if the money prices of labor and land fall, those of consumers’ goods will always fall farther, so that real factor incomes will rise. That this is always true in a progressing economy can be seen from the following considerations.

     At any time, the wage or rent of the service of an original fac­tor of production will equal its DMVP, the discounted marginal value product. This DMVP is equal to the MVP (marginal value product) divided by a discount factor, say d, which is directly dependent on the rate of interest. The MVP, in turn, is approxi­mately equal to the MPP (marginal physical product) of the fac­tor times the selling price, i.e., the final price of the consumers’ good product. Hence,

In this discussion, we are considering the prices of consumers’ goods “in general” or in the aggregate. The “real” prices of the original factors equal the money prices divided by the prices of consumers’ goods. Strictly, there is no precise praxeological way of measuring these aggregates, or “real” income, based on changes in the purchasing power of money, but we can make qualitative statements about these elements even though we cannot make precise quantitative measurements.

     Now the progressing economy consists of two leading features: an increase in the MPP of original factors resulting from more productive and longer production processes, and a fall in the discount or interest rate concomitant with falling time preference and increasing gross investment. Both elements—the increase in MPP and the fall in d—impel an increase in the real prices of factor services in a progressing economy.

     The conclusion is that in a progressing economy, i.e., in an economy with increases in gross savings and investment, money wages and ground rents may well fall, but real wages and rents will rise.[11]

     One question that immediately presents itself is: How can the prices of factors decline while the gross income remains the same and gross investment even increases? The answer is that the increase in investment goes into increasing the number of stages, pushing back the stages of production and employing longer production processes. It is this increasing “roundaboutness” that causes every increase in capital—even if unaccompanied by an advance in technological knowledge—to lead to higher physical productivity per original factor. The increase in gross investment, in particular, raises the prices of capital goods at the highest stages, encouraging new stages and inducing entrepreneurs to shift factors into this new and flowering field. The larger gross investment fund is absorbed, so to speak, by higher prices of high-order capital goods and by the consequent new stages of turnover of these goods.[12]

3. Capital Values and Aggregate Profits in a Changing Economy

     Net saving, as we have seen, increases gross investment in the economy. This increase in gross investment at first accrues as profits to the firms doing the increased business. These profits will accrue particularly in the higher stages, toward which old capital is shifting and in which new capital is invested. An ac­crual of profits to a firm increases, by that amount, the capital value of its assets, just as the losses decrease the capital value. The first impact of the new investment, then, is to cause aggregate profits to appear in the economy, concentrated in the new produc­tion processes in the higher stages. As the transition to the new ERE begins to take place, however, these profits more and more become imputed to the factors for which these entrepreneurs must pay in production. Eventually, if no other interfering changes occur, the result will be a disappearance of profits in the economy, a settling into the new ERE, an increase in real wages and other real rents, and an increase in the real capital value of ground land. This latter result, of course, is in perfect conformity with the previous conclusion that a progressing economy will lead to an increase in the real rents of ground land and a fall in the rate of interest. These two factors,  in conjunction, both impel a rise in the real capital value of ground land.

     Future rises in the real values of rents can be either anticipated or not anticipated. To the extent that they are anticipated, the rise in future rents is already accounted for, and discounted, in the capital value of the whole land. A rise in the far future may be anticipated, but will have no appreciable effect on the present price of land, simply because time preference places a very dis­tant date beyond the effective “time horizon” of the present. To the extent that rises in the real rate are not foreseen, then, of course, entrepreneurial errors have been made, and the market has undercapitalized in the present price.[13] Throughout the whole history of landholding, therefore, income from basic land can be earned in only three ways (we are omitting improving the land): (1) through entrepreneurial profit in correcting the forecasting errors of others; (2) as interest return; or (3) by a rise in the capi­tal value to the first finder and user of the land.

     The first type of income is obvious and not unique. It is pervasive in any field of enterprise. The second type of income is the general income earned by ground land. Because of the market phenomenon of capitalization, income from ground land is largely interest return on investment, just as in any other business. The only unique component of income that ground land confers, therefore, is (3), accruing to the first user, whose land value began at zero and became positive. After that, the buyer of the land must pay its capitalized value. To earn rent on ground land, in other words, a man must either buy it or find it, and in the former case he earns only interest, and not pure rent. The capitalized value can increase from time to time and not be discounted in advance only if some new and unexpected development occurs (or if better knowledge of the future comes to light), in which case the previous owner has suffered an en­trepreneurial loss in profit forgone for not having anticipated the new situation, and the current owner earns an entrepreneurial profit.

     The only unique aspect to ground land, then, is that it is found and first put on the market at some particular time, so that the first user earns pure rent as a result of his initial discovery and use of the land. All later increases in the capital value of the land are accounted for in the value, either as entrepreneurial profits resulting from better forecasting or as interest return.

     The first user earns his gain only at first and not at whatever later date he actually sells the land. After the capital value has increased, his refusal to sell the land involves an opportunity cost—the forgone utility of selling the land for its capital value. Therefore, his true gain was reaped earlier, when the capital value of his land increased, and not at the later date when he “took” his gain in the form of money.

     If we set aside uncertainty and entrepreneurial profits for a moment, and assume the highly unlikely condition that all future changes can be anticipated correctly by the market,[14] then all future increases in the value of ground rents will be capitalized back into the land when it is first found and put into use. The first finder will reap the net gain immediately, and from then on all that will be earned by him and by successive heirs or purchasers is the usual interest return. When future rises are too remote to enter into the capitalized price, this is simply a phenomenon of time preference, not a sign of some mysterious breakdown in the market’s process of adjustment. The fact that complete discounting never takes place is due to the presence of uncertainty, and the result is a continual accretion of entre­preneurial gains through rising capital values of land.

     Thus, we see, this time from the landowner’s point of view, that aggregate gains in capital value are synonymous with ag­gregate profits. Aggregate profits begin with the higher-order firms, then filter down until they increase real wages and the aggregate profits of landowners, particularly owners of land spe­cific to the higher-order stages of production. (Land specific to the lower stages will, of course, bear the brunt of decreases in capital value, i.e., losses, in the progressing economy.)

     As the only income to ground land that is not profit or interest, we are left with the original gains to the first finder of land. But, here again, there is capitalization and not a pure gain. Pioneering—finding new land, i.e., new natural resources—is a business like any other. Investing in it takes capital, labor, and entrepreneurial ability. The expected rents of finding and using are taken into account when the investments and expenses of exploration and shaping into use are made. Therefore, these gains are also capital­ized backward in the original investment, and the tendency will be for them too to be the usual interest return on the investment. Deviations from this return will constitute entrepreneurial profits and losses. Therefore, we conclude that there is practically nothing unique about incomes from ground land and that all net income in the productive system goes to wages, to interest, and to profit.

     A progressive economy is marked by aggregate net profits. When there is a shift from one savings-investment level to a higher one (therefore, a progressing economy), aggregate profits are earned in the economy, particularly in the higher stages of production. The increased gross investment first increases the aggregate capital value of firms that earn net profits. As production and investment increase in the higher stages, and the effects of the new saving continue, the profits disappear and become imputed to increases in real wage rates and in real ground rents. The latter effect, added to a fall in the rate of interest, leads to a rise in the real capital values of ground land.

     What happens when there is a shift in the reverse direction—a changed proportion such that gross saving and investment de­cline and consumption increases? For the most part, we may simply trace the above analysis in reverse—that is, consider the shift from a 338:80 situation to a 318:100 situation. During the transition to a new equilibrium, there would be a net dissaving of 20 ounces, since gross saving decreases from 100 to 80. There would also be a net disinvestment of the same amount. The cause of such a shift would be an increase in the time-preference sched­ules of the individuals on the market. This would increase the rate of interest and widen the interest spread between cumulative prices in the production stages. It would broaden the consumption base, but leave less money available for saving and investment. We may simply reverse the diagrams above and consider the reverse shift, e.g., to a shorter and wider structure of production, to a steeper price curve with a smaller number of productive stages. The interest spread goes up, but the investment base de­clines. There would be higher prices for consumers’ goods and therefore a greater demand for factors in this and other lower stages; on the other hand, there would be general abandonment of the higher stages in the face of the monetary attractions of the later stages, the decline in investment funds, and the shift of these funds from the higher to the lower stages. Specific factors will bear the brunt of lowered incomes and sheer abandonment in the higher stages, and they will gain in the lower stages.

     There will be a rise in net income and consumption, in mone­tary terms, and therefore a rise in aggregate factor income. The interest rate increases, while the gross investment base declines. In real terms the important result is a lowering in the physical productivity of labor (and of land) because of the abandonment of the most productive processes of production—the lengthiest ones. The lower output at every stage, the lower supply of capital goods, and the consequent lower output of consumers’ goods leads to a lowering in the “standard of living.” Money wage rates and money rents may rise (although this possibly might not occur because of the higher interest rate), but the prices of consumers’ goods will rise further because of the reduced physical supply of goods.[15]

     The case of decreasing gross capital investment is defined as a retrogressing economy.[16] The decreased investment is first re­vealed as aggregate losses in the economy, particularly losses to firms in the highest stages of production, the firms which are now losing customers. As time proceeds, these losses will tend to disappear, as firms leave the industry and abandon the now unprofitable production processes. The losses will thereby be im­puted to factors in the form of lower real wage rates and lower real rents, which, combined with a higher interest rate, cause lower real capital values of ground land. Particularly hard hit will be the factors specific to these lines of production.

     The reason why there are aggregate profits in the progressing economy and aggregate losses in the retrogressing economy, may be demonstrated in the following way. For profits to appear, there must be undercapitalization, or overdiscounting, of productive factors on the market. For losses to appear, there must be over­capitalization, or underdiscounting, of factors on the market. But if the economy is stationary, i.e., if from one period to another the total gross investment remains constant, the total value of capital remains constant. There might be an increase of invest­ment in one line of production, but this is made possible only by a decrease elsewhere. Aggregate capital values remain constant, and therefore any profits (the result of mistaken undercapitali­zation) must be offset by equal losses (the result of mistaken over­capitalization). In the progressing economy, on the other hand, there are additional investment funds made available through new savings, and this provides a source for new revenue not yet capitalized anywhere in the system. These constitute the aggregate net profits during this period of change. In the retrogressing econ­omy, investment funds are lowered, and this leaves net areas of overcapitalization of factors in the economy. Their owners suffer aggregate net losses during this period of change.[17]

     Thus, another conclusion of our analysis is that aggregate profits will equal aggregate losses in a stationary economy, i.e., profits and losses will equal zero. This stationary economy is not the same construct as the evenly rotating economy that has played such a large role in our analysis. In the stationary economy, un­certainty does not disappear and no unending constant round pervades all elements in the system. There is, in fact, only one constancy: total capital invested. Clearly, the stationary economy (like all other economies) tends to evolve into the ERE, given constant data. After a time, market forces will tend to eliminate all individual profits and losses as well as aggregate profits and losses.

     We might pause here to consider briefly the old problem: Are “capital gains”—increases in capital value—income? If we fully realize that profits and capital gains, and losses and capital losses, are identical, the solution becomes clear. No one would exclude business profits from money income. The same should be true of capital gains. In the ERE, of course, there are neither capital gains nor capital losses.

     Let us now return to the case of the retrogressing economy and a decrease in capital investment. The greater the shift from saving to consumption, the more drastic will the effects tend to be, and the greater the lowering of productivity and living standards. The fact that such shifts can and do happen serves to refute easily the fashionable assumption that our capital structure is, by some magical provision or hidden hand, permanently and eternally self-reproducing once it is built. No positive acts of saving by capitalists are deemed necessary to maintain it.[18][19] The ruins of Rome are mute illustrations of the error of this assumption.[20]

     Refusal to maintain the value of capital, i.e., the process of net dissaving, is known as consuming capital. Granting the im­possibility of measuring the value of capital in society with any precision, this is still a highly important concept. “Consuming capital” means, of course, not “eating machines,” as some critics have scoffingly referred to it, but failing to maintain existing gross investment and the existing capital goods structure, using some of these funds instead for consumption expenditure.[21]

     Professor Frank H. Knight has been the leader of the school of thought that assumes capital to be automatically permanent. Knight has contributed a great deal to economics in his analysis of profit theory and entrepreneurship, but his theories of capital and interest have misled a generation of American economists. Knight succinctly summed up his doctrine in an attack on the “Austrian” investment theory of Böhm-Bawerk and Hayek. Knight said that the latter involved two fallacies. One is that Böhm-Bawerk viewed production as the production of concrete goods, whereas “in reality, what is produced, and consumed, is services.” There is no real problem here, however. It is not to be denied—in fact it has been stressed herein—that goods are valued for their services. Yet it is also undeniable that the concrete capital goods structure must be produced before its services can be obtained. The second alleged correction, and here we come directly to the problem of capital consumption, is that “the production of any service includes the maintenance of things used in the process, and this includes reproduction of any which are used up . . . really a detail of maintenance.”[22] This is obviously incorrect. Services are yielded by things, at least in the cases relevant to our discussion, and they are produced through the using up of things, of capital goods. And this production does not necessarily “in­clude” maintenance and reproduction. This alleged “detail” is a completely separate area of choice and involves the building up of more capital at a later date to replace the used-up capital.

     The case of the retrogressing economy is our first example of what we may call a crisis situation. A crisis situation is one in which firms, in the aggregate, are suffering losses. The crisis aspect of the case is aggravated by a decline in production through the abandonment of the highest production stages. The troubles arose from “undersaving” and “underinvestment,” i.e., a shift in people’s values so that they do not now choose to save and invest enough to enable continuation of production processes begun in the past. We cannot simply be critical of this shift, however, since the people, given existing conditions, have decided voluntarily that their time preferences are higher, and that they wish to consume more proportionately at present, even at the cost of lowering future productivity.

     Once an increase to a greater level of gross investment occurs, therefore, it is not maintained automatically. Producers have to maintain the gross investment, and this will be done only if their time preferences remain at the lower rates and they continue to be willing to save a greater proportion of gross monetary income. We have demonstrated, further, that this maintenance and further progress can take place without any increase in the money supply or other change in the money relation. Progress can occur, in fact, with falling prices of all products and factors.[23]

[1]One thing I miss . . . in discussion generally in the field, is any use of words recognizing that profit means profit or loss and is in fact as likely to be a loss as a gain.” Frank H. Knight, “An Appraisal of Economic Change: Discussion,” American Economic Review, Papers and Proceedings, May, 1954, p. 63. Professor Knight’s great contributions to profit theory are in sharp contrast to his errors in capital and interest theory. See his famous work, Risk, Uncertainty, and Profit (3rd ed.; London: London School of Economics, 1940). Perhaps the best presentation of profit theory is in Ludwig von Mises, “Profit and Loss” in Planning for Freedom (South Holland, Ill.: Libertarian Press, 1952), pp. 108–51.

[2]We may make such value judgments, of course, only to the extent that we believe it is “good” to correct maladjustments and to serve the consumers, and “bad” to create such maladjustments. These value judgments, therefore, are not at all praxeological truths, though most people would probably subscribe to them. Those who prefer maladjustments in serving consumers will adopt the opposite value judgments.

[3]On all this, see Mises, “Profit and Loss.” On the role of the fallacy of capital’s automatically yielding profit in public utility regulation, see Arthur S. Dewing, The Financial Policy of Corporations (5th ed.; New York: Ronald Press, 1953), I, 308–53.

[4]Mises, Planning for Freedom, p. 114.

[5]Hayek, Prices and Production, pp. 48–49.

[6]See Hayek, “The ‘Paradox’ of Saving” in Profits, Interest, and Investment, pp. 199–263.

[7]This production structure diagram differs from our usual ones; it presents both the capital structure and the payment to owners of original factors as amalgamated in the same bar, to represent total investment at each stage. The steps in the diagram, then, represent the interest spreads to the capitalists (in rough, not exact, fashion).

[8]Hayek, Prices and Production, pp. 75–76.

[9]Of course, the productivity of a labor factor will differ from one task to another. No one disputes this; indeed, if this were not so, the factor would be purely nonspecific, and we have seen that this is an impossibility. “Specific” is here used to mean pure specificity for one production process.

[10]See below for discussion of this point.

[11]Historically, the advancing capitalist economy has coincided with an expanding money supply, so that we have rarely had an empirical illustration of the above “pure” process described in the text. We must remember that we have throughout been making the implicit assumption that the “money relation”—the demand for, and particularly the supply of, money—remains unchanged. Effects of changes in this relation will be considered in chapter 11. The only relaxation of this assumption here is that the number of stages increases, and this tends to increase the demand for money to that extent.

[12]The demand for money increases to the extent that each gold unit must “turn over” more times in the increased number of stages, thus tending to lower the “general level” of prices.

[13]For a view of capitalized gains similar to the one presented here, see Roy F. Harrod, Economic Essays (New York: Harcourt, Brace & Co., 1952), pp. 198–205.

[14]This is not the same as assuming an ERE, for in the ERE there are no changes to be foreseen.

[15]The rise in general money prices, in monetary terms, is accounted for by the decreased demand for money as a result of the lower number of stages for the monetary unit to “turn over” in.

[16]The definitions of the progressing and the retrogressing economy differ from those of Mises in Human Action. They are defined here as an in­crease or a decrease in capital in society, while Mises defines them as an increase or a decrease in total capital per person in the society. The present definitions focus on the analysis of saving and investment, population growth or decline being a very different phase of the subject. When we are making an historical “welfare” assessment of the conditions of the economy, however, the question of production per capita becomes important.

[17]It is possible that the changes in investment were anticipated in the market. To the extent that an increase or a decrease was anticipated, the aggregate profits or losses will accrue in the form of a gain in capital value before the actual change in investment takes place. Losses arise during retrogression because previously employed processes have to be abandoned. The fact that the highest stages, already begun, have to be abandoned is an indication that the shift was not fully anticipated by the producers.

[18]It is this assumption, coupled with a completely unjustifiable dichotomiz­ing of “consumers’ goods industries” and “capital goods industries” (whereas, in fact, there are stages of capital goods leading to consumers’ goods, and not an arbitrary dichotomy) that is at the bottom of Nurkse’s criticism of the structure of production analysis. See Ragnar Nurkse, “The Schematic Representation of the Structure of Production,” Review of Economic Studies, II (1935).

[19]The popular assumption now, in fact, is that a hidden hand somehow guarantees that capital will automatically increase continually, so that factor productivity will increase by “2–3 percent per year.”

[20]An illustration from modern times:

Austria was successful in pushing through policies which are popular all over the world. Austria has most impressive records in five lines: she increased public expenditures, she increased wages, she increased social benefits, she increased bank credits, she increased consumption. After all those achievements she was on the verge of ruin. (Fritz Machlup, “The Consumption of Capital in Austria,” Review of Economic Statistics, II [1935], p. 19)

[21]It is often assumed that only depreciation funds for durable capital goods are available for capital consumption. But this overlooks a very large part of capital—so-called “circulation capital,” the less durable capital goods which pass quickly from one stage to another. As each stage receives funds from its sale of these or other goods, it is not neces­sary for the producer to continue to repurchase circulation capital. These funds too may be immediately spent on consumption. See Hayek, Pure Theory of Capital, pp. 47ff., for a contrast between the correct and the fashionable approaches toward capital.

[22]Frank H. Knight, “Professor Hayek and the Theory of Investment,” Economic Journal, March, 1935, p. 85 n. Also see Knight, Risk, Uncer­tainty, and Profit, pp. xxxvii–xxxix.

[23]Very few writers have realized this. See Hayek, “The ‘Paradox’ of Saving,” pp. 214ff., 253ff.

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