Capital in Disequilibrium: The Role of Capital in a

Capital in Disequilibrium

Capital in DisequilibriumThe Role of Capital in a Changing World

Second Edition

Ludwigvon MieIntituteA U B U R N A L A B A M A

Copyright copy 2011 by the Ludwig von Mises Institute

Published under the Creative Commons Aribution License 30httpcreativecommonsorglicensesby30

Ludwig von Mises Institute518 West Magnolia AvenueAuburn Alabama 36832

Ph (334) 844-2500Fax (334) 844-2583

misesorg

10 9 8 7 6 5 4 3 2 1

ISBN 978-1-61016-239-5

Contents

Acknowledgments vii

Preface to the Second Edition xi

1 Introduction and Outline 1

Part I Baground Equilibrium and Change

2 What Does Equilibrium Mean A Discussion in the Context ofModern Austrian Ideas 15

3 Equilibrium and Expectations Re-Examined A DifferentPerspective 31

Part II Capital Interest and Profits

4 Capital in Historical Perspective 51

5 Modern Capital eory 79

6 e Hicksian Marriage of Capital and Time 93

7 e Nature of Interest and Profits 109

Part III Capital in a Dynamic World

8 Modern Mengerian Capital eory 125

9 Capital and Business Organizations 147

10 Organizations Money and Calculation 177

11 Human Capital 193

12 Human Capital the Nature of Knowledge and the Value ofKnowledge 225

Conclusion 237

Bibliography 243

Index 259

Acknowledgments

I owe a large intellectual debt to two remarkable and very differentteachers

e spark of interest of which this book is the culmination wasignited when as an undergraduate (in 1968) I took a course in capitaltheory from my teacher Ludwig Lachmann at the University of theWitwatersrand in Johannesburg South Africa Lachmannrsquos ideas haveinfluenced the writing of almost every page of this work From himI learned at a young and impressionable age to think critically aboutthe implications of time for human action From him I inherited anenduring fascination with the questions posed by capital theory a fas-cination enhanced by the very complexity of the subject I suspect thatit would not have troubled him in the least that his student presumedto differ from him in some ways and to extend his approach into novelareas on the contrary I imagine he would have been quite pleased Inparticular Lachmannrsquos influence as an economist was limited by theabsence of concrete or practical implications of his work Yet as I havetried to show his general insights have specific applications in theareas of the theory of the firm in human capital and many other areas

Professor Lachmann in addition to providing a crucial componentof my education helped me in other ways at the beginning of myprofessional career He was always considerate and respectful of hisstudents and his memory inspires and sustains me

I am indebted in a less personal but nevertheless important wayto Gary Becker Professor Becker was my PhD thesis commiee chair-man and my teacher for a number of graduate courses e opportu-nity to study with him was of inestimable value to me in my trainingas an economist and more particularly in gaining an appreciation ofthe importance of human capital (and related subject areas like theeconomics of the family) His influence will be particularly apparentin the chapters that deal with human capital

viii CAPITAL IN DISEQUILIBRIUM

is work then has been in the pipeline for many years dur-ing which time I have benefited from talking to many individuals Icannot hope to recall them all at least not without engaging in aninappropriate exercise of intellectual autobiography However theyinclude Karl Miermaier Landis Gabel Sam Weston Bob FormainiRoger Garrison Richard Ebeling Don Lavoie and Karen Vaughn Ihave benefited from comments on presentations at the Colloquium onAustrian economics at New York University most notably from com-ments by Mario Rizzo Israel Kirzner Peter Boeke Joe Salerno BillButos Roger Koppl David Harper Don Boudreaux Frederic Sautetand Sanford Ikeda I also benefited from comments received at pre-sentations at the Southern Economic Association and the History ofEconomics Association meetings Larry White provided very usefulcomments

I am very grateful to Steven Horwitz who read the entire manu-script of an early version and provided numerous stylistic and substan-tive corrections

is book would not have been wrien without the efforts andencouragement of Mario Rizzo It was he who first suggested it andprovided important directional indicators In addition his work inAustrian economics has been an important source of inspiration forme and has helped me to gain greater insight into and appreciation ofmany of the themes that appear in the pages that follow

In the years since the first edition of this book I have benefited fromtoomany individuals to name My coauthor Howard Baetjer cannot gounmentioned however His work on capital and knowledge is crucialto my current understanding of the subject For editorial assistance atthe Mises Institute I thank Jeffrey Tucker and Paul Foley

I need hardly add that none of the individuals mentioned above isto be implicated in any of the errors that may be found in this workespecially where they are the result of my stubborn refusal to followtheir advice

In addition to colleagues and teachers I have been fortunate tohave had the support of friends and family without which I could nothave found the time and resolve to complete this work My parentsMerle and Herman Lewin have been a constant source of support andhave stood by me in my obstinate determination to follow the calling

ACKNOWLEDGMENTS ix

of academe Tomy father-in-law Felix Shapiro alsomy constant friendand admirer I owe more than I can say And finally and mostly myfamily my children Dan Andy Shiralee and Gabbi each in their ownway has helped me in this ldquostrangerdquo project (as they must see it) andmy wife Beverley my partner in life who has struggled valiantly toidentify with her husbandrsquos determination to complete this weird time-and energy-consuming project

Preface to the Second Edition

It has been twelve years since the original publication of this bookin 1999 Much has happened in the intervening years to affect itsrelevance

In the world of economic policy the relevance of (Austrian type)capital theory has increased dramatically e appeal of what LudwigLachmann referred to as ldquoneoclassical formalismrdquo has not diminishedPolicy-makers following the counsel of their economic advisors whoare ruled by a belief in the significance of economic aggregates havepersistently ignored indeed precipitated capital structure distortionsthe results of which have been two major domestic economic crises(the dot-com bust and the housing-bubble meltdown) a global creditcrisis a chronic fiscal deficit and an exploding debt burden that threat-ens to destroy the very fabric of the economyrsquos value-creating poten-tial is book is designed for those who wish to understand in athorough and fundamental way the nature and significance of capitalWhat makes an economy ldquocapitalistrdquo How does value get created overtime If we get this wrong we may end up paying a high price indeed

e erroneous ideas upon which disastrous economic policy hasbeen based have come down from the intellectual forebears of thecurrent generation of economic advisors A full appreciation of thisentails understanding the nature of bales fought long ago over thenature and significance of capital and capital theory Accordingly thefocus of this book on this particular aspect of the history of economicthought remains very relevant

In the world of economic theory though the majority of the eco-nomics profession remains oblivious of and contemptuous of any-thing outside of its narrow quantitative orientation and indeed hasbecome even more finely specialized and technically esoteric so thatits members knowmore and more about less and less over time on thegrowing fringes of the profession a number of ldquoheterodoxrdquo approaches

xii CAPITAL IN DISEQUILIBRIUM

have prospered and are growing One of these heterodox approachesis that of Austrian economics which has continued to gain adherentsincluding from young energetic graduates who are beginning to maketheir marks I hope that the re-publication of this book in a moreaccessible form will serve to encourage this development and providea firm foundation for the diverse applications of capital theory that arenow becoming evident

One area in which such applications have been growing apace isthat of management and business studies particularly in the areasof strategic-management organization studies and entrepreneurshipeAustrian ideas most relevant to this line of research concern the na-ture of resources and how they can be organized in productive combi-nations to produce value e ldquocapital-naturerdquo of productive resourceshas pointed in the direction of the Austrians ough long interestedin Schumpeter scholars in this area have recently enthusiastically em-braced the ideas of Hayek Kirzner and most recently Lachmann Inparticular understanding resources as capital has led to an apprecia-tion of the importance of time and knowledge in productive processesand of social institutionsmdashconnected themes examined below espe-cially in Chapter 9 is literature stream has grown rapidly since1999 An indication of some of this work and its connection to thework below can be found in Lewin and Baetjer (2011)

is book is about capital in a disequilibrium world a dynamicworld In the years since its first publication the world in whichwe livehas become even more dynamic e pace of change has acceleratede ldquodigital-agerdquo works its magic every day in the form of new prod-ucts new organizations new production techniques new modes ofcommunication and who knows what else is increased dynamismhas enhanced the relevance of the capital-based framework developedin this book One shortcoming that is glaringly obvious to me nowin retrospect is the insufficient aention paid to an understandingof capital as a form of ldquoembodied knowledgerdquo as first developed byHoward Baetjer to whose work I enthusiastically refer the interestedreader (Baetjer 1998 2000 Lewin and Baetjer 2011)

I have made very few changes to the original text I have addedsome references to work published since the first edition I have addedsome explanatory footnotes and deleted some others (deemed obsolete

PREFACE TO THE SECOND EDITION xiii

or unnecessary) and I have taken the opportunity to make a few stylis-tic improvements One major advantage of the new edition is that thefootnotes are now found below the text rather than at the back of thebook

Peter LewinDallas June 2011

CHAPTER 1

Introduction and Outline

ldquoCase Studyrdquo

is book is the result of a capital project a production plan Moreaccurately it is the final product of a series of related intertemporalplans and is the intermediate product of some higher level plans isstructure of plans encompasses both my own particular plans and theplans of others like the publisher and the editors As I write this itis still too early to say whether the project is to be judged a successby me or the other planners But whatever the final judgment theplanning process is illustrative of the ingredients of capital planningin general

I am writing this introduction having already completed (at least afirst dra o) the rest of the book save for the conclusion is meansthat you the reader are going to read the introduction and the restof the book to which it refers in reverse order from the way in whichthey were wrien e reason for this is obvious I could not havewrien the introduction first or at least not most of it with all thedetails and the outline to follow because I did not know what I wasgoing to write in the book To be sure I did have a general idea ofthe chapter layout and the points that I wanted to establish in eachchapter but I was unable to imagine in any kind of detail the wordsand sentences that would eventually fill the pages is is in partdue to the fact that the writing was a kind of learning experience akind of spontaneous unfolding of ideas that depend sequentially onone another a kind of ldquolearning by doingrdquo And in part this was alsobecause of the occurrence of events that could not be anticipated inany detail I shall argue that all planning is like this to some degreeBecause of the way that we experience time plans are necessarily

2 CAPITAL IN DISEQUILIBRIUM

incompletely specified (We may say that planning for production isan rdquoemergentrdquo process)

Nevertheless my inability to completely visualize the unfoldingof my production plan which depended in part on the fulfillment ofthe plans of others and influenced the plans of still others will notin itself prevent its fulfillment It is not necessary that every aspectof the plan turn out as expected especially as there are many aspectsthat could not be expected But some thingsmust turn out as expectedAmong these are the crucial actions of mine and others which conformto certain preconceived or tacitly held notions of how people do andwill behave in certain types of circumstances is plan like any otherthat is to have a chance of success proceeded within an institutionalframework of shared ldquoways of doing thingsrdquo

is book the product of a capital project is the result of ldquoteamproductionrdquo I did the writing my editor did the guiding and the nudg-ing and the publisher did a number of things including overseeingthe whole project providing the necessary financial capital and equip-ment and the support staff is ldquoteamrdquo transcends the boundaries ofthe ldquofirmrdquo In a sense there are a number of ldquofirmsrdquo involved myselfthe editor the publisher the publisherrsquos suppliers and customers andso on We are all part of a grand matrix of organizations some ofwhose employees are part of the ldquoteamrdquo So the book is in realitya team product Each memberrsquos contribution helped to facilitate itsproduction e value of the final product is thus causally aributableto these efforts and therefore the value of these joint efforts can beimputed from a knowledge of the value of the product

Team production has to be coordinated and in order to facilitatethis coordination efficiently it may be argued that the members of theteam should receive the full value of their marginal contribution to theproduct is turns out to be quite problematic especially when theextent or the value of the contribution of any team member is whollyor partially indeterminate (difficult or impossible to measure) But asa practical maer the existence of certain types of organizations andinstitutionsmdashlike a firm that specializes in publishing and a marketeconomy where contracts and promises are made and honored and areexpected to be honored and in which money is used and understood

INTRODUCTION AND OUTLINE 3

so that decision-makers can aribute a value to the efforts of the teammembers even though there may be a large element of indeterminacysurrounding each onersquos contributionmdashhelps to facilitate the necessarycoordination

So capitalistic production is about more than the existence of capi-tal goods It involves in addition the social and institutional frameworkthat I have mentioned and the human capital of the individual teammembers

ese are also indispensable parts of the capital structure and thusof the value of any project It is true for example that my priorconscious investments in human capital (generally in learning to readand write and more specifically in the studying of economics) helpedto equip me for the task of writing this book ldquoKnowledge capitalrdquo is acrucial part of capital in general (For a discussion of the relationshipbetween knowledge and capital see Lewin and Baetjer 2011)

In this ldquocase studyrdquo I anticipate some of the themes that I shallexamine in this book

bull e complexity of plans and the inevitable existence of disequi-librium does not imply the failure of all plans or of all aspectsof plans Production occurs in a changing world but this canonly happen if some aspects of that world are relatively stableand ordered

bull Capital is more than an array of capital equipment and involvesan understanding of how value gets created by a combinationof human and physical resources over time in an organizationalstructure that facilitates that creation

bull Organizational form routines habits rules norms and moresare thus part of the social capital of any society And the knowl-edge of its members is part of its human capital And both arepart of its capital structure

bull Any social policy that involves regulating or substituting forthese largely spontaneous value-creating structures should at thevery least be aware of the complexity of this all-encompassingcapital structure

Some more detail is provided in the rest of this chapter

A Disequilibrium Approa to Capital

Most students of economics encounter the theory of capital as part ofa theory of finance andor project evaluation When considering thequestion of how to measure (known or estimated) values that occurat different points in time they get introduced to the arithmetic ofpresent values And while the notion of present value can be elabo-rated and dissected in many subtle ways its basics derive from somevery straightforward intuitive ideas It is surprising then to findthat capital theory is regarded as a particularly esoteric and largelyirrelevant part of economics

Obviously although present-value arithmetic is an important partof an understanding of capital it is only a part of that understandingIt is the other parts that have been regarded as obscure and irrelevantAlthough capital theory may be difficult it is hard to see that it couldjustifiably be judged as irrelevant Aer all the market economiesof the world are oen referred to as ldquocapitalistrdquo economies Surely agood understanding of the meaning and significance of the ldquocapitalrdquo inldquocapitalistrdquo is of some importance for history and for policy If capitalis that phenomenon that makes market economies different ought wenot to accord it a prominent place in the education of an economist

As will become clear from the discussion below (Chapter 4) muchof the reluctance of economists to deal with the theory of capital isa result of the historical context in which it was developed e his-tory of thought in capital theory contains volumes of discussion onintricate technical and sometimes philosophical issues that moderneconomists have come to think they can do quite well without isimpression was strongly reinforced by the Keynesian revolution andKeynesrsquos summary dismissal of capital theory as irrelevant Even withthe emergence of a more critical approach to Keynesian macroeco-nomics this habit of ignoring the deeper issues that a consideration ofthe nature of capital invites was not broken Capital theory is widely(if tacitly) regarded as a topic in the history of economic thought

is book is an aempt to reawaken to some extent an interestin the kind of issues that emerged in the historical capital theorydiscussions While it cannot be denied that much of those discus-sions meandered into areas of dubious relevance to the functioning

of modern capitalist economies it also remains true that many of theissues emerged and continue to emerge from any careful considerationof the nature and significance of capital A good understanding ofthese issues would hopefully enhance our ability to talk intelligentlyabout our economies and to make wise policy

e history of capital theory contains relevant lessons and I ex-amine this history in an aempt to understand it and to free capitaltheory from it in the sense that its significance will be seen to extendfar beyond the concerns to be found in those historical discussionsose concerns it seems to me are largely the result of a particularapproach to capital theory a particular mindset which we may callan equilibrium approach Dating at least from Ricardo economistshave become accustomed to thinking about economic concepts in thecontext of a world in which individual plans largely dovetailed isenabled them to build grand systems in which economic aggregates in-cluding capital (the value of capital for the economy as a whole) madeperfect sense Even with the advent of the marginalist revolution andthe related discovery of subjective utility the assumption of equilib-rium enabled the construction of logically consistent and contextuallymeaningful aggregates like national income wealth and capital

e debates in capital theory thus took it for granted that it was rel-evant to discuss such things as the correct way to measure the capitalstock theoretically So while some (like Boumlhm-Bawerk) tried to arguefor a simple logical formula involving production time (although as weshall see this was only a small part of his theory) others (like Clark andKnight) tried to finesse or banish the problem (of how capital shouldbe valued) by assuming that the market ldquotakes care of itrdquo by assuringthat the multitude of heterogeneous capital items in existence are allsomehow consistently and spontaneously integrated into the largepermanent organic network of production which had no beginningor end ese laer theorists thus wondered about the meaning andrelevance of ldquoproduction timerdquo and quite predictably the discussionprogressed into the realm of metaphysics

In a world in which individual plans may embody disparate viewsof that world which the unfolding of time would put to the test asis the case in the real world the value of capital has no objectivemeaning Yet capital evaluation is performed all the time and is a

crucial and indispensable part of the market process One might dowell therefore to abandon any search for the appropriate method tomeasure economic aggregates like the capital stock and focus insteadon understanding how the process of capital valuation actually func-tions as part of the market process as a whole is is the approachtaken in this book

Capital as Value

Physical analogies featured heavily in the capital theory debates isprobably reflects not only the difficulty of the subject in which analo-gies based on familiar physical processes helped to simplify but alsothe natural tendency to think about production as a physical processProduction aer all (oen) involves the physical transformation ofmaer from one form into a more useful one And since these physicalprocesses were seen to be involved it was but a small step to seeingthem as the essence of the process Yet I shall argue these engineeringaspects of production are among the least important for an understand-ing of the social significance of capital Production technologies existwithin a social framework It is the value that is placed on these tech-nologies under different circumstances that needs to be explainedIndeed the evaluation of technologies is also a large part of the storyof their discovery and adoption

We see capital as an aspect of wealth the result of the creation ofvalue Value is created in the context of trade (except in the unlikely in-stance of completely autarkic production ldquotrading with naturerdquo) Andtrade occurs in an institutional context Instead of focusing on themeaning and measurement of capital as an aggregate category weshall focus on the individual capital evaluation decision From theperspective of the individual capital value is the perceived value ofa particular production plan or set of plans We examine thereforethe logic of this individual evaluation where we find the arithmeticof present value to be indispensable and we examine the institutionalcontext in which these evaluations and the decisions to which theylead occur

Out of these individual decisions emerge the results of the marketprocess And these results are most oen at some variance with the

imagined and expected results of the planners whose combined andinteracting actions gave rise to them ese planners thus experiencecapital gains and losses that is revisions to the capital evaluationsembodied in original plans ese capital gains and losses are a crucialpart of the market process ey are indispensable guides to ongoingdecision-making in a changing world It is thus startling to recallthat capital gains and losses were taken out of capital theory in thetraditional approaches to capital is is related to the banishment ofprofit in the same context It is a context of the banishment of changee absence of changemeans nomore (and no less) than the coincidingof the expected with the actual and this must mean that everyoneplans on the basis of accurate and consistent expectations So if we areto understandwhy profits are earned wemust understandwhy peoplemake capital gainsmdashwhy some people are able to evaluate combina-tions of productive resourcesmdashcapital combinationsmdashmore accuratelythan others according to their judgment of the market at is wemust recognize the existence and importance of different individualevaluations even of the same things Capitalist economies are chang-ing economies How do they cope with change

Outline

emain body of this book is divided into three parts Part I consistingof two chapters examines the concept of equilibrium and its relation-ship to change Chapter 2 investigates the concept of equilibrium in thecontext of the enduring debate in modern Austrian economics aboutthe presence or absence of equilibrating tendencies is exercise inthe ldquohistory of thoughtrdquo has relevance beyond Austrian circles how-ever as the issues involved are intrinsic to the subject For exampleit is at the heart of much of the debate in macroeconomics betweenthe English Keynesians (see for example Kaldor 198560ff) and theAmerican neoclassicals What is at stake are the implications of thefact that different individuals have different and oen inconsistentexpectations Is there a tendency for these expectations to becomemore consistent over time as a result of the market process If yeswhat does this mean If no does this maer How do individualsmake decisions on the basis of inconsistent plans e inescapable and

troubling ldquoloose endsrdquo of mainstream economics are nicely brought outin this debate particularly in the insightful analysis of Israel KirznerIf we want to assume that markets are either in or are in the processof approaching equilibrium ought we not to be able to explain howthey get into equilibrium or are able to approach it

In Chapter 3 I suggest that it is the adoption of an insufficientlyexamined concept of equilibrium that is behind the apparent impassethat this and related debates have reached Specifically if equilibriumis defined along with Hayek as a situation in which individual plansare mutually consistent (and realistic) then a closer examination ofthe way in which individuals plan will reveal that economies are atany time both in and out of equilibrium and are tending toward andaway from equilibrium at the same time is paradoxical conclusionis the result of a semantical sleight of hand e Hayekian definition ofequilibrium does not examine the limits and dimensions of the individ-ual plans that feature in it Once we realize that individual plans areof necessity based on different types of knowledge are incomplete incrucial respects and are multidimensional in nature we realize thatsome aspects or plans are and must be highly or even completelyconsistent while at the same time other aspects of plans are (andmust be if we are to have the kind of change necessary for dynamicmarket processes) inconsistent And we shall see that equilibrium inrelation to some aspects or levels of plans is a necessary condition forthe toleration of disequilibrium in others the levels at which innova-tion occurs e insights derived in this chapter provide a necessarygeneral backdrop for the consideration of capital evaluation and thedecisions towhich they give rise in a changing economy which occupythe rest of the book

Part II Chapters 4 through 7 consists of investigations into thenature of capital and the related concepts of interest and profits eseconcepts cannot be adequately considered apart from their develop-ment in the history of economic thought Chapter 4 is an impression-istic historical outline of the development of the concept of capital Itis suggestive rather than accurate or complete I examine the ldquomodelrdquooffered by Adam Smith in the Wealth of Nations as a prototype ldquocorneconomyrdquo an agrarian economy devoid of disruptive innovation inproductive methods In this corn economy capital is a homogeneous

circulating fund (Adam Smithrsquos contributions to the notion of thedivision of labor will occupy us later in a different context) When wemove from Smithrsquos world to the world of Ricardorsquos Principles we findthat things are not so simple Ricardo strove valiantly to apply Smithrsquosinsights and method to a world in which much of the productive equip-ment was in the form of heterogeneous ldquomachineryrdquo He salvagedhomogeneity by banishing considerations of change by focusing onthe conditions of the ldquolong-runrdquo stationary state ose who followedRicardo thus came to see this long-run equilibrium not only as thecondition toward which the economy was always moving but also asa sort of essential reality that characterized the market system belowthe surface reality of which our senses may at any time be aware

In this sense all modern-day theorists who work in terms of sta-tionary or steady-state economics are ldquoRicardiansrdquo eir approach isto be contrasted with that of Carl Menger who while also followingAdam Smith in some respects offered a different vision of the econ-omy and of the process of production For Menger production wascharacterized by a time structure of production that was the resultof individual intertemporal planning ere is no suggestion that theeconomy is in a stationary-state equilibrium

ese two approaches exist in uneasy combination in the work ofperhaps themost famous capital theorist in economics Eugen von Boumlhm-Bawerk ough a disciple of Mengerrsquos Boumlhm-Bawerkrsquos work hasbeen adopted by neoclassicals neo-Ricardians and Austrians alike asembodying their particular approaches We thus examine how it isthat these apparently conflicting visions could coexist in the work ofthe same theorist From Boumlhm-Bawerkrsquos work we will learn a greatdeal about the ways in which time is seen to be involved in the processof production In particular his assertion that the essence of capitalistproduction is the adoption of increasingly ldquoroundaboutrdquo methods willbe seen to be of enduring relevance

One way of reading Boumlhm-Bawerk can be seen to be consistentwith the modern ldquoproduction functionrdquo approach to capital is is ex-amined in Chapter 5 e production function story rests on some par-ticular assumptions production is an unvarying input-output schemein which both inputs and outputs are unambiguous aggregate valuese logic of the production function approach is informative and yields

some important insights into the meaning of constant returns to scalediminishing returns and technological change It has also recently fo-cused aention on the important phenomenon of endogenous changeBut these insights come only by straining to the limit the boundswithin which the production function makes any sense

e debate between the Cambridges in the 1950s 1960s and 1970sfeatured the English neo-Ricardians against the American neoclassi-cals Taking the production function approach to be definitive of pro-duction economics the neo-Ricardians relentlessly picked at its logicallimits in an effort to discredit it and seem to have been largely success-ful in this But what they gained in logical consistency they arguablylost in relevance Both the Cambridges implicitly assumed a Ricardianequilibrium world in which the ldquorate of profitrdquo was uniformly equalto the rate of interest From the perspective of a technologically dy-namic market economy both approaches would appear to be largelyirrelevant

John Hicks was a penetrating thinker an economist who helpedto guide his colleagues through the difficult issues of the day He didconsiderablework on the theory of capital over his long and productivecareer and although his work as a whole defies easy categorizationhe had an abiding sympathy for the Austrian approach as exemplifiedparticularly by Carl Menger In Chapter 6 I examine his last full lengthwork on capital theory (Hicks 1973b) which he called a neo-Austrianapproach In it we shall find a convenient expression of the type ofevaluation arithmetic facilitated by a money-using market economyAlthough we cannot follow Hicks into his world of social accountingwe shall find much that is useful in his insights

In the development of capital theory various approaches to thecharacterization of profits and interest have emerged In Chapter 7I briefly review this and give prominence to one particular approachthe ldquopure time preference theoryrdquo (PTPT) of interest emost notableaspect of this view is the careful separation of the concepts of profitand interest e former is seen to be the result of changes in the valueof capital combinations in a world of change and uncertainty whilethe laer is an expression of time preference While time preferenceis indeed (and contrary to some approaches) to be seen as an expres-sion of individualsrsquo feelings of uncertainty it is to be very carefully

distinguished from the concept of profit Although they may be dif-ficult to disentangle in practice profit rent and interest are separateand distinct concepts

In Part III Chapters 8 through 12 I turn to an examination of capi-tal in a dynamic world In Chapter 8 we look at a Mengerian approachto capital theory We take Hayek to be the modern pioneer in hiswritings in the 1930s culminating in his Pure eory of Capital (1941)e Pureeory in itself is not a work about capital in a changingworldbut it points in that direction In particular in his extended analysisof the so-called problem of ldquoimputationrdquo Hayek raises questions ofrelevance to such a changing world Ludwig Lachmannrsquos work oncapital theory may be seen as picking up Hayekrsquos cue Lachmannconsciously adopts a disequilibrium framework to re-examine whathe takes to be the valid insights of Boumlhm-Bawerk He ends up witha fascinating synthesis of Adam Smith and Boumlhm-Bawerk one thatsees in the growing complexity of modern productive structures a rep-resentation of Boumlhm-Bawerkrsquos increasingly roundabout methods ofproduction and Adam Smithrsquos division of labor

As mentioned above capital evaluation decisions occur within aninstitutional-organizational framework In Chapter 9 I explore the linkbetween capital structures (narrowly understood) and organizationalstructures e original pioneering work of G B Richardson and EdithPenrose is seen to have much in common with Lachmannrsquos Mengerianapproach and from this a link is forged to some later work in theareas of production and organizations In Chapter 10 this is seen tobe relevant to the work of Mises and others on the question of capitalcalculation in market economies

In Chapter 11 I turn to an examination of human capital ehuman capital ldquorevolutionrdquo in economic theory sometimes seems tohave had more of an impact in adjacent fields like sociology and an-thropology than in economics itself It is true that the concept ofhuman capital has now permeated the mainstream in many areas forexample in growth theory in the theory of the firm and of coursein labor economics Its application to a consideration of the dynamicsof market economies has however been surprisingly limited In thischapter I aempt to draw out some implications along these lineswhilesummarizing some of the keynotes of the literature deriving primarily

from the work of Gary Becker T W Schultz and Jacob Mincer InChapter 12 I confront some subtle issues arising out of the specialnature of knowledge as a phenomenon that would seem to be relevantto human capital as a product In observing that knowledge is at oncefallible unfathomable and tacit we are drawn full circle back to adiscussion of equilibrium in a changing world

e book closes with a concluding chapter that summarizes thework and explores some implications for economic policy

PART I

BACKGROUNDEQUILIBRIUM AND CHANGE

is first part of this work consists of two chapters (2 and 3)1 InChapter 2 I summarize briefly some issues connected with the mean-ing and existence of equilibrium is controversial area has beenmade difficult by the fact that the term ldquoequilibriumrdquo is oen used inan inconsistent manner either by a single theorist in different placesand times or as between different theorists So I try first to clarifywhat is meant (or what should be meant) by equilibrium I adoptthe Hayekian definitionmdashthe mutual consistency of individual plansFrom this point of view I examine a current debate one that is specificto modern Austrian (market process) economics but is relevant to andin many ways reflective of economics in general is is the debateabout the presence or absence (and indeed meaning) of equilibratingtendencies in the economy e chief (friendly) protagonists in thisdiscussion are Ludwig Lachmann and Israel Kirzner e legacy ofthis debate is still with us

In Chapter 3 I turn to the question of what really is at stake hereI offer a different perspective a different approach to the question ofequilibrium If we say that the economy is always in disequilibriumbecause plans must be inconsistent to some degree then are we notundermining our ability to do economics to understand human actionin the economy Or is action possible and understandable in disequi-librium I shall contend that if we wish to adopt Hayekrsquos approach toequilibrium we must mean that we can act in a world where the plansthat motivate and define those actions are not mutually compatibleis is hardly controversial Aer all the market process features

1A shorter version of some of the material in this part appears in Lewin (1997c)

rivalrous actions that is actions that are part of mutually inconsistentplans Successful plans tend to displace unsuccessful ones But canwe therefore say that overall plans tend to become more consistentso that there is a lsquotendencyrsquo toward equilibrium Is this importantI shall answer both in the negative Furthermore I shall maintainthat capital accumulation and economic progress depend in a crucialway on the absence of equilibrium and in no way on our ability todiscern equilibrium tendencies More specifically I shall argue thatthe Hayekian definition requires too much Plans are complex mul-tilayered constructs Overall ldquoplan consistencyrdquo is therefore eitherimpossible or hopelessly imprecise I shall argue that at some levelsplans are and must be highly compatible while at other levels (as partof the market process for example) they are and if we are to haveeconomic progress they must be incompatible

e issues discussed in this part and the resolutions offered providean important backdrop for the consideration of capital in a dynamicworld

CHAPTER 2

What Does Equilibrium MeanA Discussion in the Context of

Modern Austrian Ideas

Equilibrium Examined and Defined

A term which has so many meanings that we never know whatits users are talking about should be either dropped from the vo-cabulary of the scholar or ldquopurifiedrdquo of confusing connotations

(Machlup 195843)

e continuing use of the word ldquoequilibriumrdquo by different people tomean different things justifies yet another brief examination No pre-tense however is made at completeness

I can think of at least seven different approaches to equilibriumese are not mutually exclusive and are indeed related in importantways

1 equilibrium as a balance of forces2 equilibrium as a state of rest (a stationary state)3 equilibrium as a state of uniform movement (a steady statemdashof

which 2 is a special case)4 equilibrium as a constrained maximum5 equilibrium as an optimum6 equilibrium as rational action7 equilibrium as a situation of consistent plans

In each case at least two dimensions can be identified Equilibrium canrelate to the entire economy (general equilibrium) or to a subset of theeconomy (partial equilibrium) or to the individual Equilibrium can beconsidered for a single all-encompassing period (static equilibrium) or

for a succession of self-contained periods (temporary equilibrium) orfor a succession of related sub-periods (intertemporal equilibrium)

Examining this further we note that equilibrium as a balance offorces (as the word implies)1 in some sense is at the base of all otherequilibrium concepts And if ldquochangerdquo (and its absence) is definedappropriately definitions 1 and 2 are seen to be equivalent So forexample the traditional supply and demand equilibrium is a balance offorces that acts to keep prices stable (at rest) In the case of the priceof an asset we may say that if the price is stable the bulls balance thebears2 In the case of a perishable good those forces (whatever theyare technology price expectations etc) which tend to influence theamounts offered for sale and purchase at various prices in a way thattends to push the price up are balanced by those that tend to push itdown is is one way to think of stable prices If neither supply nordemand change price (once in equilibrium) will not change It is alsoan optimum (definition 5) of sorts in the well-understood sense thatgiven the fundamental conditions of supply and demand buyers andsellers are doing the best they can From another perspective it is a

1Interestingly e New Shorter Oxford English Dictionary offers a number of defi-nitions

1 A well balanced state of mind or feeling 2 A condition of balancebetween opposing physical forces 3 A state in which the influencesor processes towhich a thing is subject cancel one another and produceno overall change or variation Econ A situation in which supplyand demand are matched and prices stable

Although 2 and 3 are probably the most intuitive colloquially 1 comes closest to ourusage as we shall see

2 [e market] cannot make bulls and bears change their expectationsbut it nevertheless can coordinate these To coordinate bullish andbearish expectations is the economic function of the Stock Ex-change and of asset markets in general is is achieved because insuch markets the price will move until the whole market is dividedinto equal halves of bulls and bears In this way divergent expecta-tions are cast into a coherent paern and a measure of coordinationis accomplished asset markets are inherently lsquorestlessrsquo and equilib-rium prices established in them reflect nothing but the daily balance ofexpectations (Lachmann 1976b237ndash238 italics added)

Clearly Lachmann is here using the term ldquocoordinationrdquo in a rather limited sense andin no way to suggest a rendering of expectations compatible

WHAT DOES EQUILIBRIUM MEAN 17

constrained maximum (definition 4) in that buyers and sellers maximizethe perceived opportunities to buy and sell and thereby achieve a max-imum of ldquosatisfactionrdquo as determined by their preferences in relation tothe (perceived) opportunities It may not be an optimum however ifthere are opportunities of which the economic agents are unaware (seeKirzner 1990) or if their actions affect opportunities in other marketsadversely Also it is possible to see how momentary equilibrium can begeneralized to a situation of uniform change (definition 3)mdashfor examplewhere demand and supply increase proportionately

So while in an appropriate sense equilibrium as a balance of forcesis also a state of rest (or a situation of uniform change) and a constrainedmaximum it may not be an optimum Also in each case it is possible toconceive of situations that are not in equilibrium Some theorists havefound it helpful however to define the constraints so broadly as to con-ceive of individuals as being always in equilibrium (see Shmanske 1994)So again using the example of simple supply and demand a situation ofnon-price rationing not allowing the price to rise and clear the marketcan be seen as an equilibrium situation if we include in all individual de-cisions the costs imposed by rationingmdashlike waiting in line Indeed us-ing this approach one may predict that the lines at the checkout counterof a supermarket would tend to an ldquoequilibriumrdquo size that equalizes wait-ing time us the supply curve becomes vertical at the fixed price belowthe market-clearing price In effect the money price has been reducedbut the real price (includingwaiting cost) has gone up because of a ldquoshirdquoin the supply curve to the le (from an upward slope to a vertical one)So demand always equals supply if we are careful to include all relevantfactors3 While it is clear that this approach may prove enlighteningin some cases when extended to the level of all agents for the entireeconomy it can involve disturbing and paradoxical implications usconsidering all possible costs and benefits the world is at all times ina Pareto optimal equilibrium a Panglosian ldquobest of all possible worldsrdquogiven the relevant constraints ings are what they are because we un-derstand how individuals had to act the way they acted in order to max-

3Becker (and others using the lsquoChicago approachrsquo) have used this type of reasoningto explain regulation-busting behavior (bribes black markets etc) where individualsare seen as weighing all of the costs and benefits involved in violating regulations etc(Becker 1971106ff)

imize given the constraints that existed and were perceived by them(again see Shmanske 1994 for a complete discussion) is approachuses equilibrium to characterize rational action (definition 6) where ldquora-tionalrdquo is understood to refer to the system as a whole and not just toindividuals For normative (policy) purposes this is obviously not veryhelpful e policy-maker is aer all subject to the same universallyperceived constraints We shall see that the difficulty arises because ofthe lack of a distinction between individual and system equilibrium

In a lecture delivered in 1936 Hayek defined equilibrium as a situa-tion in which ldquothe different plans which the individuals composing [asociety] have made for action in time are mutually compatiblerdquo (Hayek1937b41) is is my definition 7 As this is the definition that weshall adopt in the rest of this work it is worth examining in somedetail An important aspect is the move away from the purely physicaldimensions of equilibrium as a state of rest or balance of forces to onefirmly based in the human mind Equilibrium is here conceived asa situation in which individual knowledge and expectations and theactions based on these are compatible with the ldquodatardquo where the ldquodatardquofor one individual include the actions of other individuals Scratchingthe surface of any of the definitions offered above indeed reveals that itis impossible to think of equilibrium in economics without bringing inthe perceptions of individuals Aer all we are dealing with human ac-tions and these are determined by the perceptions of the actors So inthe case of the supply and demand of a single well-defined market forexample the price will not be observed to change when all individualsare fulfilling their mutually related plans to buy and sell and wheresuch plans are not fulfilled we may expect these plans to be revised4

evolitional intentional aspect of equilibrium is likewise obviousin all of the other approaches is is widely recognized although in

4It is possible to conceive of a situation of ldquostatisticalrdquo equilibrium where mutuallyoffseing individual errors are such as to leave the price unchanged In such a situa-tion although individual plans are not mutually compatible we have equilibrium as akind of balance of forces Individuals are right ldquoon averagerdquo Hayek discusses this casein passing (Hayek 1937b43n) In a way this anticipates aspects of the rational expecta-tions literature developed since the 1970s As we shall be concerned with equilibriumin terms of its implications for individual perceptions we shall not consider this casein any more detail A sufficient though not necessary condition for price stability inthe partial equilibrium static (non-growth) case is the compatibility of plans to buyand sell

the formal technical treatments of modern economics one is oen aptto lose sight of it as for example in the case of neo-Ricardian capitaltheory and general equilibrium theory ere is no doubt howeverthat Hayekrsquos insights have been accepted in principle and have beenvariously endorsed by a number of eminent neoclassical economistsFor example

[Equilibrium refers to] those states in which the intended ac-tions of rational economic agents are mutually consistent andcan therefore be implemented (Hahn 198444)

[Equilibrium is a] state where no economic agents have an in-centive to change their behavior the equality of demand andsupply should not be taken as a definition of equilibrium butrather as a consequence following from more primitive behav-ioral postulates (Stiglitz 198728)

us we shall say that an equilibrium situation is one in which individ-ual plans are fully coordinated Each plan can be successfully executedMeans are exactly matched to ends

Implications of Equilibrium

It will be immediately apparent that equilibrium thus defined is an ex-tremely unlikely event It is patently unrealistic One might wonder atits widespread acceptance as a standard of reference is raises the im-portant question of the function of equilibrium constructs in economictheory Obviously theoretical constructs are to a greater or lesserextent unrealistic ey all abstract from reality in order to illuminateit For example one common use to which equilibrium constructsare put is the tracing of the (ultimate) consequences of any changewhile imagining all other possible relevant changes to be absent Inthis way a general idea of cause and effect can be built up by isolat-ing the effects of different causes5 e crucial question is what are

5Machlup identifies four basic steps in equilibrium analysis

1 Initial positionmdasheverything could go on as it is2 A disequilibrating change3 Adjusting changes4 Final positionmdashnew equilibrium

Comparing 4 with 1 establishes causendasheffect (see the discussion inMachlup 195847ff)

permissible abstractions and what abstractions render a theoreticalconstruct useless When is the usefulness of the model compromisedso that its results (the causendasheffect connections that it suggests) are nolonger reliable guides to reality is is an involved question that weshall not be able to answer here in any detail I shall contend howeverand hopefully motivate in the course of our discussion that theoreticalconstructs that abstract completely from the implications for humanaction of the passage of time and its implications for changes in knowl-edge are not likely to be very helpful in understanding economic pro-cesses While it is true that equilibrium ldquois in the model and not in theworldrdquo6 I want to build a bridge between the ldquomodelrdquo and the ldquoworldrdquoand maintain that timeless models cannot do this7 is is most clearlyseen in discussing the stability of equilibrium

Before turning to this however we should pause to note someother aspects of equilibrium understood as themutual compatibility ofindividual plans including the relationship between micro and macroequilibrium or between individual and system equilibrium8 Hayekmakes an important distinction between these

I have long felt that the concept of equilibrium itself and themethods which we employ in pure analysis have a clear mean-ing only when confined to the analysis of the action of a singleperson and that we are really passing into a different sphere andsilently introducing a new element of altogether different char-acter when we apply it to the explanation of the interactions ofa number of different individuals (Hayek 1937b35)

It is from a careful consideration of the meaning of individual equilib-rium that a number of implications for our understanding of systemequilibrium emerge First Hayek argues that the ldquotautological proposi-tions of pure equilibrium analysisrdquo are not directly applicable to the ex-planation of social relations Examining individual equilibrium shows

6is phrase is from OrsquoDriscoll and Rizzo (199624) See generally Machlup (1958)7See also the discussions in Rizzo (1990 1992)8I will use this designation to distinguish in general a higher level than individual

equilibrium whether it be the entire economic system or a subsystem of it (for exam-ple an isolated market) As will become clear from the text the crucial distinctionis between equilibrium as it applies to an individual mind and as it applies to theinteraction between two or more minds

it to be equivalent to rational action ldquoWhat is relevant [however] isnot whether a person as such is or is not in equilibrium but which ofhis actions stand in equilibrium in so far as they can be understoodas part of one planrdquo (ibid36) Second the role of the individualsrsquoknowledge and therefore the knowledge of all individuals is of crucialimportance ldquoIt is important to remember that the so-called lsquodatarsquo fromwhich we set out in this sort of analysis are (apart from his tastes) allfacts given to the person in question the things as they are known to(or believed by) him to exist are not strictly speaking objective factsrdquo(ibid36) So it is quite conceivable and likely that in some respectsdifferent individualsrsquo ldquoknowledgerdquo of the same circumstance will benot only different but inconsistent And some types of knowledge arelikely to be more reliable guides to action than others

since equilibrium relations exist between the successive actionsof a person only in so far as they are part of the execution of thesame plan any change in the relevant knowledge of the personthat is any change which leads him to alter his plan disruptsthe equilibrium relations between his actions taken before andthose taken aer the change in his knowledge In other wordsthe equilibrium relationship comprises only his actions duringthe period in which his anticipations prove correct [And] sinceequilibrium is a relationship between actions and since the ac-tions of one person must necessarily take place successively intime it is obvious that the passage of time is essential to give theconcept of equilibrium any meaning

(ibid36ndash37 italics added)

So equilibrium is not only a relationship between individuals at a pointof time it is necessarily also a relationship between actions over timeFor equilibrium to exist during a period of time it must exist at everypoint of time within that period If equilibrium exists at a point of timethen individualsrsquo plans are consistent with each other and with thetechnical facts of the world such that each plan can be successfully im-plemented is means that in the absence of any change (meaning thearrival of new knowledge) equilibrium will exist at every point of timeis definition of equilibrium thus implies intertemporal equilibrium9

9See also (Hicks 196524)

A Tendency Towards Equilibrium

Hayek on Equilibrium Tendencies

In the history of the development of the equilibrium concept econo-mists have been concerned with certain basic properties that equi-libria may or may not exhibit e most basic is the question ofexistencemdashwhether or not an equilibrium can be shown logically toexist According to our definition this involves showing that a sit-uation exists (logically) such that all plans can be implemented Inthe voluminous mathematical literature on general equilibrium sucha proof was ultimately discovered but at the expense of the impo-sition of a set of heroic restrictions on knowledge preferences andtechnology It was also possible to show that under certain evenmore restrictive conditions such an equilibrium was unique (Ingraoand Israel 1990) It is clear however that the importance that theseproperties assumed is directly related to the formal technical mecha-nistic nature of the conception of equilibrium that tended to dominatethis literature (and still does) For Hayek equilibrium was never un-derstood as a state that could ever actually be said to exist althoughits logical existence is clearly implied He was more concerned withthe question of whether or not it could be shown or argued thata tendency toward equilibrium (ldquoa greater degree of plan coordina-tionrdquo) characterized the actual market process is is related to thequestions of stability andor convergence that themathematical econo-mists have been unable to answer satisfactorily10 But for Hayek(and those who followed his lead) it was not a theoretical maerAs this will be quite important I will quote at some length fromHayek

We shall not getmuch further here unless we ask for the reasonsfor our concern with the admiedly fictitious state of equilib-rium Whatever may occasionally have been said by overpureeconomists there seems to be no possible doubt that the onlyjustification for this is the supposed existence of a tendencytoward equilibrium It is only by this assertion that such atendency exists that economics ceases to be an exercise in purelogic and becomes an empirical science

10Once in equilibrium will the system remain there (stability) and starting fromany arbitrary point will it converge to equilibrium

In the light of our analysis of the meaning of a state ofequilibrium it should be easy to say what is the real content ofthe assertion that a tendency toward equilibrium exists It canhardly mean anything but that under certain conditions theknowledge and intentions of the different members of societyare supposed to comemore and more into agreement or thatthe expectations of the people and particularly of the entrepre-neurswill becomemore andmore correct In this form the asser-tion of the existence of a tendency toward equilibrium is clearlyan empirical proposition that is an assertion about what hap-pens in the real world And it gives our somewhat abstractstatement a rather plausible common-sense meaning e onlytrouble is that we are still prey much in the dark about (a) theconditions under which this tendency is supposed to exist and(b) the nature of the process by which individual knowledge ischanged (Hayek 1937b44ndash45)

is was a preoccupation of Hayekrsquos throughout his career even as hemoved beyond economics narrowly understood Whether or not hewas able to provide a satisfactory answer to items (a) and (b) in thequotation above is a maer of some debate (see for example Rizzo1990 1992 Lewin 1994)

Lamann versus Kirzner

e revival of the Austrian research program in its market processvariety since the 1970s has seen a return to this issue of equilibratingtendencies in a more energetic fashion In particular it has emergedas a defining issue within the Austrian School of economics in a waythat was clearly foreshadowed during some historical moments in June1974 in South Royalton Vermont at a conference marking the start ofthis revival (Dolan 1976) At that conference two papers in particularoutlined the two key perspectives that have appeared to be in conflictever sincemdashby Ludwig Lachmann and Israel Kirzner (Lachmann 1976aKirzner 1976) In these two papers (and some others by the sameauthors in the conference volume) we find a clear concise articulationof the issues11 Both Kirzner and Lachmann regard the market as a

11In particular Lachmannrsquos analysis of equilibrium appears in its most uncompro-mising version It is probably from here more than from any other time and placethat Lachmannrsquos reputation as a ldquoradical subjectivistrdquo gainedmomentum and has sincetended to dominate in evaluations of his work

process in time out of equilibrium Both regard the question of equi-librating tendencies to be problematic But for Kirzner the problem isresolved by the actions of the entrepreneur in noticing disequilibriumsituations and profiting by their removal thus providing a reason tobelieve in and an explanation of a tendency in markets towards equili-brium

e problem is most simply seen once again in the supply anddemand analysis of an isolated market As Kirzner remarks oen ourexplanations proceed no further than an identification of the market-clearing price at the intersection pointmdashldquoalmost implying that the onlypossible price is the market clearing pricerdquo Our common-sense expla-nations proceed in terms of familiar Walrasian equilibrating processesAt prices below market clearing there is an excess supply in the aggre-gate (unsold stocks) and this will tend to force prices down while theopposite is true for a situation of excess demand (unsatisfied buyers)ldquous we explain there will be a tendency for price to gravitate towardthe equilibrium levelrdquo We should note that it is implicitly assumedthat there is always only one price in the market ldquoOne uncomfort-able question then is whether we may assume that a single priceemerges before equilibrium is aained Surely a single price can bepostulated only as a result of the process of equilibration itselfrdquo Vari-ous explanations have been offered and devices suggested for dealingwith this problem including Marshallian adjustment processes andperfect competition none successfully e problem remains becauseldquodisequilibrium occurs precisely because market participants do notknow what the market-clearing price isrdquo (Kirzner 1976116ndash117)

is approach can be generalized to equilibrium in contexts otherthan the isolated market e problem of explaining convergence toequilibrium is a problem of explaining how individuals out of equilib-rium obtain the information necessary for them to have knowledge ofand incentives to make the appropriate adjustments In the processof developing the solution Kirzner reaffirms the Hayekian definitionof (dis)equilibrium ldquoDisequilibrium is a situation in which not allplans can be carried out together it reflects mistakes in the price in-formation on which individual plans were maderdquo (ibid118) It is theKirznerian entrepreneur who notices these mistakes and is able to takeadvantage of them Kirznerrsquos well-known and justly admired theory

of entrepreneurial action in the removal of all manner of price dis-crepancies will not be summarized here12 Suffice it to say that theentrepreneur is ldquoan all-purpose arbitrageurrdquo (my term) who is alert toprofit opportunities that exist as a result of price differences at a pointof time price differences between two points in time (aer accountingfor interest and holding costs) or price and cost differences (that is theprice of a finished product and the cost of all the resources includinginterest necessary to produce it) By exploiting these generalized pricediscrepancies the entrepreneur tends to remove them thus providingthe answer to the original uncomfortable question e tendency toequilibrium is supplied by entrepreneurial action Kirzner then statesclearly the issue that we are investigating

Disequilibrium represents a situation of widespread marketignorance is ignorance is responsible for the emergenceof profitable opportunities Entrepreneurial alertness exploitsthese opportunities when others pass them by G L S Shackleand Lachmann emphasized the unpredictability of human knowl-edge and indeed we do not clearly understand how entrepre-neurs get their flashes of superior foresight We cannot explainhow somemen discoverwhat is around the corner before othersdo so As an empirical maer however opportunities dotend to be perceived and exploited And it is on this observedtendency that our belief in a determinate market process isfounded (ibid121)

Lachmann makes it clear that he does not believe in a ldquodeterminatemarket processrdquo While he is readily prepared to endorse the notionof individual equilibrium he has no use for general equilibrium (andas is clear from the context any equilibrium other than that of theindividual) or tendencies toward it ldquoe notion of general equilibriumis to be abandoned but that of individual equilibrium is to be retainedat all costs It is simply tantamount to rational action Without itwe should lose our lsquosense of directionrsquo rdquo (Lachmann 1976a131) ereason for his rejection of market equilibrium is his understanding

12For a recent statement see Kirzner (1992) Since the first edition of this book waspublished in 1999 Kirzner has continued to explain and refine his ideas as they havegained in exposure and popularity especially in the field of management studies SeeKirzner (2009)

of the implications for action of the passage of time Once again aswith Kirzner I shall not stop to summarize in any detail Lachmannrsquoswell-known views in this regard I merely note some implications Heconsiders it axiomatic that the passage of time cannot occur withoutthe arrival of new knowledge Eachmoment in time is unique and timeis irreversible ldquoAs soon as we permit time to elapse we must permitknowledge to changerdquo (ibid127ndash128 italics removed) I have referredto this as Lachmannrsquos axiom13

Although old knowledge is continually being superseded bynew knowledge though nobody knows which piece will be ob-solete tomorrow men have to act with regard to the future andmake plans based on expectations Experience teaches us thatin an uncertain world different men hold different expectationsabout the same future event divergent expectations entail in-coherent plans what keeps this process in continuousmotionis the occurrence of unexpected change as well as the inconsis-tency of human plans Are we entitled then to be confidentthat the market process will in the end eliminate incoherenceof plans To say that the market gradually produces a consis-tency among plans is to say that the divergence of expectationson which the initial incoherence of plans rests will graduallybe turned into convergence But to reach this conclusion wemust deny the autonomous character of expectations Ex-pectations are autonomous We cannot predict their mode ofchange as prompted by failure or success (ibid128ndash129)

ere is thus no way to know which of the ldquoopportunitiesrdquo perceivedby the Kirznerian entrepreneurs are ldquorealrdquo and which are (perhapsinconsistent) figments of their disparate expectations In this wayLachmann departed company from Kirzner and Hayek and was notprepared to assert the existence of any tendency toward equilibriumldquoWhat emerges from our reflections is an image of the market as aparticular kind of process a continuous process without beginning orend propelled by the interaction between the forces of equilibriumand the forces of changerdquo (Lachmann 1976b61)14

13Lewin (1994236) ldquoAccording to a well-known Austrian axiom lsquoTime cannotelapse without the state of knowledge changingrsquo rdquo (Lachmann 198695)

14For an in-depth examination of this debate see Karen Vaughn (1992 1994ch 7)e debate continues though in muted terms since Lachmannrsquos death in 1990 Kirznerhas aempted to restate and refine his position (1992) and Mario Rizzo has provided a

e issue of convergence of a tendency toward equilibrium15 thusremains a contentious issue in which a lot is perceived to be at stakeFrom Lachmannrsquos lead further investigations of the meaning and im-plications of Lachmannrsquos axiom have followed the most elaborate ofwhich is the in-depth examination by OrsquoDriscoll and Rizzo (1996) evarying reactions to this book bear testimony to the depth of the riwithin the subjectivist Austrian family is is well captured in thetwo reviews by Kirzner (1994a) and Lachmann (1994)16 Although intra-family disputes are oen the most vociferous where there is so muchagreement on everything else of significance it is perhaps surprisingYet it appears to be fundamental

Hayekian equilibrium is a state of complete coordination of plans(and the expectations on which they depend) An equilibrating ten-dency is thus a tendency of markets to coordinate human affairs Bydenying the existence of equilibrating tendencies Kirzner worries onemay be led to deny the ldquoplausibility of possible systematic processesof market coordinationrdquo and in the extreme ldquorender economic sciencenon-existentrdquo (Kirzner 1994a40ndash41) On the other hand Lachmannworries that by affirming the existence of persistent equilibrating ten-dencies ldquowe are playing right into the hands of our opponents whomerely have to point to obvious instances of malcoordination to windebating pointsrdquo (Lachmann and White 19797) Further ldquothe rootof our difficulty lies in this in a market all coordinating activ-ity must engender some discoordination of existing relationsrdquo (Lach-mann 198611) hence endogenous change ose who take Lachmannrsquosaxiom seriously see no way to avoid the conclusion that change isendogenous and continuous thus making any statement about equi-librating tendencies inherently suspect At the heart of the problemis the ldquoautonomy of individual expectationsrdquo and the choices to whichthey lead Lachmannrsquos axiom follows from the inability to deny its im-plication that individual behavior cannot be predicted because future

further critique (Rizzo 1996) For a summary of Kirznerrsquos position see Kirzner (1997)For a more recent summary see Kirzner (2009)

15See the appendix to this chapter16Originally published soon aer OrsquoDriscoll and Rizzo (1996 first edition 1985) in

the Market Process Newsleer For references to some of the contributions to thisdebate see Boeke Prychitko and Horwitz (1994)

knowledge cannot be predicted (OrsquoDriscoll and Rizzo 1996) Expecta-tions relating to the choices of other individuals must be diverse andtherefore are bound to be falsified But if expectations are boundto be falsified implying that prediction is impossible how do we doeconomics Indeed how do we act at all Is life possible withoutequilibrium

Appendix Equilibrium Time and Expectations

eproblem of convergence to equilibrium revolves essentially aroundthe prior problem of how economic agents in a disequilibrium situationacquire information that would motivate them to take actions that wouldresult in the economy moving toward equilibrium ey cannot be pre-sumed to know what the equilibrium price is since this would assumeaway the entire problem Kirznerrsquos answer as we have seen is that theentrepreneur the important economic agent in this context acts onthe basis of price discrepanciesmdashldquobuying low and selling highrdquomdashthusmoving prices toward the establishment of one price But how do weknow that this will be the equilibrium price e problemmay be seenmost simply if we once again use the simple supply and demand caseof an isolated market

e simplest case is the one where we assume that the positionsof the supply and demand curves are unaffected by the actions ofindividuals in the market at is to say the effects of trading at ldquofalsepricesrdquo must be assumed to be negligiblemdashsmall enough to be ignoredWe thus ignore any possible income effects that might give rise topath dependence We rule out changes in the ldquodatardquo as a result of theactions of themarket participants themselvesmdashwe rule out endogenouschange and we rule out changes that emanate from outside of thismarket like changes in technologymdashwe rule out exogenous change Inthis case the equilibrium price is a fixed target an unmoving aractorShould the market arrive at it it will stay there in the absence of anyexogenous change e question is if the price is not at the equilibriumprice will it move towards it

Traditionally and predictably this problem has been answered byaempting to investigate how individuals might react to the informa-tion they receive in disequilibrium So for example when the price is

above the equilibrium price there will be more available for sale than isdemanded e existence of excess supply will tend plausibly to suggestto economic agents (or an entrepreneur will suggest to them) that theyreduce the price that they offer or ask and in this way the price will tendto fall But to what level will the price fall how do agents form theirexpectation of what the price should be ese ldquoreaction functionsrdquo canbe of greater or lesser complexity and depending on their propertiesthe problem will exhibit a ldquosmoothrdquo transition toward the equilibriumprice in each successive ldquoperiodrdquo an oscillating approach a perpetualcircling around it or an explosive divergence away from it

is is the familiar cornndashhog cycle It suffers from pretending toknow how individuals will react in any given disequilibrium situationIt is not plausible to suggest that individual reaction functions that de-pend on each otherrsquos reaction to ever increasing higher levels can bemathematically modeled in a satisfactory way However it may beargued that another route is available Whatever the precise way inwhich individuals react as long as there is enough variation in reactionsand as long as we allow enough time to elapse in the absence of funda-mental change we may argue that as a result of sheer ldquotrial and errorrdquopropelled by varying reactions to disequilibrium prices the market willeventually if not sooner then later ldquohitrdquo on the equilibrium price It ishard to believe that an unmoving equilibrium price will not eventuallybe discovered and established It is aer all a ldquopreferredrdquo price in thesense that it results in the mutual fulfillment of all buy and sell plansand we reasonably expect it to emerge out of individual free trades

Now of course the problem is that it is not at all plausible to assumethat the supply and demand curves are fixed for the duration eabove exercise may establish a convergence in principle (not a ldquorigor-ousrdquo proof but a suggestive argument) and this may suggest furtherthat as an empirical maer reactions are such in the real world thata ldquotendencyrdquo toward the equilibrium price will prevail even thoughit is continually being thwarted by shis in supply and demand eargument is that the tendency in the market is toward equilibrium Tothe extent that this is disturbed it is as a result of exogenous changesin supply and demand forces like a new technology new productsetc us it is the presence or absence of endogenous change that hasemerged as a critical issue

e simple supplyndashdemand case is suggestive in two ways Firstwhere the world is such that the ldquounderlying realitiesrdquo (in this case thepositions of the supply and demand curves or more accurately thecontingent trades that they represent) are constant it seems natural toargue that convergence will occur So even if for centuries most peo-ple believe erroneously that the world is flat and for some time thereis a variation of beliefs since the world remains round no maer whatwe believe or howwe actmessages from our experiencewill eventuallyconvince us (all of us) that it is round ere is a notable convergenceof expectations as a result of experience No one now expects to falloff the edge Generally a stable (constant) decision environment isconducive to convergence exhibiting the required feedback Secondthe simple supplyndashdemand case can be generalized to situations of mul-tiple markets as long as we continue to ignore income or wealth effectsand rule out exogenous changes en the entrepreneur becomes keyPrice discrepancies in geographically separated markets or for inputsversus outputs will then tend to be eradicated even as each market isldquogropingrdquo its way to isolated equilibrium And in this case it is easy tosee how prices are powerful transmiers of information Once againthe result is ideal depending as it does on the assumption of unvaryingunderlying realities and sufficient variation in individual reaction

CHAPTER 3

Equilibrium and Expectations Re-ExaminedA Different Perspective

[F]rom time to time it is probably necessary to detach oneselffrom the technicalities of the argument and to ask quite naivelywhat it is all about (Hayek 1937b54)

e debate referred to in the previous chapter is in many ways relatedto the general problem in economics of dealing adequately with thephenomenon of time It seems that every economist of note has in oneway or another perceived some difficulty associated with accountingfor the passage of timewhilemaintaining equilibrium and haswrestledwith it (Currie and Steedman 1990) On the one hand there is theundeniable fact of human action in an ordered society On the otherhand there are the undeniable facts of novelty and disequilibrium andthe inability to foresee all consequences All action is future orientedmdashit rests on connecting present causes to future effects which seems toimply successful prediction How is one to reconcile these apparentlyirreconcilable perspectives

Describing and Understanding Action

One possible resolution may lie in re-examining the concept of ldquoexpec-tationsrdquo and concepts related to it I offer a scheme that will include anarticulation of the following concepts eventsoccurrences laws of naturesocial ldquolawsrdquo actsactions plans knowledge and expectations We takenote of the passage of time by recording occurrences or events that wecategorize according to our understanding of them Events that occur innature that do not involve humans are understood according to whatwe think of as the forces (or laws) of nature Events that occur in soci-ety that relate to humans are understood according to the intentions

and meanings of the individuals involved At one level it is possibleto describe human events as part of events in nature physiologicallyfor example So it is possible to examine human acts in terms of thebiological processes in the brain and in the rest of the body that broughtthem about But the nature of the understanding we achieve by this isof the same type as of events in nature To acquire an understandingof events as human or social events requires examining (inter)subjectiveintentions and meanings1 We may say that events in society are theresults of actions ey involve human acts2 To describe an act satis-factorily recourse must be had to motives means and outcomesmdashevenif the laer are unintended Outcomes are connected to (understoodin terms o) a multitude of actions related and unrelated is seemsto me what we mean when we talk about equilibrium in terms of theconsistency compatibility and coordination of plans Plans embody anumber of related acts ey are related by purpose us different actsmay be complementary when they work towards the same purpose orcompetitive when they work for conflicting purposes or they may beunrelated3 e notion of ldquoplanrdquo so widely used by economists is inneed of further examination

1While differing from his approach in some respects this echoes Misesrsquo insistenceon ldquomethodological dualismrdquo (see for example Mises 1957ch 1) Misesrsquo approach tothis can be described as somewhat ldquopragmaticrdquo

What the sciences of human action must reject is not determinism butthe positivistic and panphysicalistic distortion of determinism eystress the fact that ideas determine human action and that at least in thepresent state of human science it is impossible to reduce the emergenceand transformation of ideas to physical chemical or biological factorsIt is this impossibility that constitutes the autonomy of the sciences ofhuman action (ibid93)

e ultimate givens in social science are the ideas of individuals including their judg-ments of value ere is no accounting for these in terms of more ultimate (physical)causes ldquoSaying that judgments of value are ultimately given facts means that thehuman mind is unable to trace them back to those facts and happenings with whichthe natural sciences dealrdquo (ibid69)

2ldquoAct noun 1 A thing done a deed b An operation of the mindrdquo (eNew ShorterOxford English Dictionary)

3is chapter uses material from Lewin (1997c) An anonymous referee haspointed out that an important distinction must be made between the plans of a givenindividual and the plans made by different individuals A question arises whether an

EQUILIBRIUM AND EXPECTATIONS RE-EXAMINED 33

What Do We Mean by Consistency of Plans

ere are three important things to note about plans

1 Plans depend on different kinds of knowledge As already indi-cated a plan is defined by its purpose or set of purposes Itsformulation depends on its purpose and on the desires (pref-erences) and knowledge of the planner is knowledge is aninfinitely complex phenomenon and operates at many levels aswe shall later remark in some detail in our discussion of humancapital For the moment we note simply three types or ldquolevelsrdquo

(a) e individual will have knowledge of those laws of na-ture to which we referred earliermdashknowledge type 1 isknowledge will have been gained in a variety of waysaccording to the individualrsquos perceptions and experience(and may be to some extent a priori)

(b) Second the individual will have knowledge of the socialworld ldquosocial lawsrdquomdashknowledge type 2 is knowledgewill depend on the existence of and the individualrsquos percep-tion and experience of social institutions By ldquoinstitutionsrdquowemean here those typical and stable features of the socialworld on which individuals come to rely So they includerules of behavior standard categories habits customs andthe like We will discuss this in greater detail in a moment

(c) ird the individual will have knowledge of specific andunique events that have occurred (history) and in order tocarry out the actions constituting the plan the individualmust form some mental picture of the specific possible con-sequences of those actions and decide on which are moreor less likely To be sure some actions will involve greaterand lesser degrees of conscious anticipation and somemay

individual is always aware of the complementary or contradictory nature of his or herplans Does the harboring of plans contradictory in their likely outcomes imply irra-tionality or just ignorance Presumably a ldquorationalrdquo individual would not knowinglyadopt contradictory plans For groups of individuals contradictions are inevitable inmarket economies ese contradictions and also some complementarities aremostlyunknowable to individuals ex ante and are only revealed (if at all) ex post with theunfolding of the market process

be so habitual as to seem almost reflexive Neverthelesseven these implicitly involve imagined consequences aswould presumably be brought to the fore upon interroga-tion We may hesitate to group these anticipations or ex-pectations in the category of knowledge but we do so as athird level of knowledge (knowledge type 3) in the convic-tion that expectations may be held with greater or lesserconfidence (In the case of habitual actions referred to justnow we may imagine the relevant expectations to be heldso confidently as to be indistinguishable from (tacit) knowl-edge as usually understood as some sort of absolute con-fidence) Expectations are thus here considered to be aspecial aspect of knowledge Type 1 and 2 knowledge isknowledge of an abstract kind knowledge of general prin-ciples (related to the natural worldmdashapples fall from treesto the ground exposure to bacteria can cause infectionor related to the social worldmdashpeople stop at red lightsdollar notes are a generally accepted means of payment)whereas knowledge type 3mdashhistorical knowledge and ex-pectationsanticipationsmdashis knowledge of specific uniqueevents4

2 Plans cannot be completely specified they cannot include a speci-fication of everything that can happen (imagined or unimagined)

4is discussion is in many ways similar to (perhaps the same as) OrsquoDriscolland Rizzorsquos distinction between typical and unique elements in any situation andbetween paern and detail prediction (199676ndash91) And once again there are closesimilarities to and differences from Mises Mises was concerned with the sources ofknowledge I am less so So his distinction is twofold first on the basis of whether ornot knowledge can be considered a priori and second whether or not it yields certain(unambiguous eternal) knowledge My scheme is elaborated very specifically in theservice of trying to describe how action is possible in disequilibrium (with referenceto a Hayekian equilibrium of consistency of plans) So I distinguish between differenttypes of knowledge not according to their sources but according to their degree ofcertitude and second according to their subject maer (human or natural) In thislaer regard my methodological dualism is not that different from Misesrsquo So I lumptogether knowledge that is (or might be) a priori with that gained by experience butdistinguish it according to whether it is about the social or natural world Mises wouldput mathematics in praxeology together with economics whereas I put mathematicsin natural (nonhuman) science

e notion of ldquoplanrdquo in the literature is very vague Lindahl (1929and especially 1939b)5 and Lachmann spent some time talkingabout aspects of individual plans Of these Lindahlrsquos formu-lation is the most developed6 He distinguishes for examplebetween three types of actions that affect the planrsquos ldquodegree ofdefinitenessrdquo (Lindahl 1939a45) thus conceiving of some flexibil-ity in the execution of the plan is means that even if someanticipations are not fulfilled if the plan contains sufficient flex-ibility that is sufficient room for contingencies it may not bedisappointed and thus need not be revised or abandoned Itmay be accommodated within equilibrium Likewise Lachmannin different (but similar) ways aempted to account for plansthat contained contingencies7 But neither of these authors noranyone else to my knowledge has remedied the vagueness thatcontinues to surround the concept ere is an aspect of paradoxin this It is because theorists have failed to make clear that real-world plans are necessarily vague and oen only dimly perceivedby the planners that the plans in the theoristrsquos discussion haveassumed a specious but unarticulated precision ey havefostered the (unconscious) impression that they are meant todepict detailed project analysisndashtypemeansndashends schemes eventhough such details are never provided even by way of exam-ple e necessary vagueness of real-world plans is implied bythe nature of time and the way in which we experience it inshort by Lachmannrsquos axiom As future knowledge cannot begained before its time and as plans must inevitably depend tosome degree on future knowledge many of the aspects of a planmust simply be unspecified We do not plan in terms of ldquomicrordquo

5See also Currie and Steedman (1990chs 4 and 5)6ldquoIt can hardly be pretended that every individual has a clear conception of the

economic actions that he is going to perform in a future period Nevertheless in thegreater number of cases it will certainly be found that underlying such actions thereare habits and persistent tendencies which have a definite and calculable charactercomparable to explicit plans we may accordingly without danger proceed togeneralize our notion of lsquoplansrsquo so that they will include such actions Plans are thusthe explicit expression of the economic motive of man as they become evident in hiseconomic actionsrdquo (Lindahl 1939b93)

7See Lachmann (19784 53 197140) and Lewin (1994247ndash250)

details but rather in terms of ldquomacrordquo categories We cannotexperience future events before their time and the experience isnever an exact correspondence of the anticipation both becausethe difference is a maer of degree and because some of theaspects of the event could not have been imagined8

3 Plans are multilayered that is to say an individual at any onetime will have a very large number of plans by which he con-ducts his life Each will relate to a different purpose and usuallywill have very different frames of reference including a differenttime frame So for example I may at a moment of time be actingwithin plans to teach my class (as planned) today finish a firstdra of this chapter this week fulfill the expectations of my chil-dren to help themwith their homework this entire year and saveenough money to see them through college over the next tenyears Plans may be nested (within one another) or parallel Andwhile it might be possible ideally to conceive of all of an individu-als plans as existing within one giant ldquolife planrdquo this as we shallsee can hardly advance our understanding Rather we shouldrealize that although the plans may exist in a structure of sortsone being related to the other in terms of purposes and meansthis relationship this structure is likely to be only dimly and par-tially perceived and is moreover likely to be ever changing asindividual plans are adopted revised and abandoned So whenwe speak of plan coordination across individuals and whetheror not there is a necessary tendency for them to become morecoordinated our disagreementmay be related to the fact that theconcept of plan coordination has not been clearly understood Itmay be that some types of plans do exhibit such a tendencywhileothers do not and that the functioning of the market systemdepends crucially on this difference In particular it may be as

8ldquoNo maer how I try to imagine in detail what is going to happen to me still howinadequate how abstract and stilted is the thing I have imagined in comparison towhat actually happens For example I am to be present at a gathering I knowwhatpeople I shall find there around what table in what order to discuss what problemBut let them come be seated and chat as I expected let them say what I was sure theywould say the whole gives me an impression at once novel and unique Gone isthe image I had conceived of it a mere pre-arrangeable juxtaposition of things alreadyknownrdquo (Bergson 196591 quoted in Rizzo 1994117n)

we shall argue that plans based heavily on knowledge types 1and 2 are very likely to cohere and that the opposite is true forplans that depend heavily on knowledge type 3

Before continuing it may be useful to approach this from a slightlydifferent angle Plans are based to a greater or lesser extent on ex-pectations (knowledge type 3) Expectations are of course widelybelieved to influence actions and the essential difference between the-ories is oen to be found in the different way in which expectationsare treated While the rational expectations (RE) approach implicitlyassumes that everyone has the same expectations at the other extremeLachmann emphasizes the dire consequences of expectations that nec-essarily diverge But we may now pause to ask expectations of whatRE approaches relate primarily to prices (or price indexes)mdashthey referto individualsrsquo expectations of prices Lachmann is less specific exceptto say that they are bound to be disappointed from which we shouldinfer that he is referring to expectations of the things about whichindividuals differ Realizing that expectations like the plans in whichthey are embodied are multidimensional makes us realize that the ex-pectations concerning the vast majority of things (events) about whiwe have expectations will be fulfilled We may thus question whetherLachmannrsquos statement that ldquoexperience teaches us that in an uncer-tain world different men hold different expectations about the samefuture eventrdquo is universally true and realize that it depends cruciallyon the type of event in question For a large number of events there iswidespread agreement of expectations

How are Activities Synronized and Coordinated

We may be more specific Expectations and plans are for the mostpart fulfilled because of the existence in the social world of sharedcategories and standards that facilitate the synchronization and coordi-nation of activities ese operate to give individuals hard knowledge(type 2) of the actions of others on which these plans and expectations(type 3 knowledge) depend is is most obvious and most crucial withregard to the way in which we cope with time Currie and Steedmanhave drawn aention to a remarkable work by P A Sorokin originallypublished in 1943 (Currie and Steedman 1990201ndash203 Sorokin 1964)

In this work Sorokin points out that the devices we use to organize andcope with time are cultural (rather than natural) We invent (or moreaccurately we ldquoevolverdquo) cultural time units us Sorokin contrastsldquosociocultural timerdquo with ldquocontinuous infinitely divisible uniformlyflowing purely quantitative time of classical mechanicsrdquo (Currie andSteedman 1990201) Consider the week

Factually our living time does not flow evenly is discontinuousand is cut into various qualitative links of different value efirst form of this qualitative division is given by our week Math-ematical or cosmic time flows evenly and no weeks are givenin it Our time is broken into weeks and week links We liveweek by week we are paid and hired by the week we computetime by weeks we walk and exercise or rest so many timesa week In brief our life has a weekly rhythm More thanthat within a week the days have a different physiognomystructure and tempo of activities Sunday especially standsalone being quite different from the weekdays as regards activ-ities occupations sleep recreation meals social enjoymentsdress reading even radio programs and newspapers Aweekof any kind is a purely sociocultural creation reflecting therhythm of sociocultural life but not the revolution of the moonsun or other natural phenomena Most human societies havesome kind of week and their very difference between weeks isevidence of their independence from astronomical phenomenae constant feature of virtually all is that they were alwaysfound to have been originally associated with the market our week is not a natural time period but a reflection of thesocial rhythm of our life It functions in hundreds of formsas an indivisible unit of time Imagine for a moment thatthe week suddenly disappeared What havoc would be createdin our time organization in our behavior in the coordinationand synronization of collective activities and social life andespecially in our time apprehension

(Sorokin 1964190ndash193 italics added in the last sentence)

What is true of the week is equally true of other shared time unit cat-egories like days months seasons and years even though these mayhave an original basis in astronomical regularities In their evolveddeveloped state they provide us with predictable social rhythms Andthis is even more true of the division of days into hours minutes and

seconds In our interactions we all mark time in the same way andwith reference to the same clock so that we are able to synchronize(consciously and subconsciously overtly and tacitly) most of our ac-tions or more accurately our activities (referring to action types orrepeated actions)

e knowledge of the main kinds of sociocultural rhythmsmdashnomaer whether periodical or notmdashis by itself very importantknowledge Stripped of their specific qualities all rhythmsand punctuations would disappear and the whole socioculturallife would turn into a kind of gray flowing fog in which nothingwould appear distinct (ibid 201)

e synchronization of activities is most obvious in contracts whichoen refer to units of time For example we rent space by the dayweek month or year But it occurs in all spheres of life where contractsare implicit or nonexistent We expect people to work between thehours of 8 am and 6 pm and not usually outside of that We expectpeople to be asleep between midnight and daylight e few excep-tions give rise to disappointed expectations and discoordination Butthe overwhelming conformity ensures routine expectation fulfillmentKnowledge of these time categories is a prerequisite for and gives riseto knowledge of peoplersquos typical activities

is insight may be extended to other types of shared categoriesFor example we share categories formeasuring spacemdashdistance (milesand kilometers) area (acres of land) and volume (gallons of gasoline)mdashand weight (pounds of sugar) figuring accounts classifying occupa-tions9 driving on the roads walking along pathways and innumer-able other conventions customs habits and the like which make ouractions predictable to others ese institutionalized categories andmodes of behavior (which we may designate as institutions broadlyunderstood) are the cumulative unintended results of individual ac-tions and they represent a real convergence of expectations Startingout from a position of many different standards or modes of behaviorthat converge to one or a few implies that individuals come to expectcertain kinds of behavior with a degree of confidence related to degreeof conformity of the particular standard ese institutions

9See Ebeling (198648)

enable each of us to rely on the actions of thousands of anony-mous others about whose individual purposes and plans wecan know nothing ey are the nodal points of society co-ordinating the actions of millions whom they relieve of the needto acquire and digest detailed knowledge about others and formdetailed expectations about their further action

(Lachmann 197150 italics added)

Processes of Convergence

We have a fairly good idea of how social processes that convergework A prototype case has been provided in the emergence of a singlemedium of exchange (Menger 1976248ff Selgin 1988ch 2 Horwitz1992ch 2) Money is the unintended result of individuals adoptingone out of many goods as the preferred medium of exchange Itsspontaneous emergence is facilitated by the property that the morepeople use it the greater its advantage for further use It is a graphiccase but only one case of similar processes where the advantagesof the adoption of a particular standardmdashfor example of a particularproduct or set of products to accomplish given tasks like playingvideo cassees word processing soware developmentmdashas well asgeographical location language and many other things depend posi-tively on the extent to which it has already been adopted (Arthur 1994Krugman 1991 Kirzner 1990 Liebowitz and Margolis 199410 see alsoHorwitz 1992) In such processes once a critical level of adoption hasbeen achieved adoption tends to be cumulative Individuals are ledby the clearly perceived advantages of adoption to follow suit andthe process feeds on itself until it has become an institution Not allinstitutions emerge in this way but many do

It should be clear that these convergent processes do not exist inisolation but are crucially related to each other So for example theemergence of money depends on the prior existence of establishedpractices of trade in particular the tacit or conscious enforcement ofcontracts e institution of repeat purchase tends to enforce certain

10ere is a growing literature on the many aspects and implications of these cumu-lative processes We shall have occasion later to take note of some of them For nowwe shall be content to note their existence and culmination in social institutions

practices of honest dealing And the existence of money of coursesupports a number of dependent institutions like financial accountingpractices (see Chapter 10 below) ere is in short an intricate in-stitutional structure ere is an essential complementarity betweenenduring institutions (Horwitz 1994)11 e market system is itselfdependent on the existence of important aspects of the legal structureis brings up the question of institutional change

e designation ldquoinstitutionrdquo connotes an image of permanenceof reliability e institutions that we have been talking about existas fixed points in the landscape of time within which individuals canmake their choices in the knowledge (knowledge type 2) that they theinstitutions at least will remain unchanged We will look at this alile more closely in a moment It is evident however that this per-manence must be relative for we have the fact of institutional changeStandards come and go Categories change Rules appropriate to onesociety oen disappear as the society changes Even language evolvesHow does this affect the functioning of institutions as facilitators ofcoordination e answer must be in the rapidity of change A societyin which everything changed rapidly would be one devoid of any per-ceptible order History is possible only because the historian is ableto know something about the enduring orientations inside peoplersquosminds e historical context is defined by the meaning of the insti-tutions of the society under examination But as the context changesinstitutions may be seen at one point in time as fixed points whileat another they may be seen as aspects of change It depends on thepurpose of the analysis and the time span involved What is fixedand what evolves is itself a maer of context ere seems to be acontinuing interaction between the foreground and the backgroundand which is moving depends very much on which you have in focusmuch like a three-dimensional holographic picture Commercial lawis necessary for the conduct of economic life and indeed facilitates theemergence of unpredictable novelty in economic life But economic(and technological) changes of certain types put a strain on aspectsof the law that prompt it to change For example the emergence of

11ldquoCompany Law as it has emerged in the Western world in the course of time isa delicate web within which many interests some conflicting some complementaryhave been woven into a paern of harmony rdquo (Lachmann 1979254)

electronic communications has suggested the acceptance of facsimilesignatures and has raised difficult legal questions relating to copyrightand privacy on the Internet

So convergence and permanence are relative phenomena Nev-ertheless such permanence is necessary for the existence of and forour understanding of dynamic economic processes e hectic pro-cession of new products and productive processesmdashthat is the resultof the activities of a multitude of individuals organized as companiesoperating within the constraints of contract law and so on some ofwhom succeed in their endeavors many of whom do not (as defined bythe ability to earn positive accounting profits)mdashis dependent on theseunderlying institutions While we cannot predict who will succeedand who will not while we cannot predict which products will emergeand be popular while we cannot foresee the nature of future technolo-gies we strongly believe that the process will be peaceful and will beorderly we confidently expect those who are unsuccessful to accepttheir losses peacefully and perhaps try something else those who losetheir jobs tomove on in the hope of greener pastures and thosewho dosucceed to continue to try to do so e fruits of this dynamic processdepend crucially on our willingness to accept the consequences of itsunpredictability at willingness is the vital predictable part Wehave the emergence of ldquochaos out of orderrdquo12

eanalogywith organized sports has been suggested by a numberof theorists (for example Hayek 1973115 Loasby 199432) e gameis played according to certain fixed rules (although from time to timethe rules ldquoevolverdquo to reflect new realities) e rules (both wrien andunwrien) are highly predictable Given a hypothetical contingencywe can predict its resolution e actual outcomes are uncertain andinfinitely variable at is the point of playing the game By ldquooutcomerdquowe mean not only the score but also the paern of the game in itsinfinite detail which is part of the araction If we cared only aboutthe score it would be a simple being game we are also interested inseeing how it is played and what unexpected variations are around thecorner to delight intrigue shock or disgust us e game of life and

12With apologies to Progogine and Stengers (1984) e market process is notchaotic in the colloquial sense but it is complex and unpredictable

the game of economic life in particular is like this in many respectsMost notably it depends on wrien and unwrien rules and on theresources (the abilities the equipment and the experience) of the play-ers We hope that our team will win but we usually do not go to warif they do not If we did the game would not exist and we would notbe able to enjoy it

We copewith the complexity in theworld by converging on institu-tions us once the arrival of a new range of products made possibleby the development of a new technology has been digested new cate-gories of classification tend to be developed into which these productsare grouped e categories emerge spontaneously out of individualaempts to communicate the aributes of the new products A goodexample is the products of the computer industry A whole range ofproducts exist whose workings remain a mystery to the vast major-ity of people but whose purposes needed to be explained Laptopsevolved into notebooks microcomputers into desktops At anotherlevel a series of technical standards and categories has been developedin order to cope with the complexity e aributes of computer mon-itors include its refresh rate its dot pitch as well as simply its screensize All these shorthands provide the increasingly informed publicwith a way to tailor their expectations when choosing between prod-ucts ey enhance predictability by enhancing the interpretabilityof information But these relatively predictable elements change withtime and it is no accident that conscious innovation involving productdifferentiation is oen referred to using the phrase ldquocategory killerrdquo

Novelty and Equilibrium

About some events there is no predicting ese are the specifics ofany given (future) historical situation Lachmannrsquos axiom implies theuniqueness of every experience Perhaps it is beer to say that eachexperience contains unique elements although we are able in retro-spect to describe it in terms of recognizable categories Describing asituation is never the same as being there Each moment is unique andtherefore cannot be precisely predicted us plans are never coordi-nated in every detail Such a situation is inconceivable it is a world

without time In that sense we are never in equilibrium Neverthelessin peaceful lawful societies behavior is ordered Hayek in his laterwork spoke less of equilibrium and more of order He quotes from ldquoadistinguished social anthropologistrdquo

that there is some order consistency and constancy in sociallife is obvious If there were not none of us would be able to goabout our affairs or satisfy our most elementary needs

(Evans-Prichard 195149 quoted by Hayek 197336)

It is evident that there must be uniformities and regularitiesin social life that society must have some sort of order or itsmembers could not live together It is only because people knowthe kind of behavior expected of them and what kind of behav-ior to expect from others in the various situations of life andcoordinate their activities in submission to rules and under theguidance of values that each and all are able to go about theiraffairs ey can make predictions anticipate events and leadtheir lives in harmony with their fellows because every societyhas a form or paern which allows us to speak of it as a systemor structure within which and in accordance with which itsmembers live their lives

(Evans-Prichard 195119 quoted by Hayek 1973155n)

By ldquoorderrdquo we shall describe a state of affairs in which amultiplicity of elements of various kinds are so related to eachother that we may learn from our acquaintance with some spa-tial or temporal part of the whole to form correct expectationsconcerning the rest or at least expectations which have a goodchance of proving correct (Hayek 197336 italics removed)

e (extended) order which is the society is clearly a result of the com-ponent orders which we have called institutions And the laer indeedare the results of a process by which society has (without planningto do so) converged towards their adoption ey are ldquospontaneousordersrdquo and they represent equilibria of a sort in that they are statesof convergence (rest) around which expectations are formed and con-form In this sense we may say that the social process is composedof equilibrating disequilibrating and non-equilibrating sub-processesEconomic growth the arrival of new and beer products and beer

methods of production is the result of unpredictable disequilibratingand non-equilibrating processes ere is no tendency for expectationsto cohere in these processes ey are ldquonon-expectablerdquo the results ofevents that could not have been expected

e degree of predictability of any event is related then to theextent to which it tends to exhibit repeatable typical or recognizablecharacteristics Many routine events fall within the ldquovery predictablerdquorange However in the realm of productive activity in modern econo-mies many events fall very definitely outside of this range Methods ofproduction consumer goods and services embody and depend on newknowledge to a high degree and their emergence is intimately relatedto and crucially dependent on the divergence of expectations

Predictability in one sphere is thus the necessary ingredient for copingwith its absence (novelty) in another sphere e amazingly wide rangeof products and the persistent improvement in methods of production(in terms of reducing opportunity costs) are the results of a multitudeof unintentional experimentations Of the outcomes that we observein the market system we cannot say that they are the most ldquoefficientrdquoor the ldquobestrdquo of any that we could have had and they are not an equi-librium in any Hayekian sense But to the extent that we judge them tobe beer than many alternatives to the extent that we judge progressto be occurring in that our lives are made more convenient and moreexciting we must recognize these outcomes to be the beneficial resultof the kaleidic changes of the modern world

Prices in Disequilibrium

eprices that economic agents observe and towhich they respond arenot equilibrium prices at is they are not prices that reflect an under-lying compatibility of the plans of the various economic actors in themarket If expectations were consistent across individuals in the sensethat they were all destined to be fulfilled then prices would reflect theunanimous judgments of individuals of the values of the goods tradedthey would also accurately reflect the tradeoffs involved in tradingone good for another or refusing to do so In this sense the priceswould lend a degree of objective expression to the subjective non-comparable valuations of individuals While subjective valuations are

not observable and there is no way of knowing subjective value scalesin an equilibrium situation prices provide hard information about whatindividuals are prepared to do and what various goods and servicesare ldquoworthrdquo to them In this context the exercises of modern welfareeconomics employed in the service of normative investigations of al-ternative policy scenarios or institutional structures make some senseIt is possible then to use price as a ldquoproxyrdquo for a measure of ldquoutilityrdquoreflecting social losses and gains in some indirect sense

In a disequilibrium situation however this is obviously no longerpossible If expectations across individuals differ and are inconsistentthen prices can no longer be used to reflect a unanimous judgment ofvalue e theorems of welfare economics no longer apply and as iswidely acknowledged albeit ignored notions of ldquoeconomic efficiencyrdquohave no unambiguous meaning One might wonder then what it isthat prices actually do in disequilibrium

It should be clear that a price is a social institution When a price isestablished between a buyer and a seller there is a shared understandingof what it is and what it means In the first instance the price is anexpression simply of the ldquoterms of traderdquo you give me this and I willgive you that It is a general shorthand description for expected actionaction that involves hypothetical yet-to-be-expressed details For ex-ample an advertised general price is an offer to do business that saysI will trade an unspecified amount of this for so many dollars per unitAnd although the quantities acceptable may not be unlimited there isusually understood to be an acceptable trading range So price is first astatement of mutual expectations and obligations involving real things

Second prices enable individual calculation Prices make budgetspossible In this regard the role of prices in monetary economies de-pends crucially on the existence of money as a universal medium ofexchange and therefore unit of calculation (and one presumes if ex-changes are recorded a unit of account this is discussed further inChapter 10 below) Since money is universal purchasing power it fa-cilitates production and exchange over time Prices play a pivotal rolein these production and exchange activities Without market pricescalculation would not be possible (Mises 1981) ere would be noway for an individual to estimate what someone might be willing to

exchange for various items e prices involved in any budget calcula-tion are either an expression of past transactions that actually occurredor they are expected prices of hypothetical trades that might occur inthe future It depends on whether one is doing accounting (aemptinga judgment of past action) or budgeting for future action at ispast prices express past trading achievements while expected pricesexpress perceived potential future trading achievements Either wayand connecting the two prices (third) enable trading decisions Ifexpected prices bore no relationship to the actual prices that materi-alized they would serve no purpose Indeed there must be a closerelationship close enough to yield a positive net value to the tradersinvolved on both sides of the market if there is to be a continuingmarket So enduring trade in something is evidence that expectationshave not been disappointed to the extent that trading is no longerworth while (On the inertia of prices see Mises 1971108ndash123)

Changes in prices (actual andor expected) thus induce budgetaryadjustments ey enhance or restrict the value of a budget and pro-duce the familiar individual demand and supply responses And pricediscrepancies (if noticed) provoke arbitrage activities that if unim-peded would continue until they were removed until one price onlywere established But price discrepancies are oen in the eyes of the(entrepreneurial) beholder the more so when such discrepancies referto a comparison between present and future prices Some arbitrage(for example production) ldquoopportunitiesrdquo may be inconsistent withothers and may not succeed Once again then we affirm the impossi-bility of deriving the necessity of converging expectations and pricesin the market process

An individual budget has meaning only in terms of the prices thatthe trader faces (now and in the future) and his subjective scale ofvalues So just as with other institutions the institution of price quaprice must exhibit some permanence if it is to serve its purpose Indi-viduals understand what a price any price is they understand pricesas a phenomenon Individual prices are instances of price as an in-stitution And although they do not reflect equilibrium values be-cause they are contextually meaningful they motivate and facilitateeconomic activity

Conclusion Predictability Together with Disequilibrium

Hayekrsquos notion of equilibrium as perfect plan coordination is limitedbecause plans can never be completely specified us complete plancoordination ex ante is not even logically possible In a way perhapsironically Hayekrsquos own extensive work on the importance of tacitknowledge and the inherent limits of perception and articulation (forexample 1945 1967) point in this direction

us we may conclude our examination of equilibrium by sayingthat the market process in general is not equilibrating ere is notendency for expectations in general to become more coordinated Ex-pectations operate at many different levels however And at mostof these levels for most types of things there is a tendency towardscoherence We tend to cohere around certain rules of conduct stan-dards categories and other institutional phenomena and most of ourexpectations are thus fulfilled We have predictability together withdisequilibrium where the laer refers to the characteristics of the mar-ket process Divergent expectations lead through rivalrous activityto the emergence of new products and methods of production Inthis process the production and use of specific capital goods and theacquisition of the knowledge that enables us to produce and use suchgoods play a crucial role We turn now to a closer examination of this

PART II

CAPITAL INTEREST AND PROFITS

In Part II I consider some of the more traditional areas of capital theoryChapter 4 discusses the nature of capital It is a curious fact about theconcept of capital in economics that economists still disagree aboutwhat it is A brief historical overview suggests that this probably hassomething to do with the evolution of the concept in the context of eco-nomic evolution more broadly e transition from a predominantlyagricultural economy to a predominantly industrial one and then to anincreasingly ldquoinformation-basedrdquo one has occasioned changes in theway in which economists and others have thought about productionand therefore about capital Sometimes concepts appropriate for onecontext have been transplanted to another with unfortunate conse-quences We begin with a look at Adam Smithrsquos corn economy andnote its influence on Ricardo and those who followed him We contrastthe Ricardian approach with that of Carl Menger and the AustrianSchool emost space is devoted to Boumlhm-Bawerk arguably the mostinfluential capital theorist of all In Chapter 5 I look briefly at moderncapital theory in the production function literature and the work of theCambridge neo-Ricardians We will find surprisingly that both are inthe Ricardian spirit

In Chapter 6 I examine the recent work on capital theory of JohnHicks Hicks struggled his whole professional life to reconcile variousapproaches to capital theory In his last extended aempt he providesa very interesting and useful framework for thinking about capitalvalues in and out of equilibrium

In Chapter 7 I turn to a discussion of the nature of interest as aphenomenon e nature of capital is bound up with the fact thatproduction occurs over time So the question of the relative valuationsof useful outputs at different points of time arises Does time itself

exert an influence in determining the relative value of things Indeedwe find that the fact that people are not indifferent to the date atwhich they obtain useful things is the essential explanation for theexistence of the discounting of the future which is the basis of allcapital valuations is allows us to distinguish interest which is anexpression of this time discount (time preference) from profit

Profit is seen to be the result of uncertainty It is the reward forbeing right in an uncertain world for discovering an ldquoopportunityrdquothat others had overlooked Traditionally it has been approached byexamining a world in which it would not exist a world devoid ofuncertainty In such a world all incomes are certain and can be thebasis of known contractual relationships Such incomes are composedin the aggregate only of the payments for the services of the originalfactors of production land and labor which are wages and rent andof ldquopurerdquo interest When we move from such an economy to the realworld we can then understand that profit is what is le over aerthese ldquocontractualrdquo payments have been made Profit is thus clearlydistinguished from interest and rent (on physical capital)

I conclude with some observations connecting the capital pro-cesses (the processes of production) to planning processes more gen-erally and as explored in the previous chapter is lays an importantbasis for our discussion of disequilibrium theories of capital in Part III

CHAPTER 4

Capital in Historical Perspective

Introduction e History of Capital eory is Relevant

Considerations involving capital are as old as economics itself Andperhaps more than any other field in economics current capital theorybears the stamp of its history Modern discussions are very heavilyinfluenced by the categories developed by capital theorists since AdamSmith and by the contexts in which they wrote e history of capitaltheory is a history of complex oen esoteric intellectual bales Andmore oen than not these theoretical debates about abstruse technicalissues mask the underlying ideological differences that are the realissues But there is one thing that many of the protagonists have incommon their adherence to a framework in which equilibrium insome significant sense prevails In this chapter we shall examine someaspects of the various approaches to capital that have characterizedthe history of capital theory In doing so we shall seek (a) to clarifythe significance or lack thereof of the insights gained from the highpoints in the development of capital theory (b) to remove the ambi-guity that has surrounded key terms like ldquoprofitrdquo ldquorentrdquo and ldquointerestrdquoand (c) to clear the way for a consideration of capital in situations ofdisequilibriumwhere it will be seen many of the traditional issues arerendered moot

e estions

Market economies are sometimes referred to as ldquocapitalistrdquo economiessuggesting the presence of a phenomenon called ldquocapitalrdquo that is insome way responsible for the character of the economy and for itsmode of production in particular At a general level we may want to

say that capital is ldquothat which makes production possiblerdquo Its originscan be traced to the idea of a fund of purchasing power (owned byldquocapitalistsrdquo) which when made available allows for indirect methodsof production methods that involve production (or ldquocapitalrdquo) goodsis can be explained further as follows

All production can be traced logically to the input of labor ser-vices and natural resources what we may call original inputs eseinputs can be used to produce useful outputs or they may be used toproduce other inputs ese other inputs which are produced meansof production are thus logically called capital goods ey facilitateproduction And since producing useful outputs using capital goodsnecessarily takes more time than producing outputs using only orig-inal inputs (from the vantage point of a moment in time when thecapital goods are not yet produced) the capitalistsrsquo fund is very impor-tant in allowing these (advantageous) indirect methods to be adopted(Defenders of the market system against those who seek justificationfor the earnings of these apparently ldquounproductiverdquo ldquonon-workingrdquocapitalists have oen pointed to the necessity to reward the capitalistsfor parting with their wealth in order to facilitate these ldquoroundaboutrdquomethods of production Capitalists who own the capital goods directlymay be thought of as lending the money to themselves)

Capital then originates from the idea of a fund of money thatfacilitates the time-consuming use of production goods But is it thefund or the goods or both that facilitate production Can it be saidthat while the capitalistsrsquo fund facilitates the use of production goodsunder social arrangements where such goods are privately owned it isthe production goods and not the fund that are truly productive If soit seems logical to differentiate between a capital fund which is justan accident of particular historical social arrangements and capitalproper which refers to the technologically necessary instruments ofproduction It seems natural from this perspective to think of capital asa ldquofactor of productionrdquo along with the original ldquofactors of productionrdquomdashlabor and land In modern economics it is thus this physical capitalthat is now implied when no qualifiers are used It must be recognizedthough that individual capital goods can accomplish nothing on theirown It is together with other capital goods and with labor and landthat they may be seen to be (jointly) productive How then are we to

CAPITAL IN HISTORICAL PERSPECTIVE 53

account separately for the contributions of the individual capital goodsto the value that they help to produce And if ldquocapital in generalrdquo isto be thought of as a factor of production it seems necessary that arelationship should be established between the notion of ldquocapital in theaggregaterdquo and the individual capital goods involved in the productionprocess e laer are diverse and heterogeneous in nature and it is notimmediately obvious how one should proceed to add them together Alogical method is in terms of their values their prices But as we shallsee it is only in equilibrium that such prices have the meaning that weseek and even then will not be free of contentious ambiguity

us investigations in capital theory oen return repeatedly to thesame fundamental questions

bull What is capitalbull Is it a separate factor of productionbull Is it a fundbull Or is it a physical stockbull How is capital to be measuredbull What is the nature of the earnings of capitalbull How is this related to interestbull How are capitalrsquos earnings determined and justifiedbull What determines capitalrsquos earnings in relation to earnings ingeneral that is how does capital feature in the distribution ofincome and wealth generally

ese questions are related to the historical development of capital the-ory We illustrate this with a brief impressionistic historical outline1

Adam Smithrsquos Corn Economy

Adam Smith was interested in the causes of economic progress ereis a natural and important connection between capital and economicgrowth and development Growth theory had obviously not yet be-come the technical abstract specialization that it is today Yet there isa ldquomodelrdquo implicit in his work (Hicks 196536ndash42 Kregel 197620ndash23

1is is obviously not meant as a detailed or complete history of thought in capitaltheory Such a project would require a separate and probably much longer workWhat follows here is simply a highlighting of certain ideas in their historical context

Lachmann 1996130ndash132)2 Smithrsquos world was still largely an agrariansociety but his implicit model survived the circumstances of his timeAs we shall see Ricardo in particular tried to extend Smithrsquos insightsinto a world to which it was much less suited is had significantconsequences for the development of capital theory Most moderneconomists working in the area are influenced (whether they know itor not) by Ricardorsquos agenda

We concentrate on those aspects of Smithrsquos work that arise out ofhis way of looking at capital in a predominantly agricultural society(Lachmann 1996130) although of course he was aware of and saidmuch about the implications of the rapid industrialization that wasoccurring An agrarian economy (we may designate it as a ldquocorn econ-omyrdquo) depends largely on harvests Next yearrsquos harvest depends toa large extent on how much of this yearrsquos harvest is plowed back inseeds and even more on how much corn there is this year is yearrsquosharvest has three possible uses to keep the working population aliveand perhaps growing to feed the animals used in production and touse as seed for production us this yearrsquos harvest may be seen as atype of capital sto In a modern economy it is natural to see elementsof the capital stock at any time that are not being used as a result ofobsolescence or incomplete adjustment to new conditions In a corneconomy by contrast all capital is used is homogeneous and is turnedover regularly once a year So we have an initial harvest a workingpopulation of certain size and the possibility of a harvest next yearthat is dependent on labor and its productivity It is not clear whatSmith thought about the determination of wage rates It is easiest toassume that he took it to be determined by subsistence or convention(ibid131)

We may formalize Smithrsquos model in a rather simple way (Hicks196536ndash42 Lachmann 1996130ndash142) ere is a crucial relationshipbetween this yearrsquos harvest and next yearrsquos harvest is yearrsquos output119884119905mdashour capital stock for this yearmdashis divided up into seed corn fodderand food production In the simplest formulation the whole of thecorn that the laborers uses for their (and their animalsrsquo) consumption

2is ldquomodelrdquo described below is derived by Hicks from SmithrsquosWealth of Nations(1982) book II ch III ldquoOf the Accumulation of Capital or of Productive and Unpro-ductive Laborrdquo

plus their planting may as well be counted as their ldquowagerdquo e capitalstock then comprises a ldquowage fundrdquo necessary to keep society goinguntil the arrival of the next harvest en if119873 is the number of laborersthe (average) wage rate 119908 = 119884119905 119873 or

119884119905 = 119873119908 119908 = real wages per worker

Growth in the corn economy will thus depend on the number of work-ers119873 and on productivity 119901 the amount of corn produced (on average)by each worker

119884119905+1113568 = 119901119873 = 119901119884119905 119908 or 119884119905+1113568 119884119905 = 119901 119908

us the rate of growth is equal to 119901 119908 minus 1 is growth rate variesinversely with the wage rate and directly with average productivity If119901 rises faster than population the wage rate can rise

is model neglects to account for all sections of the economy forexample the towns and the landowners If we assume that 119896 lt 1 ofany yearrsquos output is set aside each year to feed the non-agrarian classesthen the wage rate must be 119896119884119905 119873 = 119908 e capital stock is now not119884119905 but rather 119896119884119905 = 119870119905 = 119873119908 So 119884119905+1113568 = (119901 119908)119870119905 = 119896 (119901 119908)119884119905 and therate of growth is 119896 (119901 119908) minus 1 Obviously as formulated 119896 is a measureof the ldquodragrdquo on economic growth imposed by the ldquononproductiverdquoelements of society is conclusion is a result of formulating outputas consisting solely of corn and gives rise to some obvious objectionsis aspect of Smithrsquos model is of less concern to us at this pointhowever than at some others

Smith did not think of 119901 119908 and 119896 as constants Economic growthmeans that the wage fund grows ahead of population Smith believedthat 119901would increase over time as a result of the division of labor thuscausing a rise in 119908 us 119901 and 119908would grow together though not nec-essarily at the same rate Economic growth and capital accumulationin turn made the division of labor possible

e annual produce of the land and labor of any nation canbe increased in its value by no other means but by increasingeither the number of its productive laborers or the productivepowers of those laborers who had before been employed enumber of productive laborers it is evident can never be much

increased but in consequence of an increase of capital or of thefunds destined for maintaining them e productive powersof the same number of laborers cannot be increased but inconsequence either of some addition and improvement to thosemachines and instruments which facilitate and abridge labor orof a more proper division and distribution of employment Ineither case the additional capital is almost always required Itis by means of an additional capital only that the undertaker ofany work can either provide his workmen with beer machin-ery or make a more proper distribution of employment amongthem3 (Smith 1982343)

us Smith regarded saving as necessary for the achievement of eco-nomic growth and the earning of profit consequent not simply uponthe accumulation of capital but significantly upon the fruits of the divi-sion of labor In modern terms Smith sees accumulation and technicalprogress as being tied together And although he seems to identify atype of diminishing returns this is clearly not in the form of a decliningrate of return to investment in a given mode of production but ratherrefers to the eventual possible exhaustion of investment opportunitiesfor extending the division of labor (that is for the discovery and in-troduction of new and improved production methods) and this leadsnaturally to reliance on foreign markets

Smithrsquos corn economy is obviously a special case that raises a num-ber of questions It is not clear for example whether he thinks ofmachines buildings etc as capital and how their accumulation is tobe treated4 However it is an instructive special case In this economysince capital is homogeneous and is identical to output there is noproblem concerning the valuation (absolutely or relatively) of eitherus the rate of yield or of growth can likewise be measured unam-biguously It is a one-commodity subsistence fund economy in equi-librium where the capital stock uniformly lasts one period Durability

3ldquoIt is worth emphasizing that Smithrsquos concern with economic growth takes usback in a sense to the oldest part of the edifice namely his treatment of the division oflabor the point being that the increasing size of the market gives greater scope to thisinstitution thus enhancing the possibilities for expansion which are further stimu-lated by technical change in the shape of the flow of inventionrdquo (general introductionin Smith 198231)

4But see Ahiakpor (1997)

of capital thus plays no role ere is no question about the appro-priate composition or durability of the capital stock (although Smithwas aware of the changing shape of productive equipment) and pastmistakes have limited influence ere are no individual differences inexpectations regarding the type of product to be expected nor the dateat which it is to arrive (although of course there may be some short-term uncertainty regarding the harvest) us although productiontakes time time does not feature in the valuation of capital and outputexcept in so far as future output may be discounted5 Neither laborunits nor time units need to be used to value the capital stock Whenwe turn to Ricardo we see how special these conditions really are

Ricardorsquos Uniform Rate of Profit

In the more industrialized economy of 1815 it was no longertolerable even as an approximation to assume that all capitalwas circulating capital nor that even in a metaphysical senseall capital was ldquocornrdquo e self-containedness of the single pe-riod was nevertheless so powerful an instrument and so muchdepended upon it that Herculean efforts had to be made toretain it What Ricardo did in his efforts to retain it can nowbe understood (thanks to Mr Sraffa) Homogeneity was tobe retained by reducing capital to its labor content (the labortheory of value) fixed capital was to be reduced to circulatingby consideration of periods of production (in the manner tobe worked out more fully decades later by Jevons and Boumlhm-Bawerk) But all the power of these devices could not savethe self-containedness It is apparent from Ricardorsquos own workthat even in his hands the static method is already confiningitself to its proper placemdashto the comparison of static equilibriaeven of stationary states it cannot extend to the analysis of adynamic process In the light of the subsequent developmentsthere is nothing surprising about that (Hicks 196547)

Asmentioned Smithrsquos model was essentially a subsistence fund theoryere is a stock of food to maintain workers from one harvest to thenext What capital does for the owner is to facilitate the employment of

5Smithrsquos discussion of interest (book II ch IV) makes it clear that he considersinterest to be something different from profits We shall return to this question below

a certain number of workers for the production of a certain output Alleconomic considerations are such that one never has to look beyondthis one-year horizon is makes the application of the static methodpossible and largely excludes the consideration of expectations

Ricardo had to face problems that Smith was able to avoid Oncemachinery played a large part in the economy Smithrsquos assumptionof a homogeneous capital stock was no longer defensible e labortheory of value served to bring all economic goods within a commondenominator Ricardo used the ldquolabor hourrdquo as a unit of measurementlabor time is the common standard of comparison Machines corn andcale all cost labor and are seen to be comparable in those terms If wehave a stock of circulating capital (for example a stock of corn) we canask howmany hours of labor it took to produce it and get a value for theinput But if we have a machine lasting fieen years although we cansay its production took labor hours the total input is not used up in oneyear and enters successively into the output of fieen years Ricardodeals with this by regarding fixed capital likemachinery as circulatingcapital that circulates more slowly Some part of the machine gets usedup in each of the fieen years Fundamentally there is no differenceAll capital stocks rotate it is only a maer of degree It thus becomespossible to calculate the value of the inputs of any capital item thatmatures in any given year and to compare it with the value of its outputin that year thus being able to calculate a rate of return

Ricardorsquos main concern was with the distribution of income be-tween the various categories of inputs and their owners It was inorder to give an account of the earnings of capital that he had to findsome way to reduce the heterogeneous capital items to some commonmeasure His basic argument concerns the tendency for rates of returnon various capital investments to become equal is tendency pro-vides a mechanism for determining flows of capital to various types ofproduction In long-run equilibrium a capitalistic economy establishesa uniform rate of profit is is what explains the distribution of wealthIn equilibrium all capital ventures earn the same rate of profit Ricardothus started the now common practice of using what would be thestate of affairs in a hypothetical situation of long-run equilibrium asituation that is an end state of an indefinite number of interactionsin an essentially unchanging environment as if it were the everyday

state of affairs is is the equilibrium method of explanation Wespeak of the rate of profit on capital as though it were a parameter

Ricardorsquos concerns reflected his preoccupation with the future ofcapitalistic economies e event of the Napoleonic blockade and theconsequent rise in food prices led him to wonder about the long-termtrend of an economy in which the population was rising How wouldthe population get fed He seemed to accept Malthusrsquos idea that thepopulation would grow in such a way as to keep the wage rate atthe bare level of subsistence But if the population was growing thiswould lead to the use of land of progressively inferior fertility So withthe wage rate fixed at subsistence level and the margin of productionbeing extended to inferior land the earnings (rent) of the landownerson the infra-marginal land would tend to rise is means that therate of profit is bound to fall Pushed to its logical conclusion therate of profit would fall to zero at which point capital accumulationwould stop A stationary state would have been reached ere couldbe no such thing as permanent growth e only possible exceptionto this result is in ldquoimprovements in machinery connected with theproduction of necessariesrdquo ldquodiscoveries in the science of agriculturerdquoand international trade (Ricardo 1973120 Kregel 197624)

ese exceptions notwithstanding Ricardorsquos emphasis and hislegacy are his method of concentration on the hypothetical long runIt is this that prompts Lachmann to label both the Cambridge Englandneo-Ricardians and the neoclassical growth theorists as Ricardians(Lachmann 1973) ey share the method of comparative static equilib-rium analysis that derives from Ricardo and his interest in accountingfor the ldquolawsrdquo of distribution In this way the focus is clearly on themechanisms of social development and away from aspects of humanaction and decision If human planning features at all in the capitalaccumulation process it is in a mechanical and implied way Actionis relied on implicitly to bring about the equilibrium that is assumedIf some capital venture were to become unprofitable capital wouldbe withdrawn and invested elsewhere But where capital is durableit can only be withdrawn very slowly us we must assume that nochanges occur while capital is in the (long) process of being shiedfrom areas of low profitability to areas of high profitability And weare not permied to ask how it is known which are the areas of low

and high profitability Somehow the economy is envisioned to gropeits way soon enough to a configuration of capital items on which therate of profit is uniform and the maximum possible Reflecting onthe discussion of the previous chapter we realize that in a world ofcontinuous unexpected change flows of capital will not be able to keepup and equalization will never occur Prices of the various capitalgoods will be such that the original labor value invested in them hasno enduring meaning and the whole Ricardian basis would seem to beof dubious relevance Relevance rather than realism is the key andevidently relevance is oen ldquoin the eye of the beholderrdquo Ricardorsquoslong-run equilibrium method we shall see continues to commandmany adherents

In his discussion of the distinction between circulating and fixedcapital Ricardo was forced to consider the role of time in productionHis labor theory of value contains the elements of what was to becomea particular approach to dealing with the time dimension in capital the-ory In a world of heterogeneous capital items time is of the essenceA very different approach to dealing with it was provided by CarlMenger

Mengerrsquos Time Structure of Production

Mengerrsquos pioneering approach is responsible for our thinking of capi-tal in terms of a time structure reflecting the structure of capital goodsemployed in the production process ere is no aempt in Menger toreduce the variety of goods and services available at various dates toa single dimension At any moment in time some goods are useful forimmediate consumption and some are only useful in so far as they con-tribute to the production of goods available for immediate consumptionAnd since production takes time a time element is already implicit inthe contemplation of a set of economic goods at any single moment intime

Menger thus characterizes production as a sequential process inwhich goods of higher order (capital goods) become transformed intogoods of lower order (consumption goods) Capital goods are varied innature but can be classified by where they fit along a time continuuminto the production process e lowest or first-order goods are as

noted above consumption goods e lowest-order capital goods aresecond order e next highest are third order and so on With thismodel he makes clear that the element of time is inseparable from theconcept of capital Any theory that treats the process of production asinstantaneous necessarily misrepresents reality in an important way

e transformation of goods of higher order into goods of lowerorder takes place as does every other process of change in timee times at which men will obtain command of goods of firstorder from the goods of higher order in their present possessionwill be more distant the higher the order of these goods

(Menger 1976152)

And the rewards to saving result only if more time-consuming meth-ods of production are adopted

[B]y making progress in the employment of goods of higherorders for the satisfaction of their needs economizing men canmost assuredly increase the consumption goods available tothem accordinglymdashbut only on condition that they lengthenthe periods of time over which their activity is to extend in thesame degree that they progress to goods of higher order

(Menger 1976153 italics added)

e higher-order goods that people come to own must allow greaterproduction if there is to be progress at is theymust (in combinationwith other goods) be able to produce a greater volume of consumptiongoods in the future or in other words they must be able to extendconsumption further into the future It is interesting to note that whileBoumlhm-Bawerkrsquos later discussion of the greater productivity of moreldquoroundaboutrdquo methods of production is clearly drawn from Mengerthe laer was clear that there is nothing mechanical about the rela-tionship between saving (diverting consumption from the present tothe future) and productivity Saving may be necessary but it is notsufficient for economic progress He envisaged the time-consumingcreation of specific capital goods to be a necessary condition for achiev-ing economic progress

Menger first introduces these ideas in connection with processesin nature People find the fruits of nature valuable But at an earlystage in the development of civilization they learn that they can do

more than simply ldquogather those goods of lowest order that happen tobe offered by naturerdquo (Menger 197675) By intervening in the naturalprocesses individuals can have an effect on the quantity and qualityof the subsequent yield

To understand the objectives of the ldquoproducersrdquo is to under-stand that the earlier a producer intervenes the greater are theopportunities to tailor the production process to suit his ownpurposes is provides an intuitive basis for the notion thatthe more ldquoroundabout processesrdquo tend to have a greater yieldin value terms (Garrison 1985165)

It is important to realize the role of subjective value in Mengerrsquos cap-ital theory e value aributed to any capital good is prospectivenot backward looking as with Ricardo ldquoere is no necessary anddirect connection between the value of a good and whether or in whatquantities labor and other goods of higher order were applied to itsproductionrdquo (Menger 1976146) At any point in time there is a capitalstructure characterized by capital goods of various orders whose valueis determined by the values aributed by consumers to the consump-tion goods they are expected to produce ldquoe value of goods of higherorder is always and without exception determined by the prospectivevalue of the goods of lower order in whose production they serverdquo(Menger 1976150) ese values manifest in the market as prices Aslong as these prices remain (and are expected to remain) constant andas long as there are no technical changes in methods of productionthe capital structure will remain constant But if there should be apermanent change in the price of even one consumption good thiswill almost always imply the need to change the capital structure insome way Changes and substitutions will occur in response to theperceived changes in prospective output values

e level and paern of the employment of resources (includinglabor) and their earnings is determined and thus depends on the stronglink between the structure of consumption and the structure of productionChanges in the demand for one (or some) consumption good(s) (relativeto others) cause changes in the evaluation and use of particular capitalgoods and in employment e implication in Menger is that themarket can accomplish this smoothly

Time is inevitably involved in the notion of capital Since thevalue of higher-order (capital) goods depends on the prospective valueof the consumer goods they are expected to produce the elapse oftime and with it the arrival of unexpected events implies that someproduction plans are bound to be disappointed and thus the value ofspecific capital goods will be affected e economic consequences ofhuman error are implicit in Mengerrsquos view of capital

Menger and Ricardo thus present contrasting and really irreconcil-able visions Adopting Mengerrsquos perspective one cannot lose sight ofthe variety of goods and services and individual activities and choicesere is no suggestion of a uniform rate of profit And yet there is aninescapable order within the variety provided by our understanding ofthe purposes of these individuals ldquoe process of transforming goodsof higher order into goods of lower order must always be plannedand conducted with some economic purpose in view by an economiz-ing individualrdquo (Menger 1976159ndash160) We see here the need to con-sider aspects of intertemporal planning discussed above in Chapter 3No such need was suggested in our analysis of Ricardorsquos approach

Boumlhm-Bawerk Interest and the Average Period of Production

Introduction

Boumlhm-Bawerk is probably the economist most oen cited in connec-tion with the development of capital theory He is thought of as theldquofatherrdquo of Austrian capital theory and credited with being the firstto introduce the element of time and its implications clearly into con-siderations of capital (Hennings 1987d233) is conception neglectsthe contribution of Menger Boumlhm-Bawerkrsquos work on capital was aconscious extension of Mengerrsquos His departures from Menger arenot seen universally as being an advance6 As we shall see some ofthe later Austrians had reason to regret aspects of Boumlhm-Bawerkrsquoswork on capital and even more so the interpretations to which itgave rise Whereas Menger produced hardly more than twenty-odd

6is statement relates to Boumlhm-Bawerkrsquos work on capital His work on interesttheory was clearly an advance and marks the beginning of the pure time preferencetheory of interest to be dealt with below

pages on capital theory (in spite of which it may be said that he laidthe groundwork for a comprehensive theory of capital) Boumlhm-Bawerkproduced three large volumes and some shorter works It was a majorpart of his lifersquos work It is to be expected then that the scope forvarious and differing interpretations might be quite large AustrianRicardian and neoclassical capital theorists all find much with whichthey can agree in Boumlhm-Bawerk albeit much also to disagree withA reading of Boumlhm-Bawerk reveals an uneasy amalgam of the ideasof Menger and Ricardo Capital theorists in general have chosen toemphasize the Ricardian elements7 e Mengerian elements mightjust as easily have been emphasized had capital theory developeddifferently As it is modern capital theory with its reliance on ldquoproduc-tion functionrdquo reasoning can with some justification be traced back toBoumlhm-Bawerk (along with Wicksteed and some others) Much of theambiguity surrounding the assessment of his contributions relates tohis use of a theoretical device designed to provide a physical measureof the capital stockmdashthe average period of production

e Advantages and Disadvantages of Capitalistic Production

Boumlhm-Bawerkrsquos characterization of a capital-using economy is verysimilar to Mengerrsquos Production is a process involving time Originalfactors are transformed with the aid of produced means of productioninto consumption goods Like Menger he too conceived of capitalgoods as being related to one another in terms of the stage of the

7ldquoHowever much he denied any adherence to classical cost theories of value hisview of production and the role of capital and time bear the mark of the Ricardian tra-ditionrdquo (Hennings 1987a104 also Hennings 1987c) See also Hennings (1987b114ndash115)and Hennings (1997ch 8) Yet consider this same theoristrsquos capsule assessment

A leading member of the Austrian School he was one of the mainpropagators of neoclassical economic theory and did much to help itaain its dominance over classical economic theory His name is pri-marily associated with the Austrian theory of capital and a particulartheory of interest But his prime achievement is the formulation of anintertemporal theory of value (Hennings 1987a97 italics added)

Says Kregel (197628ndash29) ldquoBoumlhm-Bawerkrsquos role in the Austrian theory was to combinethe Ricardian approach to capital in terms of labor and time with the lsquonewrsquo marginalapproach to pricing through utilityrdquo

production process that they occupy And like Menger he conceivedan increase in capital to involve a change in the time structure of produc-tion (not his term) in some way It is not simply an augmenting of eachtype of capital good at each level of maturity (each stage of production)but a change in the internal structural relationships Like Menger heheld that capital goods derived their value from their usefulness inthe production of consumption goods their value was to be derivedfrom the value to consumers of the goods they produced All durablecapital goods are valued by the present value of their services usinga subjective rate of discount (to be discussed below see Hennings1997132) He emphasized the heterogeneity and specificity of individ-ual capital goods and denied that they could be aggregated into somephysical measure of the capital stock Hennings quotes Boumlhm-Bawerkas follows

A nationrsquos capital is the sum of heterogeneous concrete capitalgoods To aggregate them one needs a common denominatoris common denominator cannot be found in the number ofcapital goods nor their length or width or volume or weightor any other physical unit of measurement e only measur-ing rod that does not lead to contradictions is the value [ofthese capital goods] (Hennings 1997132 his translation of

Boumlhm-Bawerk 1959)

Boumlhm-Bawerk denies that capital goods are individually or intrinsi-cally productive and insisted that the production processes that theymake possible are the sources of any increases in value that arise Butsince these processes can be characterized by a series of stages ofproduction successively further back from the ultimate consumptiongoods in which they culminate he perceived a connection between thenumber of such stages and the amount of value added at is thereis a strong intuition connecting the length of production indicated bythe number of stages involved (the degree of ldquoroundaboutnessrdquo) andthe degree of productiveness that results

ere are two concomitants of the adoption of the capitalistmethods of production One is advantageous the other disad-vantageous We are already familiar with the advantage Withan equal expenditure of the two originary productive forces

labor and valuable forces of nature it is possible by well cho-sen roundabout capitalist methods to produce more or beergoods than would have been possible by the direct noncapitalistmethod It is a truism well corroborated by empirical evidence

(Boumlhm-Bawerk 1959 Book II 82ndash83 footnote referencescrediting Lauderdale and Jevons omied)

[O]ne thing that can be stated with a reasonable degree of cer-tainty is the proposition that as a general rule a wisely se-lected extension of the roundabout way of production does re-sult in an increase in the magnitude of the product It canbe confidently maintained that there is no area of productionwhich could not materially increase its product over the resultobtained by its present method (ibid84ndash85)

Boumlhm-Bawerk felt that a more ldquotime-consumingrdquo process of produc-tion would not be chosen unless it was more productive in this senseunless it added sufficiently more value to compensate for the longerldquowaitingrdquo required ldquoe disadvantage which aends the capitalistmethod of production consists in a sacrifice of time Capitalist round-aboutness is productive but time consuming It yields beer con-sumption goods but not until a later timerdquo (ibid82) us by wiselyselecting more roundabout methods of production increases in valuecan be obtained and these have to be weighed against the ldquocostrdquo ofwaiting In addition however it is apparent that the returns to greaterdegrees of roundaboutness must eventually diminish In summary

All consumption goods which man produces come into exis-tence through the cooperation of human powers with the forcesof nature which are in part of economic character in part freenatural powers Man can produce the consumption goods hedesires through those elemental productive powers He does soeither directly or indirectly through the agency of intermediateproducts which are called capital goods e indirect methodentails a sacrifice of time but gains the advantage of an increasein the quantity of the product Successive prolongations of theroundabout method of production yield further quantitative in-creases though in diminishing proportions

(ibid88)

Roundaboutness and the Average Period of Production

Boumlhm-Bawerkrsquos lengthy exposition is generally imprecise His discus-sions can be read as suggesting informal general properties of real cap-italist economies Capital accumulation involves judicious changes inthe time structure of production that furnish greater output value Andoutput value is increased not only by augmenting existing productsbut also by producing ldquobeer goodsrdquo Both output and input undergoldquoqualitativerdquo change as opposed to simply quantitatively augmentingexisting processes (even though he seems to be assuming a given tech-nology) And this interpretation is strengthened by his connecting thefruits of roundabout production to the division of labor

Our modern system of specialized occupations does of coursegive the intrinsically unified process of production the extrinsicappearance of a heterogeneous mass of apparently independentunits But the theorist who makes any pretensions to under-standing the extrinsic workings of the production process in allits vital relationships must not be deceived by appearances Hismind must restore the unity of the production process whichhas had its true picture obscured by the division of labor

(ibid85)

Yet perhaps in order to deal with a variety of criticisms for example asto the precise meaning of roundaboutness in the very next paragraphBoumlhm-Bawerk now aempts tomake his observationsmore formal andprecise An aempt to capture the degree of roundaboutness by mea-suring a period of production from the original factors to the emergentconsumption good would be impossible and misleading in the modernworld with its vast array of inherited capital goods One could not asit were trace production back ldquoto the moment when the first finger isstirred in the making of the first intermediate product that was laterused in the production of the good in question and as continuing untilits final completionrdquo (ibid86) And so he introduces the average periodof production

It is more important as well as correct to consider the averagetime interval occurring between each expenditure of originaryproductive forces and the final completion of the ultimate con-sumption good A production method evinces a higher or lower

degree of capitalist character according to whether on the av-erage there is a longer or shorter period of waiting for theremuneration of the expenditure of the originary productiveforces labor and uses of land (ibid86)

And he proceeds to define arithmetically the average period of produc-tion which we may succinctly express as follows

119879 =sum119899119905=1113568 (119899 minus 119905)119897119905sum119899119905=1113568 119897119905

= 119899 minus (1198991114012119905=1113568

119905 119897119905119873 )

where 119879 is the average period of production for a production processlasting 119899 calendar periods 119905 going from 1 to 119899 is an index of eachsub-period 119897119905 is the amount of labor expended in sub-period 119905 and119873 = sum119899

119905=1113568 119897119905 is the unweighted labor sum (the total amount of labortime expended) us 119879 is a weighted average that measures the timeon average that a unit of labor 119897 is ldquolocked uprdquo in the production processe weights (119899 minus 119905) are the distances from final output 119879 dependspositively on 119899 the calendar length of the project and on the relationof the time paern of labor applied (the points in time 119905 at whichlabor inputs occur) to the total amount of labor invested 1198738 Since thisformula is in units of time it may be added across various processes toyield an overall measure of roundaboutness In this way Boumlhm-Bawerkhoped to have solved the problem of measuring roundaboutness

It is highly probable that some fraction of a working day willhave been expended centuries ago But because of its minute-ness it would be a magnitude which would influence the av-erage so lile that it can almost always simply and safely bedisregarded (ibid87)

And he seemed to place a high reliance on this formulation

Wherever I have spoken in this or preceding chapters of a pro-longing of the roundabout method of production and of the

8In the special case where there is an even flow on inputs so that the same amountof labor time 1198971113577 is applied in each period sum119899

119905=1113578 (119899 minus 119905)119897119905 = (11135681113569) 119899 (119899 + 1113568) 1198971113577 and sum119899119905=1113578 119897119905 =

1198991198971113577 and therefore 119879 = 119899 1113569 + 11135681113569 or simply 119899 1113569 (when 119899 is large enough so that the11135681113569 can be ignored or when 119879 is expressed in continuous time where it is absent) So

degree of capitalist character I would have it understood thatI mean this in the sense just set forth [the average period ofproduction] [T]he measure must be the mean duration ofthe process and that mean must be computed by averagingunits each of which represents a period of time For wantof a beer term I shall use ldquoaverage period of productionrdquo todistinguish it from the absolute production period (ibid87)

In this way Boumlhm-Bawerkrsquos lengthy intuitive discussion of the natureof capitalist production as an increasing reliance on produced meansof production in specialized production processes became associatedwith this rather specific and limited formula ough in actuality asmall part of his work as a whole and arguably an aberration in hisbreadth of vision it became the focus for many prolonged and ener-getic debates in capital theory

Criticizing the Average Period of Production

Some obvious observations can immediately be made e formula iscrucially dependent on being able to identify the stages of productionIt is assumed that the process begins at stage 1 and ends at stage 119899 Inthis way any kind of ldquoloopingrdquo (coal is used in the production of ironand vice versa) where the output of one stage becomes available as aninput of an earlier stage is ruled out Second if the output is a flow (asit usually is) then we must also have some way to connect inputs thatoccur at time periods 119899 minus 119905 with precisely that output that arrives attime period 119899 and separate them from those that need to be connectedto outputs occurring at time periods 119899 + 119895 where 119895 is an index of timeperiods occurring aer 119899 In other words if the production process isa flow inputndashflow output process a set of inputs are used to producejointly a set of outputs occurring over time and the measuring of 119879becomes more problematic Similarly we must be able to identify theamount of labor time 119897 that is used is obviously presumes that it ispossible to reduce any labor heterogeneity to comparable terms likeefficiency units and then tomeasure the number of such units suppliedper period of time Also as it is formalized the services of land are

when inputs occur at the same rate over time each unit is ldquolocked uprdquo on average forhalf the length of the production period

omied although verbally they are definitely considered to be partof the process Boumlhm-Bawerk adds parenthetically ldquoLet us ignore thecooperating uses of land just for the sake of simplicityrdquo (ibid86) In-cluding the services of land while mathematically simple would raisethe practical prospect of accounting for the varying productivities ofeach unit of land used per period of time9

Traditionally Boumlhm-Bawerkrsquos average period of production con-struct though widely criticized has been popularly used (particularlyin mathematical models where it is easily converted to a continuoustime formulation (see Faber 1979 Orosel 1987)) as a purely labor-timeformulation with land neglected us it has come to seem that timeitself plays a role in the creation of value and not the contingentactivities (of humans or nature) that must necessarily occur in time ifvalue is to be created Or alternatively it could ironically be read as anexpression of the labor theory of value as suggesting that the essenceof any value is the labor time that went into it e average period ofproduction construct thus gave rise to a vision of production quite outof character with Boumlhm-Bawerkrsquos vision His general characterizationof a capital-using economy is in no way dependent on being able tomeasure practically or conceptually the degree of roundaboutness bythe average period of production or any other measure But in using itin the way that he did Boumlhm-Bawerk (inadvertently) encouraged theinterpreting of his work as suggesting a type of mechanical productionfunction in which production time could be used as a measure ofcapital itself and therefore of ldquocapital intensityrdquo e pivotal ingre-dient for the internal consistency of this approach is the presence orabsence of (Hayekian) equilibrium is can be seen by considering thecriticism leveled by Clark (and in slightly different form a generationlater by Knight against Hayek)

9It should also be clear that this formula does not allow for a unique or monotonicexpression of ldquoroundaboutnessrdquo In other words (a) this measure may yield a numberthat is consistent with an infinite number of input paerns different amounts of labortime occurring sooner or later in the process and (b) when considerations involvinginterest are included this measure may not rise or fall uniformly in any ranking ofroundaboutness as we add labor-time units at various points it may change direction(in its ranking) at some points under certain conditions if we change the inputs atvarious points in the production process ese types of considerations played animportant role in later criticisms of any aempt to measure capital in physical termsin the Cambridge debates which we will examine below

Boumlhm-Bawerk had aempted to incorporate Mengerrsquos vision oftime in the production process using a quantifiable concept Clark(1893) (and later Knight) aacked this concept as meaningless andindefensible and in the process suggested a view of capital in whichtime as we know it seemed to play no real part at all We have seenthat the average period of production can only be calculated when theproduction process is describable in a very particular way A favoriteexample in the literature is the case of wood production from a forestin which a fixed number of young trees are planted while the samenumber of trees are cut down each period It should be clear thatit is possible to say that since production and consumption go onsteadily each period10 they are in effect simultaneous11 Productionand consumption are synchronized and occur together all the time(Clark 1893313 198814ndash18 see also Hayek 1941114ndash145 181 195)In this case it is possible to calculate the period of production It isthe time that it takes on average for a tree to grow from a seedlinginto a mature tree ready to be cut If we assume that this time is thesame for each tree we have an even clearer measure Clarkrsquos criticismcan be understood to say that this time period is irrelevant since theforest is aer all a permanent source of wood Since productionand consumption are in effect simultaneous the relevant period ofproduction is zero is is the kind of vision that one is offering insuggesting that capital should be thought of as a ldquopermanentrdquo fund

10In this case as in many others ldquoproductionrdquo consists in harnessing the processesof natural biological growth for economic purposes ese were the first and in someways are the most fundamental capital processes Consequently much economic the-orizing about capital proceeds from these first cases to argue by extension and moreoen by analogy to other more complex cases

11In this example ldquoconsumptionrdquo is equated with the harvesting of trees Of coursein reality trees are inputs for further production processes that result in consumptionat a later date for example the manufacture of pencils e essential point how-ever is that the woodlot example above provides a case of perfectly synchronizedinputs and outputs that in principle could characterize other processes where inputslead ultimately to consumption Once such a process is completely established andbecomes ldquopermanentrdquo an endless and unchanging succession of inputs and outputsresults making it appear that production and consumption are indeed simultaneousAs explained in the text however this way of looking at theworld is superficially validonly as long as there are no changes in the paerns of consumption and productionAt any point of time in any real capital-using economy the capital structure thatexists will be only partially adapted to the ever changing paern of consumption

yielding a flow of income A ldquocapitalistrdquo economy is then one in whichcapital plays this role

According to Knight (1936) the period of production as applied tothe economy as a whole is always infinite or always zero dependingon the perspective that one adopts In the former case there is nosuch thing as an origin to the period of production e infrastructureof capital goods dates back to Adam and Eve ere must alwayshave been production with the help of some capital goods and partof gross output was always used to maintain current capital goods andproduce others Output is a continuous flow that never ends All socialproduction is continuous In the second case (where 119879 = 0) timeintervals are seen as irrelevant In other words we can either thinkof the production process as stretching back from the beginnings ofhuman history and forward into the unending future or we can thinkof the production process as essentially timeless since production oc-curs simultaneouslywith consumption us Clark andKnight arguedthat it is quite wrong to say that there are time intervals in productionConsumption and investment take place at the same timemdashthe two areconcurrent simultaneous e whole thing is a misconception

It is clear however that this view is valid only for an economythat has reached a state of stationary equilibriummdasha situation inwhichthe capital stock has been built up is suitably maintained and yieldsa continuous income (net of maintenance cost) It is a world whereunexpected change is absent and all production techniques are unam-biguously known is implies that all production plans are consistentwith one another In terms of the forest example the forest is alreadygrown and yielding a steady output when our analysis begins It tellsus nothing about the decisions to grow the forest in the first placewhen questions relating to the ldquoperiod of productionrdquo must have beenimportant Production and consumption only appear to be simulta-neous to the observer who does not care about the production plansthat gave rise to the production process in the first place One plantsseedlings today not in order to cut trees today but in order to cut treessome years from now One cuts trees today only because one plantedseedlings some years ago One cannot ignore the time element Wherethe capital structure and the array of consumption goods is continuallychanging production and consumption frequently do not even appear

to be simultaneous Even where we have a simultaneous and perfectlysynchronized production process considerations of the time structureand the decisions related to it must still enter ldquoe posited simultane-ity of inputs and outputs literally leaves no time for an equilibratingprocess to take [or have taken] placerdquo (Garrison 1985129)

Clarkrsquos (and aer him Knightrsquos) emphasis on the technical and logi-cal aspects of ldquoperiod of productionrdquo concepts had the effect of makingcapital debates appear to be about abstract technical issues rather thanabout real economic issues To concentrate on Boumlhm-Bawerkrsquos (andlater Hayekrsquos) way of measuring production periods was to divert at-tention away from his (and Mengerrsquos) vision of the capital structure asinvolving time in the decisions made by producers It is these decisionsthat are the roots of the changes in the capital structure e period ofproduction that is relevant is that which is perceived by every producerindividually in the process of making a decision Time enters intodecisions through producersrsquo subjective evaluations of the constraintsand possibilities e period of production as an objective constructis inherently problematic but this is irrelevant for understanding theimportance of time of the fact that different consumption goods areor were available at different times e capital structure implies atime structure of production Boumlhm-Bawerk following Menger un-derstood this even though the Ricardian aspects of his work pointedin a different direction

Boumlhm-Bawerk as Neoclassical and Ricardian

Modern reformulations of Boumlhm-Bawerk focusing on his average pe-riod of production have shown how a connection can be made be-tween his ldquomodelrdquo and a classical and neoclassical approach (Dorfman1959 see also Lachmann 1996135ndash140) If a measure exists for thecapital stock and the rate of flow of output then the average period ofproduction can be measured as 119870 119891 where 119870 is the capital stock and119891 is the output emerging from the production process in each period(Alternatively if the average period of production 119879 is known or canbe computed by reducing all inputs to labor time the value of thecapital stock 119870 can be calculated as we shall see below) Dorfmanuses the example of a reservoir in a stationary situation where the

inflow equals the outflow implying a constant water level Clearlythe quantity of water can be expressed in terms of time For examplewith 100 million gallons of water 2 million per day flowing in and outthis would imply that the average drop of water was in the reservoirfor five days e ratio of stock to outflow is 5 which is the period ofretention of each drop e same basic logic can then be applied to thecapital stock

In terms of the labor theory of value 119891 will be equal to the value ofthe labor expended to produce it Using the same notation introducedfor Smithrsquos corn model above we have 119891 = 119873119908 and the average periodof production 119879 = 119870 119873119908 or

119870 119873 = 119879119908

According to Lutz interpreting Boumlhm-Bawerk ldquoAn increase in cap-ital per worker in the process of production [is] identical with theadoption of a longer more roundabout methodrdquo (Lutz 19679) So inmodern terminology the capitalndashlabor ratio is very simply related tothe average period of production and the wage rate In a neoclassicalframework where capital and labor can be continuously substitutedfor one another changes in 119903 and 119879 must be in opposite directions forany level of output 119870 is a direct function of 119879 (119879 is a proxy for 119870) and119903 (the rate of profit on 119870) diminishes with 119870 So 119870 119873 = Φ(119908 119903) withthe first derivative positive Implicit in this approach is a ldquoproductionfunctionrdquo where output 119876 is a diminishing function of the averageperiod of production 119879119876 = φ(119879) (see Hayek 1941140ndash141 189 208) SoBoumlhm-Bawerk can be seen as part of the neoclassical tradition leadingdirectly to modern growth theory to be explored below (See alsoHennings 1997144ndash148)

Alternatively in a classical world with a given capital stock anda given number of workers if the wage rate rises the average periodof production will fall If 119908 falls it becomes possible to extend theperiod of production Given the subsistence fund 119870 and given thetechnique of production the shorter the period the less productiveit is As long as 119870 and119873 increase proportionately nothing will change119879 and 119908 will not be affected But if 119870 for example increases relativelyto 119873 119879 or 119908 or both will rise us capital accumulation puts upwardpressure on the level of wages and the average period of production In

this way Boumlhm-Bawerk can be seen to have added a new dimensiona time dimension to Ricardorsquos theory of distribution If 119879 is takento be constant (as with Smith and Ricardo) a datum of the constanttechnique of production then the classical conclusion of an inversevariation between the wage and profit rates and the earnings of laborand capital follows

Further Considerations Value Labor and Equilibrium

Consideration of Boumlhm-Bawerkrsquos work as reducible to symbolic quan-titative representation illuminates some further interesting aspects ofperiod-of-production analysis Although he previously denied thatthis was possible Boumlhm-Bawerk has been interpreted as proposingthe average period of production construct in order to provide a purelyphysical measure of capital As we have noted this involves finessingthe qualitative aspects of labor and land But it also ignores the hetero-geneity of outputs Essentially it assumes either that themix of outputsis fixed or that production techniques for the different commoditiesare identical and fixed or that only one output is produced Whicheverit is since these assumptions violate the essence of an economy whereexchange plays a role in determining value these considerations sug-gest (1) the impossibility of a purely physical measure of capital (2) thelack of validity of the labor theory of value and (3) the limitations ofequilibrium analysis

1 e impossibility of a purely physical measure of capital Actu-ally at an early stage Boumlhm-Bawerkrsquos critics pointed out that even inhis simple case of one output and one input (labor) it is impossibleto obtain a purely physical measure when the role of implicit inter-est is considered Boumlhm-Bawerk purportedly showed that if outputis produced by homogeneous labor time over a period of time in acontinuous and unchanging fashion then the accumulated value ofthat output can be calculated as a weighted average of that labor timeImplicit in this is the idea that capital acts as a subsistence fund whichhas the appropriate time structure to feed the necessary labor atis the ldquorightrdquo amount of subsistence is available at exactly the righttime to sustain the labor necessary at each moment in time Now ifthere are alternative uses for this subsistence fund we must conceive

of it earning at least a return equal to its next best use at is to saythe subsistence fund can be imagined to be earning interest over timeWhen this interest is calculated as simple interest accruing only onceevery period it can be easily shown that it cancels out of the formulafor 119879 but when it is accrued continuously as compound interest as itshould be then the formula for 119879 depends on the rate of interest (seefor example Lutz 196720ndash21)12 Since Boumlhm-Bawerk used the size ofthe capital stock as a determinant of the rate of interest showing thatthe former depended on the laer seemed to involve catching Boumlhm-Bawerk in a hopeless circularity e unsurprising truth is that thesearch for a purely physical measure of the capital stock was hopelessfrom the beginning is was to be belabored later by the Cambridge(England) capital theorists who pointed to the fact that (in part) thedistribution of wealth determined the relative prices of outputs andparticularly determined the level of wages relative to profits So if therate of profit equals the rate of interest which enters into the value ofthe capital stock then the laer is not independent of the distributionof wealth us the same physical quantities of various capital goodswill not have a unique value And according to the Cambridge neo-Ricardians since capital thus cannot be measured in purely physicalterms the notion of its marginal product is meaningless and its earn-ings are thus le unexplained We shall consider this further in duecourse

2 e la of validity of the labor theory of value is questionhaving been dealt with adequately in the literature need not detain ustoo long (see for example Hausman 198117ndash20) Significant for ourpurposes is the role of time If two processes of production have identi-cal labor inputs at identical moments in time but one must be allowedsome extra time to ldquomaturerdquo (like glue drying or wine aging) how

12is can be easily seen as follows If 119897 units of productive inputs are applied in thefirst and the second periods and if only simple interest is considered then we may usethe equation 1113569119897(1113568+119879119903) = 119897(1113568+1113569119903)+119897(1113568+119903)where 119903 is the rate of interest to solve for theunknown average period of production 119879 is gives 1113568 1113572 units which is the same valueas yielded by Boumlhm-Bawerkrsquos formula (1113568+1113569119897) 1113569119897 Using compound interest howeverthe equation changes to 1113569119897(1113568 + 119903)119879 = 119897(1113568 + 119903)1113579 + 119897(1113568 + 119903) If we solve this for 119879 we get119879 = (11136111113613(1113569+1113570119903+1199031113579)minus11136111113613 1113569) 11136111113613(1113568+119903)which contains the rate of interest 119903 (Lutz 196720ndash21)

can we say that nevertheless they have the same value If resourcesother than labor for example physical space are needed over timeand these resources have alternative uses then the extra time takenwill mean that the output requiring more ldquopure timerdquo will commanda higher value in the market if it is to be produced Time itself doesnothing but production that occurs over time (naturally or with theaid of original non-labor resources) has a value unaccounted for bythe labor theory of value is criticism could perhaps be deflected bya reformulation in which all original inputs are ldquosuitablyrdquo valued Assuch it amounts to offering a ldquocost of productionrdquo theory of value andgoes to the heart not only of issues of prime concern to capital but alsoof issues of the entire corpus of economic theory For our purposes wemerely note that ldquocost of productionrdquo can only be said to ldquodeterminerdquovalue in some sense when equilibrium exists that is when the valueof the output in the market is (as expected) exactly equal to all thepayments to the inputs ere can be no capital gains and losses isbrings us then to our third observation

3 e limitations of equilibrium analysis e symbolic represen-tation of Boumlhm-Bawerkian analysis and the criticisms that surroundit only make sense in an equilibrium context By this we mean acontext in which production occurs in a continuous and unchangingfashion over time ere can be no disappointments regarding theproduction process Production plans must be explicit and must dove-tail If this were not the casemdashif producers for example had differentconceptions of what constituted the ldquocorrectrdquo method of productionmdashwe could not speak sensibly of an average period of production to becomputed from a consideration of input requirements At the veryleast there would be as many such average periods as there were opin-ions Similarly and even more relevant there can be no innovationsin production methods that render resources obsolete (in whole orin part) Every such innovation changes the paern of inputs andthe average period of production implicit in the equilibrium situationappropriate to it We may wonder what relevance this retains in aworld in which a large part of the process of capital accumulation isassociated with technological innovation is is something that willoccupy us at some length

Conclusion e Many Faces of Austrian (Boumlhm-Bawerkian)Capital eory

Austrian capital theory has become synonymous in the literature withBoumlhm-Bawerkian capital theory Ricardians neoclassicals and modernAustrians find much with which they can agree and from which theycan draw in Boumlhm-Bawerk But they are not the same things Boththe Ricardians and neoclassicals focus on some of the technical ques-tions that surround Boumlhm-Bawerkrsquos empirical insights on the greaterproductivity of roundabout methods of production And they interpretthese within an equilibrium framework e modern Austrian (marketprocess) theorists following Mises Hayek Lachmann Kirzner andRothbard (and also Feer) focus on some of Boumlhm-Bawerkrsquos less formalpronouncements and draw some crucial insights from them In particu-lar these involve the role of time in production and the nature of profitsand interest We shall examine this below But first we must take noteof some developments arising out of these various interpretations ofBoumlhm-Bawerk notably growth theory and neo-Ricardian distributiontheory

CHAPTER 5

Modern Capital eory

Wicksell and others aempted to defend and extend Boumlhm-Bawerkrsquosapproach (Lutz 1967 Ebeling 1997) With the advent of the Keyne-sian revolution however interest in capital theory waned It revivedslowly in the post-war period In retrospect we may identify two mainlines of development One is the familiar neoclassical approach inwhich capital simply came to be understood as an amorphous stock ofproduction potential equal to 119870 as an argument in a production func-tion e other is the resurgence emanating from the contributionsof Joan Robinson (1956) and Pierro Sraffa (1960) of the Ricardian clas-sical approach (the neo-Ricardian School) in which capital and laborare not continuously substitutable for each other and the earnings oflabor relative to capital (the prime focus of this literature) are seen tobe determined by ldquosocialrdquo rather than economic conditions Moderncapital theory controversy consists largely in the clash of these twoperspectives Ironically as explained above both of these approachescan be traced to the Ricardian aspects of Boumlhm-Bawerkrsquos work

e Production Function Approa

e Production Function as Metaphor

eproduction function is a metaphorical device (Lewin 1995288ndash290)It is amathematical shorthand expression for an input-output process1

Its use was motivated primarily by an aempt to account for the way

1ldquo[T]he very idea of a lsquoproduction functionrsquo involves the astonishing analogy ofthe subject (the fabrication of things about which it is appropriate to think in terms ofingenuity discipline and planning) with the modifier (a mathematical function aboutwhich it is appropriate to think in terms of height shape and single valuedness)rdquo(McCloskey 198579)

in which economies grow It is the basis of modern growth theory andof growth accounting of the aempt to answer the question Whatfactors account for the observed growth in the economy and to whatextent As such it also answers the question What explains the earn-ings of the various inputs and their owners Aggregate output 119876is seen to result invariably and inexorably from the application ofaggregate inputs 119870 and 119873 All three have been identified with variousstatistical aggregates e classic treatment is Solowrsquos seminal article

119876 = 119860(119905) sdot 119891(119870119873) (51)

where the ldquomultiplicative factor119860(119905) measures the cumulated effect ofshis over timerdquo (Solow 1956402) e shis in the production functionto which he refers imply ldquotechnical changerdquo

As with the formulations associated with Boumlhm-Bawerkrsquos theoryit is possible to get carried away with the technical aspects of theproduction function and to spend time in detailed examination of itsvarious possible forms (CobbDouglas CES etc) and their implicationsA more charitable and perhaps more enlightening way to interpretthe growth theory literature is as ldquoan invitation to a conversationrdquo econversation is about the best way to describe ldquoeconomic progressrdquois is clear from the very start In the above formulation Solow isunable to account for the growth observed in (measured) output byconsidering inputs of (measured) 119870 and 119873 alone As a result he mustlook to something else to explain the ldquoresidualrdquo In this case it is 119860(119905)the ldquotechnical changerdquo parameter So growth is a result of inputs ofcapital labor and technical progress e subsequent conversationis basically about what this means and what these things (capital la-bor and technical progress) really are e conversation has indeedbeen considerably broadened in recent years with a revival of growththeory which has concentrated on these questions Because it hasturned to an explanation of technical progress in terms of economicallymotivated decisions rather than as an ldquoexogenousrdquo (unexplained) shiparameter it has been called ldquoendogenous growth theoryrdquo (for surveyssee Grossman and Helpman 1990 1994 Lucas 1990 Romer 1990 1994Solow 1994) In the process the meaning and nature of the productionfunction and its arguments (capital labor and technical change) have

MODERN CAPITAL THEORY 81

come under closer scrutiny We can examine this further by taking acloser look at the implications of the production function approach

Constant Returns to Scale and Endogenous Growth eory

Essentially the production function depicts a process of physical trans-formation of inputs into outputs To be of any practical use the form ofthis transformationmust be indicated at is it must be able to specifyhow the output varies in response to changes in the inputs e notionof constant returns to scale (CRS) comes to mind It seems logical thatif all of the relevant inputs were doubled the output should as a resultdouble And if CRS does prevail it then follows that returns to any oneinput factor that can be continuously varied while the others are heldconstant will diminish us the earnings of the factor inputs (and byimplication of their owners) can be explained by assuming that theyare paid in terms of the value of their declining marginal products

CRS rests as Romer (199098 199412) has put it on the notion ofreplication If all of the relevant inputs are correctly identified then itis possible in principle to replicate (therefore duplicate) the process

e most basic premise in our scientific reasoning about thephysical world is that it is possible to replicate any sequence ofevents by replicating the relevant initial conditions (is is botha statement of faith and a definition of the relevant conditions)For production theory this means that it is possible to doublethe output of any production process by doubling all of the rivalinputs (Romer 199098 italics added)

e notion of physical causation (determinism) is at the very basisof production theory is notion is surely as a principle not opento dispute It is almost tautological If all the relevant conditions(including the necessary individual actions following upon consciousdecisions) that gave rise to (ldquocausedrdquo) any situation were to somehowbe reinstated then the very same situation wouldmdashalmost by defini-tionmdasharise again is is held to be true without exception except forthe passage of time In the physical sciences when dealing with easilyverifiable and classifiable events (like the full moon the emergenceof a homogeneous product from a production line) the number of

relevant (initial) conditions is manageably small Replication identi-fication or production of the ldquosamerdquo event is thus quite simple In thesocial sciences however everything depends on correctly identifyingthese relevant conditions Although simple well-understood phys-ical processes like some production processes are easily replicatedthe transition from these to the aggregate economy level is extremelyproblematic

At the very simplest level there is the insurmountable problem ofaggregation of the diverse outputs and inputs and the correspondenceof the aggregate statistical values to the theoretical symbols (suppos-edly in purely physical terms) Yet as indicated above it is perhaps notnecessary to take these formulations so literally Looking at the pro-duction function as a metaphorical device inviting conversation andspeculation the above considerations suggest that the conversationis about the ldquorelevant initial conditionsrdquo is can be seen (and hasbeen clear for example in application of the HecksherndashOhlin theoryof international trade for many years) by considering the relationshipbetween factors of production and technical progress

Consider a CRS production function in three argumentsmdashland la-bor and capital (119871 119873 and 119870)mdashso that

119876 = 119891(119870119873 119871) and 120582119876 = 119891(120582119870 120582119873 120582119871) (52)

where 120582 is a positive scalar Call this a complete production function Itis complete in the sense that it includes every relevant and necessaryinput for the production of the product For a complete productionfunction it is possible to write

119892119876 = 1199041113568119892119870 + 1199041113569119892119873 + 1199041113570119892119871 (53)

where 119892 indicates the proportional rate of growth of the symbol and119904119894 (119894 = 1 3) is the ldquosharerdquo of the factor in (contribution to) thegrowth of the output 1198921198762 It must be true that 1199041113568 + 1199041113569 + 1199041113570 = 1 so thatthe factor shares fully exhaust the product (according to Eulerrsquos lawif the factors are paid according to their shares that is according totheir marginal products their combined earningswould equal the total

2119904119894 =119889 11136111113613119876119889 11136111113613 119865119894

where 119865119894 is the factor in question

product) Now if one were to mistakenly omit one of the argumentssay land 119871 and write the function

119876 = θ(119870119873) (54)

then this function would have diminishing returns to scale Call thisa partial production function It is inconceivable that any actually ob-served (measured) production function should not in some way be apartial production function When we use a production function tomake inferences from observed statistics we are no doubt hoping thatthe partial function that we have postulated behaves in some crucialrespects like a complete one Doubling119870 and119873would less than double119876 since 119871 is not doubled Some ldquogrowthrdquo would then be unaccountedfor If we aributed it to a shi parameter 119860(119905) as in the Solovianfunction

119876 = 119860(119905) sdot θ(119870119873) (55)

then it would appear as though growth were in part due to some ldquoex-ogenousrdquo cause (technical progress) when in fact it is due to the pro-ductivity of 119871 e same exercise can be applied to a situation in whichsome input call it 119867 acts on output 119876 by enhancing the productivityof 119873 en a complete function

119876 = 119891(119870119873119867) (56)

that omits 119867 as in equation (54) above will be ldquoshiedrdquo by ldquoexternalrdquochanges in 119867

A related consideration is the question of nonrival inputs (for ex-ample Romer 199097 199412) Nonrival inputs of which there aremany examples ldquoare valuable inputs in production that can be usedsimultaneously in more than one activityrdquo (Romer 199097) Chemicalprocesses computer chip design a mechanical drawing a metallurgi-cal (or other) formula computer soware etc are examples of nonri-val inputs (ibid) ey may be excludable (appropriable) or not If 119867 isa set of nonrival inputs and 119877 is a set of rival inputs (like 119870 119873) then

119876 = 119891(119867 119877) (57)

has the properties that

119891(120582119867 120582119877) gt 119891(119867 120582119877) = 120582119891(119867 119877) (58)

that is there are increasing returns to scale because of the ldquoexternalrdquobenefits to the private accumulation of 119867 e 119860(119905) in Solowrsquos ba-sic equation (51) above can also be understood as the expression ofnonrival inputs Identifying and talking about them renders them ldquoen-dogenousrdquo

Growth eory Input Categorization Knowledge andEquilibrium

e implications of this discussion should be clear First tautologicallyall production functions are CRS when specified correctly that iswhenall of the relevant arguments are included us technical progress canin principle be reduced to the discovery of a productive input or tothe accumulation of knowledge of how to use existing inputs and soon In principle it is possible to always account for any output by acorrect identification of all of the relevant inputs Second and moreimportant omission of any relevant input implies that CRS becomesmuch less likely Solow has responded that CRS is not necessary

[T]he model can get along perfectly well without constant re-turns to scale e occasional expression of belief to the con-trary is just a misconception e assumption of constant re-turns to scale is a considerable simplification both because itsaves a dimension by allowing the whole analysis to be con-ducted in terms of ratios and because it permits the furthersimplification that the basic market form is competitive Butit is not essential to the working of the model

(Solow 199448)

In other words in the absence of CRS one can still use the notion ofthe production function to discuss the nature and causes of economicgrowth but the content of the conversationwill be somewhat differentIndeed this is what has happened

ird this discussion suggests that although one may go to greatpains to include in onersquos measurements all of the relevant inputs onemay not be able to do so adequately because of themultiple dimensions(the unavoidable qualitative aspects) of the identified factors So to bemore specific when one includes labor as a factor of production and en-deavors to measure it by counting the number of people working andwhile adjusting for the productivity of different types of labor onemay

miss some vital ldquohuman capitalrdquo Further we need not dwell on thedifficulties of collapsing the multitude of capital items into a categorycalled 119870 And with regard to land the simple fact that ldquoclimaterdquo playsa vital and yet elusive role in many productive processes illustrates theproblem of the existence of unique fixed factors One is drawn backto the problem of aggregation and heterogeneity e problem is totry to find a satisfying categorization of inputs and outputs such thateconomic growth (progress) is considered to be explained

Two broad empirical observations feature in the literature as be-ing important in stimulating economists to re-examine the traditionalcategorizations (Lucas 1990 Romer 1994) e first is the lack of conver-gence between rich and poor countries in economic performance esecond is the fact that human capital flows toward the wealthy econo-mies in pursuit of higher returns Consider a complete productionfunction in two countries identical in every respect In the absenceof barriers to factor mobility and competitive factor pricing (so thateach factor earns a rent equal to its known marginal product) fac-tor input ratios should tend to equality as capital flows to its highestearning location is should result in capital flowing to the poorercountries where it is scarce in turn producing a higher rate of growthin the poorer countries e fact that this does not occur suggests thatsomething is being le out of consideration e same considerationsapply to the flow of human capital As Romer has put it ldquoIf the sametechnology were available in all countries human capital would notmove from places where it is scarce to places where it is abundant andthe same worker would not earn a higher wage aer moving from thePhilippines to the USrdquo (Romer 199411)

Various explanations have been given In one way or another theyinvolve the broad notion of ldquodifferences in technologyrdquo which meansin terms of this framework differences in the production functionsor the availability of the inputs But rather than stop there growththeorists have tried to consider the forces behind the technology differ-ences Again Romer ldquoTechnological advance comes from things thatpeople dordquo (ibid12) Technical change once considered beyond thescope of the discussion has now emerged as an urgent research topicIt has finally become apparent that economic advance is the result ofdetailed and difficult and frequently serendipitous experimentationleading to dramatic but piecemeal innovations and ways have been

sought to incorporate this into the analysis of growth e relationshipof human capital to RampD expenditures and to public goods has beenconsidered In particular it has been noted that innovation (of prod-ucts and techniques) is inextricably bound up with the manufacturingand distribution process (learning by doing) so that one producerrsquosexperience may benefit another ere are external effects to the pro-duction process that manifest in the accumulation of ldquosocialrdquo knowl-edge which is a nonrival input is suggests among other things thatprivate incentives for ldquosufficientrdquo investment in RampD may be lackingbecause of free-rider problems but these conclusions have been tem-pered by the extent of our ignorance in this area (ibid19ndash20) (Ourexamination of the nature of knowledge and of innovation will suggestthat the whole production function framework as helpful as it may beas an organizer of ideas is inadequate for this type of assessment) eexistence of external effects as we have seen may mean the presenceof increasing returns to scale and increasing returns to single factorslike capital In these circumstances the accumulation of capital maybe self-reinforcing that is it may not result in a decline in its marginalproduct is is one way to ldquoexplainrdquo the lack of convergence notedabove3

Limitations of the Production Function Framework

e limitations of the production function framework are related toits existence inside of an equilibrium world It is in equilibrium inthat the production function is presumed to represent knowledge that isavailable not only to the theorist but also in some way to the economicagents of the model e outputs are assumed to follow in a technicallyknown way from the application of the inputs and the value of the

3e production function is used at both the ldquomacrordquo and ldquomicrordquo levels It isthe core concept in the neoclassical microeconomic theory of the firm As such ithas recently come under increasingly critical scrutiny If the firm is portrayed as acomplete CRS production function in a competitive market then one is at a loss toexplain what limits its size and what makes it different from other firms One is lednaturally then to a discussion of scarce (inimitable) factor inputs that provide thefirm with a (transient or permanent) competitive advantage e nature of specialknowledge routines capabilities and the like feature heavily in this exciting literatureFor a brief overview see Chapter 9 below

outputs is likewise known so that the inputs are paid the value of theirmarginal products ere is no room for or analysis of differences inindividual valuations of inputs and outputs (It will not do to assumethat things are only known ldquoprobabilisticallyrdquo since this presumes thata finite number of possible outcomes and their distribution is known)ere is no competition ldquoas a discovery processrdquo As noted growththeorists have tried to extend this inherently static approach in anaempt to incorporate technological change and innovation eyhave done this by considering RampD for example as another (in partnonrival) input like119867 with a knownmeasurable marginal product Inso far as RampD leads to the discovery of ldquonewrdquo techniques and productsthis is a contradiction in terms We cannot have future knowledgein the present We may have a general expectation (based on pastexperience) or a hope that expenditures on RampD will bear fruit butwe cannot know ahead of time exactly in what way If we did theRampD expenditures would be unnecessary While the ldquonew growtheconomicsrdquo has donemuch to bring these important aspects once againwithin the scope of economics the traditional equilibrium frameworkit has used must be judged inadequate to account for these importantphenomena4

e production function approach to growth amounts to notingthat certain things (inputs) were (historically) present that might ac-count for the growth experience and arguably could feature similarlyin future growth It is a black box approach to the extent that it doesnot fully ldquoexplainrdquo the connection the process in time In particular it

4Solow has perceptively and provocatively noted ldquoe idea of endogenous growthso captures the imagination that growth theorists just insert favorable assumptionsin an unearned way and then when they put in their thumb and pull out a plumthey have inserted there is a tendency to think that something has been provedrdquo Atheory of ldquoeasy endogenous growthrdquo implies something like ldquo[S]pend more resourceson RampD there will be more innovations per year and the growth rate of 119860 [inequation (51)] will be higherrdquo (Solow 199453) It is Solowrsquos judgment that ldquothere isprobably an irreducibly exogenous element in the research and development processat least exogenous to the economyrdquo (ibid51) As we shall indicate at some lengthinnovation although it may be fostered or inhibited by the existence of certain insti-tutional environments cannot be ldquoexplainedrdquo in the same way that physical laws andoutcomes can In this sense it is exogenous or as I prefer to say autonomous is isnot meant to undervalue in any way the importance of the shi of focus that the newgrowth economics has occasioned

ignores any ldquoextra-economicrdquo factors like the political and institutionalenvironment or more accurately these are at best implicit in theanalyses (However for an aempt to account explicitly for these phe-nomena while remaining within the production function frameworksee Scully 1992)

e production function is a black box also to the extent that itsubsumes individual decision-making As Kirzner has noted

A production function can be looked at ldquopositivelyrdquo As suchit represents simply a set of technological relationships Onthe other hand a production function can be looked at as rep-resenting opportunities from among which a human being isable to make a choice Clearly an economics in which marketevents are seen as the results of deliberately planned actionsought to view production possibilities in this second way asalternatives from among which planned courses of action maybe constructed (Kirzner 196645 see also Hayek 1941147)

And in a footnote to this ldquoCurrent practice generally (and as it seemsto us unfortunately) follows the lsquotechnologicalrsquo view is is especiallythe case with respect to aggregate models this practice is especiallyunfortunate in the capital theory contextrdquo (Kirzner 196645)

e Neo-Ricardian Challenge

e production function has proven to be a very resilient metaphorEven prior to the emergence of the ldquonew growth economicsrdquo the pro-duction function approach was severely and according to some ef-fectively criticized by the neo-Ricardians is debate between theCambridges (England and United States) is well known and has beenwidely surveyed (Blaug 1974 Harcourt 1991 Harcourt and Laing 1971Yeager 1976 just to mention a few) I will accordingly not aempt yetanother comprehensive survey or evaluation here Rather we will visitthis approach only to take note of an episode in the history of capitalthat is instructive for what both sides of the debate took for grantednamely equilibrium

In many ways the challenge mounted by the neo-Ricardians re-vived familiar criticisms of the Boumlhm-Bawerkian aempt to measurecapital Growth theory is an implicit capital theorymdashit includes 119870as a factor of production where 119870 is some measure of the produced

means of production In addition growth theory appears to addressthe related question of income distribution Because capital like anyother input is subject to diminishing returns it will be accumulatedup to the point where the value of its marginal product just repaysthe opportunity cost of its employment conveniently expressed forexample by the interest cost of the financing that facilitates it Inthis way the neoclassical (production function) approach supports theimpression that thri by providing funds for investment is a positivecontributor to growth in a measure directly related to the productiv-ity of capital is incidentally also provided a justification for theearnings of capital (owners of capital) which needed to be paid thevalue of its marginal product if it were to be wisely invested e neo-Ricardians aacked these conclusions by aacking the very conceptof capital employed ey marshaled new and varied examples toshow (as we have seen in our examination of Boumlhm-Bawerkrsquos theory)that capital as a measurable quantity cannot be conceived of as be-ing independent of income distribution and prices ey showed forexample that a measure of the quantity of capital used in any tech-nique of production varied with the interest rate at which the inputsare accumulated us the same physical items will have a differentmeasure at different interest rates It is not possible to separate thevalue and the quantity of capital Moreover while one technique mayprove optimal at one interest rate and give way to another at a lowerinterest rate a paradoxical re-switching may occur at an even lowerinterest rate where the first technique again may become preferredus no maer how one ranked the techniques in terms of ldquocapitalintensityrdquo (a crucial notion for the production function that relied onvariations in the capitalndashlabor ratio) one could not in general say thatlower interest rates would induce more ldquocapital-intensiverdquo techniquesof production to be adopted and one was thus le without a theoryto explain the earnings of capital (It is also possible to show thatthere are cases even without re-switching where a fall in the interestrate results in a ldquoless capital-intensiverdquo technique a phenomenon ofldquocapital reversingrdquo) e distribution of earnings between wages andprofits appears to be arbitrarily exogenous to the economy

is is a very quick overview of the neo-Ricardian approach Itdoes not capture the intricacies with which its proponents were ableto fill many pages At the end of the day they succeeded in convincing

the neoclassicals with their technical virtuosity that from a technicalstandpoint truth was on their side Indeed a purely physical mea-sure of capital is not to be had in a multicommodity world whereincomes and prices may change And indeed capital reversing andre-switching were theoretical possibilities But as Hicks put it theylooked like ldquobeing on the edge of the things that could happenrdquo (Hicks1973b44) e neoclassicals retreated into the world of the practicaland appealed to the use of the production function as a self-evidentlyuseful metaphor (a parable Samuelson 1962) In so far as the questionof how one decides on the persuasiveness of this metaphor was leunanswered the debate must be judged as having been inconclusive

It is important to note however the rules of the game under whichit proceeded Neither side in the debate raises any questions relating tothe availability or use of knowledge or expectations regarding produc-tion techniques Both adopt the Ricardian assumption of a uniformrate of profit on capital invested equal to the rate of interest isenables both sides to talk about capital earnings as interest or profits asthough these were the same things ere is the implied presumptionthat all economic agents share knowledge about investment opportu-nities so that capital markets are always at all times fully arbitragedere is no room for differences and inconsistencies in plans and valu-ations In fact the ldquore-switchingrdquo and ldquoreversingrdquo that occurs does nothappen in time It is a question of the comparison between alternativeequilibria between alternative steady states As Yeager has remarked

It is loose but convenient to speak of interest rate movementsand of switches between techniques Strictly speaking the dis-cussion concerns not changes or events but alternative states ofaffairs ey might best be thought of as prevailing in separateeconomies identical in all respects except those necessarily as-sociated with different interest rate levels

(Yeager 1976313n)

ere is no analysis of transition from one equilibrium to anotherus although the debate seemed to be about issues in real-world

economies the relevance of the models used is very questionable eneoclassicals seemed to think that it was a question of the degree ofsubstitutability between inputs which the neo-Ricardians assumed tobe low (their models involved discrete substitutability by ldquoswitchingrdquo

from one fixed technique to another) Neither side wondered aboutthe relevance of their framework to the market process as we know it

ere is a related point (see Kirzner 1996) e neo-Ricardian cri-tique is dependent on the idea that interest is a return to capital eneoclassical approach identifies interest as the surplus value generatedby productive capital is provides a justification for the incomesearned by capitalists who are merely enjoying the value of what theircapital has created for consumers e neoclassicals are then criti-cized because capital cannot be shown to be a factor of productionwhose price varies inversely with the quantity employed (owing to re-switching reversing etc) Now there are two related problems withthis critique in addition to the question of relevance noted above Firstit should not be surprising that no measure of the capital stock thatis independent of prices (the distribution of income) exists Capitalprocesses are composed of a variety of fundamentally incommensu-rable components applied over time Changes in the rate at whichvalues are capitalized and discounted are bound to yield ambiguousresults is in itself says nothing about the justification of the earn-ings of producers But second and more important the neoclassicalsare mistaken in their view that interest is the return to capital We willshow below that it is beer understood as an intertemporal price ratiothat expresses the phenomenon of time preference If this is correctthen the earnings of producers are to be understood as somethingcompletely different Producers as workers earn wages (or salaries)and as entrepreneurs who add value by fulfilling consumersrsquo hith-erto unperceived needs they earn profits We shall thus have to lookmore closely at the nature of interest profits and wages I do this inChapter 7

Summary Conclusion

In this brief historical overview we have seen how some of the recur-ring questions in capital theory have been answered We have becomeaware of the role of time Capital describes a process in time epassage of time has implications for knowledge and expectations Dif-ferent theorists have aempted to wrestle with this in different waysIn Smithrsquos corn economy with a regular known cycle involving one

homogenous product it was hardly relevant Ricardo tried to maintainthe simplicity of the corn economy in a multicommodity world withdurable capital (variable production cycles) by imagining the economyto sele down to some known state of affairs which is duplicated everyperiod Mengerrsquos approach avoided any explicit consideration of equi-librium and highlighted clearly the role of time in any conception ofthe production process Boumlhm-Bawerk tried to combine Menger andRicardo but since they offered essentially irreconcilable views of theworld he ended up with more than one theory of his own which notsurprisingly gave rise to a varied progeny e production functionapproach as well as the approach of its most severe critics the neo-Ricardians are both in an important sense Ricardian theories

One capital theorist who defies categorization is JohnHicks Whileworking in the formalistic idiom of neoclassical economics he wasalways sympathetic to those aspects of the subject that defied formal-ization He was also a grand synthesizer and his work thus reflectsaspects of many traditions In his last extensive work he developed aframework that proves extremely useful in understanding a variety ofissues is is examined in the next chapter

CHAPTER 6

e Hicksian Marriage of Capital and Time

Reviving the Austrian eory of Capital

John Hicks has wrien extensively on capital In addition to his threevery influential books which have capital in the title (1946 1965 1973b)he has published numerous articles He was a scholar who returnedmany times in his life to the same questions sometimes with differentanswers1 In Value and Capital (1946 first edition 1939) he criticallyconsidered Boumlhm-Bawerkrsquos average period of production His Capitaland Growth (1965) was a series of exercises in growth theory Butas with all of Hicksrsquos work this book contains much discussion ofan informal nature ese extended discussions show that he wasthinking carefully about the implications of time for the theory ofcapital We see it in his introductory remarks on methodology par-ticularly his discussion of equilibrium we see it in his survey modelsof Smith and Ricardo (summarized above) and we see it in his concernabout how to portray the transition from one equilibrium steady stategrowth to another the problem of the lsquotraversersquo And then in a seriesof contributions in the 1970s including his book Capital and Time(1973b also 1976) he became very concerned with time as a topic ineconomics Along with this came a revived interest in the Austriantheory of capital

Hicks called his new approach to capital a neo-Austrian approachis label does not seem to have been auspicious for the acceptance

[is section uses material from Lewin (1997d)]1ldquoCapital (I am not the first to discover) is a very large subject with many aspects

wherever one starts it is hard to bring more than a few of them into view It is justas if one were making pictures of a building though it is the same building it looksquite different from different angles As I now realize I have been walking round mysubject taking different views of itrdquo (Hicks 1973bv)

of his approach e modern Austrians did not embrace it (Lachmann1973) and the mathematical Boumlhm-Bawerkians (Faber 1979) criticized itfor other reasons In this chapter I re-examine this new approach I findthat it is quite revealing in away that perhaps Hicks himself did not fullyrealize and that much of what we have discussed above in the impres-sionistic historical overview comes together in Hicksrsquos final treatment

His and Time

Hicks had an abiding interest in and a fascination with the implica-tions for economics of the passage of time His treatment is ambiguoushowever Hicksrsquos aitude to time parallels in many ways his relation-ship to the Austrians (particularly of the market process variety) Feweconomists have been more influential Yet few defy categorizationas he did He was at once Keynesian neoclassical and in his verbalremarks if not in his formal models he made important concessionsto the Austrians His critics thus had an easy target being able tofind numerous inconsistencies From the one side he was criticized forbeing too formal and mechanistic From the other he faced technicalchallenges to his formal models He continually walked a tightrope

We see this in his treatment of time He believed in the importanceof the ldquoirreversibility of timerdquo Time is not strictly analogous to spaceConcerning this realization he says ldquoI have not always been faithfulto it but when I have departed from it I have found myself comingback to itrdquo (1976263) One cannot escape the fact that the future is notdetermined in the same way as the past is ldquoHow easy it is [however]to forget when we contemplate the past that much of what is nowpast was then futurerdquo is has profound implications for the meaningof any time series

Action is always directed towards the future but past actionswhen we contemplate them in their places in the stream ofpast events lose their orientation toward the future which theyundoubtedly possessed at the time when they were taken Wearrange past data in time-series but our time series are not fullyin time e relation of year 9 to year 10 looks like its relationto year 8 but in year 9 year 10 was future while year 8 waspast e actions of year 9 were based or could be based uponknowledge of year 8 but not on knowledge of year 10 only on

THE HICKSIAN MARRIAGE OF CAPITAL AND TIME 95

guesses about year 10 For in year 9 the knowledge that we haveabout year 10 did not yet exist (ibid264 italics added)

One of the far-reaching implications of this concerns the theory ofcapital Consider changes in the value of the capital stock

e value that is set upon the opening stock depends in partupon the value which is expected at the beginning of the yearfor the closing stock but that was then the future while at theend of the year it is already present (or past) ere may bethings which were included in the opening stock because in thelight of information then available they seemed to be valuablebut at the end of the year it is clear that they are not valuableso they have to be excluded is may well mean that the netinvestment of year 1 calculated at the end of year 1 was over-valuedmdashat least it seems to be over-valued from the standpointof year 2 (ibid265)

We see here much with which Lachmann for example would agree(see Chapter 8) And similar statements are to be found throughoutHicksrsquos work particularly in this laer period Yet when he reviewedHicksrsquos Capital and Time Lachmann focused critically on Hicksrsquos moreformal ldquoout of timerdquo analysis (Lachmann 1973) Lachmann all but ig-nores the potential of the first two chapters and much of Part III for amore subjectivist approach one that incorporates aspects of the con-nection between time and knowledge that he hadworked out2 In whatfollows in this chapter I examine the essentials of Hicksrsquos conceptual

2It is clear that Hicks was sensitive to Lachmannrsquos criticisms

Most of my critics have been equilibrists but there is one for whomI have the greatest respect who has opened fire from the other flankProfessor Ludwig Lachmann is (like Professor Hayek) a chief sur-vivor of what I distinguished as the Mengerian sect of the Austrianschool It is clear that his view of me is like Mengerrsquos view of Boumlhm-Bawerk He cannot of course abide the steady state Even the modestuses of it which I have made fill him with dismay Even the explana-tions which I have now been giving (and which are meant incidentallyto assure him that I am more on his side than on the other) will I fearfail to placate him His ideal economics is not so far away from myown ideal economics but I regard it as a target set up from heavenWe cannot hope to reach it but we must just get as near as we can

(Hicks 1976275 footnote omied)

framework (from Capital and Time) and aempt to draw out someof the implications and insights that emerge when interpreted from asubjectivist (Mengerian) point of view is framework is a convenientand efficient organizing device in which all of the various influenceson the capital formation process come together

A Simple Conceptual Framework

Hicks begins by noting the different kinds of capital and different kindsof capital processes in which they are found

ere are different theories of capital because there are vari-eties of capital e capital the real capital of any economyextends the whole way from very durable instrumentsmdashalmostland and somewould say that land itself should be includedmdashtogoods that are in the pipeline goods in process of production

(Hicks 1973a97)

e old Austrian theory (of Menger and the Mengerian elements ofBoumlhm-Bawerk) is a ldquogoods-in-the-pipeline approachrdquowhile the produc-tion function approaches are of ldquoa quasi-land fixed capitalrdquo variety Asatisfactory theory of capital should be able to encompass both Boumlhm-Bawerkrsquos aempt to capture Mengerrsquos vision used a flow-inputndashpoint-output approach and Wicksell extended this to a point-inputndashpoint-output (aging wine) approach ese models are models of time eycharacterize the production process in terms of time (or as in the caseof Wicksell in terms of a capital quantity derived using time unitsmdashquantities of dated inputs) Hicks is concerned to provide a theoryof capital that is in time Such a theory would have to be a flow-output theory ldquoGoods that are produced by the use of fixed capitalare jointly supplied It is the same capital good which is the sourceof the whole stream of outputsmdashoutputs at different datesrdquo (ibid98see also Hayek 194167) We have already discovered this problem inreviewing Ricardorsquos theory

If it were not for joint supply we could on the whole get onvery well with a cost of production theory of value So it ishere If it were not for the joint supply that is implied in theuse of fixed capital we could get on very well with the Boumlhm-Bawerkian model in which we associated with every unit of

final output a sequence of previous inputs which have ldquoled tordquothat output so that the cost of the final output is representableas a sum of the costs of the associated inputs accumulated foreach by interest for the appropriate length of time In an econ-omy which uses fixed capital such imputation is not possible

(ibid99)3

So Hicks proposes the abandonment of the ldquoperiod of productionrdquoapproach ere is no measure of roundaboutness

What we must not abandon are Boumlhm-Bawerkrsquos (and Mengerrsquos)true insightsmdashthe things that are the strength of the Austrianapproach Production is a process in time the characteristicform of production is a sequence in which inputs are followedby outputs Capital is an expression of sequential productionProduction has a time structure so capital has a time structure

(ibid100)

us we define a production process as a stream of inputs giving rise toa stream of outputs A production process may be thought of also as atenique (for converting inputs into outputs) or a project It may takemany concrete forms like the building of a factory or the constructionof a machine or the exploration for oil etc followed by the flow ofa particular output (or set of outputs) Many (most all) productionprocesses can be characterized in this way Inputs and outputs are tobe thought of in terms of value (or expected value) so outputs couldbe negative but it is hardly conceivable that outputs should precedeinputs at the start Hicks asks a fundamental motivating questionldquoWhat in general are the conditions that must be satisfied in orderthat the process should be viablerdquo (ibid100)

Considered in this way the question can be answered by the use ofsome simple and familiar arithmetic which though simple has some

3In a footnote to this Hicks notes

e point it may be remarked is well understood by the intelli-gent accountant He is well aware that in the case of products thatare jointly supplied the allocation of overhead costs is arbitrary andhe is also aware that the depreciation allowances which he makes arearbitrary for they similarly involve an allocation of common costs tothe jointly produced outputs at different dates (Hicks 1973a99n)

important implications We start by looking at the situation faced bythe individual decision-maker ex ante So the input and output valuesare prospects In this way we are aempting to uncover certain generalprinciples that are implicit in any production plan

Every process (or project) has a capital value (familiar as the netpresent value NPV) is is the discounted flow of the sum of the netvalues yielded by the project over its life Hicks shows that a necessarycondition for the viability of any process as a whole is that its capitalvalue should be positive (or at least non-negative) at every stage inits life (Hicks 1973a17 1973b100) In other words the NPV should bepositive whatever the date for which we make the calculation ecapitalized value of the output flow must always be at least as great asthe capitalized value of the flow of inputs If this were not the case thenthe process would be abandoned at the point at which the NPV ceasedto be positive At every stage in the life of the project the questionof its continuation may be raised At each point this is essentially aninvestment decision So the project will not be continued if the valueof what remains (the remainder) at any date and contemplated fromany date is not positive (non-negative) Contemplated at the date ofinception it is possible to calculate a capital value at each imaginedfuture date in the life of the project What we are saying here is thateach and every such capital value as contemplated by the decision-maker must be non-negative If even one of them were negative thatwould indicate that the project should terminate at that date In factthat defines the termination date

While this general principle (we may call it the positive remainderprinciple) must be true as an implication of rational planning as ofthe point in time of the decision it may of course happen that inthe execution of the project the capital value at some point beforeplanned termination unexpectedly becomes negative is does notimply that the project should be immediately abandoned (although inretrospect it would seem that it should not have been started) eprinciple of the irrelevance of sunk costs applies and one would haveto consider it as a new project where the ldquocostsrdquo of abandonment (long-term contractual costs for example) have to be compared against theldquocostsrdquo of continuing (Hayek 194189) Similarly the capital values atany point may during the execution of the project turn out to beunexpectedly high uswemay define a successful plan as one whosecapital values turn out as expected (or beer)

Of course present-value criteria are well known and are implied inall discussions of capital What Hicks makes explicit here is the wayin which present-value appraisals change over time specifically overthe life of the project He addresses the intertemporal value structureof a project the logic within a single human plan concerning the re-lationship of the capital values at various contemplated dates to oneanother So when Lachmann asks ldquoWhat can we say about the firmrsquosproduction plan in general and the paern of use prescribed to itscapital combination in itrdquo and answers ldquoWe might say of course thatthe firm will act in such a manner as to maximize the present valueof its expected future income stream but such a description of theequilibrium of the firm is of very lile use to usrdquo (Lachmann 198664)he may be underestimating the usefulness of thinking in terms of theinfluences on the (present) capital value of any plan

Each plan (or capital project) will have an implicit yield beerknown as the internal rate of return (IRR) If the capitalization processis conducted using this rate then the initial value will be zero it is therate that causes the NPV at the inception date to be zero If the samerate the IRR is used to calculate the capital values at all other datesthey will become positive rise to a peak (or perhaps a series of peaks)and eventually fall again to zero at the termination point Hicks alsoshows that for projects defined in this way the IRR is unique (Hicks1973b22 but see the discussion below following the next section) eforegoing can be greatly clarified with some basic algebra

Formalization

We denote input values and output values at time 119905 (contemplated attime 0) as 119886119905 and 119887119905 Also

119886119905 =1114012119894119908119894119905120572119894119905

where 119908119894119905 is the price and 120572119894119905 is the quantity of input 119894 at time 119905 assum-ing a set of (119894 = 1 119898) inputs4 For conveniencewewill suppress the 119894

4One may think here of a production function like 119876119905 = 119891(1205721113578119905 1205721113579119905 120572119898119905) at eachpoint in time 119905 e meaning of the 120572119894119905 will depend on the context Where we think ofall factor inputs as reducible to the original inputs in a sort of ldquomacrordquo context thenthey are of the form of ldquolaborrdquo and ldquolandrdquo Considered as a component of an individualproduction plan the 120572119894119905 must include produced inputs that is capital goods

subscript assuming only one type of input andwrite 119886119905 = 119908119905120572119905withoutloss of generality (alternatively 119886 and 119908 may be thought of as vectors)Similarly we write 119887119905 = 119901119905 120573119905 where 119901 is the price and 120573 the quantityof the output5 For convenience we define 119902119905 = 119887119905 minus 119886119905 as the net outputvalue at any date 119905 We denote the capital value at time 119905 by 119896119905

119896119905 = 119902119905 + 119902119905+1113568119877minus1113568 + 119902119905+1113569119877

minus1113569 +⋯+ 119902119899119877minus(119899minus119905)

= 119902119905 + 119877minus1113568119896119905+1113568 = (119887119905 minus 119886119905) + 119877

minus1113568119896119905+1113568 (61)

where 119877 = 1 + 119903 and 119903 is the per period rate of interest or moreaccurately rate of discount is says that the capital value at thebeginning of any sub-period 119905 (119896119905) which is the discounted value of allof the remaining net outputs can also be calculated as the net valueof the output of that period (119902119905 = 119887119905 minus 119886119905) plus the capital value of the

remainder for sub-periods aer 119905 (119877minus1113568119896119905+1113568) And this holds for anyvalue of 119905

Hicks now offers what he calls the ldquoFundamental eoremrdquo it isalways true that a fall in the rate of interest (rate of discount) will raisethe capital value of any project throughout (that is as calculated at anydate 119905) while a rise will lower it e proof follows from equation (61)and it is instructive to reproduce it here at some length

[S]uppose that the 119902rsquos are unchanged but that 119903 falls so thatthe discount factor rises We see at once that 119896119905 is bound torise provided that 119896119905+1113568 is positive and provided that 119896119905+1113568 is notreduced by the fall in interest But a similar argument applies to119896119905+1113568 us we may go on repeating up to the end of the processwhere 119896119899 = 119902119899 us 119896119899 is unaffected by the fall in 119903 so 119896119899minus1113568 mustbe raised and therefore 119896119899minus1113569 must be raised and so on back to119896119905 So long as all the 119896119905rsquos are positive (as we have seen that theymust be in order that the process should be viable) every 119896119905 (0to 119899 minus 1) must be raised by the fall in the rate of interest

We have taken it for granted that the duration of theprocess remains at (119899+1)weeks [sub-periods] even though therate of interest falls But it is immediately clear that even if theduration is variable it cannot be shortened For since we have

5For a multiproduct firm 119887119905 = sum119895 119901119895119905 120573119895119905 where there are 119895=1113568 119911 outputs As with119886119905 119887119905 may be conceived of as the vector product of the vectors 119901119895119905 and 120573119895119905

shown that with unchanged duration every 119896119905 (119905 lt 119899) will beraised it must still be advantageous to go on for at least thesame duration at a lower rate of interest All that is possible isthat the process may be lengthened

But the process will only be lengthened if 119896119899+1113568 (which waszero at the higher rate of interest) becomes positive at the lowerat can happen if the lengthening requires some net input(repairs for instance which only become profitable when therate of interest falls) If it happens however all earlier 119896119905 mustbe raised a fortiori So the eorem continues to hold whenduration is variable (Hicks 1973b20ndash21)

is characterization of a capital plan thus shows in the first instancehow the plannerrsquos appraisal will be affected by changes in the discountrate applied But it is equally clear that this appraisal will depend onall of the other conditions that characterize the project For exampleif the prices of the inputs 119908119905 were to rise (or be expected to rise) thecapital values would fall Similarly a rise (expected rise) in the price ofthe product would raise all 119896119905 Changes in technology may affect theseprices by affecting processes elsewhere in the economy or they maychange the paern of inputs 120572119905 required

e value of 119903 for which 1198961113567 = 0 is the IRR is can be thoughtof as the yield of the project It represents the minimum that wouldhave to be earned on any alternative project if this one were to beabandoned in its favor If ldquowagesrdquo 119908119905 were to rise (uniformly) all ofthe 119896119905 would be reduced is implies that the yield of the project itsIRR would fall us for a given project (or set of projects) there isa trade-off between changes in 119908 and 119903 other things constant isis the sense in which the neo-Ricardians perceive the existence of aldquofactor price frontierrdquo defining different equilibrium distributions ofincome between the factors of production Considering hypotheticalchanges in 119908 and changes in 119903 necessary to ldquocompensaterdquo for thesechanges (by keeping 1198961113567 = 0) one can imagine situations in which onetechnique while dominant at a given level of 119903 loses its dominance as 119903falls and then regains it again as 119903 continues to fall with rises in 119908 esignificance of this is far from clear however given that any paern ofinputs 120572119905 is in principle possible Also there is no unambiguous wayin which we can decide which project or technique is more ldquocapitalintensiverdquo (see the discussion in Chapter 5)

Moreover it is important to note that in the context we have devel-oped above 119903 cannot be taken to be the price or rate of earnings (profits)of capital e variable 119903 is the rate of discount applied to the overallearnings of the project at different dates In fact the identification of119908 as ldquowagesrdquo is a terminological simplification that in no way assumesthat all of the inputs are reducible to labor Included among the 120572119905inputs are produced means of production e variable 119908119905 really refersto wages and rents on capital goods e neo-Ricardian frameworkthus (from our perspective) seems to be predicated on an untenableview of the nature of the earnings of capital We shall return to thisbelow

Looking Forward and Looking Baward

It should be emphasized that the view of the production process pre-sented above is a forward-looking one All of the values are prospec-tive We may even think of each project as a capital prospect As suchthere is an unavoidable but oen suppressed speculative element to itere is at least one other possible way to look at production processesin time that is retrospectively as a result of capital invested Fromequation (61)

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113569119877

minus1113569 +⋯+ 119902119905minus1113568119877minus(119905minus1113568) + 119896119905119877

minus119905 (62)

for any value 119905 between 0 and 119899 Using the IRR in 119877 1198961113567 = 0 so

119896119905 = (minus1199021113567)119877119905 + (minus1199021113568)119877

119905minus1113568 +⋯+ (minus119902119905minus1113568)119877 (63)

Looked at this way 119896119905 is the sum of the net inputs minus119902119905 = 119886119905 minus 119887119905 from 0to 119905 minus 1 accumulated by interest up to period 119905 is captures the ideaof inputs maturing at a rate equal to the IRR and emerging as a finaloutput

For plans that are successful in the sense that the capital values 119896119905turn out to be exactly equal to what they were expected to be whendiscounted or accumulated using the IRR it should be clear that thetwo ways of looking at capital (prospective and retrospective) are ex-actly equivalent they describe an ongoing and in an essential senseunchanging process is is what the assumption of a steady state buys

us namely that the processmdashall processesmdashlook the same at all pointsof time and for all points of time In the steady state since all plansare successful in this sense the interest rate on loans must be equal tothe (known) yield on projects and the laer must be uniform (for anygiven investment period) across projects We are back to a Ricardianworld

We note in passing that the neoclassical production function ap-proach is a steady-state approach in this sense Equation (51) can bewrien

119876119905 = 119860119905(119905) sdot 119891(119870119905 119873119905) (51prime)

inserting time subscripts to indicate an ongoing process in time or

119876119905 = 119860119905minus1113568(119905) sdot 119891(119870119905minus1113568 119873119905minus1113568)

if we allow for time lagsWe thus have an identical series of inputs (proportional to the

stocks of factor of production) and outputs in every period 119905 Changesin the inputs will cause changes in the outputs once and for all eprocess looks the same from all points of time

Hicks is critical of the steady state

I am very skeptical of the importance of such ldquosteady staterdquotheory e real world (perhaps fortunately) is not and neveris in a steady state A ldquosteady staterdquo theory is out of timebut an Austrian theory is in time (Hicks 1973b109)

And he goes on to explain that a theory that is in time would haveto take note of history would have to include inherited history in-cluding the inevitably less than optimal capital stock as a ldquocauserdquo ofsubsequent events

For a theory that is in time perspective maersmdashthings look verydifferent from different points of time Most specifically any processhaving a yield that is greater than the market rate of interest on loanswhich it would have to have to be undertaken in the first place wouldhave the property that the capital value measured forward (prospec-tively) will be greater than the backward (retrospective) measure Andthis will be true even at point 0 where 1198961113567 = 0 measured forward isis a basic implication of rational planning If a process is successfully

being carried out and if its yield is greater than the interest rate acapital gain will accrue at ea stage of the process Surely this is thereal meaning of profit e existence of profit in this sense absolutelydepends on a disequilibrium between the yield and the interest rateAnd this can persist only if there is no steady state if there is nouniform (zero by this definition) rate of profit e existence of profitsimplies different (varying) expectations

Technical progress will imply that the yield on new processes (em-bodying the new knowledge) will be above old processes (those pro-cesses that do not) Old processes will if there is enough time bereplaced by new ones e capital stock the stock of tangible thingswill at any point of time reflect the accumulated results of past gainsin knowledge Although this is inimical to the steady state everythingthat has been said above regarding the characterization of projectstechniques and processes that make up capital remains valid

Social accounting however can only be done consistently in asteady state Out of the steady state (a limiting case of which is theRicardian stationary state) it is strictly impossible to derive aggregatevalues for capital and therefore for output (since the value of output de-pends on the value aributed to capital maintenance) Hicks explainsthis and then proceeds to assume a steady state in order to exploreaspects of social accounting and transitions between such states isno doubt is the reason for his less than warm reception at the handsof modern Austrians Nevertheless his simple arithmetic frameworkreveals a lot even for those who believe that the market process shouldbe analyzed as a disequilibrium phenomenon Hicksrsquos framework sum-marizes nicely the various influences on the individual valuations ofany capital projects including the valuations of any components ofthat process like the individual capital goods and alerts us to be cau-tious in concluding too readily what the effects of changes in interestrates wage rates product prices or technologies might be Similarlyit can accommodate consideration of qualitative changes such as thediscovery of a new input or product Ultimately everything can beanalyzed in terms of the effect on the valuation of the particular projectunder consideration For the economy as a whole the variables inthe framework rather than being parameters will be interrelated Anincrease in the demand for a particular product for example will haveimplications for the prices of the inputs into its production But the

precise effects will depend on the paerns of complementarity andpossibilities for substitution that characterize the production processere is no simple law of derived demand for the economy as a whole(Hayek 1941appendix 3 many of the questions considered by Hayek1941 can be analyzedmuchmore succinctly within Hicksrsquos framework)We shall be able to make further use of Hicksrsquos approach

Conclusion Capital Planning

Hicksrsquos framework presented above is a convenient way to think aboutcapital It is fully consistent with a modern Austrian approach asdeveloped for example by Lachmann and Kirzner According to thisapproach capital must be thought of in terms of intertemporal plansWe must make a distinction between capital goods and capital as anabstract category e laer refers to the value to be aributed to aparticular plan or set of production plans e profits or losses tobe aributed to a production plan are the result of changes (or theabsence thereo) in the capital values aributed to it over time eseappreciations (or depreciations) in value are in turn the result of (arederived from) changes in consumersrsquo evaluation of final production

e meaning and the value of any particular capital good derivesfrom its position in a particular production plan ldquoe identificationof a lsquoresourcersquo as distinct from other physical things cannot be madewithout reference to human purposesrdquo (Kirzner 196638) All capitalgoods are in effect an expression of ldquounfinished plansrdquo (ibidch 1)As such these capital goods can be valued by what they add to thevalue of the plan e value of any income source is derived fromthe income it is expected to produce so the value of any capital goodis familiarly thought of as being equal to the discounted value of theestimated income it adds to any production planmdashthe discounted valueof its marginal product

All production plans are affected by among other things changesin the rate of discount that is pertinent to the plan A fall in thediscount rate will increase its value a rise will decrease it us ifrates of discount are affected generally by macroeconomic changesnotably changes in interest rates these may be expected to have ageneral effect on the expected value of existing and planned capitalprojects In particular those projects with the longest time horizon

will be most affected (is is well known and expressed in the propo-sition that the elasticity of present value is higher the higher the timehorizon) It is important to remember that the discount rate is only oneof the variables that affects the capital values of any and all projectsHicksrsquos approach has the virtue of providing us with a particularlyclear framework in which the various influences may be revealed Sowe might write a general capital value (vector) function as

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

indicating that 119903 is only one of the determinants of 119896119905 119903 is perhapsespecially important because of its macroeconomic significance as theindicator of the relationship between present and future prices of con-sumption goods However the structure of prices andwages in generalmay affect the project (through 119901 and 119908) and technology obviouslymaers (120572 and 120573 ) Hicksrsquos approach gives a comprehensive picture

Appendix e Meaning of the Internal Rate of Return

e rate of return on any investment is a concept that is widely usedand has high intuitive appeal We pause here to consider it a lilemore carefully We shall see that it is not quite as straightforward as itappears on the surface and that many aspects of its meaning are andmust be imposed on it by the decision-maker

Hicks presents arguments for the existence and uniqueness of theIRR Any viable process must be viable for 119903 = 0 ldquoif its inputs andoutputs are undiscounted its 1198961113567must either be zero (inwhich case 119903 = 0is its internal rate of return) or it must be positive But in the laer caseif the rate of interest rises 1198961113567 steadily diminishes and must finallybe reduced to zeromdashsave in one special case when 1198871113567minus1198861113567 is positive(or zero)rdquo which is a case of ldquoproduction without capitalrdquo If 1198871113567 minus 1198861113567 isnegative and 1198961113568 is positive (as it must be if 1198961113567 is not to be negative) itis inevitable that

1198961113567 = 1198871113567 minus 1198861113567 + 119877minus11135681198961113568

should ultimately be reduced to zero by a rise in the rate of interestSo an IRR exists e IRR is unique because the Fundamental eoremapplies as much to 1198961113567 as to any other 119896119905 ldquoIf we start from a rate of

interest which is such that 1198961113567 is zero (the other 119896rsquos being positive) anyreduction in the rate of interest must increase 1198961113567 So 1198961113567 cannot be zeroagain at any lower rate of interestrdquo (Hicks 1973a140 and 140n)

It seems that Hicks obtains this result because of the way that hedefines a project as a series of positive yields over time (for each periodexcept the first) us a negative yield (positive outlay) can be used todemarcate the start of a new project From a more general perspectivethe IRR need not be unique

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113569119877

minus1113569 +⋯+ 119902119899119877minus119899 = 0

=1198991114012119905=1113567119902119905119877

minus119905 = 0 (looking forward from 0 to 119899)

119877119899119896119905 =1198991114012119905=1113567119902119905119877

119899minus119905 =1198991114012119905=1113567119902119899minus119905119877

119905 = 0

0 = 119902119899 + 119902119899minus1113568119877 + 119902119899minus11135691198771113569 +⋯+ 1199021113567119877

119899 (looking backward

hypothetically from 119899)

e last line can be wrien

0 = 119876119899 + 119876119899minus1113568119903 + 119876119899minus11135691199031113569 +⋯+1198761113567119903119899 (64)

Where the 119876119905 are linear combinations of the 119902119905 and 119903 and it will beremembered 119877 = (1 + 119903) Equation (64) is an 119899th order polynomialwith the roots equal to the IRR(s) Generally there will be more thanone root the number of roots will be equal to the number of changesin sign of the coefficients (119876119905) at most (I owe this approach to thelecture notes of Professor L Sjaastad of the University of Chicago)Since Hicks has assumed one change in sign there is only one IRR

e use of an IRR is at boom a maer of convention It de-pends not only on how one divides up a project over time but alsoon assuming that the ldquointernalrdquo yield is the same for each subperiodIt seems intuitively clear however that the individual planner musthave in mind some benchmark against which to test (subjectively) thearactiveness of a project in comparison for example with investingin the market Each planner will define his own boundaries

CHAPTER 7

e Nature of Interest and Profits

Introduction

e above discussion clarifies I hope the nature of capital and someof the issues that surround its characterization It will be rememberedthat the rate of discount featured in considering the capital value ofany plan is is sometimes also referred to in the literature as therate of interest or the rate of profit e question arises then as tothe nature of interest as a phenomenon and the relationship betweeninterest and profit As basic as this is it remains a source of confusionin economics Once again the role of time is central What is the con-nection between interest and time Many theorists have seen interestas being determined by the technological characteristics of productionby ldquoproductivityrdquo in relation to the willingness of consumers to abstainfrom consumption to save In the conventional wisdom interest is theresult of ldquoproductivityrdquo and ldquothrirdquo While there is a sense in whichthis is true a closer and deeper examination reveals that in a morefundamental sense the phenomenon of interest per se has nothing todo with productivity Rather interest is the result of the essentialnature of time and the way that we experience it is viewpointis sometimes called a pure time preference theory (PTPT) of interestAnd interest is to be clearly distinguished from profit which as wehave tried to show is the result of changes in capital values that reflectthe implementation of successful capital investments in an uncertainworld where expectations differ

In this chapter I re-examine and re-evaluate the PTPT of interestWhile I endorse it in the main it seems to me that some of its propo-nents have perhaps fostered confusion by the way in which they havepresented it I then turn to a discussion of profit

e Pure Time Preference eory of Interest

e Interest Problem and its Resolution in Terms of PTPTRestated

e PTPT is notable for its obscurity (from the viewpoint of modernrival theories)1 and for its resilience Interest in it has recently resur-faced as part of the development of Boumlhm-Bawerkian capital theory(see Faber 1979 Pellengahr 1986ab 1996) and has been periodicallyrevisited in the process of the development of Austrian market pro-cess theory (Yeager 1979 Garrison 1979ab 1988) and most recently byKirzner (1993) Murray Rothbard is well known for his defense of thePTPT (see for example Garrison 1988) derived from Mises We beginhere with a brief restatement

If an income source (a capital asset) is known to yield a steadyincome for a finite period of time why does the price of the source notequal the sum total of the incomes earned over the life of the asset Soto be more specific a ldquomachinerdquo may be assumed to yield a net incomeof $100 a year for ten years and then be replaced by a new model2

Why can the machine not be sold for $1000 is is a simple way offormulating the generic problem If the value of an income source isderived from the value of the income it yields why is the source not

[In this section I use material from Lewin (1997b)]1At the very heart of the terminological thicket is the use of the word ldquointerestrdquo in

at least two different contexts e same word is used for a description of the ratesearned and paid on money loans in actual real-world economies and for a descriptionof the value premium of present over future goods in a hypothetical world devoid ofuncertainty and change although in the case of the laer qualifiers like ldquooriginaryrdquoldquopurerdquo ldquoneutralrdquo and ldquonaturalrdquo are sometimes added (notwithstanding that these quali-fiers are used as well by different theorists to mean different things) See for exampleRothbard (197517ndash18) On the one hand the phenomenon of ldquointerestrdquo is somethingwith which we are all in our everyday lives very familiar On the other hand if westudy economics we are told by PTPT theorists that ldquointerestrdquo while ubiquitous andcrucial to the functioning of any market economy is nothing we can actually observebecause it is hopelessly mingled with profits and losses inflation (price) premiumsand uncertainty premiums (Mises 1966253 Rothbard 1970321)

2We leave aside the question of how we know that the ldquomachinerdquo is the source ofthe income Strictly speaking we should say that the use of the machine together withother production goods adds $100 to income each year In familiar terms the marginalproduct of the machine is valued at $100 per year is will be explored further below

THE NATURE OF INTEREST AND PROFITS 111

valued at the sum total of the income yielded over its life Surely atany price below $1000 someone could buy the machine and earn anincome in excess of the price paid a surplus Why is this surplus notcompeted away

e answer provides the identification and indeed the definitionof interest as a phenomenon One hundred dollars today is not valuedthe same as $100 a year from now ey are economically differentgoods In terms of the consumerrsquos subjective preference ranking themarginal utility of $100 today is greater than the marginal utility todayof $100 a year from now is is time preference whose expression isinterest3

We may note some assumptions and implications e incomeat various dates must be that whi would be valued the same at thesame date e only differentiating factor is time (although it may beadmied that the passage of time itself cannot be without significanceof which more below)mdash it is a pure time preference Second it is im-portant to keep all notions of interest rates such as we observe in theloan market out of the picture To admit them into the individualrsquoschoice theoretic context would be to fall prey to an all too commoncircularity We cannot explain interest rates in terms of individual timepreferences if we assume an interest rate already to exist is is no dif-ferent in principle from realizing that individualsrsquo preference rankingsexist ldquopriorrdquo to and independently of the prices of the items they areranking Time preference is a subjective phenomenon like individualpreference rankings and as such is unobservable But it is neverthe-less quite real and exists even in the real world of uncertainty andinflation and is reflected (together with risk and uncertainty) in marketinterest rates just as other prices express other aspects of individualpreferences (interest rates being derived from a ratio of intertemporalprices) ird it is apparent that interest does not depend in any wayon the productivity of capital It does not even depend on the existence

3Specifically using a neoclassical approach we may say that the interest rate isthe ratio of the marginal utilities minus 1 Symbolically119872119880119905 119872119880119905+1113578 = 1113568 + 120591 where 120591equals the rate of time preference Or more generally 119872119880119905 119872119880119905+119899 = 1113568 + 120591119899 where120591119899 is the rate of time preference for time horizon 119899 Marginal utilities are understoodto be as of time 119905 So 119872119880119905+119899 is the marginal utility of the prospect in question to beenjoyed at time 119905 + 119899 but contemplated at time 119905

of productive assets (whose combined value is identified as capital)Indeed the price of a capital asset its capital value would fully reflectthe (discounted) value (by its owner and as expectedly evaluated byconsumers) of its product so that a more productive asset would costmore e rental return to capital is conceptually quite distinct frominterest Interest is not the return on capital Interest would exist in apure exchange economy as long as therewas a positive time preferenceA positive time preference is a necessary and sufficient condition forthe existence of interest In fact in this context interest and time pref-erence are virtually synonymous Interest is thus ldquoexplainedrdquo by thepropensity of individuals to discount the future And since interestby definition and by intuition would not exist in the absence of thispropensity it makes sense to say that the phenomenon of interest isdue to and only due to time preference e ldquoessencerdquo of interest istime preference

So far so good It would seem that stated in these terms or similarones (for example Kirzner 1993 Garrison 1988) PTPT would be clearif not unobjectionable and objections would be in terms of arguing forother conceptual schemes It is apparent at least to this author thatthe PTPT account of interest is not well understood even by eminenttheorists It seems that a plausible explanation for this is the way inwhich the PTPT has been developed in the literature It may be helpfulto examine certain aspects of the development of the theory e mostinfluential theorists are probably Boumlhm-Bawerk (1959) Feer (1977)Mises (1966) and Rothbard (1970)

Boumlhm-Bawerk Fetter Mises and Rothbard

Boumlhm-Bawerkrsquos exhaustive (and exhausting) survey of interest theo-ries establishes clearly the primacy of time preference He effectivelydisposes of productivity accounts in explaining the phenomenon ofinterest His account of time preference is much admired But then inhis later volume (1959) when he turns to an examination of the determi-nants of time preference he advances three reasons for the existence ofa positive rate of time preference Two of these are ldquopsychologicalrdquo (im-patience andmyopia) while the third is ldquotechnologicalrdquo (the ldquotechnicalsuperiorityrdquo of present goods over future goods) What he meant by

this third reason was the productivity of capital goods that representthe results of ldquoroundaboutrdquomethods of productionmdashbecause of produc-tivity present goods could be used to obtain a greater volume of futuregoods and so were demanded at a premium In this way he involvedhimself in an unfortunate and celebrated contradiction4 To manylater theorists it appeared as though Boumlhm-Bawerk had come to em-brace a kind of Fisherian eclecticism one that established the duality oftime preference and productivity in the determination of interest ratesIn fact much of the recent mathematical work on ldquomodern Austriancapital theoryrdquo seems to reflect this (Faber 1979 1986) In a way thecontradiction became obscured because the question changed PTPTwas never really about the determination of market interest rates itwas about explaining interest as a phenomenon (Kirzner 1993183ff)As we shall see the fact that productivity may play a role in the formerin no way diminishes its irrelevance for the laer

Frank Feerrsquos reputation as being unique among economists inhis clear grasp of the PTPT owes a great deal to Rothbard (Rothbard1977) But according to Rothbard while Feer articulated a validcriticism of Boumlhm-Bawerkrsquos inconsistency at the same time he failedto grasp certain important aspects that were valid in Boumlhm-Bawerkrsquostheory5 It was le to Mises to establish a valid theory using whatwas valuable from Boumlhm-Bawerk and Feer and puing it in his ownunique framework

e leading economist adopting Feerrsquos pure time preferenceview of interest was Ludwig von Mises Mises amended thetheory in two important ways First he rid the concept of itsmoralistic tone which had been continued by Boumlhm-Bawerk Mises made clear that a positive time preference rate is an es-sential aribute of human nature Secondly and as a corollarywhereas Feer believed that people could have either positiveor negative rates of time preference Mises demonstrated that apositive rate is deducible from the fact of human action since bythe very nature of a goal or an end people wish to achieve thatgoal as soon as possible (Rothbard 1987421 italics added)

4See however Maclachlan (199339ndash40) for a slightly different interpretation5So for example among other things he ldquonever fully realized the importance [of

distinguishing] between land (the original producerrsquos good) and capital goods (createdor produced producerrsquos goods)rdquo (Rothbard 19776)

So according to Rothbard Mises has the definitive PTPT of interestRothbard claims (a) that Mises has demonstrated ldquothat a positive rateis deducible from the fact of human action since by the very nature ofa goal or an end people wish to achieve that goal as soon as possiblerdquoand therefore (b) that time preference can never be negative

It is these claims that render the PTPT of interest obscure A closerexamination ofMisesrsquo work and Rothbardrsquos reveals that they are not soeasily established Mises and Rothbard wanted to establish (positive)time preference as a pure (nonempirical) category like action some-thing that was impossible to deny But because of its link to time andbecause of the connection of time to uncertainty (the gaining of newknowledge) the aempt to do so involved Mises (and by extensionRothbard) in a logical contradictionmdashthat is he assumed the absenceof uncertainty in order to ldquoproverdquo the necessity of time preference asan implication of action when action in a world without uncertaintyis by his own definition impossible (Lewin 1997b) e distinctionbetween assumption and empirical judgment also seems to be blurredby Misesrsquo difficulty in establishing a clear definition of time preference(see also Pellengahr 1996)

e PTPT of Interest Reformulated

is is a difficult and controversial subject No doubt others will inter-pret Mises differently and this is not the place for a lengthy defenseof my own view (which is available in Lewin 1997b) Instead I willsimply offer a reformulated account of the PTPT of interest one thatdoes not claim time preference as a ldquopurerdquo category Feerrsquos and Boumlhm-Bawerkrsquos ldquoempiricalrdquo approaches look much beer from this perspec-tive

Time preference is difficult to define e prospects being com-pared over time must in some sense be the same things but for thepassage of time What then makes them the ldquosame thingsrdquo Are theythe same goods In this case the definition of a good is problematicmdashice cream in summer versus ice cream in winter are not the same goodBut then are we talking about more ldquoultimaterdquo goods like ldquosatisfactionobtained from eating ice creamrdquo If so we are comparing a presentsatisfaction with the contemplation of an identical satisfaction in the

future How are we to calibrate these An alternative way to expresstime preference one that is purged of any ldquohedonicrdquo elements is asfollows

Comparing the purchase of (a) a prospect that is ranked 1 todaywith (b) a prospect that would be ranked 1 today if it were avail-able today but is only available tomorrow since (as indicatedby the ranking) (a) is preferred to (b) time preference exists

A key point can be made time preference is strongly intuitively con-nected to the presence and type of uncertainty in the world Considerthe simple experiment that one oen uses in teaching the concept oftime preference e teacher takes out a ten-dollar bill and asks theclass which they would prefer (1) the ten dollars right now or (2) thesame ten dollars this time next week He adds that the students maynot earn any interest on the ten dollars Of course everyone optsfor (1) en the teacher changes option (2) to (2prime) ten dollars plus119894 this time next week At some level of 119894 (2prime) will just be preferred (orthe students will be indifferent between the two) is is then usedas an indication of and as a measurement of time preference Nowif you change the choice a lile by adding the assumption that theprospect of ten dollars next week is a certain prospectmdashthe teacher is aperfectly safe bet while the studentsrsquo ability to keep the ten dollars safeover the course of the week is less than certain (for example we couldimagine a dangerous society in which predatory behavior regularlythreatens peoplersquos savings) then (2) could very well be preferred to (1)Alternatively if we assume that (2) and (1) are equally and completelycertain then a priori it does not seem to be possible to say that one willbe preferred to the other e knee-jerk preference of (1) over (2) seemsto be crucially bound up with the fact that the students automaticallyrealize that the passage of time brings with it unexpected events andthat ldquoa bird in the hand is worth two in the bushrdquo Resorting to con-structs that banish the essential nature of time seems to hinder ratherthan help in understanding time preference

It should be noted that among some writers sympathetic to thetime preference approach there is no assumption that it need always bepositive or that it is a logical rather than an ldquoempiricalrdquo phenomenonWe have already noted Feersrsquo contribution In Kirznerrsquos recent articlehe implicitly expresses doubts about Misesrsquo treatment when he says

ldquois theory solves the interest problem by appeal to widespread possi-bly universal positive time preferencerdquo (Kirzner 1993171 italics added)and again ldquoPTPT accounts for this phenomenon [value productivity]by reference to widespread possibly universal preference for the earlierrather than the later achievement of goalsrdquo (ibid192 italics added) Inconsidering why (market) interest rates cannot be negative Lachmannexplains

e ultimate reason for this lies in the simple fact that stocksof goods can be carried forward in time but not backwards Ifpresent prices of future goods are higher than those of presentgoods it is possible to convert the laer into the former unlessthe good is perishable or the cost of storing excessive while fu-ture goods cannot be converted into present goods unless thereare ample stocks not otherwise needed which their holders areready to reduce for a consideration And as there are always anumber of goods for which the cost of storage would be smallmoney being one of them a negative rate of interest would beeliminated by a high demand for present goods which are easyto store and a large supply of easily storable future goods atleast as long as the stocks carried are covered by forward sales

(Lachmann 197878)

So given that the passage of time is what it is and given that (in oursociety) generally some goods can be transferred to the future intact(notably money) we would expect time preference and interest ratesto be positive

Conclusion Interest is not Profit

Every production plan involves capital values ese depend cruciallyon the rate of discount used to obtain them is rate of discount is anexpression of a positive time preference although it may be affectedby other things Time preference is its essential explanation Sincecapital involves time it also involves time preference Observed in-terest rates which depending on the context are sometimes used toobtain capital values do not measure the return to capital Capitalis in this respect no different from any other input e contributionof any and all inputs will be similarly discounted in any productionplan Payment to the inputs would tend to reflect their opportunity

costs us any surplus remaining aer the payment to the inputs ofldquowagesrdquo and ldquorentsrdquo is profit We now take a closer look at this

e Nature of Profit

Profits In and Out of Equilibrium

One way to examine the nature of profit is to examine a hypotheticalsituation in which it would be absent is has been the basis of anumber of similar approaches in neoclassical as well as Austrian eco-nomics in the former the steady state and its extreme the stationarystate in the laer the ldquoevenly rotating economyrdquo

In an economy in which there was no uncertainty (if one couldimagine such a world) there would be no profit All production plansin such a world would be successful in the sense explained above Allcapital values 119896119905 would look the same from all points of view and toall individuals In such a world the rate of discount would equal theuniform internal rate of return on all capital projects and this in turnwould equal the rate of interest for the time period in question is isthe world of general equilibrium If we assume no growth no capitalaccumulation it is a stationary general equilibrium and also an evenlyrotating economy (ERE) (see Rothbard 1970274ff) In this kind ofworld it is possible to do some simple social accounting

e structure of production will be constant and will reflect thebest use of the generally known productive techniques is is thestate to which we are to imagine the economy will tend to move in theabsence of any change ere are no profits and losses e pricesof capital goodsmdashreflecting the value of their discounted marginalproductsmdashare fully captured by the prices of the original ldquoprimaryrdquofactors used to produce them And there are only two such primaryfactors of productionmdash(ground) land and (raw) labor Everything elsein the economy is ultimately produced using these two primary factorseither directlymdashat the highest stagemdashor indirectly combining withalready produced capital goods to add value to the next stage Allother incomes can be analytically ldquoswept backrdquo to those of the originalfactors e incomes of land and labor are incomes in the nature of arent and in the ERE only labor and land earn pure rent

A rent is the unit price of the service yielded by a long-lived assetIn the case of a nondurable good it is equal to its price In the ERE therent on a particular physical asset will equal its discounted marginalvalue product (DMVP) us all durable assets that have a value inproduction (and can be bought and sold) have capitalized values thatwill determine their prices For a perpetual income stream the capital-ized value will be equal to the rent divided by the discount rate Sinceall rents except those paid to land and labor ldquobalance outrdquomdashsince theprices paid for capital inputs by a producer of capital goods at any stageof production must be offset against the prices of the goods producedmdashthe only ldquopurerdquo capitalized values are for land and labor Since laborcannot be bought and sold in a free societymdashit can only be rentedmdashtheonly pure capitalized value that would be observed is that of land

us in this world there is a crucial distinction to be made be-tween capital land and labor since capital earns no net (pure) incomeand the distinction between land and labor has to do with the lack of amarket for the laermdasha maer we take up briefly below (and in detailin Chapter 11) To reiterate capital goods refers to produced meansof production whereas land refers to the nonproduced resources ofnature is distinction is likely to trouble the modern reader whomight find it difficult to imagine any productive land that has not beenaltered in some way in the interests of productive activity Also thefact that at a certain time in the distant past unspoiled land entered intothe production of a particular consumption good is from an economicpoint of view irrelevant Economic agents take the world as they findit and look forward when making decisionsmdashthey inherit a variety ofcapital goods whose value depends not on their history but on theirfuture usefulness For both of these reasons the distinction betweencapital and land needs to be carefully formulated Whether a pieceof land is ldquooriginallyrdquo pure land is in fact economically immaterialso long as whatever alterations have been made are permanentmdashorrather so long as these alterations do not have to be reproduced orreplaced ldquoPermanencerdquo is not really the key

e key question is whether a resource has to be produced inwhich case it earns only gross rents If it does not or cannotit earns net rents as well Resources that are being depleted

obviously cannot be replaced and are therefore land not capitalgoods (Rothbard 1970460 n 15)

So land is any nonhuman resource that cannot be ldquoproducedrdquo or ldquore-producedrdquo And capital goods are produced means of production thatrequire (allow) maintenance or reproduction As such they includethe structures on land agricultural land and valuable human-madefeatures of the landscape that need to be maintained Land then in-cludes less than what we are accustomed in common usage to meanone important element being ldquolocationrdquo ldquo[is] concept of land then is entirely different from the popular concept of landrdquo (ibid415see also Hayek 1941ch V)

An ERE at any time then will have as productive factors landlabor and capital in the sense discussed Land does not refer to theresources of nature in their pristine originality but rather to any non-reproducible resources that may happen to exist at the time that theeconomy arrived at the stationary state of the ERE (Rothbard is awarethat the ERE cannot abide depletable resourcesmdashthat would otherwisequalify as landmdashand bemoans this as an unfortunate shortcoming ofan otherwise useful construct) In this economy the only net incomesearned will be the wages of labor the rents of land and pure intereste value of the final product will be accounted for by the contribu-tions of land (in the restricted sense explained) labor and interestSo in this discussion profits and losses (which are conceptually com-pletely distinct from interest) have the necessary function to correctthe ubiquitous malinvestments and misallocations that occur outsideof the particular (zero profit) ERE to which the economy is assumedto be tending ldquoProfits are an index that maladjustments are being metand combated by the profit-making entrepreneursrdquo (ibid468 italicsremoved) And in a continually growing economy land may earn anincome in terms of an increasing capitalized value

eory and Reality

is approach is useful in sorting out some common but fundamen-tal confusions like the difference between interest and profit and isstrong for example on the explanation of the concept of rent Carefulreaders come away with a much beer understanding of fundamental

categories like interest wages rent and profit ey are thus able todemystify much of capital theory Profit is seen as a disequilibriumphenomenon a result of fluctuations in capital values in response todiverse entrepreneurial visions and actions It is not interest it is notrent and it is not a return to any single factor of production unlessentrepreneurship be regarded as a factor (something that is hard todefend) We shall return to this Once we leave the certain world of theERE (or any steady state) however it is useful to consider wages inter-est and rent as categorically separate from profits along the same linesas discussed above in that they are contractual in nature being theresult of the fulfillment of (implicitly or explicitly) contractual arrange-ments between employers and employees or borrowers and lendersProfits are familiarly understood then as the residual noncontractualpayment to the equity holders in the production process is is avaluable insight suggested from ERE steady-state type reasoning andof course also conforms to the vision of the modern property rightsapproach to the firm (See Chapter 9)

PART III

CAPITAL IN A DYNAMIC WORLD

I have to this point explored aspects of the history of capital theoryand the nature of interest profit and rent One should distinguishbetween capital goods and capital as an abstract category e laerrefers to the value to be aributed to a particular plan or set of pro-duction plans e profits or losses to be aributed to a productionplan are the result of changes (or the absence thereo) in the capitalvalues aributed to it over time ese appreciations (or depreciations)in value are in turn the result of (are derived from) changes in con-sumersrsquo evaluation of final production

e meaning and the value of any particular capital good derivesfrom its position in a particular production plan Production plans arelike any other human plans (as discussed in Part I) ey are definedby particular purposes and they are informed by particular kinds ofknowledge Every production plan must envisage a combination ofresourcesmdasha capital combination Capital goods and labor and landwork together to fulfill the plan is combination must be made bysomeone with the knowledge of how to do it is involves knowledgeof the natural world technological knowledge (knowledge type 1) andknowledge of social habits and institutions (for example if individualshave to be coordinated andmotivatedmdashknowledge type 2) It may alsoinvolve specific expectations (knowledge type 3) concerning individualbehavior (can we rely on a particular worker) or nature (will theweather be favorable) But it seems reasonable to assume that oenmost of the knowledge involved in the implementation of the produc-tion plan is heavily weighted in favor of knowledge types 1 and 2ere are notable and important exceptions those production plansthat depend heavily on the ldquospeculativerdquo actions of othersmdashfor exam-ple on the supply of a yet to be discovered source of raw materials

etcmdashor those production plans that depend heavily on the implemen-tation of innovative (untried) productive techniques and the results ofresearch programs (as in the search for a new chemical substance ormedical drug) In general production plan implementation rests heav-ily on typical events and perhaps to a lesser extent on specific ones Inaddition to successfully coordinating the inputs the successful imple-mentation of any production plan rests however on the successful saleof its output And it is this aspect that is most likely to be dependenton the particular producerrsquos expectations (knowledge type 3)

In a world in which the production and sale of outputs was part ofa plan that was assumed to be consistent with all other related plans sothat there were no disappointments in production schedules or mostnotably in the sale of output the value of the resources that werepart of the plan would clearly be certain And if everyone sharedin the knowledge of the value of the output and the contribution ofeach input then in some sense these values would be reflected inprices of the inputs In such a situation of perfect plan coordinationa meaningful capital aggregate could then be obtained1 It should beclear however that such a construction abstracts not only from timebut also from those aspects of a capital-using economic process thatare responsible for its dynamic innovative character

If it is true by contrast that production plans typically rest onexpectations of the sale of particular outputs sometimes of new prod-ucts sometimes involving new production techniques then we shouldnot reasonably expect such plans to be consistent and coordinatedwith all other plans in the economy In particular capitalistic pro-duction involves rivalrous activity that clearly implies the piing ofone entrepreneurial vision against another In such a world the valueof productive resources indeed the value of productive ventures as awhole cannot be known to all and cannot be added together Manywill depend on mutually exclusive outcomes ese outcomes mightbe simple market shares in the case of similar but differentiated (brandnamed) products or they may be the progressive adoption of particular

1It is not clear that prices would exist in a world of perfect certainty such as thatpostulated here In such a world everyone would know ahead of time who shouldhave which resources etc But resources could unambiguously be imputed valueswhich may be thought of as ldquopricesrdquo

CAPITAL IN A DYNAMIC WORLD 123

standards like Windows versus Unix or VHS versus Beta For examplewe can imagine two video stores one renting VHS cassees the otherBeta cassees reasonably basing their expansion plans on inconsistentexpectations each being on the growing adoption of their particularstandard

Production plans considered as a whole are typically in disequi-libriummdashare based at least in part on inconsistent expectations notregarding the ldquorules of the gamerdquo but regarding the viability of theproduct or the productive technique ere is no way to derive anaggregate measure of capital in this situation e net present valuesas (assumed to be) computed by each individual planner are based oninconsistent futures However this absence of equilibrium in no wayprecludes actionmdashno more so than the absence of knowledge of theoutcome of a football game prevents the players from playing Allaction occurs within an institutional environment that includes theknowledge of the actors and as we have seen much of this knowledgedoes imply a consistency of expectations

In Part II I impressionistically traced the development of capitaltheory from Adam Smith through Ricardo to modern times I drew adistinction between the Ricardian andMengerian traditions In Part IIII turn to a discussion of some non-Ricardian approaches to capitaltheory and related topics Some of these may be seen to derive fromMenger (Hayek Lachmann) while others (essentially complementaryto the Mengerian line) may be termed ldquopost-Marshallianrdquo (PenroseRichardson Teece Williamson Loasby Langlois and others) Whatthese approaches have in common for our purposes is a process ap-proach to the accumulation of capital Capital decisions are seen asoccurring within an evolving economic environment and are embed-ded within individual production plans e success or failure of theseplans is inevitably linked to the organization of production is leadstherefore to a discussion of the nature of economic organization moregenerally particularly to the economics of the firm Indeed we shallsee that capital theory cannot be separated from a consideration of theeconomics of business organization

CHAPTER 8

Modern Mengerian Capital eory

Introduction

Our considerations in Part II suggest the following conclusions fromwhich we shall proceed in this part

1 Capital theory historically involvedmisleading physical analogiesExamples are

(a) Biological analogies reproductive processes in which ldquogrowthrdquooccurs automatically (the Crusonia plant the woodlot) incuba-tion periods where capital processes are likened to physical onesthat depend primarily on the passage of time (although implicitlyit is what happens in time that maers) like aging wine

(b) Notions of interest that are linked with physical or biological ac-cretion the idea that interest is that implicit increase in value thatoccurs continuously and inexorably over the production period

An approach to capital theory disconnected from its unhelpful histor-ical baggage must realize that the production process is a process ofvalue enhancement over (in) time It may involve physical processes(transformations) but its essential characteristic and driving force isthe creation of value the regrouping of physical resources into morevaluable combinations as a result of deliberate production decisions(not to imply that all or even most of these decisions are ldquosuccessfulrdquo)We shall be concerned to discover how production decisions are madeWe realize also that interest is a phenomenon that is crucially distinctfrom productivity (although we need not deny that the rate of interestmay be influenced by productivity oen in non-obvious ways)

2 We can dispense with ldquotime period of productionrdquo approaes tocapital While we cannot but note and emphasize the importance ofthe connection between time and production and the intuitive validity

of the idea that in order to reap the fruits of more productive specializa-tionswe have to adopt productionmethods that aremore ldquoroundaboutrdquo(more complex more indirect) nevertheless we cannot capture thisidea in the form of any simple notion of ldquoperiod of productionrdquo Norneed we do so

In this regard we shall find a number of modern theorists leadingthe way eAustrian tradition emanating fromMenger in the work ofMises Rothbard Hayek Kirzner and Lachmann has provided impor-tant insights We shall focus here primarily on the work of Lachmannbut we must take note briefly of the important work of Hayek oncapital theory if only for the subsequent work which it inspired Wewill then turn to a discussion from another tradition that emanatingfrom Alfred Marshall A group of theorists who have been referred toas ldquopost-Marshallianrdquo (Foss 1994 1995 1996ab) has done considerablework on the economics of the firm which bears a clear connection toconsiderations of capital structure One of the contributions of thispart will be to illustrate the connections between these two literaturestrands and how one can inform the other

Hayek and the Fundamental estions of Capital eory

In his work on capital Hayek stands in a sense between the Boumlhm-BawerkianndashRicardian approach and the Mengerian and post-Marshal-lian approach His work on capital theory dating from the early 1930sand culminating in the publication of e Pure eory of Capital (1941)was prompted by a concern with the business cycle In Monetary e-ory and the Trade Cycle (1933) and Prices and Production (1935b) he de-veloped what came to be known as the Austrian (MisesndashHayek) theoryof the business cycle is is essentially a monetary theory of fluctua-tions but one that emphasizes a (monetarily induced) ldquodistortionrdquo ofthe capital stock Hayek thus naturally drew from the work of Boumlhm-Bawerk and the relation between the capital stock and time In sodoing he simplified and glossed over many of the subtleties and compli-cations relating to capital aggregation In his subsequent work in theenvironment of the gathering momentum of the Keynesian revolutionhe sought to clarify and develop the capital theoretic underpinningsto this work which he saw as the viable alternative to the flawed andsuperficial Keynesian approach (see the collection of articles in ProfitsInterest and Investment (1939)) Finally his writing of the Pure eory

MODERN MENGERIAN CAPITAL THEORY 127

reflects his initial determination to lay out fully the fundamentals ofcapital theory and to make plain why he maintained that an under-standing of capital was vital to a valid approach to (macro)economicpolicy1 In the actual implementation of the project he became awareof the enormity of the task he had set himself and the finished productthough intricate and involved (by far his most difficult work in eco-nomics) was seen by him as an unfinished compromise (as is very clearfrom his remarks on pages viindashix of the preface) (Hayek had planneda second volume that would have applied the Pure eory analysis totrade cycles)

e basic approach of the book is an equilibrium approach alongthe lines of (the ldquoRicardianrdquo) Boumlhm-Bawerk Wicksell and Jevons (all ofwhom he credits as having anticipated in all essential ways what he hasto say) But in his voluminous side comments and general discussionshe makes it very clear that he understands the limitations of this (equilib-rium) approach and points the way to a more ldquodynamicrdquo disequilibriumtreatment us this work contains not only a fairly early working outof what was later to become a research area of neoclassical economicsunder the rubric of intertemporal equilibrium theory but also a wealthof important observations on the meaning of capital maintenance in adynamic changing world and other important insights that served asrawmaterial for Lachmannrsquos later work on capital theory It is the laercontributions in which we will be interested

Whereas the classical (Ricardian) theory of capital (as we saw inPart II) had become concerned with explaining the determination of therate of profit earned on an abstract category of resources (or a fund)known as capital the Mengerian approach suggested paying aentionto the structure of capital Hayekrsquos sympathies lie clearly with the laer

Our main concern will be to discuss in general terms what typeof equipment it will be most profitable to create under variousconditions and how the equipment existing at anymoment willbe used rather than explain the factors which determined thevalue of a given stock of production equipment and the incomethat will be derived from it (Hayek 19413)2

1is interpretation of Hayekrsquos work on capital theory is my own2It is a problem for the reader that having stated this general objective Hayek then

turns to a protracted examination of capital under equilibrium conditions reminiscentof the classical approach and never really fulfills his originally stated objective It hasbeen suggested (byHayek among others) that Lachmann did just that (see Lewin 1997a)

Hayekrsquos compositive sympathies are clearly stated

e problems that are raised by any aempt to analyze thedynamics of production are mainly problems connected withthe interrelationships between the different parts of the elab-orate structure of productive equipment which man has builtto serve his needs But all the essential differences betweenthese parts were obscured by the general endeavor to subsumethem under one comprehensive definition of the stock of cap-ital e fact that this stock of capital is not an amorphousmass3 but possesses a definite structure that it is organized ina definite way and that its composition of essentially differentitems is muchmore important than its aggregate ldquoquantityrdquo wassystematically disregarded (ibid6 italics added)

3In this approach it is clear that both Lachmann and Hayek benefit from Schum-peterrsquos pronouncements In his lectures on capital theory Lachmann states

Schumpeter has a succinct statement of the compositive school ap-proach Whenever we are talking about a given situationmdashmeaninggiven tastes resources and technologymdashresources must exist in a cer-tain stock of inherited goods ie goods provided in the past ey aresimply there like land ese resources are limited in the way thatthey can be used e stock of existing goods constitutes a constrainton human action going forward e stock of capital is neither homo-geneous nor is it an amorphous heap Its components complement oneanother Some goods must be available for the operation of others enature of the composition of the stock is vitalmdashit constitutes a givenldquostructurerdquo (Lachmann 1996126ndash127 see also 144)

is is an allusion to the words of Schumpeter In a section entitled ldquoe Structure ofPhysical Capitalrdquo Schumpeter seems to anticipatemuch that is relevant to Lachmannrsquos(and Hayekrsquos) viewpoint

e initial stock of goods is neither homogeneous nor an amorphousheap Its various parts complement each other in a way that we readilyunderstand as soon as we hear of buildings equipment raw materialsand consumersrsquo goods Some of these partsmust be available beforewecan operate others and various sequences or lags between economicactions impose themselves and further restrict our choices and theydo this in ways that differ greatly according to the composition of thestock we have to work with We express this by saying that the stockof goods existing at any instant of time is a structured quantity or aquantity that displays structural relations within itself that shape inpart the subsequent course of the economic process

(Schumpeter 1954631ndash632 italics in original)

Hayek explains the problems associated with any aempt to aggregatethe capital stock in value terms or in terms of units of labor or time andintends to work systematically towards a theory in which this is notnecessary He begins however with a discussion of how an economydirected by a central dictator might make decisions regarding the for-mation and use of capital goods in an economy devoid of change isof course abstracts from any issues related to the relative evaluation ofconsumption goods since the only valuations that maer are the dicta-torrsquos us the solution is essentially the same as the classical one ereis by assumption no disequilibrium problem heterogeneity is seen notto maer Of course Hayek does this as a foil a relief against whichto illuminate the real-world problems of heterogeneity and change Hismethod is first to get the abstract problem right Unfortunately butunderstandably much of the literature that refers to this work concen-trates on these equilibrium exercises rather than on the original focusthat Hayek sought to maintain that is of inquiring into the decisionsgoverning the use of the various capital resources at our disposal4

e Problem of Imputation

Essentially Hayekwas concernedwith the question how are resourcesmade and used Or more accurately how are these decisions madeat is we seek to understand the decision-making process whichleads to the adoption of certain types of capital equipment in combina-tion with others Obviously decision-makers have to form a judgmentas to the worth of any capital combination and its various componentsthey have to impute a value to the capital goods they have or areconsidering acquiring or producing is is clear fromMengerrsquos notion(developed further by Wieser who seems to have invented the termldquoimputationrdquo)5 that the value of any resource is derived from the value

4In the final section of the book (pt IV) Hayek turns to some dynamic considera-tions While this section is very useful particularly in its treatment of fundamentalissues concerning saving and investment it does not really deal with capital and couldbe seen perhaps as an extended and effective (but largely ignored) reply to Keynes

5e imputation question was an important issue for the ldquosecondrdquo generation ofAustrian economists (the interwar period) and may have been responsible for a lessthan accurate understanding of Misesrsquo contribution to the socialist calculation debateon the part of some Austrian economists See Kirzner (1994bvol II 20 also chs 15and 19 thereo)

of the final output for which it is responsible But as we have notedin previous chapters the question remains as to how we are to decidewhich unit of output is aributable to which unit of input In the neo-classical literature this problem is solved by assuming that productionmethods can be varied continuously in such a way that the marginalcontributions (products) of each unit of input can be easily discoveredis is also Hayekrsquos assumption in his discussion of a centrally directedeconomy is way of dealing with the problem abstracts from themost interesting questions in capital theory questions that turn out tobe relevant to considerations of economic organization

It would seem however that there is a necessity to invoke some no-tion of marginal (value) product e producer must have in mind someopportunity cost when assigning a resource in one particular way ratherthan another and thusmust also have inmind the supposed contributionthat its (marginal) assignment makes As we shall make clear howeverin a world of uncertainty and change there is an inescapable element ofjudgment and speculation involved in this Different decision-makerswill see things differently and will (implicitly) impute different valuesto the capital resources at their disposal from what others would esedifferences produce the capital valuation process that is part of themarket process and which renders economic calculation possible

e economistrsquos description of the imputation process where thedecision-maker has recourse to the value marginal product scheduleis an idealized construct e process of actual decision-making mustmirror in an implicit way this idealization But it does so by using cer-tain simplifying conventions (for example based on accounting prac-tices) that form part of an institutional structure rendering the decisionmanageable (tractable) And in so far as these conventions reflect awidespread sharing of forms of appraisal they supply the decision-maker with knowledge (type 2) of ldquohow to do itrdquo (as distinct from whatto decidemdashtype 3) We shall return to this

Lamannrsquos Conceptual Framework

e Structure of Capital

Perhaps the most important development of Hayekrsquos original projectis to be found in Lachmannrsquos capital theory In 1956 Lachmann who

[is section uses material from Lewin (1997a)]

had been a student and colleague of Hayekrsquos at the London School ofEconomics published Capital and its Structure (Lachmann 1978)6 isworkwas really the culmination of his earlier work on capital themostcomplete of which was his 1947 article (see Lachmann 1938 1939 19411944 1947 1948 see also Lewin 1997a)

According to Lachmann

e generic concept of capital without which economists can-not do their work has no measurable counterpart among mate-rial objects it reflects the entrepreneurial appraisal of such ob-jects Beer barrels and blast furnaces harbor installations andhotel room furniture are capital not by virtue of their physicalproperties but by virtue of their economic functions Somethingis capital because the market the consensus of entrepreneurialminds regards it as capable of yielding an income [But] thestock of capital used by society does not present a picture ofchaos Its arrangement is not arbitrary ere is some orderto it (Lachmann 1978xv)

e value of the capital stock being dependent on individual expec-tations and evaluations (time preferences included) is not an objec-tively observable phenomenon or necessarily even a meaningful con-cept Only in equilibrium where all individualsrsquo expectations wereconsistent one with the other would such a value have any meaningLachmann chooses to develop his analysis in a disequilibrium frame-work In other words Lachmann considered the notion of a capitalstock (which made sense in an equilibrium context) to be untenableand unhelpful in a disequilibrium world He thus offers a theory ofthe capital structure rather than the capital sto

Lachmann thus emphasizes the heterogeneity of the capital stocke fact that capital goods are physically very dissimilar is signifi-cant precisely because of the existence of disequilibrium Physicalheterogeneity could be reduced to value homogeneity if the values

6As mentioned above there is some evidence to suggest that both Hayek and Lach-mann saw Lachmannrsquos work as a continuation of Hayekrsquos project When asked aboutthe Pure eory Hayek once remarked ldquoI think the most useful conclusions drawn fromwhat I did are really in Lachmannrsquos book on capitalrdquo (Kresge andWenar 1994142) Alsoit is clear that Lachmannrsquos inspiration was Hayekrsquos work on capital (of which e Pureeory was the culmination) In his 1948 article he refers to Hayek (1937a) and saysldquoe ideas set forth by Professor Hayek have been the main inspiration of this paperrdquo(Lachmann 1948)

of the various capital goods could be simply added together Wheredisequilibrium means that individuals have different and frequentlyinconsistent expectations one cannot simply add together individualvaluations e physical heterogeneity is not the essence of the maerDifferent physical goods that perform the same economic functioncould be counted as the same good It is the difference in economicfunction that maers For the most part different capital goods lookdifferent because they are designed to perform different functions Butthe same capital good could perform different functions under differ-ent circumstances Heterogeneity in use is the key

Although the capital stock is heterogeneous it is not an amorphousheap e various components of the capital stock stand in sensiblerelationship to one another because they perform specific functionstogether at is to say they are used in various capital combinationsIf we understand the logic of capital combinations we give meaningto the capital stock and in this way we are able to design appropriateeconomic policies or even more importantly avoid inappropriate ones(for example Lachmann 1978123)

Complementarity and Substitutability

Understanding capital combinations entails an understanding of theconcepts of complementarity and substitutability In neoclassical mi-croeconomics these concepts are developed within a market equilib-rium production function framework Production goods are substi-tutes or complements for one another to the degree to which andin the manner in which their marginal products are related emarginal products of complements are positively related while thoseof substitutes are negatively related What is envisaged is a situation inwhich production goods are combined in a technological relationshipof known and well-understood inputs and outputs e values ofall possible outputs are known with certainty (or with probabilisticcertainty) and from this it is possible to calculate the values of themarginal products under all conceivable circumstances Hence wehave the picture of a given budget line (or hyperplane) formableout of the given equilibrium prices of the production goods and thequantities used confronting a given isoquant Substitution is thensimply a maer of moving around the isoquant in two-dimensional

or multidimensional space Substitution occurs because of a changein the price of a production good ere is no analysis of any eventsthat occur in disequilibrium ie of events that occur between the timethat a price change occurs is perceived is acted upon and results inthe establishment of a new equilibrium e same sort of analysis isapplied to changes in technology which are analyzed as changes inthe positions or shapes of the isoquants

As a mental picture of a single production plan at a point of timethe isoquant diagrams (or algebras) may be enlightening ey sum-marize a certain ldquologic of choicerdquo But they have lile to do withLachmannrsquos conception of what substitution and technical progressmean in reality His concepts pertain to a world in which perceivedprices are actual (disequilibrium) prices in the sense that they reflectinconsistent expectations and in which changes that occur cause pro-tracted visible adjustments Capital goods are complements if theycontribute together to a given production plan A production plan isdefined by the pursuit of a given set of ends to which the productiongoods are the means As long as the plan is being successfully fulfilledall of the production goods stand in complementary relationship toone another ey are part of the same plan (It is not inconsistent tosay that their perceivedmarginal products are positively related in thesense that their joint outputs depend on each othersrsquo performance Anincreased availabilitymdashreduction in pricemdashof any one input raises thepotential outputs of the plan aributable jointly to all of the inputs andmay increase the (joint) demand for all of them) e complementarityrelationships within the plan may be quite intricate and may involvedifferent stages of production and distribution Substitution occurswhen a production plan fails (in whole or in part) When some elementof the plan fails a contingency adjustment must be sought7 ussome resources must be substituted for others is is the role forexample of spare parts or excess inventory us complementarityand substitutability are properties of different states of the world esame good can be a complement in one situation and a substitute inanother

7It is easy to see how his approach relates to the analysis of the individual plan-ning process suggested in Chapter 2 that is that plans depend on different kinds ofknowledge and are multilayered and necessarily vague

Lachmann uses the example of a delivery company (Lachmann1947199 and Lachmann 197856) e company possesses a numberof delivery vans Each one is a complement to the others in that theycooperate to fulfill an overall production plan at plan encompassesthe routine completion of a number of different delivery routes Aslong as the plan is being fulfilled this relationship prevails but if one ofthe vans should break down one or more of the others may be divertedin order to compensate for the unexpected loss of the use of one of theproductive resources To that extent and in that situation they aresubstitutes Substitutability can only be gauged to the extent that acertain set of contingency events can be visualized eremay be someevents such as those caused by significant technological changes thatnot having been predictable render some production plans valuelesse resources associated with them will have to be incorporated intosome other production plan or else scrappedmdashthey will have beenrendered unemployable is is a natural result of economic progresswhich is driven primarily by the trial-and-error discovery of new andsuperior outputs and techniques of production

What determines the fate of any capital good in the face of changeis the extent towhich it can be fied into any other capital combinationwithout loss in value Capital goods are regrouped ose that losetheir value completely are scrapped at is capital goods thoughheterogeneous and diverse are oen capable of performing a numberof different economic functions Lachmann calls this propertymultiplespecificity

e Capital Structure is Composed of ComplementaryHeterogeneous Items

Lachmannrsquos world is consciously similar to Schumpeterrsquos world(Schumpeter 1961) of ldquocreative destructionrdquo except that for Lachmannthe innovating entrepreneur is not disrupting some preexisting generalequilibrium His world is one in which a continuous evolutionaryprocess of changing paerns of capital complementarity is occurringAt any point in time different entrepreneurs will have different andfrequently incompatible production plans Over time the market pro-cess will validate some and invalidate others Lachmann sees the

market process as tending to integrate the capital structure in otherwords rendering plans more consistent although he is careful toadd (as we saw in Chapter 2) that the forces of equilibrium may beoverwhelmed by the forces of change

e concept of the capital structure (to be explained further below)is built out of the notion of capital complementarity A production planis a construction of the human mind As such it exhibits a necessaryinternal consistency From the point of view of the individual plannerit might be said that the plan is always in equilibrium e plan isalways in equilibrium in the sense that every planner being rationalmay always be counted on to do the best that he can given all the rele-vant constraints where such constraints include the time available toadjust to any unexpected changes at is to say at any given point oftime any individual planner is in equilibriumwith respect to the worldas he sees it at that point of time All productive resources employedin that plan stand in complementary relationships to one another Be-tween any two points of time during which unexpected changes willnecessarily have occurred resource substitutions will have been madein an aempt to adjust to the changes Complementarity is a conditionof plan equilibrium (stability) substitutability is a condition of plandisequilibrium (change)

e notion of the capital structure does encompass a sort of eco-nomy-wide equilibrium as an ideal type At the individual level dis-parate elements of the production plan are brought into consistencyby the planner ese elements are all present in a single human mindere is no such mechanism guaranteeing consistency between dif-ferent production plans e market process does however tend toeliminate inconsistencies between plans in so far as not all of them cansucceed In this way plans that are consistent with (complementary to)one another tend to prevail over those that are not8 So whereas the

8is would seem to imply that the production plans of individual firms are iden-tical with the plans of one or other individual in that firm is is not necessarily thecase however Firms must find a way to harmonize the different visions of its variousplanners Presumably the larger the firm the more difficult this is But those firmsthat do so more successfully and adopt successful supra-plans will tend to survivee market process works its way into the firm in this way In this way Lachmannrsquoswork on capital is relevant for and related to the post-Marshallian theories of the firmthat we shall examine below

individual planner ensures the complementarity of all of the resourceswithin a production plan the market process tends towards a situationof overall plan complementarity is is what constitutes the capitalstructure e heterogeneous assortment of capital goods stands atany time in a kind of ordered structure defined by their functions andby the relationships that the various plans have to one another elaer is a result not of any supra-plan but of the market process Acapital structure in which this tendencywere complete in which everycapital good and every production plan were complementary to everyother would be a completely integrated capital structure In summary

In a homogeneous aggregate each unit is a perfect substitutefor every other unit as drops of water are in a lake Oncewe abandon the notion of capital as homogeneous we shouldtherefore be prepared to find less substitutability and more com-plementarity ere now emerges at the opposite pole a concep-tion of capital as a structure in which each capital good has adefinite function and in which all such goods are complementsIt goes without saying that these two concepts of capital oneas a homogeneous fund each unit being a perfect substitute forevery other unit the other as a complex structure inwhich eachunit is a complement to every other unit are to be regarded asideal types pure equilibrium concepts neither of which can befound in actual experience (Lachmann 1947199)

Lachmann chose to describe the world in terms of a capital structurerather than a capital sto is choice reflects a judgment that to ob-scure capital complementarity through aggregation would result in aninaccurate and misleading picture of the role of capital in the economyis can be seen in his account of how the market process works

e Market Process and the Production Process

At any moment in time individual planners hold inconsistent expecta-tions is means that the passage of time must disappoint some ofthem Some production plans must fail (in part or in whole) while oth-ers of course may succeed beyond their expectations is is reflectedaccording to Lachmann in two crucial waysmdashin capital re-evaluations(capital gains and losses) and in anges in cash balances Whereasthe ldquowealth effectsrdquo of neoclassical economics are usually assumedto be small enough to be neglected the capital gains and losses of

Lachmannrsquos world are the most important forces driving changes inthe capital structure ese market evaluations of the prospects ofsuccess or failure of the firm and its capital combination are reflectedin the financial assets associated with the firm e financial assets (forexample debt and equity) form a superstructure over the capital assetsof the company and constitute its asset structure ey are claims to thephysical assets of the company and as such reflect their value (or oth-ersrsquo opinions of their value) us there is an economy-wide financialstructure (composed of the individual asset structures) that is relatedto and reflects the capital structure of the economy e capital struc-ture and the capital combinations of which it is composed are in turnrelated to the plan structure At each of these levelsmdashplans physicalassets and financial assetsmdashvarious institutions exist that help definethe various structures A vitally important institution in the financialstructure is the stock market On the stock market assets are valuedand revalued every day in accordance with companiesrsquo performancese stock market reflects a daily balance of expectations concerningthe earning prospects of companies It is probably fair to say thatLachmann considered the stock market to be the most important in-stitution of the market economy (he did not share Keynesrsquos view thatit was basically random in nature (Lachmann 197868ndash71)) and the onemore than any other that differentiated it from socialized economiesmdashthe institution that together with others in a private financial capitalmarket was responsible for facilitating the adoption of those capitalcombinations that contribute to economic progress (Lachmann 1992)

Capital gains and losses provide entrepreneurs with feedbackfrom the market Ventures that continue to sustain capitallosses will eventually have to regroup or stop operating In thisway the financial structure and the capital structure interact toproduce a continuing reshaping of the laer

(Lachmann 197894)

Cash Balances as Excess Capacity and Constraint

A more immediate form of feedback comes in the form of changes inthe cash balances of the company e company holds cash as a formof ldquoexcess capacityrdquo in order to preserve flexibility In a sense cash isthe most substitutable of the companyrsquos capital assets us changes

in cash balances like changes in inventory provide an important indi-cator of the results of the operation over a period of time A persistentnegative cash flow is the ultimate long-term discipline and oen alsothe first indicator of a problem9 Lachmann sees the traditional neoclas-sical portfolio approach to cash balance and financial asset holding asmisleading While it is true that production plans must include deci-sions about financial asset mix (the optimum manner of financing) toassume that observed cash and asset portfolios reflect optimal choicesis to lose sight of the feedback process discussed above at is to sayempirically observed changes in cash holdings and asset values reflectnot only intended outcomes but they also reflect results that are unin-tended (mistakes or surprisesmdashgood and bad) In the portfolio equilib-rium view the portfolio reflects the results of portfolio selection basedon underlying preferences and shared knowledge In Lachmannrsquos (dis-equilibrium) market process view the portfolio value reflects portfolioresults which are oen different from what was intended and cannotbe assumed to reflect accurately the preferences and intentions of theplanners Rather it is a barometer of the viability of the overall plan

Capital gains and losses [E]ssentially reflect in one sphereevents or the expectation of events the occurrence of which inanother sphere is indicated and knowledge of which is trans-mied by changes in money flows

(Lachmann 197895)

Capital Accumulation Ordinarily Involves a Changing CapitalStructure

Perhaps the most important general implication of a disequilibrium ap-proach to capital is the proposition that all capital accumulation entailsa anging capital structure is follows from the observation thatmost technical change is embodied in new (improved) capital goodsandor involves the production of new consumption goods Capitalaccumulation that accompanies economic growth as we know it isnot simply the addition of the same kinds of capital goods doing the

9Of course negative cash flows occur routinely and are planned for in start-upbusinesses some of whom go on to become corporate giants It seems as though adistinction between planned and unplanned might be useful here

same things Lachmannrsquos view of capital accumulation and economicprogress is in many ways very prophetic of the revolutionary kindof economic change that has characterized the twentieth century in-cluding the last quarter of the century It is in this view impossi-ble to separate the phenomena of technical progress and capital ac-cumulation capital accumulation always proceeds hand in hand withtechnical change By the same token failed production plans implyldquoholesrdquo in the capital structure that signal investment opportunitiesfor others An approach to economic growth that visualizes capitalas a homogeneous aggregate to which investment expenditure adds inan indiscriminate way so that a government policy adding directly toinvestment expenditure is in essence no different from an increasein private entrepreneurial investment expenditure is not only unten-able but also has far-reaching consequences e capital structurewill be irreversibly different in these two cases It is very likely thatgovernment expenditure ldquocrowds outrdquo not only private sector expen-diture but also private-sector-induced technical progress e shapeof the capital structure will be different and because capital assets areheterogeneous specific and durable will remain different from whatit would otherwise have been It takes a lot of faith in the abilitiesand objectives of the government agents involved to imagine that nosacrifice in entrepreneurial discovery is involved10

e Disequilibrium Method is Particularly Applicable in a Worldof Rapid Changes

e world around us abounds with problems to which a struc-tural theory of capital of the type outlined in this book is ger-mane It is hoped that a number of them will aract the aen-tion of economists

(Lachmann 1978xi)

e choice of how to characterize capital is dependent on the kind ofworld in which one lives In a world in which unexpected changes oc-cur relatively rarely and in which methods of production distribution

10Lachmannrsquos capital theory framework blends nicely with Kirznerrsquos views onentrepreneurship and Hayekrsquos views on information to yield some very specific in-sights on ldquoinvestment policyrdquo

and interaction are very stable (Adam Smithrsquos corn economy) it mightmake sense to characterize capital as an equilibrium stock a fund ofmore or less agreed-upon value But in a world in which change israpid and unpredictable Lachmannrsquos characterization of capital as astructure of heterogeneous items becomes even more appropriate Inparticular with regard to the effect of change on incomes employ-ment and lifestyles Lachmannrsquos changing capital structure gives in-sights that are not available from an equilibrium approach

It is generally agreed that we are living in an age of profoundchanges It is not the fact of changes in technology that is revolu-tionary it is the speed with which it is occurring that is new epace of change is not only quicker it is accelerating At the sametime however our ability to absorb and adjust to change has increasedmany-fold

Underlying virtually all of the major developments of this centuryis the revolutionary change in the way in which we generate and useinformationmdashhence the phrase ldquoinformation agerdquo In some respectsthis is only the latest in a line of similar revolutions like the originalemergence of language and the development of writing accountingand printing e latest and to date most profound development inthis line of developments is electronic communication of which thetelephone the computer and the video and audio recorder are allpart Electronic communication in all of these aspects is responsiblefor the developments of global markets of desktop publishing of fuelinjectors for automobiles of computer aided design of everything frommicrochips to airplanes and so on

To understand the phenomenon of accelerating change occurringtogetherwith our enhanced abilities to adapt to changewemust realizethat the scope and pace of tenological ange itself is governed by ourability to generate and process relevant information is means thatthe current pace of technical change is dependent on past technicaladvances particularly the ability to generate and process informationIf technological change is seen as the result of many trial-and-errorselections (of production processes of product types of modes of distri-bution etc) then the ability to generate and perceive more possibilitieswill result in a greater number of successes It will of course alsoresult in a greater number of failures Lachmannrsquos proposition thatcapital accumulation proceeding as it does hand in hand with techno-

logical change necessarily brings with it capital regrouping as a resultof failed production plans appears in this perspective to be particularlypertinent ldquo[E]conomic progress is a process which involves trialand error In its course new knowledge is acquired gradually oenpainfully and always at some cost to somebodyrdquo (Lachmann 197818)Today new knowledge acquisition is not so gradual

e Market Process has Discernible Phases Imitation andInnovation

emarket process is one of continual flux e shaping and reshapingof the capital structure is driven by the changing shape of the mix ofconsumer products is perspective led Lachmann to a characteriza-tion ofmarket activities in terms of two distinct phases ldquoA competitiveprocess taking place within the market for a good consists typicallyof two phases and in it the factors of innovation and imitation maybe isolated as iterative elementsrdquo (Lachmann 198615) e successfulintroducer of a new product or new brand of product gains temporarymonopoly power e spreading knowledge of this success aracts im-itators e learning curve for the laer is shorter Prices tend to fall asmargins are competed away is brings further pressure for productdifferentiation and capital reshuffling (reorganization) e process isinseparable from technological change Market share and firm size atany point of time thus have very lile to do with monopoly powerey are both transitory states of a continuing innovationndashimitationcycle is view finds close application in the electronics industry andthe development of personal computers fax machines copy machinescameras cellular phones and so on Notably the innovationndashimitationcycle is shortening is is another aspect of the rapidity and acceler-ation of change From this perspective the classical doctrine of capitalflows establishing a uniform rate of profit is found seriously wanting

From Boumlhm-Bawerk to Lamann and Ba e Division ofLabor and the Division of Capital

An important aspect of the information revolution is that it allows forthe formation and management of ever more complex capital struc-tures In his work on capital Lachmann proposed a reinterpretation

of a controversial aspect of Boumlhm-Bawerkrsquos theory his famous propo-sition concerning the superior productivity of roundabout production(ie of production processes that are more indirect that take moreldquoproduction timerdquo) (Lachmann 1978 ch V) Lachmann regarded Boumlhm-Bawerkrsquos use of time as a unit of measurement for the capital stockas untenable and seriously misleading He felt strongly howeverthat Boumlhm-Bawerkrsquos intuition about the sources of economic progresswas correct ldquo[T]he intuitive genius of Boumlhm-Bawerk gave an answer[that] to be sure we cannot fully accept and which moreover ismarred by an excessive degree of simplification yet an answer wecannot afford to disregardrdquo (Lachmann 197873) erefore he suggestsdispensingwith the notion ldquoperiod of productionrdquo and replacing it withthe notion ldquodegree of complexityrdquo Whereas Boumlhm-Bawerk arguedthat the period of production increased with capital accumulationLachmann argues that capital accumulation results in the increasingcomplexity of the production process In this way he hoped to havegiven a new and more appropriate meaning to the notion of increasedroundaboutness Lachmann argued that Boumlhm-Bawerkrsquos ideas wereclosely related to those of Adam Smith (Lachmann 197879) Bothwere concerned about the sources of economic progress Both lived ina world that was ldquoneither a stationary nor a fully dynamic worldrdquo(197879) Our world is however a dynamic world one in whichtechnical progress is an outstanding feature For Boumlhm-Bawerk round-aboutness was not a form of technical progress ldquoTechnical progressrequires new forms of knowledge spreading through the economic sys-tem while Boumlhm-Bawerk assumes as given knowledge equally sharedby allrdquo (197879)

For Adam Smith the division of labor was the most importantsource of progress e same principle can be applied to capitalAs capital accumulates there takes place a ldquodivision of capitalrdquoa specialization of individual capital items which enables us toresist the law of diminishing returns As capital becomes moreplentiful its accumulation does not take the form of multiplica-tion of existing items but that of a change in the compositionof capital combinations Some items will not be increased atall while entirely new ones will appear on the stage ecapital structure will thus change since the capital coefficients

change almost certainly towards a higher degree of complexityie more capital items will now be included in the combina-tions e new items which either did not exist or were notused before will mostly be of an indivisible character Com-plementarity plus indivisibility are the essence of the maerIt will not pay to install an indivisible good unless there areenough complementary capital goods to justify it Until thequantity of goods in transit has reached a certain size it doesnot pay to build a railway A poor society therefore oen usescostlier (at the margin) means of transport than a wealthier onee accumulation of capital does not merely provide us withthe means to build power stations it also provides us with themeans to build factories to make them pay and enough coal tomake them work Economic progress requires a continuouslychanging composition of social capital e new indivisibilitiesaccount for the increasing returns

(Lachmann 197879ndash80 italics in original)11

Boumlhm-Bawerkrsquos thesis about the higher productivity of roundaboutproduction is an empirical generalization It can be applied reinter-preted to our own world We have achieved and will continue toachieve greater productivity that is the production of more and bet-ter consumption goods and services by the continuing introductionof new indivisible production goods (which embody new productiontechniques) is can be cast in terms of Boumlhm-Bawerkrsquos idea of ldquostagesof maturityrdquo Boumlhm-Bawerk argued that capital accumulation will takethe form of an increase in the number of stages of production ldquoericher a society the smaller will be the proportion of capital resourcesused in the later stages of production the stages nearest to the con-sumption end and vice versardquo (Lachmann 197882) (We leave asidethe question of identifying a ldquostage of productionrdquo concentrating onthe intuitive meaning of Lachmannrsquos point) e increased number ofstages is indicative of increased complexity which in turn is indica-tive of increased productivity Increased complexity implies ldquoan evermore complex paern of capital complementarityrdquo (ibid85)

11In an important sense durability is an aspect of indivisibility ldquoWhile it mightbe technically possible the cost of producing a one-blow hammer would be certainto exceed the value of this taskrdquo (Steele 1996144) e profitability of producing ahammer thus depends on there being sufficient demand for its multiple uses

We conclude that the accumulation of capital renders possiblea higher degree of the division of capital that capital specializa-tion as a rule takes the form of an increasing number of process-ing stages and a change in the composition of the raw materialflow as well as of the capital combinations at each stage thatthe changing paern of this composition permits the use ofnew indivisible resources that these indivisibilities account forincreasing returns to capital and that these increasing returnsto the use of capital are in essence the ldquohigher productivity ofroundabout methods of productionrdquo

Finally Lachmann contends that the increased complexity of the capi-tal structure also implies an increased vulnerability

A household with six servants each of whom is a specialist andnone of whom can be substituted for another is more exposedto individual whims and the vagaries of sickness than one thatdepends on two or more ldquogeneral maidsrdquo us an ldquoexpandingeconomyrdquo is likely to encounter problems of increasing com-plexity [among which are] disproportionalities and the re-sultingmaladjustment of the capital structure [which] may giverise to serious problems in economic progress

(Lachmann 197885)

Concluding Summary

Lachmannrsquos capital theory seems to have been ahead of its time Itwas mostly ignored Yet when considered in the light of recent devel-opments in the theory of organizational structure one finds a strikingnumber of commonalities (without any reference to Lachmann how-ever)13 Lachmannrsquos capital theory can be seen as a kind of unintended

12e reference here to increasing returns is especially noteworthy in light of thecurrent rediscovery of the phenomenon in the context of a variety of new initiativesin economics ese include the new focus on nonlinear economics (Day and Chen1992) the economics of ldquolock inrdquo (Arthur 1989 1994) institutions and economics andevolution and economics (Hodgson 1988 1993) Economists are now beginning toplace greater emphasis on the importance of particular historical events in explainingthe emergence of technologies in a manner that Lachmann clearly foreshadowed inhis capital theory On the topic of increasing returns see Buchanan and Yoon (1994)

13At the time of this second edition this has changed dramatically e manage-

prelude to some of this work In addition these commonalities reflectback on Lachmannrsquos work in giving a new and arguably more com-plete view of capital and its structure

Lachmann establishes that the competitive process and capital ac-cumulation are inextricably linked Furthermore capital accumulation(the progressive creation of capital value over time) necessarily impliesan evolving capital structure that is a capital structure that is becom-ing more ldquocomplexrdquo e degree of specialization and interdependencegrows He captures this interdependence by the notion of comple-mentarity Resources that depend on each other in joint productionare complementary In the face of unexpected changes such ldquojointventuresrdquo (capital combinations) oen have to be regrouped Muchdepends therefore on the degree to which existing resources can beadapted to originally unintended uses a property that Lachmann callsmultiple specificity e variations in the degree of specificity are re-flected in the capital gains and losses experienced as a result of thechanges that occur and are the crucial driving force of the marketprocess

Lachmannrsquos theory is thus a theory of progress in which suchprogress is reflected in and achieved by a continuing specialization ofeconomic activities a growing division of capital to supplement (andcomplement) Adam Smithrsquos division of labor we have in general anincreasing division of function What is noticeably absent from thetheory is an explanation apart from a kind of ldquoblack boxrdquo reference tothe market of how this is accomplished at is to say we are not toldhow this progressing complexity is managed14 How to use Hayekrsquosfamous phrase is the necessary ldquodivision of knowledgerdquo implied by theincreasing division of function to be organized Lachmannrsquos theorysubsumes and does not explain an organizing function which he del-egates to the entrepreneur Lachmann would surely agree however

ment and organizational literature is now replete with references to Hayek Kirznerand most recently Lachmann most prominently in the growing area of entrepre-neurial studies See for example Chiles Bluedorn and Gupta (2007) for an apprecia-tion of Lachmannrsquos work See also Chiles Tuggle McMullen Bierman and Greening(2010)

14He seems to imply that a progressive vertical disintegration takes place thussuggesting an immanent theory of the size of the firm In this way his theory is relatedto the literature on the dynamics of the firm to be discussed below

that the evolving capital structure is necessarily part of an evolvingorganizational structure

Since all production in themodernworld is joint production involv-ing capital combinations (that is combinations of resources in generalincluding capital) production necessarily involves organizing or coor-dinating the various activities of the resources involved How is thisdone Who owns the resources and why More specifically relatingto the imputation problem anticipated above there is always a problemof how to share the fruits of any joint venture All production activ-ities are joint (cooperative) ventures directly or indirectly betweenindividuals (workers capital owners entrepreneurs) So the questionof organizational structure arises logically out of Lachmannrsquos world-view

CHAPTER 9

Capital and Business Organizations

[I]n capitalist reality as distinguished from its textbook picture[the] kind of competition which counts [is] the competitionfrom the new commodity the new technology the new sourceof supply the new type of organization

(Schumpeter 194784ndash85 italics addedquoted in Penrose 1995114n)

Boumlhm-Bawerk argued that economies progress by the progressiveadoption of wisely chosen roundabout methods of production Lach-mann reinterpreted this to mean the evolution of abilities enabling theuse of more and more complex production structures How is it thatBoumlhm-Bawerkrsquos ldquowise choicesrdquo get made and that such abilities to usemore complex methods evolve

In this chapter I investigate the relationship between capital andbusiness organizations e classical approach to capital that devel-oped out of the economics of Ricardo (whether in its neo-Ricardianor neoclassical variety) did not feature ldquocapitalistrdquo institutions in anyway And although Carl Menger was among the first and most pro-found of economists to analyze the diverse nature and function ofinstitutions he did not tie up his insights into the compositive natureof capital with the decision-making functions of business institutionsHayek and Lachmann working in the Mengerian tradition elaboratedon Mengerrsquos insights but did not develop a theory of organizationalstructure to complement the theory of the capital structure examinedin the previous chapter

A large literature on the structure of business organizations hasrecently developed It has been variously characterized as the newinstitutional economics (Langlois 1986b) transaction cost economics

evolutionary economics and post-Marshallian economics1 In manyways it is most accurately thought of as an alternative to (critique ofextension o) the neoclassical theory of the firm It is beyond ourpurpose to undertake here a review or evaluation of this literatureWe examine however its implications for an understanding of howa ldquocapitalistrdquo economy works

at there are indeed such implications is perhaps the explana-tion for the scarcity in modern economics of contributions that canbe classified in the field of capital theory e highly abstract debatesexplored in Part I take on an increasingly sterile appearance in thelight of these mounting contributions on the periphery of mainstreameconomics relating to an understanding of the organizations that ac-tually accumulate and use capital is literature has only recentlyaempted a connection to the theory of capital more broadly Webegin by examining two pioneering contributions

Capabilities and Capital

is new literature on business organizations is sometimes also referredto as the ldquocapabilitiesrdquo literature2 is is in reference to the conceptionof a firm as a repository of certain kinds of evolving abilities that arethe key to understanding the ldquowhyrdquo and ldquohowrdquo of the firm (Demsetz1991) It is in order to organize the necessary capabilities in a reliablemanner that the firm is seen to derive its purpose So in a fundamentalway this literature grows out of the problem originally posed by RonaldCoase (1937) in his classic article probing the essential rationale of thefirm (Williamson and Winter 1991) Using the market to purchase thenecessary inputs (capabilities) is costly involving transactions costs (theneed to locate identify and bargain for inputs and construct and en-force contracts) which have to be balanced against the costs of internalownership and direction of resources (the costs of training monitoring

1e invocation of Marshallrsquos name is related not to his ldquoneoclassicalrdquo theory ofcosts and supply but rather to his insistence that biology and evolution are moreenlightening in the business environment than are mechanics and physics and to hismany discussions of the role of institutional factors (like trade practices and agree-ments) in the ldquoordinary business of liferdquo

2It is closely related to and oen overlaps with contributions in ldquomanagerial eco-nomicsrdquo and corporate strategy and is sometimes referred to as the ldquoresource-basedviewrdquo of the firm See for example Collis and Montgomery (1998) For an importantpioneering article see Teece (1982)

CAPITAL AND BUSINESS ORGANIZATIONS 149

and policing) e nature of these various costs have been the substancein much of the discussion of this literature It is not surprising as weshall emphasize below that they involve considerations relating to thenature and acquisition of different types of knowledge

A parallel source of origin of this ldquocapabilitiesrdquo literature and theone from which it derived its name is the pioneering work of G BRichardson (1990 1972)3 and Edith Penrose (1995) is approach ismore concerned with the way in which firms function and grow thanin explaining their existence although the laer emerges by implica-tion So this second source has adopted a more dynamic evolutionaryapproach and one that is more obviously related to the question ofcapital accumulation

Capabilities and Equilibrium G B Riardson

In common with Lachmannrsquos approach to capital Richardsonrsquos exam-ination of investment in business institutions is an avowedly disequi-librium approach In strikingly similar fashion to Lachmann (but ap-parently independently)4 Richardson mounts a devastating critique(perhaps the finest to be found) of the relevance of the model of per-fectly competitive equilibrium (1990pt 1) ere are as we will seeother informative commonalties

Richardson advocates

the seing aside of the concept of perfect competition both asan explanatory device and as an ideal my aim being to demon-strate that even as a hypothetical system it has one quite funda-mental flaw the exposure of which will point the way in whichconstructive revision can most properly be made

(Richardson 19901)

is ldquofundamental flawrdquo is the inability of entrepreneurs (investors incapital) to get the necessary information in or out of equilibrium Ifthey were in equilibrium how would they know it how would theyknow their actions were optimal If they were out of equilibriumhow would they get the information necessary for them to take theactions that would produce a tendency toward equilibrium (Recallour discussion in Chapter 3)

3e term ldquocapabilitiesrdquo in this context was invented by Richardson4It seems that the common denominator is Hayek (1937a)

Given the manifest inconsistencies and implausibilities of the equi-librium model Richardson sets himself the task of explaining howit is that investment activities actually proceed in a highly orderlyfashion in which the activities of suppliers manufacturers and con-sumers are in great measure highly coordinated even in the face ofchanges in the economic environment He begins by distinguishing be-tween two kinds of relevant investment information market informa-tionmdashinformation about the activities of other market participantsmdashcustomers competitors or suppliersmdashwhich obviously influences theprofitability of investment and tenical informationmdashinformation re-lating to the physical transformation possibilities It is the availabilityof market information that Richardson sees as most problematic

It is evident an entrepreneur could rationally undertake an in-vestment decision only if he had some minimum informationabout what other entrepreneurs would or would not do if hewere assured that competitive investment would not exceedand complementary investments would not fall short of certaincritical levels (Richardson 199032)

Since ldquoa general profit potential which is known to all and equallyexploitable by all is for this reason available to no one in particularrdquo(ibid14) Richardson is concerned to determine how entrepreneurs ob-tain the minimum necessary information Investors in capital projectsneed information about complementarities and about substitutes Weconsider these in turn

Complementarities occur at two levels On one level they refer tonecessary complementary activities required to complete the projectis includes the supply of materials by suppliers the provision of ser-vices by contractors and similar activities And obviously these com-plementary activities must be available at the right time in the rightsequence We see here a manifestation of the time structure of pro-duction At another level there are complementarities in consumptionthat will determine the profitability of any investment project taken inisolation5 e sale of radios will depend on the availability of electric-ity (One may recall here Lachmannrsquos discussion of indivisibilities andthe scale and scope of investments a theme echoed by many theorists

5Activities are complementary ldquoin the sense that their combined profitability whenundertaken simultaneously exceeds the sum of the profits to be obtained from eachof them if undertaken by itselrdquo (Richardson 199072)

in this literature) Computers must be sold in order for the productionof printers and of soware to be profitable (and vice versa) We seehere a manifestation of a structure of consumption activities whichhas its own logic in time and space and which will concern us later

Richardson is grappling with the evolution of the capital structureldquofrom the boom uprdquo as it were Like Lachmann he perceives thisstructure as held together by complementarities at various levels no-tably levels internal and external to the firm6 But he is much moreexplicit regarding the microeconomics of the evolution of this capitalstructure e capital structure exists within and is dependent on abroader decision-making structure that addresses the problem of howthe minimum information necessary for the making of decisions ismade available to the decision-makers Richardson identifies a numberof ldquohelpful imperfectionsrdquo that constitute this decision-making struc-ture Among competitors we find numerous types of trade agreements(defining aspects of ldquothe rules of the gamerdquo) joint ventures and tacitunderstandings that ensure that perceived opportunities are not squan-dered Much evidence exists (Chandler 1977 1990 1992) to suggest thatcartel formation antitrust concerns to the contrary notwithstandingwere crucial stages in the emergence of modern capitalism7

A different kind of ldquoimperfectionrdquo exists that helps to ensure thatresponses by competitors to perceived profit opportunities do not

6ldquoAn entrepreneur will have to recognize that the profitability of his own invest-ment will depend on the terms on which he can obtain inputs and therefore indirectlyon the volume of the investment which has been or will be undertaken elsewhereus the same kind of complementarity whi exists between the application of differentresources within the firm exists also between the application of resources by differentfirms In the former case coordination designed to ensure the best combination ofcomplementary factors is brought about directly by the entrepreneur in control inthe laer it has to be achieved by different meansrdquo (Richardson 199073 italics added)And in considering the interdependence as well as the cost structures of differentfirms he notes ldquoe whole economy one may presume is united by bonds of thiskind the strength of which will vary widely according to circumstancesrdquo (ibid74)

7As I have suggested repeatedly and shall have occasion to repeat again theseevolved devices are made necessary by the dynamic nature of the world in whichinvestment decisions are taken In a world in which no significant changes weretaking place they would be (or would become) unnecessary And indeed in such aworld cartel and price fixingmarket sharing agreements might indeed be a concernfor eager policy-makers But a world of persistent technological change invites andrequires persistent organizational change and in any case is not conducive to suchldquoanticompetitiverdquo agreements enduring over time

negate them (the opportunities) ese fall into the category of fac-tors limiting the ability of individual firms to expand in responseto perceived opportunities Unlike the neoclassical firm8 firms ina dynamic world are idiosyncratic they possess unique (inimitable)and limited capabilities that they have developed over the course oftheir histories (not always in a conscious manner)9 Richardson refershere to ldquoeconomies of experiencerdquo that serve as natural and helpfulbarriers to entry (ibid60) us not every would-be investor is in aposition to take advantage of a perceived opportunity at any pointof time or within the relevant period (indeed the very perception ofthe opportunity may depend on particular capabilities) Emphasis islaid here on the importance of investments in specific and specializedassets that is assets whose value is somewhat unique to the firmwithinwhich they are combinedwith other specific assets in a complementaryrelationship

e more specific the resources required for the manufactureof the product and the smaller their elasticity of supply thegreater will be the likelihood that scarcities and bolenecks willdeter further expansion Expansion in the capacity of someindustry may be temporarily held up that is to say by delayin undertaking complementary investment elsewhere

(ibid61)

e information requirements implied by complementarities are simi-larly mitigated by information networks and specific capabilities Ev-ery investment project can be conceived of as a conscious if necessar-ily and deliberately vague (because of the need for adaptability) plan

8It is interesting to note that in the neoclassical literature the production functiondoes ldquodouble dutyrdquo serving as a tool of analysis for both the economy as a whole andfor the individual firm Given the assumption of CRS in readily identifiable inputsthis is not surprising since there is nothing to limit the size of firm In an importantsense the economy is simply ldquothe firm writ largerdquo

9It is difficult to avoid the use of anthropomorphic language that suggests the firmpossesses some sort of collective consciousness I affirm strongly however that it isultimately the individuals in the firm at any point in time in their various capacitiesthat are the decision-makers and the perceivers of information and in whom the capa-bilities ldquoof the firmrdquo must ultimately reside I hope to make clear in what way the orga-nization (the firm) maymanifest these capabilities in different individuals at any pointof time yet provide for their carrying forward through time and across individuals

Every business can be regarded as having to formulate withgreater or lesser precision an investment program consistingof a set of planned activities related through some process ofproduction or transformation It will be based on an assessmentof the various technical and market conditions upon which theprices at which the firm will buy its inputs and sell its outputswill depend As this assessment is likely to be in the form notof certain knowledge but of expectations of varying degreesof reliability an entrepreneur will wish his program to be asflexible or adaptable as possible in order that it can be modifiedto take account of changing and unexpected circumstances

(Richardson 199079)

at plan will usually include contracts of various terms and condi-tions which will tend to reduce the degree of uncertainty aachingto the production plan but only at the sacrifice of adaptability Inaddition the freedom of choice of the entrepreneur is further likelyto be restricted by the fact that certain work is already in progressand certain specific inputs have already been purchased One mayassume that the entrepreneur will aempt to balance adaptability anduncertainty in a dynamic way as time unfolds is uncertainty is ofa ldquoradicalrdquo or ldquostructuralrdquo nature (Langlois and Robertson 1995) thatis it is not probabilistic uncertainty but uncertainty about the verystructure within which decisions will have to be made in the future Itincludes ldquouncertainty about the particular factor combinations whichat some future date it will provemost advantageous to adoptrdquo (Richard-son 199083) Richardson is thus emphasizing the ldquoelement of trial anderrorrdquo present in every real-world production process uswe can sayldquothere is no unique single way in which complementary investmentscome to be coordinatedrdquo (ibid84) And there is certainly no uniqueway that is known ahead of time to all producers as suggested by asimple production function formulation In terms of the market (or theeconomy) as a whole then the firm cannot be said to be in equilibriumere is no overall plan consistency ldquo[D]ifferent people may formdifferent expectations or beliefs on the basis of identical informationrdquo(ibid 188)

Richardson does not dwell on the necessary failures that must oc-cur as a result of these inconsistenciesmdashthe trial-and-error process atthe level of themarketmdashand ismore concerned to showhow successful

production decisions can be made His analysis is rich and (although itwas relatively neglected for some time) has laid the basis of a numberof important contributions to our understanding of the workings oforganizations and investment processes

Penrose and the Growth of the Firm

Perhaps an equally important and in very many ways complementarypioneering work is that of Edith Penrose (1995) Penrosersquos work isconcerned with the dynamics of firms What external and internalfactors are responsible for the way in which firms develop over timethe activities they undertake (or contract with others to undertake)the techniques they adopt the products they choose to produce andso on10 e firm is viewed as a specialized ldquopool of resourcesrdquo (cfcapabilities)11 whose nature (productive potential) changes over timein response to events internal and external to the firm Penrose has acompelling bona fide theory of endogenous change

With the passage of time the knowledge possessed by the employ-ees in any firm changes is knowledge which includes productiveand organizational skills related to the firmrsquos particular experienceis a productive resource specific in some degree to the firm uswith time and experience the firm accumulates productive capabilitiesthat provide it with an important source of ldquoexcess capacityrdquo Forexample in the earlier stages of the production and introduction ofa new product employees are in the process of trial and error learningabout the product As they accumulate expertise much of which is ofan informal noncommunicable nature they will find that they needless effort to achieve the results e accumulated skills will presentthe firm with a form of increasing returns and indivisibilities that cryout to be used and provide an irresistible internal impetus to expansionMuch of what was novel becomes ldquoroutinerdquo leaving capacity for thedevelopment of new endeavors is expansion occurs naturally intothe production of new products and services that use similar skills (apoint emphasized also by Richardson (1972)) Skills however are con-

10We note again the caveat about using language that suggests that the firm per seldquochoosesrdquo

11Penrose refers to these as ldquocompetenciesrdquo

tinually changing Since experience generates new knowledge ldquotheproductive opportunity of a firm will change even in the absence ofany change in external circumstances or in fundamental knowledgerdquo(Penrose 199556 see also Loasby 199162)

Expansion may occur through merger and acquisition which is away to acquire specialized human capital or through internal expan-sion But however it occurs in a competitive technologically progres-sive industry a firm specializing in the production of given productscan hope tomaintain its positionwith respect to those products ldquoonly ifit is able to develop an expertise in technology andmarketing sufficientto enable it to keep up with and participate in the introduction ofinnovations affecting its productsrdquo (Penrose 1995132)

Expansion is also oen necessary in a growing market becausea firmrsquos share in the market is sometimes itself an importantcompetitive consideration In some industries for example inthe production of certain types of durable consumer goods con-sumer acceptance of the product is influenced by whether theproducer can reasonably claim to be one of the ldquoleadingrdquo pro-ducers It is under these conditions that growth is oen saidand with good reason to be a necessary condition of survival

(Penrose 1995133)

is insight may be described as a ldquogrow or dierdquo hypothesisIn commonwith Richardson Penrose notes the importance of com-

plementarities in consumption in sometimes influencing the nature offirm expansion especially when similar skills are called for in produc-tion marketing or distribution e same firms that make washerstend to make dryers In the final analysis however it is the ability ofthe firm to maintain the productive value of its basic abilities its hu-man and physical resources that determines its ability to survive Cap-ital investment takes place within a perceived decision-making struc-ture only part of which consists of the technical intertemporal imper-atives of production In a very real sense prospective demand has tobe ldquomanufacturedrdquo through internal organization market agreementsdistribution arrangements and marketing efforts and these will haveto be continually adapted

In the long run the profitability survival and growth of a firmdoes not depend so much on the efficiency with which it is able

to organize the production of even a widely diversified rangeof products as it does on the ability of the firm to establish oneor more wide and relatively impregnable ldquobasesrdquo from which itcan adapt and extend its operation in an uncertain changingand competitive world (Penrose 1995137)

Each business is thus a kind of ldquoresearch programrdquo (Loasby 1991) inwhich products processes and methods of production and organiza-tion are continually being tried out

Organizations in a Dynamic World

Joint Production is the Key

Penrose and Richardson laid the basis for much of the work that fol-lowed in exploring the nature of business organizations in a dynamicworldmdasha world of incessant unpredictable technological change eseorganizations can be seen as evolved responses to the need to makedecisions in such a world It may be doubted that organizations suchas the firm would have any enduring rationale or would survive in aworld of stable equilibrium Seen from the perspective of the evolvingcapital structure of the economy as a wholemdashthe matrix of valuablerelated productive capabilitiesmdashfirms are incubators and filters throughwhich these capabilities become available to the economy as a wholee nature of the firm is thus relevant to the nature of the productionprocesses What is the rationale of the firm and what determines itsboundaries and how they change over time

A crucial feature of the firm from our perspectivemdashindeed inmany ways its defining characteristicmdashis the fact of joint production(We recall Hicksrsquos (1973b) emphasis of ldquojointnessrdquo as the key definingcharacteristic of (the problem o) capital) e fact that resourceshave to be combined in diverse and sometimes mysterious (not fullyperceived) ways in order to be productive can be seen to be the centralprinciple around which firms function Firms are in the business ofmaking monitoring and altering productive capital combinations (cfLachmann 1978) We must include in the ldquocapitalrdquo of these capitalcombinations the human capabilities (skills perceptions judgmentsetc) to which we referred above and which we shall examine furtherin Chapter 11

e problem that the firm faces is quite simply the imputation prob-lem (e imputation problem contains within it other (sub)problemslike forecasting the level of sales is will emerge from our discus-sions below) When a number of resources cooperate jointly in theproduction of a common output unless we are dealing with a fairlydivisible repeatable process in which the levels of output and inputcan be varied along a broad continuum so as to isolate in an ldquoobjectiverdquoway the contribution at themargin of each input (physical and human)there is bound to be a substantial degree of indeterminateness aboutthe relative input contributions

We may contrast this with the neoclassical competitive model inwhich the productive processes are in effect standardized e produc-tion function approach is one in which by assumption input and outputcan be easily connected thus facilitating the identification of marginalproduct Competition thus ensures that earnings of the factor ownerswill tend to equal the values of the marginal products and this of coursealso militates in favor of the most efficient use of resources Efficiencyand fairness are bound together It is also a world in which the capitalvalues of the individual capital items that constitute the capital stock canbe easily and conveniently calculated as the present value of the streamof value marginal products thus identified And in this world the per-ception of capital in terms of aggregate economic values makes sense

But in su a world there is no reason for the firm All resourcescould be separately owned in a state of complete decentralization andcould be brought together when necessary in order to fulfill profitablejoint ventures Since the marginal products are known to all themaer can be handled by contracting with each of the factor own-ers Labor could be seen to hire capital just as validly as the otherway round12 It is natural therefore that in seeking to explain the

12Joseph Salerno points out (followingMises) that given that production takes timeit is natural that ldquocapitalrdquo employs ldquolaborrdquo as it is the capitalist that saves and advancesthe resources with which labor must work So property rights considerations can alsobe seen to be implied by the temporal nature of production But surely this would bethe case only in a world of uncertainty In a world where everything was accuratelyforeseen complete contracts could be wrien for the advancement and use of thecapitalistsrsquo savings No hierarchical relationship need be implied An ldquoemploymentrdquorelationship seems to be the result of the need to adapt to open-ended futures inwhich discretionary command (in order to adapt to unexpectable contingencies) mustreside with one or other party as discussed below in the text

existence of the firm in amanner basically consistent with the perfectlycompetitive model recourse should be had to the costs of contractingand exchangingmdashtransactions costs

Yet as we shall see when examining this approach in greater de-tail the existence of the firm must lead to an abandonment of theessentials of the competitive model and to the embrace of the firm asa response to productive processes which have an irreducible degreeof indeterminateness (and arbitrariness) e seminal article in whichCoase (1937) sought an explanation for the existence of the firm andwhich has been the seed of a voluminous and diverse literature onthe firm and its nature and development was at its base an appeal toproblems presented by the incompleteness in some sense of informa-tion Transactions costs are introduced as ldquofrictionsrdquo in the otherwisesmooth functioning of the economic system As has been noted manytimes however ldquoall transactions costs are at base information costsrdquo(Langlois and Robertson 199530 referencing Dahlman 1979)

e Existence of the Firm and its Boundaries13

Following Alchian and Woodward (1988) and Langlois and Robertson(1995) we note that the transactions costs literature can be dividedinto at least two (apparently) distinct approaches One emphasizesthe costs of administration direction negotiation and monitoring ofthe joint productive activities while the other emphasizes more specif-ically the problems of assuring quality or performance of contractualobligations Langlois and Robertson call the former the measurementcost view and the laer the asset specificity view

13e dimension along which the boundaries of the firm are drawn may be an issuee usual one is ownership is is a legal distinction (Masten 1991) But it is not theonly one Another is control For example the owner of the firm does not own thelabor that it employs In what sense are the employees working ldquowithinrdquo the firme usual answer is that there exist long-term contracts that effectively give the ownerof the firm ownership over the outputs of the labor employed and control over theirinputs However they do not always go together Along the control dimension con-trol over resources may exist even in the absence of ownership as in the case of jointventures between two separate legal entities Alternatively divisions within firmsmay behave with a great deal of autonomy effectively like separate firms We shallretain the familiar dimension of ownership realizing that the dividing line betweenthe market and the firm is in many ways quite fuzzy

e central notion of the measurement cost approach is connectedto the indeterminateness of joint production e difficulties in (in-ability to) isolate individual input contributions lead to a variety ofimportant organizing problems which the business organization is de-signed to solve is approach focuses on the indivisibilities inherentin team production which may lead to shirking or fraud which iscostly to monitor and detect (Alchian and Demsetz 1972) An apparentimplication of this is the suggestion that the residual claimant be theone to monitor and control since he has the most incentive to do sois begs the question of who the residual claimant should be YoramBarzel (1982) has suggested it be the owner of the input whose contri-bution to the joint output is most difficult to measure is is the inputfactor whose owner is most tempted by the potential fruits of moralhazard and therefore most in need of self-policing is person thenbecomes the principal leaving the inputs more easily measured to beowned by the agents But this in turn rests on the presumption thatwe know ahead of time which contributions are easiest to measureand monitor In some situations this may be obviously true but surelynot generally suggesting that a certain degree of arbitrariness (noneco-nomic considerations) may be inevitable in determining the structureand boundaries of ownership

e asset specificity approach as its name implies focuses on theinformation problems associated with the fact that joint productionrelies to a large extent on assets that are specific to their current em-ployment is is an (unconscious) application of Lachmannrsquos conceptof multiple specificity An asset is specific when its opportunity costis substantially below the value of its current contribution to produc-tion In other words the price that the asset could fetch in the mar-ket for employment in its next best use is substantially below (thediscounted sum o) its current marginal value product(s)14 It is pro-ducing a ldquorentrdquo (surplus) e greater the specificity the greater theldquorentrdquo is means that it (its owner) is both powerful and vulnerable

14Of course as I point out an important aspect of using the firm to organize pro-duction is that marginal products are not easy to determine Still where an asset isspecific in nature it is clear to all those involved in the production process that thevalue of its marginal contribution is substantially above its opportunity cost even ifa degree of arbitrariness aaches to the measurement of these values

depending on which contingency one considers On the one handthe owner of a specific asset can engage in profitable opportunisticbehavior the more essential the asset is to the joint product by threat-ening to ldquohold uprdquo the production process unless the terms of the jointproduct agreement (contract) are altered in its favor On the otherhand the other factor owners could behave opportunistically by threat-ening to cut out the specific factor thus subjecting its owner to acapital loss directly proportional to the degree of specificity unlessthe ldquorentrdquo appropriation is altered in their favor e outcome willthus depend on the (perceived) balance between these two risks and onthe costs of enforcing (at law or otherwise) any prior existing explicitcontracts ere is a large literature on these questions which includesdiscussions of specific historical examples like General Motors and theFisher Body Company (for overviews seeWilliamson andWinter 1991Langlois and Robertson 1995)

Both of these approaches suggest that the firm is an organizationwhose purpose is to cope with the inevitable information problemsof joint production If information were completely available albeitat a (known) cost then all production could be handled in a series ofspot and long-term contracts ldquoWhen contingencies can be adequatelyspecified or when the decisions of the cooperating parties donrsquot af-fect one another contracts are possible and integration [into firms]is unnecessaryrdquo (Langlois and Robertson 199528) As it is contractsare necessarily and deliberately incomplete ere is no way to ac-count completely for all of the possible contingencies In the literaturethis is sometimes described by saying that agents are ldquoboundedly ra-tionalrdquo andor that information is ldquoimpactedrdquo (contains unfathomableimplications) ese are variations around the HayekPopperPolanyitheme concerning the special characteristics of knowledge (and theinformation fromwhich it derives) which we discussed above in Chap-ter 2 In this context the ldquoknowledge problemrdquo is very specificallyrelated to the indeterminacies of team production involving as it doescomplementarity specificity indivisibility and change Productionnot only involves complementary specific assets that are indivisiblebut these relationships change over time e importance of changeis not always sufficiently emphasized and we shall return to it in amoment

As suggested one way to cope with the necessary incompletenessof the joint production contract is through the distinction betweenresidual rights and specific (contractual) rights All factor owners be-sides the residual claimant are paid a preagreed rate of earnings esurplus over and above this is counted as profits (as suggested in ourdiscussion on the nature of profits in Chapter 7 above) Profits thenserve as the barometer by which a firmrsquos performance is judged efirm is owned by the residual claimant who contracts with other factorowners e residual claimant must make a judgment as to whichfactors to own and which to buy (or rent)

uswhere one draws the line between ldquothe firmrdquo and ldquothemarketrdquodepends on a variety of considerations that derive from the natureof joint production e same indeterminacies and uncertainties ofjoint production that provide for opportunistic behavior also accountfor and provide clues to coping with the difficulties of framing mon-itoring and enforcing explicit contracts As Langlois and Robertson(1995) suggest however these considerations are likely to be contin-ually changing over time and thus the boundaries of the firm are un-likely to be static15

Production and Change

Production is a joint venture and production takes time ese twocharacteristics account for many (perhaps all) of the interesting andproblematic aspects of the production process When we say thatproduction is a joint venture this includes not only the fact that pro-duction processes may involve combining inputs in close proximityor under centralized control but the more general fact that whetherunder centralized control or not production is a process of value cre-ation (when successful) that depends on a variety of complementaryinputs Production is characterized by an implicit (and evolving) inputand output structure that transcends the boundaries of the firm e

15In relation to the question of the boundaries and existence of the firm and the gen-eral discussion found in this section I have been asked whether I thought uncertaintywas a necessary and sufficient condition for the existence of the firm While I cannotaempt a complete answer here it seems to me that while it may not be sufficientit is surely necessary For as indicated above in a world of perfect certainty therewould be no need for the firm

institutional (organizational) structure overlays and is intimately re-lated to the production structure in such a way that it is impossible tocharacterize accurately the production structure without bringing inbusiness organizations Organization maers for production It is partof the ldquocapitalrdquo of any economy Synergies of joint production (in thisgeneral sense) underlie the emergence of excess capacity (economiesof experience) that Penrose describes and provide the basis for theldquohelpful imperfectionsrdquo identified by Richardson which constrain theactions of competitors and influence the norms of trade Synergiesof joint production are also at the root of the transactions costs ofnegotiating and monitoring armrsquos-length contracts for joint outputsand of avoiding the moral hazards of holdups

Joint production would not be a problem were it not for the factthat production occurs over time Time and knowledge belong to-gether is is Lachmannrsquos axiom discussed in Chapter 2 ldquoAs soonas we permit time to elapse we must permit knowledge to changerdquo(Lachmann 1976a127ndash128 italics removed) It is inconceivable thattime should elapse without learning is is as true of the productionprocess as of anything else We can see how time and change enterinto the production process in at least four different ways16

1 Aswe have discussed ongoing processes of joint production con-tain an element of irreducible indeterminateness in deciding therelative contributions of the inputs It is not possible to know atany point of time what the relative contributions of the variousinputs are with any definite ldquoobjectivityrdquo

2 Rewarding the factor inputs in terms of the value of theirmarginalproducts assumes knowledge of the value of the final output perperiod of time Yet since input necessarily precedes output thevalue of the laer is a maer of speculation even assuming thatthere are no uncertainties aaching to the technical aspects ofthe process

16As Peter Boeke points out time jointness and multiple specificity are all nec-essary to explain the four indeterminacies (and the implied need for organizationaldevices to cope with them) If resources were completely homogeneous no combi-nation problem would exist similarly if resources were completely specific therewould be no choices involving variations in the components of combinations Whereresources are heterogeneous and multiply specific my conclusions follow

3 Technical and organizational aspects are however bound to beuncertain to a greater or lesser degree concerning the quantityor quality of any output Over time as learning proceeds thingsget done differently and in ways no one could have expected

4 Even assuming that 1 2 and 3 above were not problems thereremains the problem of connecting units of specific input withspecific units of output over time something we discussed inChapter 4 above

Echoing some aspects of our discussion of Boumlhm-Bawerkian capitaltheory if the process were fairly divisible and if it were unchangingover time thenwith enough time one could (or themarket would) varythe input configurations over a sufficiently wide range to be able tosolve the imputation problem Competition would then tend to ensurethat each factor was paid the value of its marginal product When theworld is one of constant innovation and the innovations oen come inldquolumpsrdquo (embodied in indivisible units or nonrival inputs) this is notpossible We shall encounter these issues in our consideration of howfirms engage in productive activities below

Organizations and Change

In a number of contributions Richard Langlois (for example 19921995 Langlois and Robertson 1995) has extended the capabilities ap-proach to business organizations to provide a dynamic theory of theboundaries of the firm He considers the firm to be a device for ac-quiring and economizing on useful knowledge (see also Demsetz 1991)Firms are able to do this because they are institutions Institutionsbroadly understood are systems of rule-following behaviors As wediscussed in Chapter 3 rules (or in the context of the firm routines)provide a way of acquiring information about the future actions ofothers within particular domains (we confidently expect everyonein the United States to drive on the right side of the road) eserules can be understood sometimes as an aspect of human behaviorin the form of tacit knowledge (people follow them unconsciously)or alternatively as constraints external to the individual (like privateproperty) In both cases they are conducive to an ldquoorderly paern ofbehaviorrdquo (Langlois 1992166)

A firm is an organization embodying a system of (sometimes unar-ticulated) rules and routines (Vanberg 1992 also relevant is Nelson andWinter 1982) Vanberg considers a firm as a ldquoconstitutional systemrdquowithin which behaviors are conditioned by the wrien or unwrienrules of the constitution is constitutional aspect is made necessaryby the nature of joint (team) productionmdashthe dependencies of team-work necessitate contractual constraints of certain kinds and durationus the firmrsquos constitution like Britainrsquos political constitution is im-plicit and composed of the understood rules of conduct that facilitateconcerted and cooperative action ldquoe procedural rules that underlieorganized or corporate action can justly be viewed as a constitutionbecause they constitute organizations as corporate actorsrdquo (Vanberg1992136) Perhaps one way to think of the effect of the constitution ofa firm (or any organization) is to suppose that the behavioral response(choice) to certain categories of events is independent of the respond-ing (choosing) individual in that organization is requires that theindividuals of an organization have internalized the rules routinesprocedures etc that constitute its constitution its ldquoculturerdquo Langloisconnects this with the capabilities of the firm by ldquoapplying the ideas ofrule-following to questions of organizational form the rulesmdashtheroutinesmdashthat agents follow within an organization embody (oentacit) knowledge that is useful for action is knowledge constitutesthe capabilities of the firmrdquo (Langlois 1995251)

Although the founding of a firm may have been the result of awell-articulated plan (and purpose) there is a sense in which firmsare organic rather than pragmatic organizations (Menger 1985) Fol-lowing Vanberg (1989) Langlois (1992 1995) has added a dimension toMengerrsquos well-known distinction between organic and pragmatic insti-tutions e distinguishing feature in Menger was the question of ori-gin He distinguishes between pragmatic institutions (like firms clubslegislation) that were created for specific purposes and organic institu-tions (like common law language money) that are the unintended re-sults of behavior Hayek working along this Mengerian theme distin-guishes between orders and organizations according to whether theyserve a specific purpose or not ldquoe rules of an order are abstractand independent of purpose whereas the rules of an organization areconcrete and directed toward a common purpose or purposesrdquo (Lang-lois 1992168 Hayek 197338)

Orders Organizations

Spontaneous Organic orders (lawlanguage money)

Organic organizations(firms bureaucracies)

Planned Pragmatic orders(designed constitutionsor contracts)

Pragmatic organizations(firms clubs)

Table 91 Types of institutions

us instead of a single-dimensional line we have a two-dimensionalmatrix of institutional types (see Table 91)

Langlois writes

Both parts of the term spontaneous order are of interest Whatmakes a system of rules spontaneous rather than planned isin effect a question of origin Unlike an organic system ofrules a pragmatic structure is one set in motion by consciousintention and thus in a sense is a creature of planning Atthe same time a system of rules in Hayekrsquos theory can be eitheran order or an organization In an order the rules that guidebehavior are abstract and independent of purpose in an organi-zation those rules guide behavior toward more or less concreteends17 (Langlois 1995249)

It is clear that the firm should be in the right column in Table 91 Butit is not clear that it fits obviously into either the top or boom rowexclusively and in an important sense it is a hybrid Although it maybe a creature of the conscious design of its ownerfounder it almostnever develops in a predictable way especially if it is to be adaptableenough to survive in a dynamic world As Langlois conjectures themore dynamic the environment the more abstract the nature of theorganizationrsquos constitution needs to be for it to survive the more itneeds to be like an order Hence the firm is more akin to an organicorganization

To see more specifically how firms evolve one needs to focus onthe capabilities and routines that constitute it In Langloisrsquos theory the

17From a ldquoGodrsquos eyerdquo perspective or from a public choice perspective the or-ganicpragmatic dimension might collapse rdquo[O]ne might easily portray the entirePublic Choice theory of politics as undermining a conception of government as apragmatic institutionrdquo (Langlois 1992169)

determinants of organizational structure are the nature of the capabilitiesboth within and outside the firm on the one hand and the nature ofchange and uncertainty that it faces on the other e story of economicprogress and development is the story of the introduction of innovationsof various types at various levels new products new characteristics ofexisting products new methods of production or some combination ofthese In terms of their effects we may distinguish between two types ofinnovation systemic innovations and autonomous (I prefer ldquostand alonerdquoor decomposable) innovations (Teece 1986 Langlois 1995) Systemic in-novations have system-wide implications they require (if they are to besuccessful) changes in several related stages of production is impliesthat some existing assets would be rendered obsolete and capabilities notpreviously valued or perhaps not yet available would become useful

is ldquoregroupingrdquo of capital combinations (Lachmann 1978) whichconstitutes the changing (ldquomutatingrdquo) capital structure carries with itimplications for the organizational structure Existing capabilities maybe under separate ownership

Under this scenario the business firm arises because it canmorecheaply redirect coordinate and where necessary create thecapabilities necessary to make the innovation work Becausecontrol of the necessary capabilities in the firm would be rela-tively more concentrated than in a market-based organizationalstructure such a firm could overcome not only the recalcitranceof asset holders whose capital would be the victim of creativedestruction but also the ldquodynamicrdquo transaction costs of inform-ing and persuading new input holders with necessary capabili-ties (Langlois and Robertson 19952)

Dynamic transactions costs are the ldquocosts of not having the capabilitiesyou need when you need themrdquo (ibid2n)

According to Langlois this scenario is an accurate description ingeneral terms of the historical development of many of the enterprisesthat feature in the ldquosecond Industrial Revolutionrdquo in North Americaand Germany in the late nineteenth and early twentieth centuries aschronicled in the work of Alfred Chandler (Langlois 1991 Chandler1977 1990 1992) Systemic innovations like the lowering of trans-portation and communication costs created profit opportunities forthosewho could createmassmarkets and take advantage of productioneconomies of scale and scope (steel farm machinery meat soap and

1198601113568rarr1198601113569rarr1198601113570rarr1198601113571rarr11986011135721198611113568rarr1198611113569rarr1198611113570rarr1198611113571rarr11986111135721198621113568rarr1198621113569rarr1198621113570rarr1198621113571rarr1198621113572

1198631113568rarr1198631113569rarr1198631113570rarr1198631113571rarr1198631113572

1198641113568rarr1198641113569rarr1198641113570rarr1198641113571rarr1198641113572time

Figure 91 Cra production

many others) In an important sense we see in retrospect that a seriesof innovations were connected in a complementary way but theseprofitable improvements implied the destruction of existing decentral-ized systems of production and distribution in favor of integrationinto large-scale production Integration is seen in many cases to benecessary to overcome the ldquoopposition of vested interestsrdquo (Langlois1995252) of people doing things the old way

Organizational structure is here seen to be the result of entrepre-neurial innovation In order to exploit perceived opportunities entre-preneurs had to change the existing organizational structures in addi-tion to production structures or more accurately in order to effectthe laer they had to accomplish the former An excellent genericexample of how altering the organization of production can be a value-creating innovation is provided by Axel Leijonhufvud (1986 see alsoLanglois and Robertson 1995ch 3) Leijonhufvud shows that it is notjust (or even necessarily) a maer of using large-scale machinery thataccounted for the profitability of factory production To make thepoint schematically he contrasts cra production with factory produc-tion In cras production craspeople sequentially complete all theoperations necessary to make the product In factory production bycontrast each worker specializes in one operation We recall AdamSmithrsquos pin factory where ldquothe important business of making a pinis divided into about eighteen distinct operations which in somemanufactories are all performed by distinct handsrdquo (Smith 19824ndash5quoted by Leijonhufvud 1986208)

For example imagine five distinct operations being performed byfive different craspeople Each one works at their own pace anddiffers in skill (both absolutely and relatively) across the different op-erations is is depicted in Figure 91

1198601113568rarr1198611113569rarr1198621113570rarr1198631113571rarr11986411135721198601113568rarr1198611113569rarr1198621113570rarr1198631113571rarr11986411135721198601113568rarr1198611113569rarr1198621113570rarr1198631113571rarr11986411135721198601113568rarr1198611113569rarr1198621113570rarr1198631113571rarr11986411135721198601113568rarr1198611113569rarr1198621113570rarr1198631113571rarr1198641113572

Figure 92 Factory production

Now suppose that we simply rearrange the work as depicted inFigure 92 Work previously done in parallel now proceeds in seriesWorker A specializes in performing operation 1 worker B in perform-ing operation 2 and so on We have introduced joint or team produc-tion Each individual now has to work at the pace of the team makingsupervision easier It is important to note however that the engineer-ing parameters of the production process have not been changed etools are the same in kind (although each worker no longer needs acomplete set)18 and the workers are the same people Yet we mayexpect an increase in product Production is not simply a maer ofidentifying and combining the inputs (in an unspecified way) unlesswe broaden what we mean by ldquoinputrdquo so as to empty it of all analyt-ical power As Leijonhufvud pertinently notes this ldquosequencing ofoperations is not captured by the usual production function represen-tation of productive activities nor is the degree to which individualagents specialize Smithrsquos division of labormdashthe core of his theoryof productionmdashslips through modern production theory as a ghostlytechnological-change coefficient or as an equally ill-understood econo-mies-of-scale property of the functionrdquo (Leijonhufvud 1986209)

e economies achieved by moving from cras to factory produc-tion arise from an increased division of labor a move from individ-ual to team production Leijonhufvud enumerates three aspects ofthis First team production results in product standardization workers

18In this sense the innovation is capital saving rather than requiring capital oflarger scale Also it is possible that the new process may need less ldquogoods in processrdquoinventory In cras production workers may leave goods unfinished as they movefrom one operation to another working on a few goods at a time In team productionthis does not happen (Leijonhufvud 1986210)

produce the same product Second greater coordination is achieved intime sequencing supervision under a shared set of rules routines andtacit understandings (that improve over time) ird the labor of in-dividual workers becomes complementary inputs rather than compet-itive activities e absence of any worker will disable the productionprocess

Recalling the context of Adam Smithrsquos original observations it hasoen been noted that human capital is intimately involved Smithexplains how specialization improves dexterity saves time and leads toworker-inspired innovations To this we should add that specializationmay result in the saving of certain kinds of human capital Workersneed no longer possess the skills necessary to make a pin from begin-ning to end (Leijonhufvud 1986211) e division of labor is also inan important sense a division of (human) capital In this context it iseasy to see how the assumption of a homogeneity of human capital isevery bit as misleading as the assumption of homogeneity of physicalcapital As the society and the economy progresses people obviouslylearn ldquomorerdquo and the knowledge ldquoof the societyrdquo is in a very real sensegreater But it is also true that in another sense individuals do nothave to know as much in so far as they are more specialized is issomething we shall examine further in Chapter 11

An interesting aspect of this example is the fact that the increasein output occurs without any change in the types of inputs (and withfewer capital goods and goods in process) or any change in techno-logy Although changes in technology may follow upon or precedeorganizational changes as this example shows organizational changesthemselves can sometimes bring improvements in productivity isunderlines the problems associated with physical notions of the capitalstock In this example considering capital as being composed of thetypes and quantities of the inputs fails completely to capture the sourceof any increase in value that arises is suggests that organizationalstructure is a crucial aspect of the capital structure in general

Obviously this example is suggestive of particular types of organi-zational innovation one employing a vertical division of labor It givesone reason that integration of workers may prove profitable But otherforms of profitable organizational change may not be so clear in theirimplications for organizational type

1198601113568rarr1198611113569rarr1198621113570 1198641113572 1198631113571

1198651113568rarr1198661113569rarr1198671113570 1198681113572

Figure 93 Parallel processes and indivisibilities

Leijonhufvud notes that economies are to be gained from judicioushorizontal divisions as well is can result from the indivisibilitiesthat come with prior innovations So for example imagine that oneof the stages of productionmdashstage 4mdashis running at half capacity (a rail-way car a telegraph system) Imagine running two parallel productionprocesses as shown in Figure 93 ere is twice the output of just oneprocess but the double output comes at the expense of less than twicethe inputs a clear economy of scale of the Lachmann variety eseeconomies of scale come from organizational change rather than fromtechnology although the indivisibility that makes it possible may bethe result of a technological innovation

In this example the two ldquoindustriesrdquo or firms or processes shareoperation 4 eymay not even be the same processes eymay havea common need for operation 4 (like transportation communicationor electricity) and be quite different in other respects is is a differenttype of division of labor Stage 4 has become a specialized activity onits own It is clear that these economies of scale depend in a crucialway on the ldquoextent of the marketrdquo or on the ldquothroughputrdquo (Lachmann1996147ndash148) that is on the size of the demand for the services of thevarious stages that are supplied in indivisible multiples It is also clearthat more complex paerns will most likely emergemdashwith indivisibil-ities and crossprocess connections at more than one stage e degreeof returns to scale depends on the amount of excess capacity at eachstage (A similar observation is made by Penrose considering resourcecombinations within the firm that have to be made up to the ldquolowestcommon multiplerdquo (Penrose 199572ndash73)) If the number of stages isheld constant these economies become less and less significant as out-put is increased and in this case approach constant returns to scalein the limit (Leijonhufvud 1986214) However an aspect of economic

progress is an increasing number of interrelated activities or stages ofproduction (Lachmann 1978ch V see also Chapter 8) Pursuing thisline of reasoning there is then an unending source of scale economiesin the market process

As Leijonhufvud explains (interpreting Smith and Marx) the pro-cess of the division of labor is connected to the process of technologicalchange ldquoAs one subdivides the process of production vertically intoa greater and greater number of simpler tasks some of these tasksbecome so simple that a maine could do them [We are led to]the discovery of opportunities for mechanizationrdquo (Leijonhufvud1986215) If we think of each of the organizational schemes of pro-duction such as those discussed above as being one of many possi-ble schemes then we can easily see the part they could play in anevolutionary process toward greater complexity (a larger and largernumber of interdependent productive activities and stages) In effect(paradoxically) greater complexity in production leads to the achieve-ment of greater simplicity and convenience in consumption (emorecomplex the central processing unit of the computer the more userfriendly it can be made)

So returning to Langloisrsquos dynamic theory of the firm changesin organizational structure lead (directly and indirectly) in a plausibleway to changes in production costs In the move from cra productionto a factory this implies a form of vertical integration as did the kind ofchanges required in the Second Industrial Revolution Integration is fa-vored in situations where changes are systemic and require large-scaleentrepreneurial reorganization of existing capabilities and where newrequired capabilities are not easily available from themarket Butmoregenerally for example in the case of indivisible shared resources it isnot so clear that change leads to integration and may lead in the oppo-site direction to disintegration or ldquospinoffsrdquo In many cases the innova-tionsmay be local or decomposable Perhaps themost important exam-ples occur in modular systems like personal computers stereo soundsystems telephone systems and the like ldquoFor present purposes thekey feature of a modular system is that the connections of lsquointerfacesrsquoamong components of an otherwise systemic product are fixed andpublicly known Such standardization creates what we might call ex-ternal economies of scoperdquo (Langlois 1992253) is is a phenomenon ofcomplementarities in consumption (household production) that both

Richardson and Penrose noted It allows component manufacturers tospecialize their capabilities independently but confident of a sufficientmarket (cf Richardson 1990)

As economies develop the capabilities needed for innovation aremore likely to be found in the market and Chandler-type integrationmay be unnecessary Even if at first the firm may find it necessaryto develop its own marketing and distribution networks and special-ized production capabilities over time with the growth of knowledgeoutside specialists may develop So integration may be a phase that be-comes superseded by disintegration (as happened for example in thecase of Ford Motor Company) In addition some of the obsolete exist-ing capabilities may already exist inside the firm and require excisionas in the case of ldquodownsizingrdquo caused by technological restructuringOn the other hand this situation may account for an element of inertiain some corporations making it more difficult for them to adapt Asin the computer industry and the illustrative case of IBM ldquoeconomicchange has in many circumstances come from small innovative firmsrelying on the capabilities available in the market rather than existingfirms with ill-adapted internal capabilitiesrdquo (Langlois 1995253)19

According to Langlois the boundaries of the firm are thus notonly a maer of transactions costs and moral hazard but must beseen within a changing environment as a form of strategic adapta-tion In the absence of change knowledge of prices products abilitiesreputations and anything else that is important to the (unchanging)production process becomes general and the need for the firm as anorganizing device progressively disappears (Opportunistic behaviorfor example is less profitable when the same game is repeated manytimes (Langlois 1992)) But in a dynamic world the capital structureevolves within an evolving institutional and organizational structure

Implications and Conclusion

As discussed Langloisrsquos work provides a framework for interpretingthe trend toward large-scale integration of industrial structures that

19e ldquomake or buyrdquo decision may also be influenced by the regulatory structurein the face of competition and change as for example in the case of the decision toldquooutsourcerdquo to non-union specialist manufacturers

occurred at the turn of the century as well as the opposite sort oftrend toward disintegration or divestment as companies move towardsconcentration on their ldquocore competenciesrdquo Some of the specific in-sights that emerge from this dynamic transaction cost framework areas follows

1 Organization maers for production e discussion of the articleby Leijonhufvud above shows clearly how a simple reorganiza-tion of the same inputs can sometimes lead to increases in output

2 Indivisibilities that result from systemic innovations imply exter-nal economies of scale and scope is resonates with Lachmannrsquos(1978) analysis of the evolution of the capital structure ese in-divisibilities also explain the emergence of specialized industrieslike power communications and computing

3 When innovations occur whi render existing capabilities obsoleteor redundant the response will be either (a) retraining or reorien-tation if possible or (more likely) (b) ldquodownsizingrdquo or (c) inertiaand failure or some combination of the three

4 Product life cycles are oen accompanied by organizational-typelife cycles For example at the start of the implementation of aninnovation a firm may need to develop its own supporting capa-bilities sometimes to overcome inertial vested interests like theproduction of spare parts or technical support As the innovationand its implications are diffused and over time the knowledgespreads and output grows these capabilities come to be found inspecialists in the market (outside the firm) So the organizationfirst internalizes and then spins off these particular capabilities

5 e nature of the organization is influenced by the type of knowl-edge embodied in the capabilities required and by the nature andtype of innovations that it faces Examples at two extremes arethe hierarchical organization where information flows mainlyfrom the top downwards (requiring that supervisors have asmuch or more knowledge than their subordinates of what thesubordinates need to do) and the participatory organization(where information flows in all directions because team mem-bers are highly specialized and use highly specialized knowl-edge the usefulness of which depends on the willing contribu-tions of all team members)

In summary in this chapter we have seen that the neoclassical firmas a ldquoblack box production functionrdquo bears very lile resemblance tothat dynamic enigmatic ever changing business organization that weknow from our everyday experience as the firm Instead we havelearnt from a number of theorists to view it in a different light as aremarkable organizational device for the achievement of productiveactivity e firm in this view is ldquoa device for the coordination anduse of particular kinds of knowledge including the coordination ofknowledge generation by the imposition of an interpretive frame-workrdquo (Loasby 199159) It is an important example of the coexistenceof equilibrium and change discussed in Chapter 3 As a system of(sometimes tacit) rules routines procedures and cues it evolves overtime but it does so sufficiently slowly if it is to succeed to providea stable under-standable environment within which decision-makerscan act can conjecture about product types methods of productiontypes of inputs the meanings of market signals and the like Eachfirm based on its experience (the experience of its members) ldquoacquiresa unique character as an interpretive system construing events andacting on the basis of its interpretationsrdquo (Loasby 199160) e decisionoutcomes are thus the results of idiosyncratic interpretation combinedwith commonly observed information like market prices in a gener-ally understood decision-making process that we can characterize asthe ongoing calculation of capital value

e same evolved capabilities that have served some firms in goodstead in favoring it to adapt to particular circumstances may in othercircumstances prove to be its undoing Firms used to a particular ldquowayof doing thingsrdquomay exhibit a degree and type of inertia or narrownessof approach that may render it unsuitable for particular environmentsIn such situations we get radical organizational change And this mayoccur at the market level where those organizations that happen tohave the right configuration and approach will be favored and at thefirm level where those firms that are able to adapt survive An exam-ple might be the emergence of the M-form structure of corporation(Williamson 1985) or the move toward nonhierarchical organizations(Minkler 1993)20 Oen the crucial factor in these shis is the changingnature of the knowledge utilized by business organizations

20Minkler provides an interesting analysis of organizations with ldquoknowledgeable

Knowledge is a key concept in analyzing all productive activityand its organization is harks back to our discussion of knowledgetypes in Chapter 2 and suggests a closer look at the meaning and roleof productive knowledge in relation to capital21 which we consider inChapter 11 on human capital

workersrdquo that is to say workers who possess not only a degree of ldquoknow-howrdquobut moreover the capacity to make decisions in hitherto unencountered situationsmdashldquoinitiativerdquo Such organizations would under most situations tend to be participatoryrather than hierarchical So as the nature of productive knowledge changes so mustthe nature of the organization See also Drucker (1993) and (Nonaka and Takeuchi1995)

21is chapter neglects the important relationship between capital and knowledgethat emerges when we consider capital goods as embodying the knowledge of howto do certain specific and specialized things With some justification capital can beviewed as embodying productive knowledge in the same way as human capital em-bodies productive knowledge is leads to a ldquocapital-basedrdquo view of the firm Forfurther explanation and investigation of the important implications of this view seeLewin and Baetjer (2011)

CHAPTER 10

Organizations Money and Calculation

Introduction Firms and Calculation

e discussion in the previous chapter suggests that firms derive theirrationale from the fact that the organization of production maersfor its results By the same token as the economy changes and theproduction structure changes along with it the advantages of differenttypes of organization will also change Still with all the far-reachingeconomic changes that have occurred the firm as a category (the mod-ern business corporation) has remained a dominant form of economicorganization It is an institution that is unique to a market (ldquocapitalistrdquo)economy In an important way the market economy owes its successto the business firm

In his discussion on the feasibility of central planning under statesocialism Mises pointed to the ability of private owners (investors)to calculate profitability as being the indispensable ingredient of a de-centralized system the absence of which accounted for the inevitablefailure of a centrally planned one (Mises 1920 1981 1966) is waspart of the famous socialist calculation debate (Hayek 1935a Hoff 1981Lavoie 1985a Ramsay-Steele 1992) which has recently shown signs ofresurfacing (Horwitz 1996 Ramsay-Steele 1996) According to Misesin a centrally planned economy (in which the means of productionwere collectively owned) the planners would lack any basis on whichto price the means of production Without private ownership alterna-tive outputs would not have prices nor would the inputs required toproduce them Without this the value of alternative uses would notbe discernible e scope of the debate was considerably broadened byHayek (in the 1930s) in his consideration of what information would be

[is chapter uses material from Lewin (1998)]

necessary for private owners in their calculation of prospective profitsand the observation that much of this information was not simplyavailable to be collected but in fact emerged from the market processitself Abolishing private ownership thus abolished the source of thiscrucial information much of it reflected in prices necessary for basiceconomic calculation (Hayek 1935a210ndash211) Mises wrote in 1927

is is the decisive objection that economics raises against thepossibility of a socialist society It must forgo the intellectualdivision of labor that consists in the cooperation of all entrepre-neurs landowners and workers as producers and consumers inthe formation of market prices But without it rationality iethe possibility of economic calculation is unthinkable

(Mises 192775)

Horwitz (1996) has recently pointed to the connection between theseinsights and the role of money In a market economy the existenceof money together with the institution of private property facilitatethe emergence of money prices which form the basis of the necessaryeconomic calculation that drives the market process In the light ofour discussion about business organizations above how does the firma dominant market institution fit in with this

We should recall that the advantages of corporate organizationderive from incentive control and information issues By combiningresources within the orbit of a single firm it is sometimes possibleto reduce the costs of monitoring and controlling production teamsand of avoiding the need to monitor and enforce the fulfillment of spe-cific armrsquos-length contracts between independent parties Instead thefirm provides the necessary relative predictability and stability of long-term open-ended contractual obligations with employees1 e bound-aries of the firm are dynamically and experimentally balanced by theseadvantages weighed against the advantages of using specialists ldquofromthe marketrdquo Juxtaposing this line of thinking with the MisesHayekrejection of the feasibility of socialist planning and production raisessome interesting questions

1We have not mentioned the limitation on individual liability provided by themodern joint stock corporation that may also be a factor

ORGANIZATIONS MONEY AND CALCULATION 179

1 On the one hand if socialism is indeed irrational in the senseof precluding the ability to perform the necessary calculationshow is it that the firm is not similarly encumbered Aer allis not a state socialist system simply one large firm And arefirms not islands of socialism in a market sea If so how doescalculation proceed inside the firm

2 On the other hand if the market is necessary because it pro-vides the necessary prices for productive calculation why arefirms necessary at all Why not simply conduct all transactionsthrough market spot and forward contracts

We have already answered question 2 In a nutshell there are coststo using the market that are avoided by using the institution of thecorporate firm And these transaction costs are ultimately related tothe presence of certain types of irreducible uncertainty e answeroen given to question 1 is more interesting Of course it is a non-sequitur to conclude that if state socialism is impossible then anythingresembling central planning such as a firm should also be impossibleIn fact they are not the same things Planning within firms proceedsagainst the necessary badrop of the market Planningwithin firms canoccur precisely because ldquothe marketrdquo furnishes it with the necessaryprices for the factor inputs that would be absent in a fullblown stateownership situation2 And we have already seen what sorts of consid-erations determine the boundaries between the firm and the market

e Firm Provides the Necessary Structure for theCalculation of Profit

ese answers however are not fully satisfactory and raise some fur-ther interesting issues We start by making the important assertionthat if the market is necessary for the viability of the firm the opposite

2Peter Klein has recently used this type of reasoning in interpreting Rothbard (whoin turn was extending Mises on the impossibility of socialist calculation) ldquo[N]o firmcan become so large that it is both the unique producer and user of an intermediateproduct for then nomarket based transfer prices will be available and the firmwill beunable to calculate divisional profit and loss and therefore unable to allocate resourcescorrectly between divisionsrdquo (Klein 199615)

appears to be just as true at is the firm is necessary for the smoothoperation of the market process is assertion is based on noting thecentral importance of economic calculation in the market process andthe way in which the firm provides for such calculation We see thisby examining the calculation of profits e calculation of profits isboth simple and indispensable for production decisions It is simple inthe sense that the arithmetic is simple even though the elements thatconstitute the evaluation are oen highly speculative It is indispensablein that it provides the basis for discrimination between viable and non-viable production projects (cf Hicks 1973b as discussed in Chapter 6)

Retrospective Profits

First consider profit in a retrospective context at is how do we de-cide whi projects have been profitable Profit is revenue minus cost3

Revenue is the proceeds from the sale of the relevant outputs and isrelatively easy to measure in a monetary economy Costs howeverpresent formidable problems that go to the heart of the nature of teamproduction In a market economy when inputs are purchased theirpurchase price serves as the accounting cost From an economic pointof view it can be seen to represent the market value of opportunitiesforgone as a result of purchasing the input in question But whatabout inputs owned by the firm How does one determine the costsof using them What we require is an estimate of the opportunitiesforgone by using inputs in one combination rather than another (thenext best alternative) is requires an estimate of the hypotheticalrelative contributions of inputs under alternative scenarios We havealready seen that the nature of team production is such that it is impos-sible to measure objectively the precise contribution of any memberof the team (physical or human) If one were required to determineldquocompletely accuraterdquo contributions and to use these contributions asthe basis of cost calculations the problem would be insoluble as withfullblown state ownership devoid of monetary calculation where noclue at all is provided

3Recall our discussion of profit as a category of earnings in Chapter 7 Profit de-pends crucially on the presence of uncertainty In the present discussion the absenceof uncertainty would imply that all earnings (wages rents and interest) could andwould be contracted for and there would be no residual

e question is what is the relevant opportunity forgone Shouldit be the value of the net revenue forgone by the firm by doing thingsone way rather than another or is it alternatively the net revenue thatwould be added elsewhere in the economy by redeploying the inputin question is laer measure is an indication of what the inputmight fetch in the market if it were rented out and is closer to whatwe usually understand by cost in the accounting sense It is also thecost that is relevant for the (actual or prospective) investor in the firmwhose hypothetical alternatives involve moving between firms underthe assumption that the firm takes care of the internal allocations Butfrom the point of view of efficient allocation as seen by the firm theformer measure using the next best alternative wherever it occurs isthe more relevant

us in the case of the market firm the labor inputs are paidaccording to a(n) (implicit or explicit) monetary contract and similarlywith physical inputs (capital goods) that are rented through the mar-ket We leave aside for the moment the determination of these rentalvalues From the perspective of the decision-makers in the firm theyare ldquogiven by the marketrdquo For capital goods that are owned howeverthe costs associated with their use are more problematic and have tobe estimated according to certain accounting conventions ese con-ventions use procedures to estimate (implicitly) the value of the assetin the current rather than in alternative uses is implies that a basicingredient for this conventional calculation is and apparently mustbe the value of the asset itself which in some way is derived from theestimated value of its estimated alternative possible contributions tooutput An alternativeway of looking at this is to say having arrived ata cost for the assetmdashderived (againmostly implicitly) as the discountedvalue of its estimated next best outputmdashone must then estimate (inorder to arrive at an ldquoaccurate user-cost measurerdquo) how much of thisvalue is ldquoused uprdquo (per periodmdashits displaced marginal value product)or sacrificed in current production is is an estimate of how muchvalue is forgone by pursuing this line of production as compared to therelevant alternative (howmuch revenue net of replacement could havebeen earned by this asset in the relevant period) ere is obviouslyno ldquocorrectrdquo way to do this So again we are faced with the problemof measuring the relative contributions of the inputs And we recallagain the imputation problem

In sum then where markets exist the value of the joint output forany project as a whole once measured (or estimated) is much easierto determine than in the absence of markets In a sense one half ofthe problem is solved that of valuing an output however measuredAs for measuring the (contribution to) output there is no avoidingcertain elements of convention (judgment) What the institution of thefirm does (together with the institutions of money and accounting) is toprovide these conventions By distinguishing between contractual andowned inputs one avoids the need to estimate the alternative marginalproducts of the former e judgment involved in measuring the laeraffects the profit calculation and lends it an unavoidable element ofarbitrariness is means that profit even measured retrospectivelynecessarily contains elements of subjective judgment or convention

We should distinguish however two importantly different aspectsof the profit calculation Profit understood as the residual aer allcontractual obligations have been met but making no allowance forthe costs of use of owned resources is from the perspective of the firmnot arbitrary in the sense just discussed Market prices provide thenecessary ldquoobjectiverdquo ingredients for a simple calculation From theldquolong-termrdquo perspective therefore where all capital assets must beused up or completely replaced profit appears less arbitrary It isthe division between ldquotrue profitrdquo and profit unadjusted for user costthat is the problem However this division is done it clearly doesget done And the profit calculations that emerge provide a widelyaccepted (peaceful) way of adjudicating between viable and nonviableprojects is is reinforced in the long term by the presence or absenceof cash flow If the short-term division is injudiciously made the cashflow will eventually become negative as the underestimation of usercosts becomes apparent and cash is absorbed in the replacement or re-pair of capital assets So in this way the firm and the market togetherprovide the indispensable basis for the calculation of profits

We asserted that market prices provide the cost signal for contrac-tual inputs while leaving aside how the market price is determinedOf course in the final analysis even when a rental price of a durableasset (like a physical capital asset or the price of labor (human cap-ital) services) is determined by contractual arrangement the terms

of the contract most especially the price must be determined withreference to exactly the same considerations that are relevant in thecase of owned resources namely the value of opportunities forgonee market is aer all just a shorthand reference to the results ofdecisions taken by everyone else So what determines these other peo-plersquos decisions are the same things that determines the firmrsquos Marketprices emerge when assets are generic enough have enough multipleuses in the market that peoplersquos judgments of their worth becomeembodied in the stock of information available to decision-makers ingeneral (good examples are the published set of prices for used carsor certain kinds of production equipment or wages for certain kindsof labor services) As such they reflect to some extent the trial-and-error experience of many decision-makers And as such this kind ofinformation is not available without the market

us though necessarily subjective and involving elements ofentrepreneurial judgment calculations of profit involving as theymust the imputation problem are facilitated by the framework pro-vided by at least three interacting institutions namely the firm moneyand accounting practices all within the umbrella institution of privateproperty e indispensable element of judgment involves the aribu-tion of relative shares (contributions) to the inputs which is necessaryto arrive at an estimate of what each input ldquocostsrdquo that is what sacrificeeach input entails

Prospective Profits

is framework provides the basis for the prospective calculation ofprofits as entrepreneurs project on the basis of past information andconjecture the emergence of profits in the sense just discussed Andby comparison between prospective projections and retrospective cal-culations further decisions can be made over time

Two important notes First there is nothing in this account tosuggest that the decisions taken with regard to profitability are ina global sense ldquooptimalrdquo Successful projects are viable not optimalere is no way to decide in this open-ended framework whetherPareto optimality will emerge or not is is related to the second

point (already discussed above in connection with the uncertaintiessurrounding team production) e prices of contractually purchasedfactor inputs (labor and capital or land) are sometimes said to be equalto or to tend to be equal to their marginal products In so far as teamproduction does not admit of any simple solution to the imputationproblem it is difficult to see how this could happen in any simple wayTo be sure in a market environment of negative feedback that is tosay when certain key aspects of the environment like the available setof techniques of production consumer tastes etc are unchanging orchanging very slowly then sufficient variations in adopted techniquesare likely to result in the gravitation towards valuations of markettraded inputs that in a meaningful sense represent the values of theirmarginal products is is because under the postulated conditionsthe market provides for ldquocontinuousrdquo variations in input and resultantvariations ceteris paribus in output4 But this is by no means assuredand in the absence of such ldquostablerdquo processes the prices of the factorsmust be seen to represent simply the marketrsquos assessment of theirworth at is these prices are what people given their best guessesand estimates have been willing to pay As time passes the prices willchange as the projects in which the inputs are employed succeed or failand to the extent that they are specific to those projects as discussedabove emarket prices for inputs are not equilibrium prices but theydo furnish an important and indispensable basis for the calculation ofprofits Without market prices firms could not plan as they do5

4is is of course a nutshell evolutionary argument with a stable equilibriumIt contains the necessary elements of mutation (variation) selection (competition)and replication (continuity in the firm as an institutional entity that replicates certainkinds of behaviors) See Vroman (1995)

5In the Hicksian framework developed earlier we might write a general (and nec-essarily subjective) capital value (vector) function as

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

indicating in a general way the determinants of capital value 119896119905 of any project evariable 119903 is perhaps especially important because of its macroeconomic significanceas the indicator of the relationship between present and future prices of consumptiongoods However the structure of market prices and wages in general may affect theproject (through 119901 and 119908) and tenology (120572 and 120573mdashthe types and combinations ofinputs and outputs) obviously maers All of the insights offered by Hicks in termsof intertemporal behavior of 119896119905 follow

Money and Production Ba to Menger

eability to calculate profit (both expected and past) is essential to theworking of the market process as we know it It cannot be duplicatedby a central planning system It is a trial-and-error process in whichthe variables are not only the varied and oen spontaneously emerg-ing techniques of production but also the various incentive informa-tion alignments that come with different combinations of firm shapesand sizes and contractual obligations that characterize the market Inaddition the prices for the factor inputs though not equilibrium pricesbear a crucial connection to the prices of the outputs that they helpto produce and therefore to the preferences of the consumers whobuy them Producers take their signals from prospective revenuesand (implicitly) impute values to inputs when they exercise judgmentin the formation of capital combinations Without the institution ofmoney this could not happen

Without money and money prices producers could not make thecalculations necessary for production processes to be initiated and con-tinued While central planners could use administered prices as thebasis for capital projects the values of these projects would lack anybasis in terms of the values of the outputs they produced e ad-ministered prices would not be economically meaningful not havingemerged from a process of individual evaluations e existence ofmoney together with private property and the division of labor andcapital is thus indispensable for economic development

e phenomenon of money presupposes an economic order inwhich production is based on the division of labor and in whichprivate property consists not only of goods of the first order(consumption goods) but also in goods of higher orders (pro-duction goods) In such a society production is ldquoanarchisticrdquo

(Mises 198141)

is statement can be interpreted superficially as suggesting that thesevarious ingredients (money private property division of labor andcapital goods) could exist independently and that it is their joint occur-rence that ensures decentralized production An advocate of centralplanning might wonder why each of these ingredients is so jointlynecessary and concoct various substitutes for one or the other (see

Corell and Cocksho 1993) is is a misconception e institutionson which economic development is based do not only exist togetherthey are inextricably bound up with one another ey are in animportant sense part of the same institutional nexus if any one iscompromised they all collapse So nationalizing the means of pro-duction will inevitably lead to a collapse of the monetary system andthe unraveling of the fruits of the division of labor and capitalisticproduction We can see this by considering how money develops andof course for this we must go back to Menger

In Mengerrsquos work (1976) we find a full treatment of the questionof the origins and development of money Menger explains how withthe development of trade certain commodities come to be traded morefrequently than others ese products have a high level of marketabil-ity At some point individuals begin to accept these commodities notin order to use or enjoy them but for the purpose of trading them ata later date for what they really want At that point the product hasbecome money

Goods derive their value from individualsrsquo appraisal of them Sincedifferent people value different goods differently trade is mutuallyadvantageous Wherever people gather together in society they de-velop trade But trade without the benefit of money is severely limitedby the need to uncover a double coincidence of wants In perhapsmore revealing terms trade without money is limited by overwhelm-ing information requirements By providing a generalized means ofpurchase money dramatically reduces the information necessary toconclude any number of transactions is means that a monetaryeconomy is fundamentally different from a barter economy It is differ-ent precisely because a barter economy in whi the same transactionsare accomplished as in an existing monetary economy is literally incon-ceivable It is inconceivable because without money individuals couldnot acquire the information necessary to conclude the necessary trans-actions And without an explanation of how individuals could comeby this information we have no methodological basis for postulatingsuch an economy

What Menger shows then is that money facilitates exchange Buthe goes further He shows that money also facilitates productionWithout money the degree of specialization would be greatly aen-

uated because of the increased risks involved Specialized economicactivity (like all economic activity) is conditioned by the individualrsquosperceptions of the risks and benefits available Specialization impliesproducing for exchange ie producing more than one intends toconsume In a barter economy specialization is thus limited by whatproducers believe consumers will be willing to exchange for their (theproducersrsquo) surplus and towhat extent this corresponds to their desiresBy commiing onersquos resources to the production of only one or a fewcommodities a producer risks the accumulation of unwanted stocksbecause of the inability to find consumers willing to exchange whatthe producer needs is risk is considerably reduced in a monetaryeconomy since what the producer (in common with all producers)ldquoneedsrdquo is money Or more accurately with money producers can besure of obtaining what they need Producers may also postpone theirconsumption decisions In this way the existence of money suppliesthe degree of confidence necessary for producers to undertake an in-creasingly complex set of specialized activities ey need neverworryabout communicating their desires as consumers to the purchasersof their products us money serves not only to separate the actsof purchase and sale but also to separate the acts of production andconsumption

When Mises writes ldquoe phenomenon of money presupposes aneconomic orderrdquo with the division of labor etc he means as Mengerhas shown that the phenomenon of money develops along with thesethings and as Steven Horwitz correctly points out ldquo[F]rom the startthe existence and use of money is inherently linked with private prop-erty in themeans of productionrdquo (19958 italics added see alsoHorwitz1996)

It is thus difficult to exaggerate the importance of money in thesmooth functioning of a modern economy e institution of moneyis intimately related to every other economic and many noneconomicinstitutions Horwitz (1992) has done some work on the analogiesbetween money and language But this is not so much an analogyas a vital connection Money could not exist without language it is ina sense a derivative of language e use of money in fact all tradeimplies verbal communication It also implies the use of arithmeticand this brings us back to the question of calculation

Money and Calculation e Ability to Budget

Mises claims that the inability to calculate the economic significance ofcapital projects is what dooms central planning with public ownershipof the means of production Horwitz argues that Mises bases thisclaim on his understanding of the fundamental properties of moneyand the emergence of money prices for the heterogeneous means ofproduction We have discussed above the more precise context ofthese money prices For Mises they are ldquoaids to the human mindrdquo inperforming the calculations on which actions are based e crucialpoint here it seems to me is that the institution of money and moneyaccounting allows decision-makers to budget Without the ability tobudget production could not occur it could not be organized Bud-geting implies an intertemporal framework the tracking of value overtime It provides the individual planner with meaningful orientationpoints against which to measure action e meaningfulness derivesfrom the fact that money prices within the framework of money ac-counting are socially meaningful they are understood by all marketparticipants they are part of a shared language or orientation Whenmoney is functioning normally (that is to say when there is no infla-tion) money prices represent a shared sense of ldquowhat things are worthrdquoin the market what can be got for them us meaningful moneyprices in the absence of private property is a contradiction And it isprivate property that allows for the orderly development of productionactivities By ldquoorderlyrdquo we mean widely understood and acceptedmdashpeaceful

We can understand this (once again) in terms of the simple ideal-ized present-value arithmetic that we imagine decision-makers to usewhen appraising capital projects e prospective capital value of anyproject (good or process) is thought of as the discounted present valueof all of the useful outputs which it is expected to yield over its lifee retrospective capital value of the same project is the accumulatedvalue of the investments actually made Any difference between thetwo is a capital gain or loss (see Hicks 1973b and Chapter 6) As aresult of the occurrence of capital gains and losses producers alterthe capital structure Successful ventures displace unsuccessful onese whole process proceeds peacefully though not painlessly as the

economy engages in a form of implicit experimentation whose resultsare calibrated in the form of money

In a single firmrsquos accounting statement itemizing the total costsof a project and comparing this total to the revenues receivedis contained a wealth of scarcity information that neither theaccountant not any other agent in the system could ever gatherEach price of purchased rented and hired factors reflects acomplex tension among diverse plans that have tried to pullthe relevant factor into alternative uses e profit and losscalculus itself then determines whether the particular combi-nation of inputs under consideration yields an output that isexpected to pay its way in the market e fact that all thisscarcity information is expressed in quantitative form permitseach decisionmaker to test extremely complex combinations offactors for their profitability while simultaneously relying onsimilar tests being conducted by rival decisionmakers

(Lavoie 1985b71)

e Effect of Macroeconomic Policy on Capital Calculation

One well-known application of Austrian capital theory is the Austriantheory of the business cycle is theory developed in different waysby Mises and Hayek makes use of Boumlhm-Bawerkrsquos theory of capital asroundabout production As suggested above (Chapter 8) Hayek uses asimplified version of Boumlhm-Bawerkrsquos theory to explain how the capitalstock becomes distorted as a result of inappropriate monetary policiesthat reduce the market interest rate below the level that is consistentwith the time preferences of the consumers in the economy

is theory is well known and will not be surveyed or evaluatedhere e vision of capital offered in the present work is one that isless abstract less quantitative and less aggregative than that of Boumlhm-Bawerk In addition our focus is primarily on the way in which adynamic society evolves how its capital structure changes in a peace-ful but unpredictable way against the backdrop of a structure of in-stitutions that include a sufficient commitment to the principles ofprivate property And in this chapter we have considered how it isthat individuals are able to make capital project decisions in such an

environment It is of some interest however to consider briefly howshort-term government policy actions might affect this ability

We have already noted that inflation by compromising the abilityof money to connote value will affect the ability of decision-makers tomake successful decisions Inflation by compromising the institutionof money in effect compromises all of the related institutions mostnotably the institution of accounting In the extreme in situations ofhyperinflation no capitalist production will take placemdashthe economywill revert to a barter system But what about less extreme monetarypolicies that aim only to ldquostimulaterdquo economic activity by keeping in-terest rates low

While it is difficult in a dynamic complex economy to know withany degree of confidence what the typical effects of such a policymight be (as contrasted with the degree of knowledge suggested by theAustrian business cycle theory) we can see immediately how individ-ual business decisions might be affected We recall that every capitalinvestment decision can be generally characterized by a (necessarilysubjective) capital value (vector) function as

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

indicating in a general way the determinants of capital value 119896119905 of anyproject We can thus say two things about the reduction of interestrates on the perceived value of any project

1 As Hicks has explained a reduction in 119903 will ceteris paribusincrease the value of any project

2 is effect will (usually depending on the precise nature of theincome flow) be greater for those projects that have a longertime horizon

us in a situation in which there is a generally perceived decrease inthe rate of discount one may expect a shi toward projects of longertime horizon In other words there will be a change in the capitalstructure and a concomitant change in the paern of employmentInterest has centered around whether this change is a sustainable oneor whether because it was precipitated by a change in the supply ofmoney rather than a spontaneous fall in individual time preferencesit is based on an illusion and must necessarily be only temporary

Clearly if one makes the assumption that individual time prefer-ences as expressed on the margin in the market remain unchangedin the face of the policy or at least remain above the (equivalent)market rate of interest then it follows trivially since the shi is basedon an illusion it must be temporary e increase in production andemployment will be reversed and there will be a cycle e assumedillusion is of the form that the planned time structure of productionthe planned arrival times of various products is out of sync with theplanned time structure of consumption So the discoordination willbecome apparent when consumer demands in the shorter rather thanthe longer term go unsatisfied at prevailing prices and when pricesrise the capital values of the longer-term projects will in general beadversely affected (as shown in the capital value vector function aboveconsidering 119908 and 119901) So production plans become undone

ere is no guarantee however that the decline in market ratesprecipitated by cheap monetary policy will indeed be taken by in-vestors as a signal of a decrease in time preference In other wordsthere is no guarantee that producers in general will decide that 119903 theappropriate rate of discount for their projects has fallen If they re-gard the policy as inflationary they may well decide that a higher 119903 isappropriate e policy may be doomed from the start

Nevertheless it does seem possible to draw the conclusion thatsuch policies and particularly anges in policies do introduce anadded degree of uncertainty (noise) into individual decision-makinge world is full of changes anyway Most capital projects will fail inpart To have to factor in an expectation of changes in government poli-cies (interest rates taxes regulations etc) and their effects places anadded burden on the decision-maker e policies affect not only theviability of capital projects in terms of their straightforward incentiveeffects (by making them more or less expensive) but they affect theirviability also by influencing the degree and type of risk that aachesto the projects For risk-averse individuals the aractiveness of anycapital value is reduced And this effect is likely to be greater thelonger the time horizon of the project

In general short-term macroeconomic policies may be seen to dis-rupt the longer-term adaptations that we have been analyzing in thisbook and are likely to affect adversely the creative dynamism of the

economy Interest rate policy is only one kind of a set of policieswhereby the government to a greater or lesser extent encroaches onthe decision-making territory of private consumers and investors Allof these policies rest on problematic assumptions about the nature ofknowledge and incentives We will return to this in the final chapter

Conclusion

In this chapter we have investigated the role of money and monetarycalculation in the determination of the production structure of themodern economy We have found that the social institution of moneyis inextricably bound upwith other social institutions like private prop-erty and business organizations e possibility of conceiving theoret-ically of a system without money in which all calculation is done insome arbitrary numeraire should not blind us to the reality that inbusiness organizations it is the ability to calibrate plans and results inthe form ofmoney that allows it to function smoothly Money providesthe report card for business Anything that compromises the reliabil-ity of the monetary system thus compromises the functioning of theproduction system is is as true for the aempt to impose a collec-tivist economy without the use of money reminiscent of the Bolshevikexperiment as it is of the many experiences of inflation So muchhas been asserted many times What we have underlined here is thecrucial dependence of ordinary business calculations for the purposeof undertaking capital investments on a reliable monetary system

e ability to make useful calculations to guide decisions thus de-pends on the stability of certain critical elements of the institutional en-vironment of which money is one and private property is another ecorporate structure also crucially facilitates calculation in providing acognitive framework a set of rules and routines (some of them tacit)governing individual behavior of firm members to guide the decision-makersrsquo expectations It is important to note that in addition to theseconsiderations useful calculation assumes the ability to calculate Mak-ing useful calculations presupposes not only some basic arithmetic andaccounting but also other forms of knowledge and understanding relat-ing to the various aspects of the business us in the next chapter weturn to an examination of the nature and importance of human capital

CHAPTER 11

Human Capital

Hayek (1945) did not emphasize an even more significant im-plication of his analysis although he must have been aware ofit e specialized knowledge at the command of workers isnot simply given for the knowledge acquired depends on incen-tives Centrally planned and other economies that do not makeeffective use of markets and prices raise coordination costs andthereby reduce incentives for investments in specialized knowl-edge (Becker and Murphey 1993306)

Introduction Human Capital and the Nature of Knowledge

Market economies are characterized by complex capital structures inwhich individual complementary capital goods combine either directlyor indirectly through the market process to produce valued outputs Allproduction is essentially ldquoteam productionrdquo We have noted at variouspoints the role of knowledge in this process Knowledge is necessaryfor action and indeed motivates action Multiperiod plans involvingcapital are informed in various ways by the knowledge of the plannersIn this chapter we examine in more detail the importance and natureof knowledge in the production of valued outputs We shall see thatthe human capital literature which has developed in the last three ormore decades has much that is relevant to an understanding of capitalin general even more so when a disequilibrium framework is assumed

We have seen that most production involves the flow of inputservices for the purpose of producing a flow of valued outputs (orservices) (Simple ldquopoint inputndashpoint outputrdquo processes are quite rare)is input flow is provided by the efforts of physical or human re-sources traditionally referred to as labor and capital Sometimesthe identifying difference between labor and capital is the distinction

between ldquooriginalrdquo and ldquoproducedrdquo means of production1 When con-sidering the role of knowledge in production one comes quickly torealize however that there is lile that is ldquooriginalrdquo in the type oflabor effort that is typically provided in modern production processesIt is obvious first that human effort in production must be governedby certain types of very specific or general knowledge and that sec-ond much of this knowledge is intentionally acquired One is facedtherefore either with abandoning the distinction between original andproduced means (for other reasons this distinction as applied to landis of dubious value) or of treating knowledge per se as a separateproduced input is laer strategy is essentially what the humancapital approach does Knowledge conditions (determines) the type ofservice that gets ldquoput inrdquo whether from labor or capital So knowledgeis ldquoembodiedrdquo in both physical and human resources2 although thereare some important distinctions in the way in which this happensAnd knowledge takes time to acquire Seen as the ability to produceor contribute (directly or indirectly) toward the production of somevalued output knowledge emerges as a special and very importanttype of capital (Education considered as a pure consumption good canbe accommodated in the above framework if one considers householdproduction as will become clear below)

In some ways the term ldquohuman capitalrdquo is unfortunate It orig-inates probably from the fact that in an essential way knowledgemust be embodied in the human mind ere is no human knowledgewithout a human knower is aspect of knowledge suggests that itmust be thought of as ldquosubjectiverdquo although information fromwhich itderives is ldquoobjectiverdquo Knowledge and information though oen usedinterchangeably are distinct phenomena3 It is knowledge that im-bues information with value Disembodied information information

1See the discussion in Chapter 7 2See Baetjer (1998) Lewin and Baetjer (2011)3ldquoWe shall use the words information and knowledge respectively to mean the

tradable material embodiment of a flow of messages and a compound of thoughts anindividual is able to call upon in preparing and planning action at a given point intime Our distinction between the two terms thus rests in part on that between a so-cially objective entity and a private and subjective compound of thoughtsrdquo (Lachmann198649 see also Lewin 1994235ndash236) Also ldquoWhether applied to comprehensiveor noncomprehensive planning the knowledge problem argument crucially dependson the view that knowledge is not the same as data that is given pieces of explicitinformationrdquo (Lavoie 1985b57)

HUMAN CAPITAL 195

without cognition is valueless In a sense knowledge is informationtransformed into capital and in fact all capital has a similar knowl-edge dimension In this sense all capital is ldquohumanrdquo Capital is re-sources (information and other resources) plus meaning the meaningthat humans by virtue of their purposes impose on the resources attheir disposal Since knowledge must reside in the human mind theenhancement in value that it occasions when applied by humans tophysical resources is naturally referred to as human capital

Knowledge of course inmanyways defies characterization Whilewe may think of it as capital knowledge as such is never traded al-though information is Knowledge is inevitably dispersed among indi-viduals and can never be collected in a single place It has aspects thatare inexpressible even by the knower aspects that are tacit (Polanyi1958) is bears on the familiar implications for the impossibility ofsocialist planning made famous by Hayek (1945) In addition as KarlPopper has shown knowledge has an open-ended naturemdashhe referredto knowledgemdashperhaps unfortunately given our characterization ofknowledge as ldquosubjectiverdquomdashas being ldquoobjectiverdquo in nature meaningthat as we shall show it has implications beyond the comprehensionof any subjective mind (Popper 1972) So when we think of human be-ings as intentionally acquiring knowledge that is embodied completelywithin the human mind we shall have to be a bit careful Knowledge(or potential knowledge) exists outside of the human mind in the sensethat certain machines for example embody the potential to producecertain outcomes only if used by someone who ldquoknows howrdquo to useit but does not necessarily ldquoknow whyrdquo in a more fundamental sensecertain results are produced is laer type of knowledge is embodiedwithin the machine It was put there by someone who presumablyknew how to make the machine so that it would work as intended4

equestion ofwhere ultimately the knowledge actually resideswouldappear to be a metaphysical one whose answer maers less for ourpurposes than the fact that knowledge is necessary for productionwherever we may visualize it residing We need machines of certainphysical configurations embodying certain production potentials andwe need the know-how to operate them Knowledge of some typeat some level must always be available in any production plan It

4See Baetjer (1998)

is inconceivable that a production plan could exist without humanknowledge It is not simply another analogous type of capital in thesame way as physical and human resources which supply the energyand effort for its implementation So a beer term might have beenldquoknowledge capitalrdquo While bearing this in mind for ease of referenceand comparison we shall continue to use the term ldquohuman capitalrdquo

In this chapter I will examine some important aspects of humancapital that derive from the existing literature especially from thework of T W Shultz and Gary Becker We shall see that many of thevaluable insights survive when considered outside of the neoclassicalequilibrium world of fully consistent plans More importantly addi-tional implications emerge as a result of this transplant I then returnin the next chapter to the inimitable nature of knowledge touched onabove

Human Capital and the Firm

Business organizations provide for the coordination of resources inproduction ese resourcesmay be physical or human In consideringeither of these types of resources decision-makers face exactly thesame type of decision In particular they are concerned about the capi-tal value of any combination of resources whether they be physical orhuman and must take cognizance of the fact that the value of humanresources may be enhanced by training and experience Certainlythere are important and significant differences between investmentsin human as compared to physical resources but there are importantsimilarities as well

Knowledge as we have seen (Chapter 3) comes in many formsSome knowledge is helpful in all or many different production set-tingsmdashwe will call this general human capital e ability to readand write to follow instructions to communicate instructions etcare examples Some knowledge is of value in a limited number of (inthe extreme only one) production seings We will call this specifichuman capital Knowledge that relates uniquely to the procedures androutines of a particular firm or to particular production processes areexamples Some forms of general human capital are obtained through

HUMAN CAPITAL 197

specialization in education in other words through the devoting ofwhole units of time (years of schooling) to the acquisition of certainkinds of knowledge And some forms of general training are providedby firms On the other hand specific human capital is obtained mainlyon the job although full-time training courses in specialized subjectareas are an exception to this With both general and specific trainingan important difference between human and physical capital is that theownermust be present at the investment stage and the implementationstage Physical capital can be (and mostly is) produced and used awayfrom its owner But at least in an economy without slavery humancapital is tied to its owner is has some very important implicationsIt means first that firms cannot own human capital they can onlyrent its services As a corollary it means also that any decision thefirm might make with regard to training must be a joint decision takentogether with the employee receiving the training So it is of someinterest to ask when and under what circumstances a firm might payfor specific or general training (Becker 1993ch III)

We can examine this by considering the elements of the individualinvestment-in-training decision e most important elements relateto earnings e benefits of training come mainly from enhanced earn-ings in the post-training period while the costs come mainly fromreduced earnings during the training period For simplicity we mayfor the meantime ignore the nonpecuniary aspects of training thatis we ignore any direct satisfaction that the employee may derivefrom the training process or its results (satisfaction of curiosity self-esteem etc)5 Also we assume that the employerrsquos best estimate of themarginal value of the employeersquos services is reflected in the wage ratepaid In this way we shall see both the employeersquos and the employerrsquosvaluation of the costs and benefits of the training are reflected in wage

5is can be easily accommodated by adding the net nonpecuniary gains to thevalue of the investment Adam Smith recognized that differences in nonpecuniaryaspects of different jobs would be reflected in market wages is remains true forjobs that require training us rates of return from observed wages do not alwaystell the whole story not only because outcomes will differ from expectations but alsobecause wage differences must be adjusted for preferences for and against differentkinds of jobs if the returns are to be taken to imply a net gain to the investor Stillconsidering large groups across different occupations does yield important insights

rates We recall equation (61) the formula for the capital value of anyprospective stream of returns from the perspective of point 0

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113567119877

minus1113569 +⋯+ 119902119899119877minus119899 =

1198991114012119905=1113567119902119905119877

minus119905 (111)

119902119905 = 119887119905 minus 119886119905 are the net returns benefits (119887119905) minus costs (119886119905)

and119877 = (1 + 119903)

where 119903 is the rate of discount (time preference) In order to calculatethe internal rate of return (IRR) we put 1198961113567 = 0

In the case of investments in training the costs and benefits havea special paern e costs of the investment will be captured bythe (estimated) earnings profile that would have been earned in theabsence of the training and this must include any direct out-of-pocketcosts Using our previous notation 119886119905 = 119908119905120572119905 where 119908119905 are the wagerates of the employeersquos services 120572119905 in the absence of training and119887119905 = 119908prime119905120573119905 where 119908prime119905 are the wage rates of the employeersquos services(adjusted for any out-of-pocket training costs) 120573119905 with the benefit oftraining Since 120572119905 and 120573119905 refer to the services of the employee (beforeand aer training) these are most conveniently expressed in terms oftime units that is number of hours of input of a particular type ofemployee service us we may normalize by taking the basic unit tobe one (hour day year etc) then (since 120572119905 = 120573119905 = 1) equation (111)becomes

1198961113567 =1198991114012119905=1113567(119908prime119905 minus 119908119905)119877

minus119905 (112)

e projected gain from training consists of the prospective annualwage differentials each year over the working life (119899 years) of the em-ployee e internal rate of return (IRR) or perceived yield is obtainedby puing 1198961113567 = 0 or

1198961113567 =1198991114012119905=1113567

(119908prime119905 minus 119908119905)(1 + 119903)119905

= 0 (112prime)

HUMAN CAPITAL 199

Call this rate of return 119903lowast en the training will be undertaken when-ever 119903lowastgt 119903 where 119903 is the best perceived alternative due account beingtaken of risk uncertainty and other relevant factors It is clear that119903lowast depends not only on the perceived alternative earnings streams butalso on the perceived length of the payoff period 119899 And this payoffperiod is influenced by the length of life and the degree of labor-forceparticipation of the employee (We shall consider later how humancapital investmentsmay increase the value of timemore generally thatis for time used in- and outside of the labor market)

Wemay note at this point two other important differences betweeninvestment in human and physical capital Again this is related to thefact that this human capital must be embodied in the human body

1 Since human life and human working life is finite it has animportant effect on the perceived rate of return in investmentin human capital It is in general higher in younger peopleand they are likely to predominate in training programs efiniteness of the payoff period is an important reason for the ex-istence of diminishing returns to investments in human capitalAs years of training and schooling are added the payoff perioddiminishes by an equal extent (unless the investment lengthenslifespan as in the case of investments in health but even thenthe degree of flexibility is very limited)

2 With each successive investment in human capital the valueof the employeersquos time in the market is rising So the valueof earnings forgone tends to rise along with the benefits Forexample in the case of formal schooling a graduate studentforgoes more while in school than a high-school graduate

us although as we shall argue significant complementarities existbetween different types of human capital that are likely to raise therate of return as investment proceeds diminishing returns to marginalinvestments in individuals must eventually obtain because of the tworeasons just given is is in marked contrast to investments in phys-ical capital in general or in human capital from the economy-widemacro-level point of view when investments across different individ-uals can be considered

It should also be noted however that these differences can beoverstated especially in a rapidly changing economy In a dynamic

rapidly changing world the relevant payoff period for any investmentis more oen than not not the physical life of the human or physicalasset but rather its (shorter) economic life e scrapping or retoolingof machines oen comes not so much from the physical depreciationof the asset as from its technological obsolescence And this is moreand more true also of human capital where individual skills lose theirvalue not somuch from physical deterioration or handicap as from (un-expected unplanned for) technological change As the pace of changeaccelerates the likelihood that the economic life of a skill is less thanits physical life increases and the need for midlife retraining (with areduced payoff period) increases We shall see this phenomenon in ourdiscussion of specific training below Capital losses (and gains) occurwith both physical and human capital in categorically identical ways6

Perfectly General Training

We may now consider the question of who is likely to pay for trainingIn the case of perfectly general training it should be clear that thefirm is less likely to pay than the employee e reason is that generalhuman capital is perfectly portable e training increases (and isknown to increase) the value of the employeersquos services as much in

6Lachmann asserts

e fundamental difference between labor and capital as ldquofactors ofproductionrdquo is of course that in a free society only the services of laborcan be hired while as regards capital we usually have a choice of hiringservices or buying their source either outright or embodied in titlesto control e chief justification of a theory of capital of the typepresented here lies in the fact that in the buying and selling of capitalresources there arise certain economic problems like capital gains andlosses (Lachmann 197887n)

e distinction that Lachmann makes here is surely without substance e fact thathuman capital cannot be transferred does not prevent it from being valued in the mar-ket by its owners and by its renters e capital value will vary directly with the rentalrate (earnings) Most important exactly the same considerations that apply to thetheory of capital and make it interesting in Lachmann s view apply to human capitalCapital gains and losses most definitely aach to human capital in an uncertain worldand are part of the market process of continual re-evaluation of production plans Weshall return to this below

HUMAN CAPITAL 201

other (competitive) firms as it does in the one providing the training7

Since firms cannot own human capital they cannot capitalize the valuecreated by buying it as is the case with physical capital So the moralhazard problem cannot be solved by ldquointernalizingrdquo the investmentprocess It is possible for firms to provide the training if they canbe insured against the likelihood that the employee will quit and takehis skills elsewhere For these purposes contracts are sometimes fash-ioned an example being the armed forces8 but enforcement costs canbe prohibitive An easier solution is for the employee to pay einalienable property right that the employee has in his skills is thesource of his incentive to invest in training by taking a temporary ldquocutrdquoin earnings

us for firms providing general training with the employee pay-ing the employeersquos earnings during the training period would be re-duced by the cost of training Employees pay for general training byreceiving wages below what they could receive elsewhere In this waycurrent earnings (negatively) include capital investment items Sounlike formal educational courses (schooling) expenditure for trainingon the job is ldquoautomaticallyrdquo deducted from earnings All costs thenappear as the value of forgone earnings to workers receiving generalon-the-job training and an estimate of their value depends on expecta-tions of future post-training earnings

Perfectly Specific Training

Specific training illustrates an aspect of the heterogeneity of humancapital As with physical capital heterogeneity implies complemen-tarity Specific human capital is valuable in specific combinations ofgeneral and specific human capital and physical capital

7One does not require a situation of equilibrium here Irrespective of whetherplans exactly match outcomes or not perfectly general training like literacy benefitsthe individual in a general way that is in a variety of situations to the same extentEven though the precise benefit may be uncertain the differential benefit as betweenone work situation and another is zero

8Where the military pays for general training for example for pilots and doesnot pay the market wage for graduate trainees there is a problem of re-enlistmentand losses in favor of businesses in the private sector like the private airlines (Becker199339)

Perfectly specific training increases the expected earnings of theemployee only in the firm providing the training In this case theemployee has a substantially reduced incentive to pay for the trainingOn the other hand since the skills obtained are not portable the firmhas a substantially increased incentive to pay for its acquisition Sincethe employeersquos post-training skills are more highly valued in the firmthat has provided the training than in the ldquomarketrdquo they have a muchreduced incentive to quit iing would necessitate taking a pay cutIf the firm could be confident that the employee would not quit in spiteof this reduced incentive it would be prepared to pay the full costfor this training Since however no such absolute assurance could beobtained the training costs are likely to be shared even in the case ofperfectly specific training

Where the firm pays all or part of the costs of training wagesduring the training period are likely to be more than the ldquofull worthrdquoof the marginal value to the firm of the employeersquos services and to beless than this ldquofull worthrdquo in the post-training period (where such val-ues can be estimated) is will most likely manifest in the employeeearning more than the ldquomarketrdquo for his current skills will pay duringthe training period And since his skill is specific to the firm he willearn more than the ldquomarketrdquo in the post-training period as well9

Multiple Specificity in Training

In reality training is seldom likely to be perfectly specific to a partic-ular firm Rather the training may have a greater or lesser degree ofspecificity and this may vary across space and (importantly) acrosstime A firm that is technologically innovative and pioneers a par-ticular process or product might for example have to provide all

9As Becker notes Marshall was clearly aware of the difference between generaland specific training

us the head clerk in a business has an acquaintance with men andthings the use of which he could in some cases sell at a high price torival firms But in other cases it is of a kind to be of no value save to thebusiness in which he already is and then his departure would perhapsinjure it by several times the value of his salary while he could not gethalf that salary elsewhere

(Marshall 1949626 quoted in Becker 199344n)

HUMAN CAPITAL 203

of a particular type of training itself and would be prepared to do sosince the training was of use only to it As time passed however andthe benefits of the new process or product became diffused throughthe economy and imitated by competitors the training would becomemore general in nature is is a risk of which innovative firms arewell aware and may be a reason for endeavoring to shi some of thetraining costs onto the employee As a general rule the fraction of thetraining costs paid by firms would be inversely related to the perceivedimportance of the general component of the training and positivelyrelated to the perceived enduring specificity of the training Firms paygenerally trained employees the same wage and specifically trainedemployees a higher wage than they would get elsewhere

An important implication of this consideration of specific trainingis that turnover depends on the wage rate and the degree of specificityFirms are concerned about the turnover of workers with specific train-ing and would therefore be prepared to offer a premium to prevent itBy the same token employees are concerned about the possibility ofbeing laid off (or fired) its and layoffs in turn affect the expectedreturns to firms and workers respectively of investments in trainingEmployees with specific training have less incentive to quit and firmshave less incentive to fire them Accordingly the quit and layoff ratesare inversely related to the amount of specific training possessed otherthings constant

us an unexpected (and isolated) decline in demand could beexpected to affect generally trained workers more than those withspecific training Generally trained workers would be laid off beforespecifically trained ones for two reasons First firms have sunk invest-ments costs in specifically trained employees that may be partiallyrecouped in the event that the decline in demand is temporary Sec-ond if it is indeed temporary newly hired workers would have to beretrained in the specifics possessed by existing employees were thelaer to be let go In this sense labor can be seen as a ldquoquasi-fixedfactor of productionrdquo (see Oi 1961 Becker 199346) Specific trainingthus implies the existence of a bond between employee and employerwhich provides a measure of security of service to the firm and jobsecurity to the employee It is however a double-edged sword Forthe firm investing in specific training represents a risk in the event

that as noted above the specificity does not endure For the employeeinvesting in specific training is risky to the extent that it ties the em-ployee to a specific employer and its fate To the extent that a specificproduct or process loses out in the marketplace and suffers bankruptcyor downsizing the loss to specifically trained employees is greaterthan to generally trained ones

Furthermore both parties (employees and employers) are subjectto the threats of opportunism and holdups noted above in Chapter 9(Rosen 1991) Shared investment costs require sharing later returnsand can lead to problems relating to opportunistic behaviormdashshirking(thus preventing the collection of the returns) andor threatening tohold up production As with specific physical capital it should be clearthat holdup threats can occur on both sides of the market e firm canhold out the threat of termination of a specifically trained employeein an effort to secure ldquopost-contractrdquo reductions in earnings and theemployee could threaten to quit and take a valuable skill with him in aneffort to secure higher earnings In this regard the situation representsa bilateral monopoly10

Pension plans that incorporate gradual vesting provide a type ofinsurance to firms against premature quiing of specifically trainedworkers Consequently specifically trained workers would find suchplans more valuable than generally trained ones Similarly firms aremore likely to pay the moving expenses of employees who are or willbe specifically trained Migration is a form of human capital invest-ment and migration costs are likely to be shared in proportion to thedegree of specificity of the employeersquos skills Similar considerationsaach to the firmrsquos contemplation of investments in the health of itsemployees Finally to the extent that different types of organizationalarrangements affect the motivation and performance of employeesthis must be seen as a type of (knowledge) capital us for exam-ple where the conditions are right firms may be expected to takean interest in and subsidize the consumption of its employees Inless developed countries ldquoan increase in consumption [may have] a

10is is really just another aspect of the general imputation problem aaching toteamproduction ldquoPerfectly efficientrdquo imputationwould facilitate ldquoperfect learningrdquo ofproduction processes and would thus facilitate perfect coordination and enforcementover time in competitive markets

HUMAN CAPITAL 205

greater effect on productivity and a productivity advance [mayraise] profits more thererdquo than in more developed countries (Becker199357)

Human Capital and the Individual

e investment approach to human capital outlined above thus pro-vides many insights to the type of decisions that firms and employeestogether face in the production process is approach can also beused to investigate aspects of individual behavior more generally In-dividuals face human capital decisions not only in or in relation to theworkplace although traditionally and logically this is the place to startin any investigation e opportunities available to individuals in theworkplace condition and constrain them in the other aspects of theirlives We must begin this more general discussion by visualizing therelationship between individual workers and their earnings over time

AgendashEarnings Profiles

As noted the ldquohumanrdquo aspect of human capital is responsible for im-portant differences between investments in physical and human assetsBoth involve considerations of timemdashintertemporal planning and theevaluation of earnings at different points in time For investment inindividual human capital however the elapse of time necessarily sug-gests aging that cannot be reversed e tracking of earnings over timeis thus oen referred to as an agendashearnings profile

Typically agendashearnings profiles (with earnings on the vertical andage on the horizontal axes) are concave to the horizontal axis suggest-ing that earnings rise over time at a decreasing rate is shape sug-gests that ldquoexperiencerdquo has value as a form of on-the-job training evenin the absence of formal (conscious) training as earnings increase withtenure and job experience e fact that the increase tapers off suggeststhe influence of finite life e typical shape of the agendashearnings pro-file is a very robust observation found widely where statistics exist(Becker 199312) However the height and rate of change of the profilevaries with circumstances From a human capital perspective certainimplications emerge

e agendashearnings profiles of less trained workers are likely to beflaer (rise more slowly) than those of trained workers is is be-cause the agendashearnings profile includes the returns to training eprofiles of generally trained workers are likely (other things constant)to be steeper than the profiles of specifically trained workers Withspecifically trained workers the firm pays for all or part of the trainingthus paying the worker more than their opportunity cost during thetraining period and less than their opportunity cost aer training thusflaening out the profile Agendashearnings profiles and investments in hu-man capital go a longway towards explaining the personal distributionof earnings (Becker 1993109ff Mincer 1974 more below)

Full-time schooling is oen a form of investment in general humancapital (although there are degrees of specificity that aach to it thedegree of specificity rising usually with the level of education) usschoolingmay be expected to steepen agendashearnings profiles Typicallyfor example the agendashearnings profiles of college graduates start laterand below those of high school graduates rise much more steeply andrapidly overtake the laer e same paern is observed by comparinggraduate and college degree earnings profiles is suggests a phe-nomenon that we shall examine more closely below namely that hu-man capital investments are likely to be (sequentially) complementaryin nature College graduates though sacrificing some earnings growthwhile in college and thus having to start at a wage below that of theirmore experienced coworkers who entered the work force right aerhigh school are able to catch up rapidly as a result of the knowledgethat they have accumulated11

Investments and the Allocation of Time over Time

e human capital approach to agendashearnings profiles shows that anindividualrsquos earnings are not simply given to him as an exogenousconstraint Rather it is a result of their actions over timewith regard tothe time he devotes to investing in human capital and other activities

11We do not consider here alternative explanations like the ldquoscreeningrdquo hypothesisthat formal education serves merely to ldquoweed outrdquo already existing abilities For aconvincing (to me) rejection of these types of explanations see Becker (19938)

HUMAN CAPITAL 207

In this way the human capital approach integrates many aspects ofindividual behavior

e amount of time an individual spends investing in human capi-tal would tend to decline with age for two reasons that we have alreadydiscussed

1 e number of remaining periods and thus the present value offuture returns would decline with age

2 e cost of investing would tend to rise with age as human capi-tal accumulation proceeded because the forgone earnings of theindividual would rise

We note now that the rise in the value of the individuals time applieswith equal force to the time spent within the household and generallyoutside of the workplace Assuming that work was not an end initself an increase in the amount of time spent working or investing inhuman capital would raise the marginal value of ldquoconsumptionrdquo timeto the individual e agendashearnings profile implies an age investmentprofile Generally an individualrsquos investment time will rise with age ata decreasing rate mirroring the path of earnings but wouldmost likelypeak before the peak in earnings (For a more precise discussion seeBecker 199370ndash85) During time periods when an individualrsquos valueof time was rising most they would tend to economize on other usesof their time is implies in addition to forgoing work time and theearnings that come with it forgoing ldquoleisurerdquo or ldquoconsumptionrdquo timeLeisure time appears most expensive when one could be buying largeincreases in ldquocareer advancementrdquo with it As increases in earningspotential taper off the tradeoff against leisure time becomes less arac-tive and eventually the pendulum swings in the other direction withmore time being devoted to consumption and leisure at higher agese capital theoretic decision is thus seen to apply to this margin oftime as well

e Illiquidity of Human Capital

e above discussion suggests that the investment approach to humancapital resources is a powerful and simple tool for explaining a widerange of phenomena It is predicated on lile more than the basiclogic of capital value and individual rationality (in the Misesian sense

of internal consistency between means and ends) It requires that theindividual weigh in a consistent manner the costs and benefits ofalternative decisions as they see them Of course all decisions aretaken within a social framework and we have implicitly assumed thatthese imagined and projected costs and benefits correspond closely tomaterialized reality To be sure investments in human capital likeall investments may have outcomes that differ to a greater or lesserextent from the planned outcomes on which they were based As withall actions they are based to some extent on disparate plans and arethus in part bound to fail We shall examine some implications of thisbelow ere are in addition some special considerations that aachto human capital of which we take note at this point

ldquoSince human capital is a very illiquid assetmdashit cannot be soldand is rather poor collateral on loansmdasha positive liquidity premiumperhaps a sizable one would be associated with such capitalrdquo (Becker199391) is is a consequence of the inalienability of human capitaland the finiteness of human life Loans to finance investments canbe obtained with greater or lesser ease (on beer or worse terms) de-pending on the degree of confidence that the financiers have in theinvestment and on the degree to which the alternative value of the in-vestment assets themselves provide some safeguard against the failureof the investment Assets of a failed business can be separated fromthe business and sold (redeployed) to help offset the loss In the case ofhuman capital however the asset is inseparable Furthermore loansfor investment in assets depend on the reputation of the investor Ayoung investor anxious to start his own business must convince thefinancier that he is creditworthy If necessary he can postpone theinvestment a while in order to accumulate a track record and somepersonal capital Human capital investments cannot be so easily post-poned (Becker 199394) Relevant to this is the fact that for investmentin human capital the individual must of necessity use his own time(in addition to any other resources and other peoplersquos time that maybe necessary) in a rather rigid manner in order to accomplish the in-vestment In other words there is no substitute for ldquobeing thererdquo fora minimum amount of time12 In the case of physical capital a project

12e necessity of the individualrsquos own time in the investment process promptedBecker to liken the process to the Austrian period of production model His model is

HUMAN CAPITAL 209

previously postponed can oen be expedited later by increasing therate of application of inputs

For these reasons human capital is likely to be much more illiquidand less easily financed Like other investments there is a greater orlesser degree of uncertainty depending on the situation Some of theelements that contribute to uncertainty in the case of human capitalhave been analyzed

ere has always been considerable uncertainty about the lengthof life one important determinant of the return People areuncertain about their ability especially younger persons whodo most of the investing In addition there is uncertainty aboutthe return to a person of given age and ability because of nu-merous events that are not predictable e long time requiredto collect the return on an investment in human capital reducesthe knowledge available for the knowledge required is aboutthe environment when the return is to be received and thelonger the average period between investment and return theless such knowledge is available

(Becker 199391ndash92 italics added)13

said to be ldquoalmost identical to those used in the lsquoAustrianrsquo theory of capital to explainoptimal aging of trees or wine Indeed the main relevance of the Austrian approach inmodern economies is to the study of investment in human capitalrdquo (Becker 1993113n)One may appreciate the point being made here namely that in a consideration ofinvestments of human capital one comes to appreciate the importance of time in theinvestment process and also that there is very lile scope for substitution when itcomes to individual ldquotimerdquo One can learn more or less intensively but ldquocrash coursesrdquoare less effective (productive) than more leisurely ones Nevertheless as with theAustrian period of production approach it can be fundamentally misleading Timeas such is never ldquoput inrdquo to anything Time is not a substance or a resource Rather itis what happens over time that is important Sometimes as with the aging of wine ithappens almost incidentally Mostly it is a maer of conscious effort or a by-productof such effort as in the case of the acquisition of tacit skills or ldquoexperiencerdquo

13Becker refers here again to Marshall

Not much less than a generation elapses between the choice by parentsof a skilled trade for one of their children and his reaping the full resultsof their choice And meanwhile the character of the trade may havebeen almost revolutionized by changes on which some probably threwlong shadows before them but others were such as could not havebeen foreseen even by the shrewdest persons and those best aquaintedwith the circumstances of the trade the circumstances by which theearnings are determined are less capable of being foreseen [than arethose for machinery] (Marshall 1949571 Becker 199392)

ese remarks suggest that financial markets cannot be relied on asreadily with human as with physical capital e relative illiquidityof human capital also explains aspects of the personal distribution ofearnings

Human Capital and the Personal Distribution of Earnings

Comparison of different agendashearnings profiles suggests that differentpeople invest different amounts in human capital It is clear also thatdifferent people invest in different types of human capital If peoplewere identical in their abilities and opportunities (reflected in an ac-curate assessment of the returns) we would expect to see everyoneinvesting in the same way and earning the same returns An explana-tion of differences in earnings (from work) naturally therefore shouldturn to an examination of differences in abilities and opportunities(including ldquoluckrdquo) is is the approach taken by Becker in a seminallecture (the Wyotinsky lecture reprinted in Becker 1993109ff)

In this approach differences in the amounts invested by differentpeople in human capital are related to differences in the rates of re-turn available from investing and in the opportunities to finance suchinvestments Becker calls the former the differences in rates of returnavailable differences in ability It should be clear that ldquoabilityrdquo heredoes not necessarily mean differences in innate capacities like cogni-tive ability or IQ although thesemay play some part14 Rather it refersto the differential capacities that individuals have for learning andfor turning that learning into economically advantageous outcomeswhich is obviously a much more complex set of phenomena than abil-ity as measured by any one-dimensional criterion15

14Recent research into the connection between traditional measures of intelligenceand economic success have cast doubt on any simple connection See for exampleGoleman (1995ch 3)

15It is possible of course that differences in amounts invested in human capitaland in type of human capital reflect differences in preferences (however caused) eanalysis in the text abstracts from this in effect assuming that such differences in pref-erences are less important than differences in abilities and opportunities Certainlyboth forces are at work affecting the demand for human capital ere is very lilethat one can say systematically about differences in preferences One suspects thatthe larger the population under discussion the less likely that systematic differences

HUMAN CAPITAL 211

Consider then a situation in which all individuals had the sameopportunity to invest Differences in the amounts invested and inearnings from human capital would then be explained solely by dif-ferences in perceived rates of return Indeed for the same amountinvested more ldquoablerdquo individuals would earn more But more ableindividuals would be inclined to invest more (their demand curves forhuman capital would be higher) us if the marginal cost of investingin human capital were rising (an upward-sloping supply curve) thenmore able investors would be observed to earn a higher rate of returnand would invest more And the more elastic the supply of humancapital (or the supply of financing for human capital) the greater willbe the variance in earnings and human capital investment

If on the other hand everyone was equal in abilitymdashinvesting thesamewould bring the same rate of returnmdashthen differences in earningsand rate of return would be explained by differences in opportunitiesis view goes back at least to Adam Smith

e difference of natural talents in different men is in real-ity much less than we are aware of and the very differentgenius which appears to distinguish men of different profes-sions when grown up to maturity is not upon many occasionsso much the cause as the effect of the division of labor edifference between a philosopher and a common street porterfor example seems to arise not so much from nature as fromhabit custom and education (Smith 198228ndash29)

Smith quotes David Hume as follows ldquoConsider how nearly equalall men are in their body force and even in their mental powers andfaculties ere cultivated by educationrdquo (ibid28 quoting David Hume)Opportunities to invest in human capital will be determined by accessto financial markets and by socioeconomic background Because hu-man capital is rather poor collateral much human capital investmentis financed by parents and other family members us people withthe same ability but a superior (more affluent) background would tend

in preferences will explain differences in (average) earnings It is also important tonote that differences in rates of return (and therefore earnings) that are observed forindividuals who invest the same amounts in the same type of human capital cannotbe explained by differences in preferences

to accumulate more human capital Conversely scholarships based onneed would work in the other direction16

In reality both abilities and opportunities differ across individ-uals Abler persons tend to invest more than others and the distri-bution of earnings would be very skewed to the right even if abilitywere symmetrically distributed and people had ldquoequalrdquo access to fi-nance In fact abilities and opportunities may even be positivelycorrelated in that more able people are more likely to have accessto loans and other types of financial assistance is would tend toreinforce the explanation of why earnings distributions are positivelyskewed

Human capital investments serve partially as inheritances

Inheritances appear to be received by only a small and selectpart of the population because small inheritances are investedin human capital and therefore are not reported in inheritancestatistics As the amount inherited by any person increased alarger and larger fraction would be invested in physical capitalis can explain the sizable inequality in reported inheritancesand can contribute to the large inequality in physical capitaland property income (Becker 1993148)

Agendashearnings profiles together with the above considerations explainalso why earnings inequality appears to increase with age Abler andmore fortunate people who invest more (and for a longer time) in hu-man capital take longer to reach their peak earnings e absolute gap(though not necessarily the proportional gap) between people withdifferent amounts invested in human capital rises with age

16e presence of state subsidies for education and other human capital investmentwould normally set up compensating variations in private investments For exampleparents might be inclined to spend less of their aer-tax dollars on human capital in-vestment in the presence of subsidies to their children As we have discussed humancapital is poor collateral erefore investments are unlikely to be financed to the fullextent desired by poorer parents (were they beer collateral) in the absence of stateassistance us state assistance is likely to result in more (of certain types) of humancapital (at the expense of other types of expenditure) than would be accumulatedotherwise

HUMAN CAPITAL 213

Conclusion

is common framework helps explain many aspects of individual hu-man behavior and their outcomes17 We have yet to consider the fullimplications of rapid change for human capital investment decisionsBefore we do however we should take note of the role of humancapital in the economy as a whole

Human Capital and the Economy

When we shi our view from the individual to the economy we musttake account of the way in which the knowledge possessed by differentindividuals is combined in joint and related projects One is drawnnaturally to the concept of the division of labor

Recognition of the phenomenon of human capital and its role inthe economy is clear in Adam Smithrsquos treatment of the division oflabor in the Wealth of Nations He gives the following as (two outof the three) reasons that the division of labor leads to an increasein output (increasing returns) that the specialized individual workerboth improves in dexterity over time and may be expected oen to dis-cover improved methods of production (Smith 198217ndash18) We havealready seen an example of this in our discussion of the firm and ofthe connection between the division of labor and the acquisition ofknowledge (human capital) by the worker and also in our discussion ofLachmannrsquos capital theory and his reinterpretation of Boumlhm-Bawerkrsquosnotion of increasing roundaboutness e division of labor appears tobe involved implicitly or explicitly in many aspects of capital theoryIn addition as Carl Menger has pointed out ldquoAdam Smith has madethe progressive division of labor the central factor in the economicprogress of mankindrdquo (Menger 197672)

Menger goes on however to criticize Smith He points out thateven in primitive societies labor is efficiently specialized yet the im-provement in production is not such as is typical of technologically

17e work of Gary Becker and his collaborators has extended this approach to thesearch for explanations of observed outcomes relating to intergenerational individualand family mobility and aspects of family economics in general We shall have anopportunity to visit some of this below

progressive societies18 Production may be efficient within the givenstate of the arts progress consists in breaking out of the existing frame-work in visualizing and implementing newmethods of production Tobe fair it seems to me that Smith does indeed imply this in his thirdreason for the importance of the division of labor (ldquothe inventions ofcommon workmenrdquo etc (Smith 198219ndash22)) Be that as it may thepoint is that the division of labor occurs within a given known wayof doing things and it is primarily through changes in the laer thatprogress occurs

e quantities of consumption goods at human disposal are lim-ited only by the extent of human knowledge of the causal con-nections between things and by the extent of human controlover these things Increasing understanding of the causal con-nections between things and human welfare and increasingcontrol of the less proximate conditions responsible for humanwelfare have led mankind therefore from a state of barbarismand the deepest misery to its present stage of civilization andwellbeing and have changed vast regions inhabited by a fewmiserable excessively poor men into densely populated civi-lized countries Nothing is more certain than that the degreeof economic progress of mankind will still in future epos becommensurate with the degree of progress of human knowledge

What presumably Smith would argue is that advances in knowledge(human capital accumulation) and the division of labor are intricatelyconnected

is is the theme of some recent work (Becker and Murpheyreprinted in Becker 1993) integrating human capital coordination ofteam production and economic progress Becker and Murphey arguethat the degree of the division of labor is governed not only by the

18ldquoWe may assume that the tasks in the collecting economy of an Australian tribeare for the most part divided in the most efficient way among the various members ofthe tribe Some are hunters others are fishermen and still others are occupied exclu-sively with collecting wild vegetable foods We may imagine the division of laborof the tribe to be carried still further so that each distinct task comes to be performedby a particular specialized member of the tribe [e improvement in allocation andthe increase in production that results from this] is very different from that which wecan observe in actual cases of economically progressive peoplesrdquo (Menger 197672ndash73)Essentially the same point was made at length by T W Schultz (1964)

HUMAN CAPITAL 215

extent of the market as Smith would have it but also by ldquothe costs ofcombining specialized workersrdquo We have already discussed problemsof team production that manifest in principal-agent difficulties freeriding communication difficulties and the like Becker and Murpheysuggest that these considerations ldquoimply that the costs of coordinatinga group of complementary specialized workers grows as the numberof specialists increasesrdquo (ibid300) More specifically

e productivity of specialists at particular tasks depends onhow much knowledge they have e dependence of special-ization on knowledge available ties the division of labor to eco-nomic progress since economic progress depends on growth inhuman capital and technologies (ibid300)

As societies progress they become more complex in the sense thattasks become more specialized is echoes the views of Lachmannand Boumlhm-Bawerk It is in this sense that progress implies a greaterdegree of roundaboutness We see this in the specialization of theprofessions (for example in physicians with their specializations andsubspecializations) and in the way in which new industries developMuch of this increased specialization ldquohas been due to an extraordi-nary growth in knowledgerdquo (ibid307) is knowledge embodied inthe human capital of specialized workers not only raises the averageproduct of each worker but also raises the marginal product of thelarger team Teams may be within or between firms Specialized mem-bers of a team who are employed by the same firm get coordinated bythe rules and routines of the firm Specialists who are employed bydifferent firms have their activities coordinated by contracts and otheragreements across firms

e modern market economy as Hayek (1945) has pointed outfacilitates the coordination of larger more complex teams than wouldbe possible in other types of economy And larger and more complexteams facilitate economic progress19 So teams get larger and workersbecome more specialized and expert over a smaller range of skills as

19ldquoIt is the extensive cooperation among highly specialized workers that enablesadvanced economies to utilize a vast amount of knowledge is is why Hayekrsquosemphasis on the role of prices and markets in combining efficiently the specializedknowledge of different workers is so important in appreciating the performance ofrich and complex economiesrdquo (Becker and Murphey 1993308)

human capital and technology grow While in Smith causation goesfrom the division of labor to greater knowledge in Becker and Mur-phey it also goes from greater general knowledge to a more extensivedivision of labor and greater task-specific knowledge

ere are important complementarities between different types ofhuman capital20 In particular general knowledge is usually comple-mentary with investments in task-specific knowledge (adding anotherdimension to the distinction between specific and general human cap-ital discussed earlier) us increasing general knowledge increasesthe demand for specific knowledge By the same token increases ingeneral scientific and other knowledge together with the decline incoordination costs that a mature market system brings raise the bene-fits from greater specialization Declining transportation costs raisingthe effective size of the market are seen by Becker and Murphey as analternative and additional explanation but this may be equally seen

20Although he oen does not seem to see the significance of this and indeed some-times claims to assume exactly the opposite Becker (and his collaborators in this work)clearly see human capital as a heterogeneous structure much in the same way as Lach-mann thinks of physical capital structures that is in which the elements are cruciallycomplementary Another example ldquoAn important function of entrepreneurship isto coordinate different types of labor and capitalrdquo (ibid305 italics added) Perhapssurprisingly this is clearly recognized by the founder of the concept of human capitalT W Schultz who states

I have argued that while a strong case can be made for using a rigor-ous definition of human capital it will be subject to the same ambigui-ties that continue to plague capital theory in general and the conceptof economic growth models in particular [Particularly problematic]is the assumption underlying capital theory and the aggregation ofcapital in growth models that capital is homogeneous Each form ofcapital has specific properties a building a tractor a specific type offertilizer a tube well and many other forms not only in agriculturebut also in all other production activities As Hicks has taught us thiscapital homogeneity assumption is the disaster of capital theory Itis demonstrably inappropriate in analyzing the dynamics of economicgrowth whether capital aggregation is in terms of factor costs orin terms of the discounted value of the lifetime services of its manyparts One of the essential parts of economic growth is thus con-cealed by such capital aggregation (Schultz 198110ndash11)

It does not seem as though this insight has permeated the human capital literature ingeneral

HUMAN CAPITAL 217

as a particular aspect of the growth of knowledge and a decrease incoordination (communication) costs

It is important to emphasize that the incentive to invest in knowl-edge depends partly on the degree of specialization In this way the es-sential and vital complementarities between different types of knowl-edge is brought out At the economy level investments in knowledgeare not subject to diminishing returns in the usual way that invest-ments in physical capital are thought to be (but remember our dis-cussion on growth theory above in Chapter 5) Greater knowledgeraises the productivity of further investment in knowledge (ibid312)Greater specialization enables workers to absorb knowledge more eas-ily which tends to offset the tendency toward diminishing returnsus complementarities obviously exist within as well as betweenindividual workers One has to learn how to learn and having done socan learn more easily and productively (we will return to this below)

According to Becker and Murphey the increasing returns associ-ated with the division of labor and the accompanying accumulation ofknowledge are garnered by increasingly more ldquoroundaboutrdquo produc-tion of human capital All people who help produce human capitalare called ldquoteachersrdquo e human capital of the economy is ldquoproducedrdquoover many succeeding generations ldquoe human capital of workers inlater periods is produced with more lsquoroundaboutrsquo methods and hencelonger lineages than the human capital of workers in earlier periodsrdquo(ibid316) So the effects of human capital accumulation on the degreeof specialization implies that members of more roundabout sectorstend to specialize in a narrower range of tasks is provides someinsight into the ldquoevolutionrdquo of human capital All surviving humancapital is of relatively old vintage-lineage

Becker andMurpheyrsquos vision complements the endogenous growthliterature (see Chapter 5) in explaining the absence of any tendencytoward diminishing returns in expanding economies and in explainingwhy human capital tends to migrate toward them rather that towardless developed and more slowly expanding economies Rates of returnon investment in knowledge depend on the costs of coordinating spe-cialized workers

Countries with lower coordination costs due to stabler andmore efficient laws or other reasons not only have larger

outputs but they also tend to grow faster because lower costsstimulate investments in knowledge by raising the advantagesof a more extensive division of labor (ibid314)

In sum ldquoAn analysis of the forces determining the division of laborprovides crucial insights not only into the growth of nations but alsointo the organization of product and labor markets industries andfirmsrdquo (ibid318)

Human Capital and the Family

Introduction

Among the changes that have occurred in the twentieth century per-haps none is more profound than the changes that have occurred in thenature and role of the family in the economy and in society as a whole

e family in the Western world has been radically alteredmdashsome claim almost destroyedmdashby events of the last threedecades e rapid growth in divorce rates has greatly increasedthe number of households headed by women and the number ofchildren growing up in households with only one parent elarge increase in labor force participation of married womenhas reduced the contact between children and theirmothers andcontributed to the conflict between the sexes in employment aswell as in marriage e rapid decline in birth rates has reducedfamily size and helped cause the increased rates of divorceand labor force participation of married women Converselyexpanded divorce and labor force participation have reducedthe desire to have large families (Becker 19911)

Among those women who were married for the first time in the 1950sless than 15 percent have been divorced whereas the comparable num-ber for those first married in the 1980s is around 60 percent e aver-age household size has declined by one-third since the end of the nine-teenth century Female-headed households increased from 15 to 31 per-cent of all households (in the United States) between 1950 and 1987Labor force participation rates of women especially married womenrose precipitously in all of the advanced economies of the world in thepostwar period (see Becker 1991 and the references therein)

HUMAN CAPITAL 219

Economists have generally not shown much interest in the familyand where they have it has been primarily from the point of view ofpopulation growth Changes in fertility are a major determinant ofchanges in population growth and these affect not only the size of thepopulation at any given point in time but also the age compositionof the population through time In this regard the most famous con-tribution is that of Malthus Even here however subsequent to thediscrediting of the dire predictions of Malthusian theory economistspaid very lile aention to the determinants of population growth andsimply took it to be ldquoexogenously givenrdquo as for example in growth eco-nomics e human capital ldquorevolutionrdquo introduced a new and richerperspective on population questions e human capital approach infact began with this new look at population In a very influentialarticle Jacob Mincer (1962) argued persuasively that the labor forceparticipation of married women was determined not only by theirearnings but also by the earnings of their husbands the number ofchildren they have and other aspects of the family In this way itwas seen that population influences the economy not only by its sizeand composition but in a more detailed way by the degree and typeof participation of the elements of the population in work and otheractivities And these in turn are the results of ldquoendogenousrdquo forcesbasic economic decisions involving intertemporal planning

While economists are used to analyzing the decisions of economicagents with regard to their consumption paerns hours of work in-vestment prospects and the like they have tended to ignore thosedecisions relating to marriage children health and other ldquopersonalrdquomaers But this dichotomy between ldquopersonalrdquo and ldquoeconomicrdquo mat-ters is surely an artificial one that can be maintained only at the riskof ignoring important aspects of both People aer all do not makesuch decisions in isolation one from the other Rather they makeand change lifetime plans involving jointly work marriage leisurechildren and retirement Each of these decisions influences and isinfluenced by the others in ways on which economic reasoning canthrow considerable light is is the project of the ldquofamily economicsrdquothat Gary Becker deals with in much of his work and most particularlyin his A Treatise on the Family (1991 second enlarged edition)

Children

e unprecedented rise in labor market opportunities available forwomen in this century (as caused for example the rapid expansionof the service sector) manifesting in an increase in the relative wagerate earned has changed the value of time spent in the home by bothhusband and wife is is the major cause of the increased partici-pation of married women in the labor force e traditional divisionof labor between husband and wife has become less advantageous orldquomore expensiverdquo More families have decided that they cannot affordfor the wife not to work and forgo the second source of income isincrease in the opportunity cost of the wifersquos time has meant that allthose things that are produced in the household that intensively useher time have become ldquomore expensiverdquo is includes children

Childcare is a very time-intensive activity especially involvingthe time of the mother when the child is still young us the de-cline in fertility according to this perspective is simply a reflectionof a decline in the demand for children It is a reflection also of ashi with urbanization of the changing role of children in the familyWhereas in traditional societies children are an important source ofwealth both in the form of labor and as a form of social security inmodern urbanized societies this is no longer true Children are desiredmore exclusively as ends in themselves and can no longer be relied onas sources of wealth is reinforces the effect of an increasing cost oftime in making them more expensive21

e decline in the average size of the family has been accompaniedby an increase (both absolutely and relatively) in the amount spent on(invested in) the smaller number of children ere has been a shiaway from ldquoquantityrdquo to ldquoqualityrdquo (Becker 1991ch 5) In importantrespects this development stands the Malthusian model on its headIt is true that other things constant an increase in incomes leadsgenerally to an increase in the demand for children and therefore toan increase in family size which reduces income per capita WhatMalthus neglects are the implications of an increase in the value of

21An explanation in terms of the advances in the technology of birth control hasbeen investigated and found wanting ere is historical evidence to suggest thateffective forms of birth control have always been readily (cheaply) available (Becker1991)

HUMAN CAPITAL 221

time Other things are not constant when incomes rise as a result ofan increase in earnings from work (as contrasted for example withan increase in property or inherited income) A rise in the earningsrate of a family member increases the cost of using that memberrsquostime in household activities and when this applies to women theimplication is a substitution effect away from children toward othertypes of expenditure that (if it is strong enough) will outweigh theMalthusian income effect In addition with rising incomes and thechanging role of children there is a tendency to ldquowant more for onersquoschildrenrdquo that is an increase in the demand for ldquochild qualityrdquo

We saw earlier that differences in earnings among people couldbe explained by the interaction of ldquoabilitiesrdquo and ldquoopportunitiesrdquo Wecan see now that these ldquoabilitiesrdquo are most likely largely determinedby the kinds of family decisions that we are discussing e qualityand quantity of human capital invested in children is profoundly in-fluenced by parentsrsquo lifetime decisions concerning family size laborforce participation and the division of labor in the home investmentsin physical and financial assets and the success or failure of marriages

e Family and the Division of Labor

Considering the family as a productive unit one gains insights into thetype and extent of the division of labor within it As expected at anypoint of time the division of household tasks for the accomplishmentof mutually beneficial outputs is determined by the perceived compara-tive advantages of the various family members We abstract here fromthe question of how and by whom decisions within the family aremade although clearly this is a relevant determinant of the allocationof tasks Given a particular decision-making regime the perception ofcomparative advantages will be important e same principles thatgovern the identification of the gains from trade in an internationaltrade context (or in any market context) operate as well within organi-zations in general and within the family in particular And just as hasbeen recently emphasized in the international trade literature (Krug-man 1991) so with the family the degree and type of specialization isat least in part endogenously determined over time by the investmentdecisions of the traders Resources are not simply given

e rising wage rates of married women has meant an increase in

the cost of their home time and an economizing of it within the familyis has implied a reduced division of labor within the household agreater sharing of traditionally specialized tasks is has as we haveseen also implied a decline in the size of families a reduction in thenumber of children per family ese developments have in effectreduced the gain frommarriage and increased the likelihood of divorceAnd an increase in the likelihood of divorce has in turn reduced theadvantages of specialization within the family

e incentive to invest in human capital specific to a particularactivity is positively related to the time that one anticipates will bespent on that activity e traditional division of labor between menand women with men specializing in the accomplishment of market-oriented tasks andwomen specializing in the accomplishment of house-hold-oriented tasks is predicated on the assumption that men wouldspend a sizeable proportion of their time in the labor market and moreimportantly that women would spend the bulk of their time in thehome As a result men tended to invest primarily in market-specifichuman capital and women in household-specific human capital usthe traditional division of labormay not be the result of (large) intrinsicdifferences between people in general or between the sexes in particu-lar but rather are the path-dependent result of decisions to specializeBecause of complementarities in learning and between different typesof specific human capital investments in specialized human capitalproduce increasing returns and thereby provide a strong incentive forthe division of labor even among basically identical people Initiallysmall differences between people become over time transformed intolarge observed ones (Becker 199157ff)

Divorce

As the amount of time that women anticipate spending in the homehas gone down their incentive to invest in household-specific humancapital has diminished and this has reinforced the move away from thetraditional division of labor In addition as the probability of divorcehas risen the incentive of women to invest in ldquomarriage-specificrdquo hu-man capital has likewise diminished To some extent the acquisitionof market skills by women is a type of ldquodivorce insurancerdquo as it is they

HUMAN CAPITAL 223

who are most likely to obtain custody of any children and to have toprovide for them (the degree of contributions by divorced fathers beingnotoriously low) Expectations of divorce are in this way partly self-fulfillingmdashthe perception of reduced gains from marriage has led to areduced commitment to marriage

ere is an element of paradox in this It is almost as if to someextent people marry in the expectation of geing divorced Yet funda-mentally divorce is a result of plan failure it is an indication that themarriage has failed It is in this sense an indicator of disequilibriumin the ldquomarriage marketrdquo Another way of looking at it is to see thegains from marriage as having become more uncertain inviting theprovision of more contingency planning Just as rapidly changing tech-nologies have implied the expectation of a reduced tenure within firmsthe disappearance of the career track so these same changes have im-plied a ldquoreduced tenurerdquo of marriage Women are more economicallymobile more commied to market production and less able to relyon the contributions of their potential spouses ey therefore investless in marriage and get divorced much more oen And while it istrue that men are investing more in household- and marriage-specifichuman capital than they used to this is much too weak to offset themuch larger change in the status and role of women (See Horwitz andLewin (2008) for a more extensive discussion)

Conclusion e Evolution of the Family

e momentous changes in the familymdashin fertility divorce and thedivision of labormdashcan thus be seen as a response (to some extent anunconscious one) to the rapid changes of our technologically advancedsociety and the uncertainty that it implies

Traditional societies have enormous problems coping with uncer-tainty and changes in knowledge (Becker 1991ch 11) Societies ex-emplified by traditional farming and hunting (fishing) economies donot experience rapid and cumulative changes in techniques In suchsocieties the family or more accurately the kinship group or extendedfamily is very important in protecting members against uncertaintye family serves as both a social and a productive unit e character-istics of the members of the group are well known and their behavior

is easily (inexpensively) monitored since they live together or closeby Elders are venerated because of their knowledge the value of theirspecific human capital is knowledge is particularly valuable in sta-tionary societies where it can be passed down to younger generationsthrough the family mainly via the cultural inheritance of childrennephews and other young relatives In such societies occupationaltracks across generations coincide with families Families can be con-sidered as small specialized schools that train graduates for particularoccupations and accept responsibilities for aesting to qualificationsand suitability for certain tasks especially where such is not easilyascertained (ibid344)

In dynamic economic environments where technologies incomesand opportunities change rapidly the knowledge accumulated by oldermembers of society is much less useful especially to youngermemberse young face a different and continually changing environmentGeneral human capital (acquired in large schools) becomes much morevaluable e ability to adapt becomes crucial e importance ofkinship thus declines Market insurance replaces reliance on the familyMarket contracts replace informal family contracts Members of thekin scaer Individualism replaces group identity

ere is some indication that the above trends in fertility divorceand the division of labor may be slowing down and even partiallyreversing perhaps with a renewed appreciation or reappraisal of thecosts they have entailed In particular as Becker has argued familiestend to be held together by altruism by sharing of concerns acrossfamily members and those families that behave more altruisticallytend to be more socially and economically successful Altruism is inthis way ldquoselectedrdquo

[A]ltruistic parents tend both to have larger families and tospend more on each child than selfish parents with equal re-sources If children ldquoinheritrdquo culturally or biologically a ten-dency to be like their parents families with greater altruismwould become relatively more numerous over time

(Becker 19918ndash9)

It remains to be seen what this implies for the nature of the family inthe future

CHAPTER 12

Human Capital the Nature of Knowledgeand the Value of Knowledge

Introduction e Implicit Tension

To create knowledge is not to fathom or command it or ownit All knowledge is born and forever dwells behind a veil thatis never shed Aer their birth bodies of knowledge remainforever unfathomed and unfathomable ey remain foreverpregnant with consequences that are unintended and cannotbe anticipated (Bartley 199032)

Having reviewed some of the implications of the human capital ap-proach we may now return to an unfinished theme started in theintroduction to the previous chapter Human capital refers to the per-ceived value of accumulated knowledge in various contexts Yet ashas been noted at various points in this work knowledge is a verydifficult phenomenon to analyze e term ldquoknowledgerdquo encompassesan enormous amount It underlies every action every thought Itis riddled with paradoxes and self-references On the one hand itis certainly clear as suggested above that an essential aspect of eco-nomic development and progress lies in the existence and growth ofvast bodies of knowledge On the other hand although knowledge isoen consciously and purposefully acquired (ldquoproducedrdquo) in recogni-tion of its necessary role as a facilitator of growth and developmentthere are aspects of knowledge that cannot be purposefully acquiredbecause they cannot be perceived ahead of time ere is a real sensein which ldquoknowledge of knowledgerdquo is an impossibility In this sectionwe aempt a resolution of this implicit tension How can knowledgeat once be consciously produced and an unfathomable phenomenon

Part of the resolution lies in recognizing that the phenomenon werefer to as ldquoknowledgerdquo is jam-packed with many diverse subphenom-ena ere are many different dimensions that emerge when knowl-edge is ldquounpackedrdquo Along some of these dimensions knowledge canbe shown to be fallible unfathomable inexpressible and tacit

Knowledge is Fallible

One dimension along which one can think about knowledge is its truth-fulness its fallibility Following the work of Karl Popper it is widely(though perhaps not universally) held that knowledge is and must al-ways be fallible Todayrsquos valid theories may be refuted tomorrowAlthough he was talking primarily about scientific knowledge Pop-perrsquos work can be (and has been) applied to knowledge in general withscience seen as a metaphor for all knowledge

My interest is not merely in the theory of scientific knowledgebut rather in the theory of knowledge in general Yet the studyof the growth of scientific knowledge is I believe the mostfruitful way of studying the growth of knowledge in generalFor the growth of scientific knowledge may be said to be thegrowth of ordinary human knowledge writ large

(Popper 1989216)

All knowledge according to Popper is accumulated by trial-and-errorelimination of error In scientific endeavors the elimination of error ismore conscious than in everyday life but the process is essentially thesame An implication is that all bits of knowledge all theories are atbase ldquoconjecturesrdquo held with a greater or lesser degree of confidenceAnd conjectures can never be positively justified or verified althoughthey can (ideally) be refuted All knowledge is thus tentative to somedegree ere can be no ultimate and absolute knowledge Knowledgeis always fallible1

A model in which human capital is purposefully accumulated inresponse to the accurate perception of its benefits is thus if we followPopper an inadequate depiction of the truth More importantly it

1For an interesting application of Popperrsquos ideas to the understanding of entrepre-neurship see Harper (1996)

HUMAN CAPITAL amp THE NATURE amp VALUE OF KNOWLEDGE 227

would seem to be inappropriate as an aid to understanding how andwhy knowledge is accumulated For such a model presupposes that aparticular and certain (infallible) stock of knowledge exists (or couldbe produced) and is available to be replicated and distributed Yet ifon the contrary all knowledge is tentative how is it that people areable to make decisions regarding the acquisition of something whoseproperties are inherently and radically (as opposed to probabilistically)uncertain

Knowledge is Unfathomable

A related but distinct and more subtle dimension that can be used tothink about knowledge is its understandability its fathomability eunfathomability of knowledge transcends its fallibility ldquoUnderstand-ingrdquo is related to but is different from knowledge It is not easy toexplain what understanding is (one suspects to anticipate that there isan element of tacitness to it) Various aspects of cognition defy verbalexpression Bartley hazards

To understand what a theory asserts will require among otherthings understanding its logical implications its content and itscontext what historical problem situations it addresses whatproblems it can solve and how it interconnects logically withother theories Among these preconditions for understandingthe hardest to understand (sic) and to characterize and conveyadequately is the idea of content even though or perhaps be-cause we all have an intuitive idea of what must be involved

(Bartley 199034)

In exploring ways to characterize content Bartley defines two relatedconcepts logical content and informative content Together they makeup the objective content of a theory or body of knowledge

1 e logical content of a theory (or a body of knowledge) is allthe non-tautological consequences that can be logically derivedfrom it All statements that follow logically from it as well asfurther implications that result from combining this theory withother theories proposed or assumed are part of its logical con-tent ldquoIt is well known that the logical content of any theorymust be infiniterdquo (ibid35)

2 e informative content of a theory is the set of statements thatare incompatible with it It is also infinite e more a theoryforbids the more it says To say that it will either rain today or itwill not is not very informative and does not exclude very muchof interest

e logical and informative contents are distinct but related e el-ements of the informative content of a theory stand in a one-to-onecorrespondence to the elements of the logical content of a theory iscan be seen by realizing that for every element in either set there is inthe other set its negation ldquoHence the logical and informative contentof a theory increase and decrease togetherrdquo (ibid36) To explain theinfinite size of the informative content of any theoretical system andtherefore of its logical content Bartley uses the well-known exampleof the relationship between Newtonrsquos and Einsteinrsquos theories of gravi-tation

Call Newtonrsquos theory 119873 and Einsteinrsquos 119864 Any statement ortheory that is incompatible with 119873 will belong to the informa-tive content of 119873 and similarly any statement or theory that isincompatible with 119864will belong to the informative content of 119864Since Newtonrsquos and Einsteinrsquos theories are mutually incompati-ble each belongs to the informative content of the other [But]Einsteinrsquos theory is not simply incompatiblewithNewtonrsquos it ishistorically connected with it in the important sense of havingsuperseded it It has superseded it in the sense that Newtonrsquostheory is inadequate to the facts and that Einsteinrsquos theoryappears to come closer to the truth is illustrates that anynew theory that supersedes a reigning theory has to belongto the informative content of the superseded theory [us wemay say] any existing theory includes in its informative contentany theory that will eventually supersede it and in its logicalcontent the denial of any theory that will eventually supersedeit (ibid36ndash37)

is should be sufficient to illustrate the sense in which it can beclaimed that knowledge is a product not fully known (or knowable)to its creator eoretical systems have objective content beyond theaccessibility of any individual mind e full extent of a theory cannever be fathomed e content of Newtonrsquos theory is not identicalwith Newtonrsquos thoughts or opinions about it

Bartley points out that the meaning and relevance of any theoret-ical system in the sense of the common understanding of it at anyparticular time is in an important way a historical maer as well aspartly a maer of logic e significance of a theory ldquodepends on whathas been discovered at a certain time in the light of the prevailingsituation about the theoryrsquos content it is as it were a projection ofthis historical problem situation upon the logical content of the theoryrdquo(Popper 197628) Bartley calls this projection the ldquoaccessed slicerdquo of theobjective content of a theory

e historical relevance of a theory suggests that its meaning haslile to do with the particular words and terms used in it Almostany statement may be rendered in different terms without change inmeaning In fact meaning and objective content are not identical emeaning relevance and common understanding and thus also theeconomic value of a theory (or a body of knowledge) ldquoshis as weuncover more of or gain access to a larger slice of its objective logicaland informative contentrdquo (Bartley 199038)

Knowledge existing at any point in time is reflected in the ldquoknowl-edge objectsrdquo to which it gives rise Books tapes and computer pro-grams are obvious examples But in an important sense a pharmaceu-tical drug a machine or a bunch of keys are also ldquoknowledge objectsrdquo

What is crucial [in our present context] about an item of objec-tive knowledgemdasha book or a pill for instancemdashis its potentialfor being understood or being utilized in some way that hasnot yet been imagined a potential that may exist without everbeing realized (ibid44)

Bartley is here (unconsciously) pointing toward the essential and se-quential complementarity of knowledge elements and an importantand unnoted implication of this e value of any item of knowledge de-pends crucially onwhat is already known Expectations of the prospec-tive value of any knowledge object depend on what has already beenlearnt about it in existing applications So for example the valuableuse of many medical drugs arises out of imaginative conjectures andserendipitous extensions to applications other than those for whichthey were created (like the use of blood pressure medicine to aid inthe growth of hair) So the creation of the objects or indeed theteaching of any theory could not have been completely connected

to and could not have taken full account of their prospective uses(because of the impossibility of acquiring the knowledge on whichthose uses will depend) although retrospectively one can (in principle)trace out the changing influences on their values Since knowledge as aproduct is sequentially complementary and since future knowledge isunavailable the productivity of knowledge can never really be knownahead of time One may again question the sense in which individualmotivations can be captured in observed (calculated) rates of return tothe accumulation of human capital

e fact that knowledge is unfathomable that its objective con-tent is beyond the reach of any human mind is another aspect of thedifference between information and knowledge As we have notedinformation may be traded although knowledge may not We see nowthat information is pregnant with meaning but that meaning may notalways be and frequently will not be available to any individual be-cause its objective content is infinite It is the content of knowledgethat in a sense extends beyond the individual knower not the knowl-edge itself which is subjective and contextual What is valued in themarketplace is the accessed slice of any particular body of knowledge

Demand for an item of knowledge to the extent that it is avail-able in the marketplace will be based on dispersed subjectiveunderstandings or estimates of or preferences for its accessedslice and on speculations about its potentialities It will notand cannot be based on its objectivemdashunfathomable and au-tonomousmdashlogical and informative content is is not avail-able or readily accessible for anyone to value

(Bartley 199048)

Knowledge is Tacit

Knowledge can also be thought about in terms of its explicitness Ithas been recently acknowledged in a number of different contextsmdashinthe philosophy of science (Polanyi 1958)2 economics and political econ-

2Polanyi (1958) (and related work) is the best known but the work of many di-verse and oen seemingly inconsistent philosophers of science like Popper Kuhnand Lakatos all arguably imply a similar conclusion with regard to the question oftacit knowledge For a remarkablemdashthough necessarily incompletemdashsurvey that mo-tivates this position see Lavoie (1985bappendix)

omy (Hayek 1979) and even recently in the theory of business manage-ment and organization (Nonaka and Takeuchi 1995)mdashthat knowledgeis at least in large part tacit in nature is distinction between tacitand explicit knowledge is related to the dimensions of fallibility andfathomability Our acceptance of and our understanding of bodiesof knowledge rest necessarily on tacit (unarticulated and frequentlyinarticulable) rules conventions and inclinations e question raisedhere is if tacit knowledge is as it must be part of human capital howis it valued and how is it produced If we do not even ldquoknowrdquo what itreally is how is it that we are able to ldquoteachrdquo it If it cannot be taughthow is it transmied and acquired

A particularly relevant and well-known application of the impor-tance of tacit knowledge emerged from the ldquosecond roundrdquo of the so-cialist calculation debate particularly in the work of Hayek (and theseminal article that followed it surely one of the most widely quotedarticles in economics (Hayek 1945)) It has since permeated (as we sawabove) into the theory of the business organization particularly in theprolific work of Herbert Simon and of Oliver Williamson

Hayek argues that the economic problem does not consist in achiev-ing the best allocation of resources among the various means availableas though the means and ends were somehow given and known

e economic problem of society is not merely a problem ofhow to allocate ldquogivenrdquo resourcesmdashif ldquogivenrdquo is taken to meangiven to a single mind which deliberately solves the problemset by these ldquodatardquo It is rather a problem of how to secure thebest use of resources known to any of the members of societyfor endswhose relative importance only these individuals knowOr to put it briefly it is a problem of the utilization of knowledgewhich is not given to anyone in its totality

(Hayek 194577 italics added)

Knowledge is dispersed and it is specialized Individuals have specialknowledge of ldquotime and placerdquo and they are oen not even aware ofthe knowledge that they have e implications of this for the impos-sibility of central planning have been well covered (see for exampleLavoie 1985ab Kirzner 1992ch 6) e fact that much of our knowl-edge is tacit and inarticulate and unconscious places insurmountablebarriers in the way of would-be central planners trying to duplicate

the achievements of decentralized market systems It is not simply aproblem of the technical difficulty of collecting and processing all ofthe relevant information It is furthermore the impossibility of beingable to

1 extract from this information the necessary knowledge2 know what needs to be known when the individuals in posses-

sion of the necessary knowledge might not even be aware thatthey have it

3 gather the necessary information when much of it has yet to begenerated by the market process

e market indeed is a process that coordinates inarticulate knowl-edge by continual and implicit trial and error e ldquoknowledgerdquo pos-sessed by different individuals is oen inconsistent How then couldit possibily be centralized

e tacitness of knowledge is thus of singular importance in un-derstanding the market process Its importance is further enhancedby a realization that all articulated knowledge rests on unarticulatedfoundations e component parts of any statement accepted as true(one plus one equals two) include undefined words which cannot becompletely defined Requiring a complete articulation of all termspushes us into either an infinite regress or into circular reasoning3

And moreover the very act of formulating any general statementnecessarily requires using rules of proper statement formulationwhichare themselves inarticulate For example in describing real situationswe must always select certain abstract qualities to which we wish todraw aention is implies that nothing can be completely articu-lated since the very process of articulation involves abstracting fromreal features of the phenomenon being described (Lavoie 1985b60 alsoHayek 1967 and 1973) Perhaps the most graphic illustration of thenecessity of tacit knowledge is the way that children learn languageA child who usually does not learn the rules of grammar early in life ifever can nevertheless construct grammatically correct sentences isis evidence of the kind of tacit knowledge that underlies all articulated

3ldquoIt was Alfred North Whitehead (196895) who so concisely pointed out lsquothere is not a sentence which adequately states its own meaning ere is alwaysa background of presupposition which defies analysis by reason of its infinitudersquo rdquo(Lavoie 1985b60)

knowledge ldquoIt is only because our minds are capable of operatingaccording to effective rules of which we are unaware that we are ableto learn to speak a languagerdquo (Lavoie 1985b61) Another example is theact of riding a bicycle and other acquired skills ldquoArticulation then isjust one kind of skill that we learn without knowing precisely how weaccomplish itrdquo (ibid62)

e fact that all knowledge is in part tacit and that all explicitknowledge rests on tacit foundations implying that knowledge cannever be made fully explicit raises interesting questions for the eco-nomics of information in general and human capital in particular

Equilibrium and the Nature of Knowledge

Many aspects of the human capital model suggest the assumption thatagents operate in a context of equilibrium In particular there is thesuggestion that the data historically observed in the labor market onearnings in relation to education and training are to be thought of asvalid and accurate guides to the decisions that brought the data about(and for that maer to decisions relating to the current future) isimplies that the projections that motivated the decisions are borne outby the outcomes that resulted and that there are no inconsistencies inthe perceptions and plans of the various decision-makers It impliesin short a Hayekian equilibrium (see Chapter 3)

If this were true we would have to conclude that the human capitalapproach not only abstracts from important aspects of time and changeit also begs certain important questions raised by the nature of knowl-edge discussed above If knowledge is fallible unfathomable and tacitit must be a product whose value cannot be fully known ahead of timeand whose value is continually changing e analogizing of knowledgeto a consciously produced product is fraught with pitfalls and paradoxesarising out of the fact that it is a product of unknown quality and formSo we must ask how do the seemingly valuable insights of the humancapital approach apply in a disequilibrium world

e world as we know it is and must be in disequilibrium in thesense that individuals at any given moment are operating under dif-ferent and oen inconsistent expectations and theories e outcomesthat we observe in the labor market and elsewhere are the results ofindividual decisions that have been and are bound to be to a greater

or lesser extent mistaken Just as observed financial portfolios do notrepresent except in a trivial sense optimal portfolios (ie those thatwould have been chosen if all the knowledge now available were avail-able at the time of decision) so portfolios of human capital cannot beoptimal Capital gains and losses are and must be experienced as partof the market process e market value of accumulated knowledge isan outcome that is (with rare exceptions) different from its anticipatedvalue to the extent that it can be anticipated

I would suggest however that in order tomake sense of our (tacit)understanding of the market process of our very real conviction thatpeople do accumulate education and training in the reasonable expec-tation of economic (and other) gain we re-examine our understandingof equilibrium and the nature of knowledge As was suggested in Chap-ter 3 rather than seeing equilibrium as an all-or-nothing propositionwe should realize that we are in relation to the various aspects of ourlives and the decisions we take simultaneously in both equilibrium anddisequilibrium It will be recalled that I suggested a simple tripartitetaxonomy of knowledge Knowledge type 1 (K1) is knowledge of thelaws of nature knowledge type 2 (K2) is knowledge of ldquosocial lawsrdquoof conventions routines customs etc and knowledge type 3 (K3) isknowledge of specific and unique events that have occurred (history)or will occur Knowledge types 1 and 2 are knowledge of an abstractkind knowledge of general principles (related to the natural worldmdashapples fall from trees to the ground or related to the social worldmdashpeople stop at red lights dollar notes are a generally accepted meansof payment) whereas knowledge type 3mdashhistorical knowledge andexpectations or anticipationsmdashis knowledge of specific unique events

It should be clear that K1 and K2 are necessarily fallible unfath-omable and involve tacit elements many of which are the evolvedresult of spontaneous social interaction Even knowledge of the natu-ral world is fallible as we have seen following Popper At any pointof time there will however be a (more or less widely) shared under-standing of ldquohow the world worksrdquo in Bartleyrsquos terms the ldquoaccessedslicesrdquo of the various bodies of knowledge and this will inform andhelp coordinate individual actions in important ways Similarly withldquosocial lawsrdquo of behavior many of which will be tacit to the extent thatthey are widely ldquounderstoodrdquo they will serve to harmonize important

aspects of individual plans With regard to K3 we expect there to beinconstancy and disequilibrium Since individualsrsquo plans are multilay-ered they could be and we contend are in equilibrium with respectto some aspects (like what they will do or not do if profits are notearnedmdashthey will not go to war or resort to the) while they arein disequilibrium with regard to other aspects (like being unable toanticipate accurately the level of profits or indeed the returns toinvestment in education) As we have seen however the disequi-librium aspects do not incapacitate the decision-making abilities ofeconomic agents precisely because such decisions are taken within aninstitutional environment that provides K1 and K2 with meaningfulcontent

Calculated rates of return on investments in human capital rep-resent historical outcomes but these historical outcomes will informindividual decisions to the extent that such outcomes are regarded asreliable guides to the future A priori there is very lile that one cansay in general about how likely this is It is clear that individualsdo look at educational opportunities as opportunities for economicadvancement Some of these opportunities will be regarded as morespeculative than others For example investments in general humancapitalmdashgeneralized training that is not specific to any firm or indus-try or generalized education (such as high school)mdashwill generally beregarded as being more secure than an investment in more specializedspecific training Investments in general training may be regardedas investments in K1 and K2 (their accessed slices) as may some in-vestments in certain types of specific training e uncertainty thataaches to the value of acquiring different types of knowledge is a func-tion not only of the changing fortunes of different products servicesand the technologies associated with them but also to the shiingsands of the validity of different principles and theories as new slicesare accessed e above discussion relating to general and specifictraining certainly continues to apply One should emphasize how-ever that cost and benefit calculations should be interpreted from aprospective perspective in so far as they are motivators of decisionsEvery such decision is an entrepreneurial decision with a greater orlesser degree of speculation involved In this regard human capital isno different from physical capital

ere remains the question of how tacit knowledge may be pur-posefully acquired Clearly not all such knowledge can be To theextent that we have knowledge of which we are not aware we cannothave been aware of acquiring it But there are types of tacit knowledgeof which we are aware Although we may not know exactly (fromthe point of view of physics) how it is that we learn to ride a bicyclewe do know what we have to do in order to learn e connectionbetween practice (experience) and performance provides a pragmaticor practical guide for very accurate decision-making even though wemay not know why rough trial and error we discover beer orworse ways of teaching language Apprenticeships and internships ofa very informal nature are oen effective even if they mean simplyproviding the right environment for the spontaneous emergence ofcertain skills

Conclusion

Summary

A world in which all individual plans in every relevant detail aremutually consistent is a world in which economic analysis is greatlysimplified It is a world devoid of essential change All economicvalues have universal and unambiguous meaning e capital stockthat set of productive instruments in combinations that give effectto universally perceived productive techniques has an unambiguousvalue Each productive instrument can be unambiguously valued interms of its clearly identified contribution to the valued production ofwhich it is a part And any contemplated difference (one hesitates tocall it a change) in any of the parameters of the system like the heightof any interest rate will have predictable and definite effects on thevalue of the capital stock and the other values in the system

Such a world although it strains the imagination and renders non-sensensical the meaning to be aached to the passage of time is nev-ertheless illuminating as a contrast And although it is seldom postu-lated so graphically it does form the basis of much theorizing in capitaltheory and in economic theory generally It is the implicit basis for aconception of capital as a substance analogous to a physical substancewhether valued in terms of time labor hours or any other metricAnd it is the basis for the world of ldquoperfect competitionrdquo so popularin contemporary theorizing in which no competition actually occursand in which no innovation is possible no mistakes made

An equilibriumworld in the above sense makes the connection be-tween capital and time manifest in such a way that capital can actually(and somewhat misleadingly) be expressed in terms of time In such aworld one can characterize every productive process as a process thatculminates in the production of a particular output at a particular timeIt is thus possible to connect every input to a specific part of every

output and since each output has an unambiguous value it is possibleto impute exhaustively and accurately that value to the specific inputsand it is thus possible to calculate for how long on average each inputremains in the productive pipeline

In this book I have tried to suggest that such a treatment of cap-ital is inadequate and that to the extent that it has encouraged us tothink in terms of capital stocks as ldquolongerrdquo or ldquoshorterrdquo it has beenunfortunately misleading Outside of equilibrium such notions haveno ready application Furthermore to think of capital in these termsthat is in terms of equilibrium encourages thinking of capital accu-mulation as an automatic process of value accretion It encourages akind of ldquocapital illusionrdquo an implicit conviction that by providing thenecessary financial capital or even the specific tangible instrumentsfor various capital combinations one automatically can achieve thekind of value creation that characterizes the ldquocapitalisticrdquo economiesof our real world

I have suggested a view of capital that is firmly rooted in individualplanning in a disequilibrium world Such a view sees value creation asthe result of individual decisions and suggests that to understand howsuch value is created one cannot avoid looking at the decision-makingenvironment e decision-making environment necessarily includesthe institutions of the economy and the knowledge of the decision-makers Both of these are part of the ldquocapitalrdquo of the economy I havesuggested a view of capital as a structure rather than a stock In the firstinstance the capital of an economy is embodied in the largely unde-signed network of capital combinations of individual capital goods andhuman resources is structure operates within a superstructure of(many undesigned) institutions like the institution of money of privateproperty commercial law and crucially the private firm Withinthe private productive organization that we refer to generically as thefirm capital combinations get made and changed against a backdropof shared ldquoways of doing thingsrdquo that serve to coordinate individualactions by harmonizing their expectations Certainly such institutionsas firms and the law are not rigid unchanging restraining devicesey do change But they change slowly enough to provide a reli-able backdrop for effective decision-making So the capital structureoperates within an institutional structure is institutional structure

CONCLUSION 239

encompasses and gives meaning to the financial structure the set offinancial instruments and practices that facilitate the formation andmutation of the capital structure e financial structure is volatileand cannot be designed but in its absence the capital structure has nomeaning and no value

Finally the productive structure as a whole encompassing the cap-ital structure (narrowly understood) and the institutional structure (in-cluding the financial structure) must also be seen to include the valueof human capital In fact the human capital structure is arguably themost essential (and the most difficult to replicate) ingredient of theentire productive structure Human knowledge has value It is anasset e human capital structure is however indescribably complexand unfathomable While it is possible to understand how individualdecision-makers invest profitably in certain types of knowledge acqui-sition human capital as a whole remains an unpredictable amalgamof diverse incommensurate elements many of which are unknownunarticulated and unpredictable It is one of the strengths of a marketsystem that it is able (and has been seen empirically to be able) toevolve the kind of human capital structures necessary to form thecapital structures that have brought the kind of creation of value thatmany have characterized as nothing short of miraculous4

Implications for Policy

If the above vision is correct then the accumulation of capital is morethan a quantitative phenomenon Adding to the capital of an econ-omy is a complex multidimensional process It involves not only orprimarily the addition of existing capital equipment but rather the in-troduction of progressively more technically advanced equipment theproduction of which is made possible by an institutional environmentin which the discovery of such technical advances is encouraged One

4In this book I have also suggested that the above conception of equilibrium is ina sense too broad at is it encompasses too much by requiring that all expectationsof everyone be consistent I have suggested that more restricted view in which someexpectations must be and others must not be mutually consistent In short I havesuggested that the real world of capital accumulation is one that is simultaneouslyboth in and out of equilibrium

must be clear that what is involved is indeed ldquodiscoveryrdquo rather thanthe implementation of already known techniques I am suggesting thatthe process involves a real Popperian ldquogrowth of knowledgerdquo

Capital accumulation thus necessarily involves ldquoknowledge accu-mulationrdquo It is true that capital accumulation involves the introductionof more ldquoroundaboutrdquo or more ldquocomplexrdquo methods of production asBoumlhm-Bawerk and Lachmann have suggested e real question how-ever is how do we come to know about these new and improvedmethods If the characterization of knowledge as fallible tacit andunfathomable is correct then knowledge in general is not somethingthat can be planned for in a concrete way It is a product whose valueand character cannot be fully known to its owner is has profoundimplications

e superior performance of capitalistic economies thus cannot belogically ldquoprovedrdquo e resort to the efficiency properties of perfectlycompetitive economies is not only irrelevant and misleading it is actu-ally counterproductive For the perfectly competitive model suggeststhat knowledge is a standardized product equally available to every-one including would-be central planners (as was quickly recognizedby the socialist protagonists in the socialist calculation debate) esuperior performance of capitalist economies rests rather on the factthat they do not rely on central planners (policy-makers) knowingvery much at all It is as Hayek realized (1945) rather that capitalisteconomies are able to effect a division of knowledge that facilitates theaccumulation and division of capital Knowledge is in effect econo-mized on But it is also true that capitalist economies ldquoknow morerdquoe most significant aspect of accumulation is in fact the (largely un-designed and unplanned) accumulation of knowledge

is has relevance to the efficacy of piecemeal economic plan-ning whether it be interest rate engineering antitrust regulationantipoverty planning or environmental husbanding To be effectivepolicy-makers must have or must be able to acquire knowledge ofthe relevant economic future of techniques of preferences of val-ues In addition since government action requires resources thatwould otherwise be available to private individuals who would be im-plicitly through the competitive process experimenting with varioustechniques and theories the extent of ldquodiscoveryrdquo displaced by such

CONCLUSION 241

government action is inestimable ere is literally no way to estimatethe ldquocostrdquo of government since a crucial part of that cost is the loss ofvaluable knowledge Knowledge lost cannot be known about

is is relevant also to the problem of economic development eldquotransition to capitalismrdquo cannot be simply bought Capital equipmentcan be bought Buildings can be built Experts can be hired Butrespect for private property cannot be produced A system of lawsthat interprets and innovates property rights cannot be easily acquiredA functional monetary system cannot be centrally designed and im-plementedmdashthe money has first to be accepted And the necessaryhuman capital structure in all its subtleties and depths cannot simplybe replicated Some transfers can be simply taught others can bepainfully acquiredmdashldquolearning by doingrdquo or by immersion in ldquootherculturesrdquomdashother aspects are more elusive Prosperity is a miraculousand improbable evolutionary outcome If it can be transferred at all itwill be by allowing and encouraging the local population to evolve itsown particular brand privately

Bibliography

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Alchian A and H Demsetz 1972 ldquoProduction information costs and eco-nomic organizationrdquo American Economic Review 62 no 5 772ndash795

Alchian A and S Woodward 1988 ldquoe firm is dead long live the firmA review of Oliver Williamsonrsquos e Economic Institutions of CapitalismrdquoJournal of Economic Literature 26 no 1 65ndash79

Arthur W B 1989 ldquoCompeting technologies increasing returns and lock inby historical eventsrdquo Economic Journal 99 116ndash131

1994 Increasing Returns and Path Dependency in the Economy AnnArbor University of Michigan Press

Baetjer H 1998 Soware As Capital An Economic Perspectives on SowareEngineering Los Alamos IEEE Computer Society

2000 ldquoCapital as embodied knowledge Some implications for the the-ory of economic growthrdquo Review of Austrian Economics 13 no 1 147ndash174

Bartley William Warren III 1990 Unfathomed Knowledge UnmeasuredWealth On Universities and the Wealth of Nations La Salle IL Open Court

Barzel Y 1982 ldquoMeasurement costs and the organization of marketsrdquo Journalof Management 17 99ndash120

Becker G S 1971 Economic eory New York Alfred A Knopf

1991 A Treatise on the Family second edition Cambridge HarvardUniversity Press

1993 Human Capital third edition Chicago University of ChicagoPress

Becker G S and KMurphey 1993 ldquoe division of labour coordination costsand knowledgerdquo manuscript 1993 Reprinted in Becker (1993) [1989]

Bergson H 1965 ldquoe Possible and the Realrdquo in An Introduction to Meta-physics e Creative Mind Totowa NJ Lilefield Adams 1965 TransM L Andison [1946]

Blaug M 1974 e Cambridge Revolution Success or Failure LondonInstitute for Economic Affairs

Boeke P J and D L Prychitko eds 1994 e Market Process Essays inContemporary Economics Brookfield VT Edward Elgar

Boeke P J D L Prychitko and S Horwitz 1994 ldquoBeyond EquilibriumEconomics Reflections on the Uniqueness of the Austrian Traditionrdquo inBoeke and Prychitko (1994)

Boumlhm-Bawerk E von 1959 Capital and Interest South Holland LibertarianPress 3 vols in 1

Buchanan J M and Y J Yoon eds 1994e Return to Increasing Returns AnnArbor University of Michigan Press

Chandler A D 1977eVisible Hand eManagerial Revolution in AmericanBusiness Cambridge MA e Belknap Press of Harvard University Press

1990 Scale and Scope e Dynamics of Industrial Capitalism Cam-bridge MA e Belknap Press of Harvard University Press

1992 ldquoOrganizational capabilities and the theory of the firmrdquo Journalof Economic Perspectives 6 no 3 79ndash100

Chiles T H A H Bluedorn and V K Gupta 2007 ldquoBeyond creative de-struction and entrepreneurial discovery A radical austrian approach toentrepreneurshiprdquo Organization Studies 28 no 4 469ndash493

Chiles T H C S Tuggle J S McMullen L Bierman and D W Greening2010 ldquoDynamic creation Extending the radical austrian approach to entre-preneurshiprdquo Organization Studies 31 no 1 7ndash46

Clark J B 1893 ldquoe genesis of capitalrdquo Yale Review 302ndash315

1988 Capital and Its Earnings New York Garland [1888]

Coase R 1937 ldquoe theory of the firmrdquo Economica (new series) 4 386ndash405

Collis D S and C AMontgomery 1998Corporate Strategy A Resource BasedApproa New York McGraw-Hill

BIBLIOGRAPHY 245

Corell A andW P Cocksho 1993 ldquoCalculation complexity and planninge socialist debate once againrdquo Review of Political Economy 5 no 1 73ndash112

Currie M and I Steedman 1990 Wrestling with Time Problems in Economiceory Ann Arbor University of Michigan Press

Dahlman C 1979 ldquoe problem of externalityrdquo Journal of Law and Economics22 141ndash162

Day R H and P Chen 1992Nonlinear Dynamics and Evolutionary EconomicsOxford Oxford University Press

Demsetz H 1991 ldquoe eory of the Firm Revisitedrdquo in Williamson andWinter (1991)

Dolan E G ed 1976 e Foundations of Modern Austrian Economics KansasCity Sheed and Ward

Dorfman R 1959 ldquoWaiting and the period of productionrdquo arterly Journalof Economics 73 351ndash367

Drucker P F 1993 Post Capitalist Society New York Harper Business

Ebeling R M 1986 ldquoTowards a Hermeneutical Economics ExpectationsPrices and the Role of Interpretation in aeory of the Market Processrdquo inI M Kirzner ed Subjectivism Intelligibility and Economic UnderstandingEssays in Honor of Ludwig M Lamann on his Eightieth Birthday NewYork New York University Press 1986

1997 ldquoMoney Economic Fluctuations Expectations and PeriodAnalysis e Austrian and Swedish Economists in the Interwar Periodrdquoin W Keizer B Tieber and R van Zip eds Austrian Economics in DebateNew York Routledge 1997

Evans-Prichard E E 1951 Social Anthropology London

Faber M 1979 Introduction to Modern Austrian Capital eory New YorkSpringer-Verlag

ed 1986 Studies in Austrian Capital eory Investment and TimeBerlin Heidelberg and New York Springer-Verlag

Feer F A 1977Capital Interest and Rent Essays in theeory of DistributionKansas City Sheed Andrews and McMeel Ed with intro by Murray NRothbard

Foss N J 1994 ldquoe theory of the firm e Austrians as precursors andcritics of contemporary theoryrdquo e Review of Austrian Economics 7 no 131ndash65

1995 ldquoe economic thought of an Austrian Marshallian GeorgeBarclay Richardsonrdquo Journal of Economic Studies 22 no 1 23ndash44

1996a ldquoPost-Marshallian and Austrian economics Toward a fruitfulliaisonrdquo Advances in Austrian Economics 3 213ndash221

1996b ldquoAustrian and Post-Marshallian Economics e BridgingWork of George Richardsonrdquo in N J Foss and B J Loasby eds Capabilitiesand Coordination Essays in Honor of G B Riardson London and NewYork Routledge 1998

Garrison R W 1979a ldquoComment Waiting in Viennardquo in Rizzo (1979)

1979b ldquoIn defense of the Misesian theory of interestrdquo Journal ofLibertarian Studies III no 2 141ndash150

1985 ldquoA Subjective eory of A Capital Using Economyrdquo inOrsquoDriscoll and Rizzo (1996)

1988 ldquoProfessor Rothbard and the eory of Interestrdquo in W Blockand L H Rockwell Man Economy and Liberty Essays in Honor of MurrayN Rothbard Auburn Ludwig von Mises Institute 1988

Goleman D 1995 Emotional Intelligence New York Bantam

Grossman G M and E Helpman 1990 ldquoTrade innovation and growthrdquoAmerican Economic Review 80 no 2 86ndash91

1994 ldquoEndogenous innovation in the theory of growthrdquo Journal ofEconomic Perspectives 8 no 1 23ndash44

Hahn F H 1984 Equilibrium and Macroeconomics Cambridge MA MITPress

Harcourt G C 1991 Some Cambridge Controversies in the eory of CapitalLondon Ashgate

Harcourt G C and N F Laing 1971Capital and Growth Middlesex Penguin

Harper D A 1996 Entrepreneurship and the Market Process An Enquiry intothe Growth of Knowledge London Routledge

BIBLIOGRAPHY 247

Hausman D 1981 Capital Profits and Prices An Essay in the Philosophy ofEconomics New York Columbia University Press

Hayek F A 1933 Monetary eory and the Trade Cycle London JonathanCape

1935a Collectivist Economic Planning Critical Studies on the Possibil-ities of Socialism London Routledge 1935

1935b Prices and Production London Routledge and Kegan Paul1935

1937a ldquoInvestment that raises the demand for capitalrdquo Review ofEconomic Statistics 19 174ndash177

1937b ldquoEconomics and knowledgerdquo Economica (new series) 4Reprinted in Hayek (1948)

1939 Profits Interest and Investment London Routledge

1941 e Pure eory of Capital Chicago University of ChicagoPress

1945 ldquoe use of knowledge in societyrdquo American Economic Review35 no 4 Reprinted in Hayek (1948)

1948 Individualism and Economic Order Chicago University ofChicago Press

1967 Studies in Philosophy Politics and Economics London Routledgeand Kegan Paul

1973 Law Legislation and Liberty Vol 1 Chicago University ofChicago Press

Hennings K H 1987a ldquoEugen von Boumlhm-Bawerkrdquo Entry in Capital eory(e New Palgrave)New York Macmillan 97ndash107 1987

1987b ldquoCapital as a factor of productionrdquo Entry in Capital eory(e New Palgrave)New York Macmillan 108ndash122 1987

1987c ldquoMaintaining capital intactrdquo Entry in Capital eory (e NewPalgrave) New York Macmillan 200ndash205 1987

1987d ldquoRoundabout methods of productionrdquo Entry in Capital eory(e New Palgrave) New York Macmillan 232ndash236 1987

1997 e Austrian eory of Value and Capital Studies in the Life andWork of Eugen von Boumlhm-Bawerk Brookfield VT Edward Elgar

Hicks J R 1946 Value and Capital Oxford Oxford University Press (1st edn1939)

1965 Capital and Growth Oxford Oxford University Press

1973a ldquoe Austrian eory of Capital and its Rebirth in ModernEconomicsrdquo in Carl Menger and the Austrian Sool of Economics OxfordClarendon Press 1973 Reprinted in J R Hicks (1983)Classics and ModernsCollected Essays on Economic eory vol III Cambridge MA HarvardUniversity Press 96ndash102

1973b Capital and Time A Neo-Austrian Analysis Oxford OxfordUniversity Press 1973

1976 ldquoSome estions of Time in Economicsrdquo in Tang A M F MWesterfield and J SWorley eds Evolution Welfare and Time in EconomicsLexington Brooks D C Heath 1976

Hodgson G M 1988 Economics and Institutions A Manifesto for ModernInstitutional Economics Philadelphia University of Pennsylvania Press

1993 Economics and Evolution Bringing Life Ba Into EconomicsAnn Arbor University of Michigan Press

Hoff T J 1981 Economic Calculation in the Socialist Society Indianapolis INLiberty Press [1949]

Horwitz S 1992Monetary Evolution Free Banking and Economic Order Boul-der CO Westview Press

1994 ldquoHierarchical metaphors in Austrian institutionalism Afriendly subjectivist caveatrdquo Unpublished manuscript

1995 ldquoEconomic calculation in the theory of money and creditMoney and Misesrsquos critique of planningrdquo Unpublished manuscript

1996 ldquoMoney money prices and the socialist calculation debaterdquoAdvances in Austrian Economics 3 59ndash77

Horwitz S and P Lewin 2008 ldquoHeterogeneous human capital uncertainty

BIBLIOGRAPHY 249

and the structure of plans A market process approach to marriage anddivorcerdquo e Review of Austrian Economics 21 no 1 1ndash21

Ingrao B and G Israel 1990 e Invisible Hand Economic Equilibrium in theHistory of Science Cambridge MA MIT Press

Kaldor N 1985 Economics Without Equilibrium New York M E Sharpe

Kirzner I M 1966 An Essay on Capital New York Augustus M Kelly

1976 ldquoEquilibrium Versus Market Processrdquo in Dolan (1976)

1990 ldquoKnowledge problems and their solutions Some relevant dis-tinctionsrdquo Cultural Dynamics Reprinted in Kirzner (1992)

1992 e Meaning of Market Process Essays in the Development ofModern Austrian Economics London and New York Routledge

1993 ldquoe Pure Time-Preference eory of Interestrdquo in J M Her-bener ed e Meaning of Ludwig von Mises Contributions in EconomicsSociology Epistemology and Political Philosophy Auburn Ludwig vonMises Institute 1993

1994a ldquoOn the Economics of Time and Ignorancerdquo in Boeke andPrychitko (1994)

1994b Classics in Austrian Economics London William Pickering1994 3 vols

1996 Essays on Capital and Interest An Austrian Perspective Alder-shot Edward Elgar

1997 ldquoEntrepreneurial discovery and the competitivemarket processAn Austrian approachrdquo Journal of Economic Literature XXXV no 1

2009 ldquoe alert and creative entrepreneurrdquo Small Business Economics32 no 2 145ndash152

Klein P 1996 ldquoEconomic calculation and the limits of organizationrdquo Reviewof Austrian Economics 9 no 2 3ndash28

Knight F H 1936 ldquoe quantity of capital and the rate of interestrdquo Journalof Political Economy 44 433ndash463

Kregel J A 1976 eory of Capital London Macmillan

Kresge S and L Wenar eds 1994 Hayek on Hayek An AutobiographicalDialogue Chicago University of Chicago Press

Krugman P 1991 Geography and Trade Cambridge MA MIT Press

Lachmann L M 1938 ldquoInvestment and costs of productionrdquo AmericanEconomic Review 28 469ndash481 Reprinted in Lavoie (1994)

1939 ldquoOn crisis and adjustmentrdquo Review of Economics and Statistics21 62ndash68 Reprinted in Lavoie (1994)

1941 ldquoOn the measurement of capitalrdquo Economica 8 367ndash377Reprinted in Lavoie (1994)

1944 ldquoFinance capitalismrdquo Economica 11 64ndash73 Reprinted in Lavoie(1994)

1947 ldquoComplementarity and substitution in the theory of capitalrdquoEconomica 14 108ndash119

1948 ldquoInvestment repercussionsrdquo arterly Journal of Economics 63697ndash713 Reprinted in Lavoie (1994)

1971 e Legacy of Max Weber Berkeley CA Glendessary Press

1973 ldquoSir John Hicks as a neo-Austrianrdquo South African Journal ofEconomics 41 no 1 54ndash62

1976a ldquoOn the Central Concept of Austrian Economics MarketProcessrdquo in Dolan (1976)

1976b ldquoFrom Mises to Shackle An essay on Austrian economics andthe kaleidic societyrdquo Journal of Economic Literature XIV

1978 Capital and its Structure Kansas City Sheed Andrews andMcMeel [1956]

1979 ldquoe flow of legislation and the permanence of the legal orderrdquoORDO 30 no 1 69ndash70

1986 e Market as Economic Process Oxford Basil Blackwell

1992 ldquoSocialism and the market A theme of economic sociologyviewed from a Weberian perspectiverdquo South African Journal of Economics60 24ndash43 (Posthumously published paper)

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1994 ldquoOn the Economics of Time and Ignorancerdquo in Boeke andPrychitko (1994)

1996 ldquoTime complexity and change Ludwig M Lachmannrsquos contri-butions to the theory of capitalrdquo Advances in Austrian Economics 3 107ndash165[1968]

Lachmann L M and L H White 1979 ldquoOn the recent controversy concern-ing equilibrationrdquo Austrian Economics Newsleer 2 no 1

Langlois R ed 1986a Economics as a Process Essays in the New InstitutionalEconomics New York Cambridge University Press 1986

1986b ldquoe New Institutional Economics An Introductory Essayrdquoin Langlois (1986a)

1991 ldquoe capabilities of industrial capitalismrdquo Critical Review 5 no4 513ndash530

1992 ldquoOrders and Organizations Toward an Austrian eory ofSocial Institutionsrdquo in B Caldwell and S Boumlhm eds Austrian EconomicsTensions and Directions Dordrecht Kluwer 1992

1995 ldquoDo firms planrdquo Constitutional Political Economy 6 no 3247ndash261

Langlois R and L Robertson 1995 Firms Markets and Economic Change ADynamic eory of Business Institutions London Routledge

Lavoie D 1985a Rivalry and Central Planning e Socialist Calculation De-bate in Perspective Cambridge Cambridge University Press 1985

1985b National Economic Planning What is Le Washington DCCato 1985

ed 1994 Expectations and the Meaning of Institutions Essays inEconomics by Ludwig Lamann New York New York University Press

Leijonhufvud A 1986 ldquoCapitalism and the Factory Systemrdquo in Langlois(1986a)

Lewin P 1994 ldquoKnowledge expectations and capital e economics ofLudwig M Lachmannrdquo Advances in Austrian Economics 1 233ndash256

1995 ldquoMethods and metaphors in capital theoryrdquo Advances in Aus-trian Economics 2B 277ndash296

1997a ldquoCapital in disequilibrium A reexamination of the capitaltheory of Ludwig M Lachmannrdquo History of Political Economy 29 no 3523ndash548

1997b ldquoRothbard and Mises on interest An exercise in theoreticalpurityrdquo Journal of the History of Economic ought 19 1ndash19

1997c ldquoHayekian equilibrium and changerdquo Journal of EconomicMethodology 4 no 2 245ndash266

1997d ldquoCapital and time Variations on a Hicksian themerdquo Advancesin Austrian Economics 4 63ndash74

1998 ldquoe firm money and economic calculationrdquo American Journalof Economics and Sociology 57 no 4 499ndash512

Lewin P and H Baetjer 2011 ldquoe capital-based view of the firmrdquo Reviewof Austrian Economics (forthcoming) Published online April 2011

Liebowitz S J and S E Margolis 1994 ldquoNetwork externality An uncommontragedyrdquo e Journal of Economic Perspectives 8 no 2 133ndash150

Lindahl E 1929 ldquoe Place of Capital in the eory of Pricerdquo in Lindahl(1939a)

1939a Studies in the eory of Money and Capital London GeorgeAllen and Unwin 1939

1939b ldquoe Dynamic Approach to Economic eoryrdquo in Lindahl(1939a)

Loasby B 1991 Equilibrium and Evolution An Exploration of ConnectingPrinciples in Economics Manchester Manchester University Press

1994 ldquoEvolution within equilibriumrdquo Advances in Austrian Eco-nomics 1 69ndash11

Lucas R E 1990 ldquoWhy doesnrsquot capital flow from rich to poor countriesrdquoAmerican Economic Review 80 no 2 92ndash96

Lutz F A 1967 e eory of Interest Dordrecht D Reidel

Machlup F 1958 ldquoEquilibrium and disequilibrium Misplaced concretenessand disguised politicsrdquo Economic Journal 68 Reprinted in F MachlupEssays in Economic Semantics New York W W Norton 1967

BIBLIOGRAPHY 253

Maclachlan F C 1993 Keynesrsquo General eory of Interest A ReconsiderationLondon and New York Routledge

Marshall A 1949 Principles of Economics London Macmillan

Masten S E 1991 ldquoA Legal Basis for the Firmrdquo in Williamson and Winter(1991)

McCloskey D N 1985 e Rhetoric of Economics Madison University ofWisconsin Press

Menger C 1976 Principles of Economics New York New York UniversityPress [1871]

1985 Investigations into the Method of the Social Sciences with SpecialReference to Economics New York New York University Press [1883trans 1963]

Mincer J 1962 ldquoOn-the-job training Costs returns and some implicationsrdquoJournal of Political Economy 70 no 5 50ndash79

1974 Sooling Experience and Earnings New York Columbia Uni-versity Press

Minkler A P 1993 ldquoKnowledge and internal organizationrdquo Journal of Eco-nomic Behavior and Organization 21 no 1 17ndash30

Mises L von 1920 ldquoEconomic Calculation in the Socialist Commonwealthrdquoin Hayek (1935a)

1927 Liberalism in the Classical Tradition Irvington on the HudsonNew York Foundation for Economic Education (Reprinted 1985)

1957 eory and History New Haven Yale University Press

1966 Human Action Chicago Henry Regnery [1949]

1971 e eory of Money and Credit ninth edition New YorkFoundation for Economic Education [1912]

1981 Socialism Indianapolis IN Liberty Classics [1922]

Nelson R R and S G Winter 1982 An Evolutionary eory of EconomicChange Cambridge MA Harvard University Press

Nonaka I and H Takeuchi 1995 e Knowledge Creating Company OxfordOxford University Press

OrsquoDriscoll G P and M J Rizzo 1996 e Economics of Time and IgnoranceLondon Routledge [1985]

Oi W 1961 ldquoLabor as a quasi fixed factor of productionrdquo Unpublisheddissertation University of Chicago

Orosel G O 1987 ldquoPeriod of productionrdquo Entry in Capital eory (e NewPalgrave)New York Macmillan 212ndash219 1987

Pellengahr I 1986a ldquoAustrians Versus Austrians I A Subjectivist View ofInterestrdquo in Faber (1986)

1986b ldquoAustrians Versus Austrians II Functionalist Versus Essential-ist eories of Interestrdquo in Faber (1986)

1996 e Austrian Subjective eory of Interest An Investigation intothe History of ought Frankfurt Peter Lang

Penrose E T 1995 e eory of the Growth of the Firm Oxford BasilBlackwell [1959]

Polanyi M 1958 Personal Knowledge Towards a Post Critical PhilosophyChicago University of Chicago Press

Popper K R 1972 Objective Knowledge An Evolutionary Approa OxfordOxford University Press

1976 Unended est An Intellectual Autobiography La Salle ILOpen Court

1989 Conjectures and Refutations London Routledge [1963]

Progogine I and I Stengers 1984 Order Out of Chaos Manrsquos New DialogueWith Nature New York Bantam

Ramsay-Steele D 1992 From Marx to Mises Post Capitalist Society and theChallenge of Economic Calculation La Salle IL Open Court

1996 ldquoBetween immorality and unfeasibility e market socialistpredicamentrdquo Critical Review 10 no 3 307ndash331

Ricardo D 1973 e Principles of Political Economy and Taxation Londone Guernsey Press [1817]

Richardson G B 1972 ldquoe organization of industryrdquo Economic Journal 82883ndash896

BIBLIOGRAPHY 255

1990 Information and Investment A Study in the Working of theCompetitive Economy Oxford Clarendon Press [1960]

Rizzo M J 1979 Time Uncertainty and Equilibrium Exploration of Austrianemes Lexington D C Heath

1990 ldquoHayekrsquos four tendencies toward equilibriumrdquo Cultural Dy-namics 3 12ndash31

1992 ldquoEquilibrium visionsrdquo South African Journal of Economics 60no 1 117ndash130

1994 ldquoTime in Economicsrdquo in P J Boeke ed e Edward ElgarCompanion to Austrian Economics Brookfield VT Edward Elgar 1994

1996 ldquoIntroductionrdquo in OrsquoDriscoll and Rizzo (1996) [1985]

Robinson J 1956 e Accumulation of Capital London Macmillan

Romer PM 1990 ldquoAre nonconvexities important for understanding growthrdquoAmerican Economic Review 80 no 2 97ndash103

1994 ldquoe origins of endogenous growthrdquo Journal of EconomicPerspectives 8 no 1 3ndash22

Rosen S 1991 ldquoTransactions Costs and Internal Labor Marketsrdquo inWilliamson and Winter (1991)

Rothbard M N 1970 Man Economy and State A Treatise on Economic Prin-ciples Los Angeles Nash

1975 Americarsquos Great Depression third edition Kansas City Sheedand Ward [1963]

1977 ldquoIntroductionrdquo in Feer (1977)

1987 ldquoTime Preferencerdquo in e New Palgrave A Dictionary ofEconomics New York Macmillan 1987 Reprinted in Richard Ebeling ed(1991)Austrian Economics A ReaderHillsdale Hillsdale College Press

Samuelson P A 1962 ldquoParable and realism in capital theory e surrogateproduction functionrdquo Review of Economic Studies 39 193ndash206

Schultz T W 1964 Transforming Traditional Agriculture New Haven Con-necticut University Press

1981 Investing in People e Economics of Population ality Berke-ley CA University of California Press

Schumpeter J A 1947 Capitalism Socialism and Democracy second editionNew York Harper

1954 History of Economic Analysis New York Oxford UniversityPress

1961 e eory of Economic Development Cambridge MA HarvardUniversity Press Trans Redvers Opie [1934]

Scully G W 1992 Constitutional Environments and Economic Growth Prince-ton Princeton University Press

Selgin G A 1988 e eory of Free Banking Money Supply Under Competi-tive Note Issue Totowa NJ Rowman and Lilefield

Shmanske S 1994 ldquoOn the relevance of policy to Kirznerian entrepreneur-shiprdquo Advances in Austrian Economics 1 199ndash222

Smith A 1982 An Inquiry into the Nature and Causes of the Wealth of NationsIndianapolis IN Liberty Classics [1776]

Solow R 1956 ldquoA contribution to the theory of economic growthrdquo arterlyJournal of Economics 70 no 1 65ndash94

1994 ldquoPerspectives on growth theoryrdquo Journal of Economic Perspec-tives 8 no 1 45ndash54

Sorokin P A 1964 Sociocultural Causality Space Time A Study of ReferentialPrinciples of Sociology and Social Science New York Russel and Russel[1943]

Sraffa P 1960 Production of Commodities by Means of Commodities Preludeto a Critique of Economic eory Cambridge Cambridge University Press

Steele G R 1996 e Economics of Friedri Hayek London Macmillan

Stiglitz J E 1987 ldquoe causes and consequences of the dependence of qualityof pricerdquo Journal of Economic Literature 25

Teece D 1982 ldquoTowards an economic theory of the multi-product firmrdquoJournal of Economic Behavior and Organization 3 39ndash63

1986 ldquoProfiting from technological innovation Implications for in-

BIBLIOGRAPHY 257

tegration collaboration licensing and public policyrdquo Resear Policy 15285ndash305

Vanberg V 1989 ldquoCarl Mengerrsquos evolutionary and John R Commonsrsquos col-lective action approach to institutionsrdquo Review of Political Economy 1Reprinted in Vanberg (1994)

1992 ldquoOrganizations as constitutional systemsrdquo Constitutional Polit-ical Economy 3 no 2 223ndash254 Reprinted in Vanberg (1994)

1994 Rules and Choice in Economics London Routledge

Vaughn K I 1992 ldquoe problem of order in Austrian economics Kirzner vsLachmannrdquo Review of Political Economy 4 251ndash274

1994 Austrian Economics in America e Migration of a TraditionCambridge Cambridge University Press

Vroman J J 1995 Economic Evolution An Enquiry into the Foundations of NewInstitutional Economics London Routledge

Whitehead A N 1968 Essays in Science and Philosophy New York Green-wood Press [1947]

Williamson O E 1985 e Economic Institutions of Capitalism New YorkFree Press

Williamson O E and S G Winter eds 1991 e Nature of the Firm OriginsEvolution and Development Oxford Oxford University Press

Yeager L B 1976 ldquoToward understanding some paradoxes in capital theoryrdquoEconomic Inquiry 14 313ndash346

1979 ldquoCapital Paradoxes and the Concept ofWaitingrdquo in Rizzo (1979)

Aaction 31ndash32

competitive vs complementary 32dependence on rules 42ndash43predictability 38ndash39 42 45

Ahiakpor James W C 56 243Alchian Armen 158 159 243Arthur W Brian 40 144 243asset specificity 158ndash159Austrian School 23 49 64 98Austrian theory of the business cycle

126average period of production 63ndash78

BBaetjer Howard xii 175 194 195 243

252Bartley William Warren III 225

227ndash230 234 243Barzel Yoram 159 243Becker Gary vii 12 17 193 196 197

201ndash203 205ndash207 209 210212ndash218 220 222ndash224 243

Bergson Henri 36 244Bierman Leonard 145 244Blaug Mark 88 244Bluedorn Allan C 145 244Boeke Peter viii 162 244Boumlhm-Bawerk Eugen von 5 9 11 49 57

61 63ndash71 73ndash78 79 80 88 89 9293 95 96 97 110 112ndash114 126127 141ndash143 147 189 213 215240 244 247 248

Buchanan James M 144 244budget 46ndash47 188ndash192

Ccapital

capital accumulation 14 54 55 56 5967 74 77 86 117 123 138ndash139142ndash145 149 207 214 217 230239 240 255

capital goods 3 48 52 53 60ndash67 7276 102 104 105 113 117ndash119121 129 131ndash134 136 138 143169 175 181 185 193 238

capitalist economy xi 5 7 51 58 5964 72 122 148 177 186 238

capital stock 5 6 54ndash58 64 65 72ndash7476 91 95 103 104 126 128 129131 132 142 157 169 189 237238

capital structure xi 3 11 60 62 7172 73 126ndash128 130 131 134ndash142144ndash146 147 151 156 166 169172ndash173 188 189 190 193 216238 239 241 250

capital theory vii xi xii 4ndash7 10 1119 49 51 53 54 63ndash64 69 78 7988 91 93 95 96 110 113 120121 123 125 126 127 128 130139 144 148 163 189 200 209213 216 237 243 250 251 252255 257

human capital vii 3 11 12 33 85 86155 169 175 182 192 193ndash200201ndash224 225ndash226 230 231233ndash235 239 241 243 248

Chandler Alfred 151 166 172 244Chen Ping 144 245children 220ndash221Chiles Todd H 145 244Clark John Bates 5 70 71ndash73 244

Coase Ronald 148 158 244Cocksho W Paul 186 245Collis David S 148 244constant returns to scale (CRS) 10

81ndash84 152 170constrained maximum 15 17convergence to equilibrium 22 24

26ndash30 40 42 86Corell Allin 186Currie Martin 31 35 37ndash38 245

DDahlman Carl 158 245Day Richard H 144 245Demsetz Harold 148 159 163 243 245discounted marginal value product

(DMVP) 118disequilibrium xii 8 11 13 24 25 28 29

31 34 45 46 48 50 51 104 120129 131 132 133 135 138 139194 223 233 234 235 238 252

division of labor 9 11 55 56 67 141 142145 168ndash171 178 182 185ndash187211 213ndash218 220ndash224

divorce 222ndash223Dolan Edwin G 23 245 249 250Dorfman Robert 73 245Douglas Cobb 80Drucker Peter F 175 245

EEbeling Richard M viii 39 79 245 255endogenous change 10 27ndash29 154 217

219 221 246Endogenous Growth eory 81ndash84equilibrating tendencies 7 13 27

and Austrian economics 7rdquolong-runrdquo stationary state 9 59

equilibrium 8absence of 14as a rdquobalance of forcesrdquo 16 17as a result of plans 32definition 13 15ndash18effect of time 21 26empirical nature 23general equilibrium 15

equilibrium (cont)implications of 19ndash21individual vs system 20intertemporal equilibrium 16 21micro and macro 20momentary equilibrium 17partial equilibrium 15static equilibrium 15supply and demand 16temporary equilibrium 16tendency toward 14 25 36volitional aspect 18

equilibrium price 28ndash30market-clearing price 24price discrepancies 28 47supply and demand 29

Evans-Pritchard Edward E 44 245evenly rotating economy (ERE) 117ndash119exogenous change 28ndash30 80 87 89 206

FFaber Malte 70 94 110 113 245 254Feer Frank A 78 112ndash114 115firm vii 2 11 86 99 100 120 123 126

135 137 141 145 148 149151ndash175 177ndash185 189 192 196197 200ndash206 213 215 218 223235 238 243 244 245 246 251252 253 254 256 257

Foss Nicholai J 126 246

GGarrison Roger W viii 62 73 110 112

246Goleman Daniel 210 246Greening Daniel W 145 244growth theory 11 53 74 78 80 81 88

89 93 217 246 256Gupta Vishal K 145 244

HHahn Frank H 19 246Harcourt Geoffrey C 88 246Harper David A viii 226 246Hausman Daniel 76 247

INDEX 261

Hayek Friedrich A xii 8 11 13 1418ndash24 26 27 31 34 42 44 45 4870 71 73 74 78 88 95 96 98105 119 123 126ndash131 139 145147 149 160 164 165 177 178189 193 195 215 231ndash233 240247 250 252 253 255 256

definition of equilibrium 8 13 14 1827

effect of time on equilibrium 21Monetary eory and the Trade Cycle

126Prices and Production 126e Pure eory of Capital 126equilibrium tendencies 22existence of equilibrium 22individual and system equilibrium 20

Hennings Klaus H 63ndash65 74 247Hicks John R 10 21 49 53 54 57 90 92

93ndash107 156 180 184 188 190216 248 250 252

Capital and Growth 93Capital and Time 93 95 96Pure eory of Capital 11Value and Capital 93Fundamental eorem 100ndash101 106intertemporal equilibrium 21neo-Austrian approach 10

Hodgson Geoffrey M 144 248Hoff Tigre J 177 248Horwitz Steven viii 27 40 41 177 178

187 188 223 244 248human capital see capitalHume David 211

Iinterest 109ndash120internal rate of return (IRR) 99 101 102

106ndash107 197

JJevons William Stanley 57 127joint production 156

KKeynes John Maynard 4 7 94 126 129

137 253Kirzner Israel M viii xii 8 13 17

23ndash28 40 78 88 91 105 110 112113 115 116 126 129 139 145231 245 249 256 257

definition of disequilibrium 24Klein Peter 179 249Knight Frank H 5 70ndash73 249Knowledge capital 3 225ndash236

informative content 227 228logical content 227 228objective content 227

Kregel Jan A 53 59 64 249Kresge Stephen 131 250Krugman Paul 40 221 250Kuhn omas S 230

LLachmann Ludwig M vii xi xii 11 13

16 23ndash28 35 37 40 41 43 53 5459 73 78 94 95 99 105 116 123126 127 128 130ndash146 147 149150 151 156 159 162 166 170171 173 194 200 213 215 216240 250 251 252 257

Capital and its Structure 131ndash146Lachmannrsquos axiom 26 27 35 43 162

Laing N F 88 246Lakatos Imre 230Langlois Richard 123 147 153 158 160

161 163 164 165 166 167 171172 251

Lavoie Donald C viii 177 189 194230ndash233 250 251

Leijonhufvud Axel 167ndash171 173 251Lewin Peter xii 3 13 23 26 32 35 79

93 110 114 127 130 131 175177 194 223 248 251 252

Liebowitz Stan J 40 252Lindahl Erik 35 252Loasby Brian 42 123 155 156 174 246

252Lucas Robert E 80 85 252Lutz Friedrich A 74 76 79 252

MMachlup Fritz 15 19 20 252Maclachlan Fiona C 113 253Malthus omas 59 219 220 221Margolis Stephen E 40 252market-clearing price 24marriage 222ndash223Marshall Alfred 24 123 126 135 148

202 209 246 253Marx Karl 171 254Masten Sco E 158 253McMullen Jeffrey 145 244measurement cost approach 159Menger Carl 9ndash11 40 49 60ndash65 71 73

92 95ndash97 123 125ndash127 129 147164 185ndash187 213 214 248 253257

Time Structure of Production 60ndash63Mincer Jacob 12 206 219 253Minkler Alanson P 174 253Mises Ludwig von 11 32 34 46 47 78

110 112ndash114 115 126 129 157177 178 179 185ndash189 207 246248 249 250 252 253 254

modern growth theory 74 80Montgomery Cynthia A 148 244multiple specificity 134 145 159 162 202Murphey Kevin 193 214ndash217 243

NNelson Robert R 164 253neo-Austrian 10 93 248 250neo-Ricardian 9 10 19 49 59 76 78 79

88ndash91 92 101 102 147net present value (NPV) 98ndash99Nonaka Ikujiro 175 231 253

OOrsquoDriscoll Gerald P 20 27 28 34 246

254 255Oi Walter 203 254On the Principles of Political Economy

and Taxation 9Orosel Gerhard O 70 254

PPellengahr Ingo 110 114Penrose Edith T 11 123 147 149

154ndash156 162 170 172 254Polanyi Michael 160 195 230 254Popper Karl 195 226 229 230 234 240

254price

as a measure of worth 46as a mode of calculation 46as a social institution 46changes in 47discrepancies 28 47effects within disequilibrium 46

processes of convergence 40ndash43rdquoproduction functionrdquo approach to

capital 9 79ndash92capital intensity 89 101capital reversing 89challenge to 88ndash91complete production function 82constant returns 10diminishing returns 10 56 89endogenous change 10 27 28Endogenous Growth eory 81ndash84limitations 86ndash88partial production function 83technological change 10

profit 10 50 117ndash120prospective profits 183ndash184retrospective profits 180ndash183

Pure eory of Capital 11 126Pure Time Preference eory (PTPT) 10

109ndash117

RRamsay-Steele David 177 254Ricardo David 5 9 49 54 57ndash60 62ndash64

73 75 92 93 96 123 147 254Richardson George B 11 123 149ndash154

155 156 162 172 246 254Rizzo Mario J viii 20 23 26ndash28 34 36

246 254 255 257Robertson Paul L 153 158 160 161 163

166 167 251Robinson Joan 79 255

INDEX 263

Romer Paul M 80 81 83 85 255Rosen Sherwin 204 255Rothbard Murray 78 110 112ndash114 117

118ndash119 126 179 245 246 252255

roundabout methods of production 9 1152 61 62 65ndash68 70 74 78 97113 126 142ndash144 147 189 213215 217 240 248

SSalerno Joseph viii 157Samuelson Paul A 90 255Schultz eodore W 12 196 214 216Schumpeter Joseph Alois xii 128 134

147 256Scully Gerald W 88 256Selgin George A 40 256Shackle George L S 25 250Shmanske Steven 17 18 256Simon Herbert 231Smith Adam 8 9 11 49 51 53ndash58 74 75

91 93 123 140 142 145 167ndash169171 197 211 213 214ndash216 256

corn economy 53ndash57 74 140 145Solow Robert 80 83 84 87 256Sorokin Pitirim A 37 38 256specific human capital 195Sraffa Pierro 57 79 256steady-state economics 9 103ndash104 117Steedman Ian 31 35 37ndash38 245Steele Gerhard R 143 177 254 256Stiglitz Joseph E 19 256

TTakeuchi Hirotaka 175 231 253technical information 150Teece David 123 148 166 256theory of the firm see firmtime 60ndash63 66 70 71 73 75 91 94ndash96Treatise on the Family A 219Tuggle Christopher 145 244

UUniform Rate of Profit 57ndash60

VVanberg Victor 164 257Vaughn Karen viii 26 257Vroman Jack J 184 257

WWealth of Nations 8 213Wenar Leif 131 250Whitehead Alfred North 232 257Wicksell Knut 79 96 127Wieser Friedrich von 129Williamson Oliver E 123 148 160 174

231 243 245 253 255 257Winter Sidney G 148 160 164 245 253

255 257women in the workforce 218ndash222Woodward Susan 158 243Wyotinsky Lectures 210

YYeager Leland B 88 90 110 257Yoon Yong J 144 244

Title Page

Copyright Page

Table of Contents

Acknowledgments

Background Equilibrium and Change

What Does Equilibrium Mean A Discussion in the Context of Modern Austrian Ideas

Equilibrium and Expectations Re-Examined A Different Perspective

Capital Interest and Profits


Modern Capital Theory

The Hicksian Marriage of Capital and Time

The Nature of Interest and Profits

Capital in a Dynamic World

Modern Mengerian Capital Theory



Human Capital

Human Capital the Nature of Knowledge and the Value of Knowledge

Conclusion

Bibliography

Index

Capital in DisequilibriumThe Role of Capital in a Changing World

Second Edition

Ludwigvon MieIntituteA U B U R N A L A B A M A

Ph (334) 844-2500Fax (334) 844-2583

misesorg

10 9 8 7 6 5 4 3 2 1

ISBN 978-1-61016-239-5

Contents

Acknowledgments vii

Conclusion 237

Bibliography 243

Index 259

Acknowledgments

ACKNOWLEDGMENTS ix

CHAPTER 1

Capital as Value

Outline

PART I

CHAPTER 2

(Machlup 195843)

CHAPTER 3

PART II

CHAPTER 4

e estions

119884119905+1113568 = 119901119873 = 119901119884119905 119908 or 119884119905+1113568 119884119905 = 119901 119908

(Menger 1976152)

Introduction

(ibid88)

(ibid85)

119879 =sum119899119905=1113568 (119899 minus 119905)119897119905sum119899119905=1113568 119897119905

= 119899 minus (1198991114012119905=1113568

119905 119897119905119873 )

119905=1113578 (119899 minus 119905)119897119905 = (11135681113569) 119899 (119899 + 1113568) 1198971113577 and sum119899119905=1113578 119897119905 =

119870 119873 = 119879119908

CHAPTER 5

Modern Capital eory

119876 = 119860(119905) sdot 119891(119870119873) (51)

119876 = 119891(119870119873 119871) and 120582119876 = 119891(120582119870 120582119873 120582119871) (52)

119892119876 = 1199041113568119892119870 + 1199041113569119892119873 + 1199041113570119892119871 (53)

2119904119894 =119889 11136111113613119876119889 11136111113613 119865119894

119876 = θ(119870119873) (54)

119876 = 119860(119905) sdot θ(119870119873) (55)

119876 = 119891(119870119873119867) (56)

119876 = 119891(119867 119877) (57)

119891(120582119867 120582119877) gt 119891(119867 120582119877) = 120582119891(119867 119877) (58)

(Solow 199448)

(Yeager 1976313n)

Summary Conclusion

CHAPTER 6

His and Time

(Hicks 1973a97)

(ibid99)3

(ibid100)

Formalization

119886119905 =1114012119894119908119894119905120572119894119905

119896119905 = 119902119905 + 119902119905+1113568119877minus1113568 + 119902119905+1113569119877

= 119902119905 + 119877minus1113568119896119905+1113568 = (119887119905 minus 119886119905) + 119877

minus1113568119896119905+1113568 (61)

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113569119877

minus119905 (62)

119896119905 = (minus1199021113567)119877119905 + (minus1199021113568)119877

119876119905 = 119860119905(119905) sdot 119891(119870119905 119873119905) (51prime)

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

1198961113567 = 1198871113567 minus 1198861113567 + 119877minus11135681198961113568

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113569119877

minus1113569 +⋯+ 119902119899119877minus119899 = 0

=1198991114012119905=1113567119902119905119877

119877119899119896119905 =1198991114012119905=1113567119902119905119877

119899minus119905 =1198991114012119905=1113567119902119899minus119905119877

119905 = 0

0 = 119902119899 + 119902119899minus1113568119877 + 119902119899minus11135691198771113569 +⋯+ 1199021113567119877

0 = 119876119899 + 119876119899minus1113568119903 + 119876119899minus11135691199031113569 +⋯+1198761113567119903119899 (64)

CHAPTER 7

Introduction

(Lachmann 197878)

e Nature of Profit

eory and Reality

PART III

CHAPTER 8

Introduction

(Lachmann 197894)

(Lachmann 197895)

(Lachmann 1978xi)

(Lachmann 197885)

Concluding Summary

CHAPTER 9

(Richardson 19901)

(ibid61)

(Richardson 199079)

(Penrose 1995133)

Langlois writes

1198601113568rarr1198611113569rarr1198621113570 1198641113572 1198631113571

1198651113568rarr1198661113569rarr1198671113570 1198681113572

CHAPTER 10

(Mises 192775)

Prospective Profits

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

(Mises 198141)

(Lavoie 1985b71)

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

Conclusion

CHAPTER 11

Human Capital

HUMAN CAPITAL 195

4See Baetjer (1998)

HUMAN CAPITAL 197

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113567119877

minus1113569 +⋯+ 119902119899119877minus119899 =

1198991114012119905=1113567119902119905119877

minus119905 (111)

and119877 = (1 + 119903)

1198961113567 =1198991114012119905=1113567(119908prime119905 minus 119908119905)119877

minus119905 (112)

1198961113567 =1198991114012119905=1113567

(119908prime119905 minus 119908119905)(1 + 119903)119905

= 0 (112prime)

HUMAN CAPITAL 199

6Lachmann asserts

HUMAN CAPITAL 201

HUMAN CAPITAL 203

HUMAN CAPITAL 205

HUMAN CAPITAL 207

HUMAN CAPITAL 209

HUMAN CAPITAL 211

HUMAN CAPITAL 213

Conclusion

HUMAN CAPITAL 215

HUMAN CAPITAL 217

Introduction

HUMAN CAPITAL 219

Children

HUMAN CAPITAL 221

Divorce

HUMAN CAPITAL 223

CHAPTER 12

(Popper 1989216)

(Bartley 199034)

(Bartley 199048)

Knowledge is Tacit

Conclusion

Summary

CONCLUSION 239

CONCLUSION 241

Bibliography

BIBLIOGRAPHY 245

BIBLIOGRAPHY 247

BIBLIOGRAPHY 249

BIBLIOGRAPHY 251

BIBLIOGRAPHY 253

BIBLIOGRAPHY 255

BIBLIOGRAPHY 257

Aaction 31ndash32

Ccapital

31 34 45 46 48 50 51 104 120129 131 132 133 135 138 139194 223 233 234 235 238 252

89 93 217 246 256Gupta Vishal K 145 244

INDEX 261

93ndash107 156 180 184 188 190216 248 250 252

106ndash107 197

23ndash28 40 78 88 91 105 110 112113 115 116 126 129 139 145231 245 249 256 257

16 23ndash28 35 37 40 41 43 53 5459 73 78 94 95 99 105 116 123126 127 128 130ndash146 147 149150 151 156 159 162 166 170171 173 194 200 213 215 216240 250 251 252 257

161 163 164 165 166 167 171172 251

93 110 114 127 130 131 175177 194 223 248 251 252

110 112ndash114 115 126 129 157177 178 179 185ndash189 207 246248 249 250 252 253 254

254price

109ndash117

246 254 255 257Robertson Paul L 153 158 160 161 163

166 167 251Robinson Joan 79 255

INDEX 263

118ndash119 126 179 245 246 252255

91 93 123 140 142 145 167ndash169171 197 211 213 214ndash216 256

231 243 245 253 255 257Winter Sidney G 148 160 164 245 253

Title Page

Copyright Page

Table of Contents

Acknowledgments












Human Capital


Conclusion

Bibliography

Index

Ph (334) 844-2500Fax (334) 844-2583

misesorg

10 9 8 7 6 5 4 3 2 1

ISBN 978-1-61016-239-5

Contents

Acknowledgments vii

Conclusion 237

Bibliography 243

Index 259

Acknowledgments

ACKNOWLEDGMENTS ix

CHAPTER 1

Capital as Value

Outline

PART I

CHAPTER 2

(Machlup 195843)

CHAPTER 3

PART II

CHAPTER 4

e estions

119884119905+1113568 = 119901119873 = 119901119884119905 119908 or 119884119905+1113568 119884119905 = 119901 119908

(Menger 1976152)

Introduction

(ibid88)

(ibid85)

119879 =sum119899119905=1113568 (119899 minus 119905)119897119905sum119899119905=1113568 119897119905

= 119899 minus (1198991114012119905=1113568

119905 119897119905119873 )

119905=1113578 (119899 minus 119905)119897119905 = (11135681113569) 119899 (119899 + 1113568) 1198971113577 and sum119899119905=1113578 119897119905 =

119870 119873 = 119879119908

CHAPTER 5

Modern Capital eory

119876 = 119860(119905) sdot 119891(119870119873) (51)

119876 = 119891(119870119873 119871) and 120582119876 = 119891(120582119870 120582119873 120582119871) (52)

119892119876 = 1199041113568119892119870 + 1199041113569119892119873 + 1199041113570119892119871 (53)

2119904119894 =119889 11136111113613119876119889 11136111113613 119865119894

119876 = θ(119870119873) (54)

119876 = 119860(119905) sdot θ(119870119873) (55)

119876 = 119891(119870119873119867) (56)

119876 = 119891(119867 119877) (57)

119891(120582119867 120582119877) gt 119891(119867 120582119877) = 120582119891(119867 119877) (58)

(Solow 199448)

(Yeager 1976313n)

Summary Conclusion

CHAPTER 6

His and Time

(Hicks 1973a97)

(ibid99)3

(ibid100)

Formalization

119886119905 =1114012119894119908119894119905120572119894119905

119896119905 = 119902119905 + 119902119905+1113568119877minus1113568 + 119902119905+1113569119877

= 119902119905 + 119877minus1113568119896119905+1113568 = (119887119905 minus 119886119905) + 119877

minus1113568119896119905+1113568 (61)

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113569119877

minus119905 (62)

119896119905 = (minus1199021113567)119877119905 + (minus1199021113568)119877

119876119905 = 119860119905(119905) sdot 119891(119870119905 119873119905) (51prime)

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

1198961113567 = 1198871113567 minus 1198861113567 + 119877minus11135681198961113568

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113569119877

minus1113569 +⋯+ 119902119899119877minus119899 = 0

=1198991114012119905=1113567119902119905119877

119877119899119896119905 =1198991114012119905=1113567119902119905119877

119899minus119905 =1198991114012119905=1113567119902119899minus119905119877

119905 = 0

0 = 119902119899 + 119902119899minus1113568119877 + 119902119899minus11135691198771113569 +⋯+ 1199021113567119877

0 = 119876119899 + 119876119899minus1113568119903 + 119876119899minus11135691199031113569 +⋯+1198761113567119903119899 (64)

CHAPTER 7

Introduction

(Lachmann 197878)

e Nature of Profit

eory and Reality

PART III

CHAPTER 8

Introduction

(Lachmann 197894)

(Lachmann 197895)

(Lachmann 1978xi)

(Lachmann 197885)

Concluding Summary

CHAPTER 9

(Richardson 19901)

(ibid61)

(Richardson 199079)

(Penrose 1995133)

Langlois writes

1198601113568rarr1198611113569rarr1198621113570 1198641113572 1198631113571

1198651113568rarr1198661113569rarr1198671113570 1198681113572

CHAPTER 10

(Mises 192775)

Prospective Profits

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

(Mises 198141)

(Lavoie 1985b71)

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

Conclusion

CHAPTER 11

Human Capital

HUMAN CAPITAL 195

4See Baetjer (1998)

HUMAN CAPITAL 197

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113567119877

minus1113569 +⋯+ 119902119899119877minus119899 =

1198991114012119905=1113567119902119905119877

minus119905 (111)

and119877 = (1 + 119903)

1198961113567 =1198991114012119905=1113567(119908prime119905 minus 119908119905)119877

minus119905 (112)

1198961113567 =1198991114012119905=1113567

(119908prime119905 minus 119908119905)(1 + 119903)119905

= 0 (112prime)

HUMAN CAPITAL 199

6Lachmann asserts

HUMAN CAPITAL 201

HUMAN CAPITAL 203

HUMAN CAPITAL 205

HUMAN CAPITAL 207

HUMAN CAPITAL 209

HUMAN CAPITAL 211

HUMAN CAPITAL 213

Conclusion

HUMAN CAPITAL 215

HUMAN CAPITAL 217

Introduction

HUMAN CAPITAL 219

Children

HUMAN CAPITAL 221

Divorce

HUMAN CAPITAL 223

CHAPTER 12

(Popper 1989216)

(Bartley 199034)

(Bartley 199048)

Knowledge is Tacit

Conclusion

Summary

CONCLUSION 239

CONCLUSION 241

Bibliography

BIBLIOGRAPHY 245

BIBLIOGRAPHY 247

BIBLIOGRAPHY 249

BIBLIOGRAPHY 251

BIBLIOGRAPHY 253

BIBLIOGRAPHY 255

BIBLIOGRAPHY 257

Aaction 31ndash32

Ccapital

31 34 45 46 48 50 51 104 120129 131 132 133 135 138 139194 223 233 234 235 238 252

89 93 217 246 256Gupta Vishal K 145 244

INDEX 261

93ndash107 156 180 184 188 190216 248 250 252

106ndash107 197

23ndash28 40 78 88 91 105 110 112113 115 116 126 129 139 145231 245 249 256 257

16 23ndash28 35 37 40 41 43 53 5459 73 78 94 95 99 105 116 123126 127 128 130ndash146 147 149150 151 156 159 162 166 170171 173 194 200 213 215 216240 250 251 252 257

161 163 164 165 166 167 171172 251

93 110 114 127 130 131 175177 194 223 248 251 252

110 112ndash114 115 126 129 157177 178 179 185ndash189 207 246248 249 250 252 253 254

254price

109ndash117

246 254 255 257Robertson Paul L 153 158 160 161 163

166 167 251Robinson Joan 79 255

INDEX 263

118ndash119 126 179 245 246 252255

91 93 123 140 142 145 167ndash169171 197 211 213 214ndash216 256

231 243 245 253 255 257Winter Sidney G 148 160 164 245 253

Title Page

Copyright Page

Table of Contents

Acknowledgments












Human Capital


Conclusion

Bibliography

Index

Contents

Acknowledgments vii

Conclusion 237

Bibliography 243

Index 259

Acknowledgments

ACKNOWLEDGMENTS ix

CHAPTER 1

Capital as Value

Outline

PART I

CHAPTER 2

(Machlup 195843)

CHAPTER 3

PART II

CHAPTER 4

e estions

119884119905+1113568 = 119901119873 = 119901119884119905 119908 or 119884119905+1113568 119884119905 = 119901 119908

(Menger 1976152)

Introduction

(ibid88)

(ibid85)

119879 =sum119899119905=1113568 (119899 minus 119905)119897119905sum119899119905=1113568 119897119905

= 119899 minus (1198991114012119905=1113568

119905 119897119905119873 )

119905=1113578 (119899 minus 119905)119897119905 = (11135681113569) 119899 (119899 + 1113568) 1198971113577 and sum119899119905=1113578 119897119905 =

119870 119873 = 119879119908

CHAPTER 5

Modern Capital eory

119876 = 119860(119905) sdot 119891(119870119873) (51)

119876 = 119891(119870119873 119871) and 120582119876 = 119891(120582119870 120582119873 120582119871) (52)

119892119876 = 1199041113568119892119870 + 1199041113569119892119873 + 1199041113570119892119871 (53)

2119904119894 =119889 11136111113613119876119889 11136111113613 119865119894

119876 = θ(119870119873) (54)

119876 = 119860(119905) sdot θ(119870119873) (55)

119876 = 119891(119870119873119867) (56)

119876 = 119891(119867 119877) (57)

119891(120582119867 120582119877) gt 119891(119867 120582119877) = 120582119891(119867 119877) (58)

(Solow 199448)

(Yeager 1976313n)

Summary Conclusion

CHAPTER 6

His and Time

(Hicks 1973a97)

(ibid99)3

(ibid100)

Formalization

119886119905 =1114012119894119908119894119905120572119894119905

119896119905 = 119902119905 + 119902119905+1113568119877minus1113568 + 119902119905+1113569119877

= 119902119905 + 119877minus1113568119896119905+1113568 = (119887119905 minus 119886119905) + 119877

minus1113568119896119905+1113568 (61)

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113569119877

minus119905 (62)

119896119905 = (minus1199021113567)119877119905 + (minus1199021113568)119877

119876119905 = 119860119905(119905) sdot 119891(119870119905 119873119905) (51prime)

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

1198961113567 = 1198871113567 minus 1198861113567 + 119877minus11135681198961113568

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113569119877

minus1113569 +⋯+ 119902119899119877minus119899 = 0

=1198991114012119905=1113567119902119905119877

119877119899119896119905 =1198991114012119905=1113567119902119905119877

119899minus119905 =1198991114012119905=1113567119902119899minus119905119877

119905 = 0

0 = 119902119899 + 119902119899minus1113568119877 + 119902119899minus11135691198771113569 +⋯+ 1199021113567119877

0 = 119876119899 + 119876119899minus1113568119903 + 119876119899minus11135691199031113569 +⋯+1198761113567119903119899 (64)

CHAPTER 7

Introduction

(Lachmann 197878)

e Nature of Profit

eory and Reality

PART III

CHAPTER 8

Introduction

(Lachmann 197894)

(Lachmann 197895)

(Lachmann 1978xi)

(Lachmann 197885)

Concluding Summary

CHAPTER 9

(Richardson 19901)

(ibid61)

(Richardson 199079)

(Penrose 1995133)

Langlois writes

1198601113568rarr1198611113569rarr1198621113570 1198641113572 1198631113571

1198651113568rarr1198661113569rarr1198671113570 1198681113572

CHAPTER 10

(Mises 192775)

Prospective Profits

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

(Mises 198141)

(Lavoie 1985b71)

119896119905 = 119896119905(119908 120572 119901 120573 119903 119899)

Conclusion

CHAPTER 11

Human Capital

HUMAN CAPITAL 195

4See Baetjer (1998)

HUMAN CAPITAL 197

1198961113567 = 1199021113567 + 1199021113568119877minus1113568 + 1199021113567119877

minus1113569 +⋯+ 119902119899119877minus119899 =

1198991114012119905=1113567119902119905119877

minus119905 (111)

and119877 = (1 + 119903)

1198961113567 =1198991114012119905=1113567(119908prime119905 minus 119908119905)119877

minus119905 (112)

1198961113567 =1198991114012119905=1113567

(119908prime119905 minus 119908119905)(1 + 119903)119905

= 0 (112prime)

HUMAN CAPITAL 199

6Lachmann asserts

HUMAN CAPITAL 201

HUMAN CAPITAL 203

HUMAN CAPITAL 205

HUMAN CAPITAL 207

HUMAN CAPITAL 209

HUMAN CAPITAL 211

HUMAN CAPITAL 213

Conclusion

HUMAN CAPITAL 215

HUMAN CAPITAL 217

Introduction

HUMAN CAPITAL 219

Children

HUMAN CAPITAL 221

Divorce

HUMAN CAPITAL 223

CHAPTER 12

(Popper 1989216)

(Bartley 199034)

(Bartley 199048)

Knowledge is Tacit

Conclusion

Summary

CONCLUSION 239

CONCLUSION 241

Bibliography

BIBLIOGRAPHY 245

BIBLIOGRAPHY 247

BIBLIOGRAPHY 249

BIBLIOGRAPHY 251

BIBLIOGRAPHY 253

BIBLIOGRAPHY 255

BIBLIOGRAPHY 257

Aaction 31ndash32

Ccapital

31 34 45 46 48 50 51 104 120129 131 132 133 135 138 139194 223 233 234 235 238 252

89 93 217 246 256Gupta Vishal K 145 244

INDEX 261

93ndash107 156 180 184 188 190216 248 250 252

106ndash107 197

23ndash28 40 78 88 91 105 110 112113 115 116 126 129 139 145231 245 249 256 257

16 23ndash28 35 37 40 41 43 53 5459 73 78 94 95 99 105 116 123126 127 128 130ndash146 147 149150 151 156 159 162 166 170171 173 194 200 213 215 216240 250 251 252 257

161 163 164 165 166 167 171172 251

93 110 114 127 130 131 175177 194 223 248 251 252

110 112ndash114 115 126 129 157177 178 179 185ndash189 207 246248 249 250 252 253 254

254price

109ndash117

246 254 255 257Robertson Paul L 153 158 160 161 163

166 167 251Robinson Joan 79 255

INDEX 263

118ndash119 126 179 245 246 252255

91 93 123 140 142 145 167ndash169171 197 211 213 214ndash216 256

231 243 245 253 255 257Winter Sidney G 148 160 164 245 253

Title Page

Copyright Page

Table of Contents

Acknowledgments












Human Capital


Conclusion

Bibliography

Index

Documents

Capital in Disequilibrium: The Role of Capital in a