5. Capital Interest and the Temporal Regulation of the Structure of Production

We have already pointed out that as a rule, it is possible to expand production by means of two methods: On the one hand, by increasing the factors of production employed where this increased employment will be subject to the law of diminishing returns; and, on the other hand, by expanding production without increasing the number of factors of production such that a temporal pushing back of the initial employment of individual factors of production takes place and the result of this choice of lengthier roundabout methods of production is an increase in output. We discussed this in great detail in connection with the doctrine of the roundabout methods of production. There it was also explained that the possibilities of lengthening the roundabout methods of production—inasmuch as such a thing may be desirable because of its higher productivity—are limited because the length of the possible roundabout method of production is constrained by the supply of capital. It is now our task to integrate the doctrine of the roundabout method of production with the theory of the formation of prices of factors of production and the law of costs. In an economy that is characterized by exchanges and in which the individual owners of factors of production can measure the success or lack of success of their economic activity in terms of prices, the employment of capital—the choice of a roundabout method of production—can only be directed by the formation of prices. The owner of capital will measure in terms of prices how he can correctly, i.e., with the greatest possible revenue for him, invest his capital. The first question now is which prices are significant here.

Let us assume an entrepreneur chooses to organize a roundabout production process. In order to clearly see the function of capital here, let us assume there is an entrepreneur without any assets who obtains capital from an owner of capital. We will assume further—in order not to complicate matters unnecessarily—that the entrepreneur only needs laborers in addition to the capital he has acquired.

If availability of capital means nothing other than the possibility of beginning roundabout methods of production, thus using factors of production today which only later provide a return, then this capital market is essentially characterized by an exchange of “present goods” for “future goods.” The owner of capital gives the entrepreneur something making it possible for the entrepreneur to “invest” what he has received in a roundabout method of production, whereby the owner of capital is satisfied with a return that can only be made when the roundabout method of production has been successfully completed. And if we now ask what the owner of capital hands over to the entrepreneur, then in a first step (and recalling here our previously discussed most elementary case) we can identify this capital with a subsistence fund. Here we are faced with a case of organizing a production process employing capital out of the “state of nature” in which an economy does not yet possess any produced factors of production. The only form of capital present is saved means of subsistence. The entrepreneur will no longer employ his hired laborers in “momentary production”—this, of course, would be the opposite of choosing a roundabout method of production—and pay their wages out of the immediate return from this production process, but instead he will direct labor into the roundabout method of production until the products are achieved, and will pay the laborers out of the free capital that he has acquired from the owner of capital. The subsistence fund, which alone assumes the function of capital, serves to support the laborers for the duration of the roundabout production process and thereby is used up successively. It is clear that the entrepreneur cannot employ laborers—who themselves are not owners of capital and who thus must continuously reap a return for their labor in a roundabout production process—unless he has access to a subsistence fund.

Now, in order to obtain supply and demand curves, let us assume that in an economy which heretofore has worked exclusively in momentary production, a number of entrepreneurs in one or a few lines of production in which the choice of roundabout production methods can bring about a large increase in returns begin to introduce roundabout production methods by employing subsistence funds in the way just described. It is possible for them to do this because other economic subjects who have become owners of capital by saving have offered them a subsistence fund for future returns on the emerging capital market. If entrepreneurs attract laborers from other production processes—we have assumed that labor is the sole factor of production for simplicity’s sake—and begin roundabout methods of production, then in the end they will attain a larger return with these laborers than would have been possible in momentary production. If we wish to follow this process in the realm of prices, we will notice two movements: First, the laborers’ wages will have risen. For the laborers will only be drawn out of their previous employment with higher wages. However, this change might not be very significant if introducing a roundabout method of production only affects a relatively small part of the economy. It can even be completely absent if we imagine that entrepreneurs who until now have worked in momentary production begin to introduce roundabout production methods with the previously employed laborers. Second, however—and this is of greater significance—we will have to expect a drop in the price of the product after the completion of the roundabout method of production. This is because in roundabout production more products can be produced. Because of this movement in prices, the span which the greater productivity of the roundabout method of production leaves open for profit above labor costs will be reduced. We will now see that with a correct entrepreneurial decision, however, some such span must nonetheless remain, and hence, a roundabout method of production can only be adopted if such a span between the costs of labor and the price of the product exists.

In order to illustrate this clearly we would like to use a formulation which was used previously. The entrepreneur has two possibilities for expanding production: He can either employ more laborers, or lengthen the roundabout production process. With respect to employing more laborers the situation is obvious; in this case a linear expansion of production takes place. In the same momentary production, twice as many laborers will produce twice as many products.²⁷ With respect to lengthening the roundabout method of production, however, something must be added to what we have already said about this situation.

It cannot be doubted that a “cleverly chosen” extension of the roundabout method of production, i.e., the introduction of a time span between the expenditure of the factor of production and the attainment of the finished product, can increase returns. Once this point of departure is secured, that which makes the roundabout method of production possible must be regarded as a means of increasing output, just as would an additional amount of any originary means of production. We can label “that which makes the roundabout method of production possible” a factor of production P₁, just as we call labor or land factors of production. P₁ can be “combined” with another factor of production P₂—for example, human labor—whereby extensive variability in the way in which they can be combined exists. The interaction of two economic factors of production, however, must be subject to the principle of diminishing returns.²⁸ This means that the combination of a given quantity of P₁ with an increasing number of units of P₂ will result in an always decreasing growth in output. We first presented the deduction of this principle of the interaction of factors of production with respect to the so-called law of diminishing returns of agricultural production, and we then immediately recognized that it is a general principle of the combination of factors of production: No one would offer anything for the addition of P₁ in production if it were possible, solely by means of increasing the use of P₂, to attain a proportionally increased output. From this it follows that if any combination of P₁ and P₂ is given, a “decreasing” increased output can be achieved by adding individual units of P₁, or by adding individual units of P₂. Hence, the law of marginal productivity is applicable for P₁ as well as for P₂. It is thereby irrelevant which kind of production factor it is, whether it is labor or land or “that which makes the adoption of roundabout methods of production possible.” We have now arrived at the application of the principle of marginal productivity regarding the employment of capital. Since the use of free capital in our examples has permitted the choice of the roundabout method of production, and since the “factor of production” which by lengthening the roundabout method of production permits the increase in output is the subsistence fund, this factor also receives a share of the returns according to its marginal product.

Recall again our earlier formulation. The entrepreneur takes on the consumers’ demand and transforms it into a demand for various factors of production. He will be able to pay for each factor of production according to its marginal productivity. In so doing, he will prefer that factor of production which provides him with a greater return at a lower cost, and he will get rid of individual units of those factors of production whose marginal product is less than the price he would have to pay to use it until the marginal product is equal to this price. He will not use a single unit of a factor of production that does not at least result in a growth in output equivalent to the cost of using this factor. This holds for labor and land, as well as for the subsistence fund. In “correctly” carrying out production, the entrepreneur can return not only this subsistence fund to those who provide him with it, thereby making the introduction of a roundabout method of production possible, but in addition he can also pay them interest. The former is obvious, for the size of the subsistence fund that is used in production is identical to the sum of wages. This cost expenditure must be covered by the product. But the latter is also clear, for each “ration” of the subsistence fund which has served to pay a wage has meant not only that a labor unit could be employed, but also that it could be employed earlier in production to the same extent as the length of time for which this subsistence fund had been tied up in the production process. If it had not been for this portion of the subsistence fund, the labor could still have been employed—but only at the last moment in production when it would have received wages directly from returns. The fact that this labor could be employed earlier, thus increasing returns, is the result of the cooperation of the subsistence fund. Increased output is solely the result of this circumstance—increased returns are dependent on the condition that a subsistence fund is used. Thus the employment of a subsistence fund must create a time span between the costs of labor and the price of the product. A part of the returns, which can be described in terms of marginal productivity, is dependent on the expenditure of a subsistence fund. For this reason, an entrepreneur can pay interest according to the marginal product.²⁹ However, the entrepreneur will also have to pay capital interest as long as a limited supply of capital is faced with a demand which can increase its output by using more capital, by lengthening the roundabout method of production. Only if the entrepreneur can pay capital interest will he be able to keep pace with entrepreneurs competing with him on the capital market.

We noted earlier that the higher returns to be expected from the adoption of roundabout methods of production will bring about a tendency to reduce the profit margin by causing, on the one hand, wages to rise, and on the other hand, product prices to fall. Now it may be briefly mentioned that the situation of choosing roundabout methods of production is no different from that of introducing any new production process. When any new production process is begun, the entrepreneur must attract factors of production, and in increasing the products, he will push down their prices. However, in the case of a “correct choice,” he will only begin such production processes which, in spite of these counter effects, do not lead to any losses. Obviously, the appearance of one single entrepreneur will often neither drive up the price of a factor of production so dramatically nor force the price of the product down so far that it would be necessary to be concerned about these two movements. Here we only point out this case in order to be able to apply it to the case of introducing roundabout methods of production: Here, too, the entrepreneur will only be able to adopt roundabout methods of production that yield a surplus return and thus allow him to pay capital interest in addition to his other costs.

The rest is simply the application of a line of reasoning with which we are already familiar. For a moment, let us further consider the subsistence fund as a form of capital. The more capital of this kind that is formed, the more and the longer roundabout methods of production can be introduced until in the end all production is carried out using roundabout methods. The greater productivity of these roundabout methods of production will actually vary. Those roundabout methods of production which result in the greatest capital return will be preferred. The changes will thereby not only be restricted to changes from one production process to another, not only to an expansion of one and a reduction of another production, but also within the individual production processes the roundabout methods will have to be shortened or lengthened. It is not the subsistence fund as such that is traded on the capital market, but capital that is free for some time until it is repaid, i.e., something which can be captured by the formula: capital multiplied by time. And finally, it is clear that in a smoothly operating model, a price in the form of a uniform interest rate must arise for this object on the capital market. The owners of capital will try to achieve the highest possible interest rate; and as a result of the greater productivity of the roundabout methods of production, the entrepreneurs will be in a position to pay back what they have received plus interest. The supply of the owners of capital is faced with the entrepreneurs’ demand which will be stratified according to the degree of greater productivity of the individual roundabout method of production and its suitability for supporting a higher or lower interest rate. Just as with each price formation, that demand will succeed which is capable of paying the highest price, in this case the highest interest rate. Among all of the possible roundabout methods of production, only those will be able to be carried out which can produce surplus returns that are in line with the market rate of interest. Those roundabout production processes that cannot pay this free-market interest rate must not be started. However, the stratification of the demand for capital is not only determined by the possibility of achieving a larger or smaller return in one or another line of production, but beyond this is determined by the possibility of achieving a larger or smaller increase in returns, depending on the duration of each individual production process. Consequently, we see the decisive function of capital interest: it alone offers the possibility to the entrepreneur of determining time limits for the roundabout method of production. Lowering the interest rate offers the possibility of investing capital in even more lengthy roundabout methods of production, i.e., in those in which the “marginal product” of capital is lower, while a rise in the interest rate forces a shortening of the roundabout method of production.

It is exclusively the height of interest—and not, for example, the size of the subsistence fund that he plans to use as capital—that has become a new cost factor for the entrepreneur employing capital in a production process. For in the case considered here—of production carried out from beginning to end by one entrepreneur such that no capital goods arrive on the market—capital is identical to the sum of wages that the entrepreneur must “advance” to laborers before the product is completed. The situation is simply that each prior wage expenditure must not only find an equivalent in its product, but this product must also include capital interest as determined by the length of time for which this capital has been “tied up.” Any other use of a subsistence fund cannot be justified in the framework of price calculations. In a complex economy, the owner of capital must invest his subsistence fund in such a way that each time his capital is invested, he receives the interest rate prevailing for this time period on the market. The entrepreneur will not be able to obtain capital if he cannot carry this “additional” cost burden.

One must pay attention, however, to the fact that as a result of the above mentioned possible variations in the employment of capital, with respect to capital the “mechanism” of the law of costs will be more complicated than with regard to other production factors. In any case, the principle of the marginal product will be applicable here, too. More capital means an increase in a production factor which will be subject to the law of diminishing returns. Let it only be said here that the “clever choice” of productive combinations will prefer that kind of rearrangement between production factors for which the expected surplus return is greater. The same will also apply to the case of restricting the employment of capital in production.

It will not be difficult for us to proceed now from the construed case of carrying out production by one entrepreneur from beginning to end to that corresponding to a real economy in which production is not carried out without interruption by one single entrepreneur, but instead is distributed “vertically” among a number of entrepreneurs. What emerges as a problem in this case is the formation of the prices of capital goods. Since it is obvious that the prices of these capital goods as well as all other prices of products in the course of a static economy will be cost prices, it suffices here to give a brief indication of the effect of cost expenditures within continuously proceeding production. In breaking down this production, the capital good will have to be exchanged at that price which corresponds to the costs expended in the course of production. These cost expenditures determine at each moment the cost value of the product which becomes the cost price and hence, with an organization of production corresponding to the law of costs, determine the market price as soon as the capital good leaves the firm and arrives on the market. It should now be beyond any doubt that for each previously expended unit of capital, interest is calculated according to the length of time the capital was tied up, and must be included in the costs. Similarly, it cannot be doubted that interest will also have to be calculated as a cost factor of the capital good according to the period of time for which capital is tied up. Finally, it is also clear that wherever a capital good (a machine) is used to produce a greater number of product units which can only be completed over a longer period of time, the average duration of the tying up of capital invested in this factor of production must be included in the calculation of the cost burden of interest. The principle of price formation for durable capital goods will thus take effect in the same way as for intermediate products.

If, however, capital interest becomes the selection principle for choosing the length of the roundabout method of production, then it will also determine the extent to which free capital can be transformed into durable capital goods. Durable goods only come about through the investment of free capital, just as do intermediate products. The entrepreneur who produces durable capital goods chooses a particularly long roundabout method of production; he invests free capital in a roundabout method of production from which only later can a complete release be possible. Hence, it is clear that a lower interest rate will encourage the formation of durable capital goods. From this it is obvious how necessary the calculation of interest is for roundabout production. Without a calculation of interest there would be absolutely no indication to what extent the tying up of capital in durable investments is possible without a lack of the complementary good of free capital arising. More will have to be said about this relationship later.