8. The Principle of Substitution and the Horizontal Connectivity of Prices

If in a smoothly functioning market only one uniform price can arise for goods of the same kind, then it is not much more than a continuation of this thought if this principle is expanded to the law that goods which can be substituted for each other will attain the same price. It is clear that disparities in the prices of goods which can be substituted for each other will lead to changes in the form of supply and demand. This can be most simply explained with respect to the area of consumer goods. If two consumer goods A and B (for example, foods) can be put to essentially the same use, but good A is significantly more expensive than good B, then the demand for good A will fall whereas the demand for good B will rise, thus setting in motion a tendency towards equalizing both prices.⁴¹ This interconnectedness of product prices will also be reflected in a connectivity of prices of factors of production: Since the demand for A is co-determined by the price of B, the price of a factor of production suitable for product A will also be co-determined by the price of the factor of production suitable only for product B.

Here we are interested primarily in the interrelation of prices of factors of production resulting from the possibility of substitution. For example, there is the possibility of substituting unskilled for skilled labor. A multitude of unskilled labor can occasionally be substituted for a unit of skilled labor, and this substitution possibility must be reflected in the relation between both prices. Furthermore, there can be a substitution between labor and land: Production by a single entrepreneur can be expanded by increasing labor or by increasing land (and restricted, respectively). In fact, we are faced with nothing here but a particular application of the principle of diminishing returns. The relationship between the prices of labor and land will be the determinant for the employment of these factors in production.

Finally, the substitution of originary factors of production, primarily labor, and capital, is possible. The common point of view assumes that (relatively) more expensive labor will be replaced by cheaper machine power⁴² and vice versa. However, since every capital good is simply previously expended originary factors of production, here the substitution goes in this direction: The expenditure of more labor in a briefer roundabout production process or of less labor in a more lengthy roundabout production process (by employing more capital) and vice versa. The entrepreneur calculates the possibility of substituting when calculating costs. He will employ previously done labor in the form of capital goods to a greater extent if at the given prices, i.e., in particular at the going interest rate, the earlier expenditure of labor brings a better return. For the entrepreneur, earlier employment of labor means on the one hand, an increase in the cost burden (of the labor wage) due to interest; on the other hand, however, it means an increase in output equal to the difference between the productivity of an earlier labor expenditure and that of a later one. The result here is an interrelation of the price of labor employed in the realm of consumer goods production and the labor employed in much earlier production stages, even if, because of the friction associated with reallocating labor, an equalization of wages is not possible.

These brief explanations only serve to point out that the plain model of supply and demand and the cost principle alone are not able to determine once and for all the system of prices as long as one avoids considering the changes of market configurations which arise from the relationship between presently existing prices. We merely seek to emphasize the even stronger interconnectedness of the system of prices that results from this fact. For the special purposes of our study, no further deductions are needed. If we later assume a system of prices and study disturbances in the structure of this system, we will primarily be concerned with the vertical connectivity of prices. This is related to the subject matter of our study: For the specific function of capital is the structuring of production processes in vertical stages. In an exchange economy based on division of labor, these stages will be determined by the relationship between prices. Consequently, for the analysis of capital the structure of the price system is primarily of interest as regards the relationships of preceding and succeeding prices, i.e., regarding the relationships between the prices of factors of production, capital goods, and consumer goods.