Chapter 6. The Dependence of the Division of Labor on Capitalism II: The Price System and Economic Coordination

CHAPTER 6

THE DEPENDENCE OF THE DIVISION OF LABOR ON

CAPITALISM II: THE PRICE SYSTEM AND ECONOMIC

COORDINATION

PART A

UNIFORMITY PRINCIPLES

T he dependence of the division of labor on the price system centers on the coordinating function of prices. The price system coordinates the various branches of the division of labor in a variety of essential respects. It keeps the various branches of industry, and thus the production of the various products, in proper balance with one another by appropriately adjusting their relative size. It does the same with respect to the relative size of the various occupations. It also achieves a harmonious balancing of the supplies of the various products produced with respect to their distribution in terms of place and time. These results are accomplished by the operation of a series of principles that I call uniformity principles, which are described and elaborated in the first four sections of this part.

1. The Uniformity-of-Profit Principle and Its

Applications

The best way to begin to understand the functioning of the price system, and thus the full nature of the dependence of the division of labor on capitalism, is by understanding the following very simple and fundamental principle. Namely, there is a tendency in a free market toward the establishment of a uniform rate of profit on capital invested in all the different branches of industry. In other words, there is a tendency for capital invested to yield the same percentage rate of profit whether it is invested in the steel industry, the oil industry, the shoe business, or wherever.

Profit, of course, is the difference between sales revenues and costs. The rate of profit on capital invested is the amount of profit divided by the amount of capital invested. 1

The reason for the tendency toward a uniform rate of profit on capital invested is that, other things being equal, investors naturally prefer to earn a higher rate of profit on their capital rather than a lower one. The higher is the rate of profit they earn, the larger is the amount of profit they earn per year and thus the more rapidly they can augment their wealth through saving and, at the same time, the more they can afford to consume. As a result, wherever the rate of profit is higher, and all other things are equal, investors tend to invest additional capital. And where it is lower, they tend to withdraw capital they have previously invested. The influx of additional capital in any initially more profitable industry, however, tends to reduce the rate of profit in that industry. This is because its effect is to increase the industry’s production and thus to drive down the selling prices of its products. As the selling prices of its products are driven down, closer to its costs of production, the rate of profit earned by the

1 Tvehrey r daitfef oefr epnrot pfirto ofnit c maparitgailn isn mveusstte edx sihsot iufl edq nuoatl b raet ceosn offu psreodf iwt oitnh c thape ictoaln icnevpets otef dp raorfei tto m eaxrigsitn. T. Ahu psr,o thfiet mpraorfgiti nm ias rpgrionf iint t tahkee rne atasi al gpreorcceernyta bgues oinfe ssasl ewso reuvlde nhuavese, t noo bte c jaupsitt a2l p inervceesntet;d th. Bate ocfa tuhsee s otefe tel cmhinlli,c 1a0l f paecrtcoerns tc;e anntder tihnagt oonf t thhee epleercitordics uotfi tliimtye, 2w0h picehrc menuts,t i enl oarpdseer b feotrw aelle onf o tuhtelmay tso o efa cranp ait raalt aen odf r percoefiipt tosn o cf asaplietasl r ienvveensuteed, d oiff f1e0re pnetr icnednuts.tries tend to earn permanently unequal profit margins, even though they tend to earn equal rates of profit on capital invested. Thus, for example, a retail grocery business, which has a substantial portion of its capital invested in merchandise of the kind that is sold within days of purchase, or even on the very same day, may have annual sales revenues equal to five times its capital. A steel mill, on the other hand, may have annual sales revenues that are merely equal to its capital. An electric utility may have annual sales revenues that are equal to only half of its capital. Because of these very different rates of capital turnover—i.e., ratio of sales to capital—namely 5:1, 1:1, and [[$E1/2]]:1,

THE PRICE SYSTEM AND ECONOMIC COORDINATION 173 industry necessarily tends to fall. Conversely, the withdrawal of capital from an initially less profitable industry tends to raise the rate of profit in that industry, because less capital means less production, higher selling prices on the reduced supply, and thus a higher rate of profit on the capital that remains invested in the industry.

To illustrate this process, let us assume that initially the computer industry is unusually profitable, while the motion-picture industry is earning a very low rate of profit or incurring actual losses. In such conditions people will obviously want to invest in the computer industry and to reduce their investments in the motion-picture industry. As investment in the computer industry is stepped up, the output of computers will be expanded. In order to find buyers for the larger supply of computers, their price will have to be reduced. Thus, the price of computers will fall and, as a result, the rate of profit earned in producing them will fall. On the other hand, as capital is withdrawn from the motion-picture industry, the output of that industry will be cut, and the reduced supply it offers will be able to be sold at higher prices, thereby raising the rate of profit on the investments that remain in the industry.

In just this way, initially higher rates of profit are brought down and initially lower rates of profit are raised up. The logical stopping point is a uniform rate of profit in all the various industries.

Keeping the Various Branches of Industry in Proper Balance

This principle of the tendency of the rate of profit toward uniformity is what explains the amazing order and harmony that exists in production in a free market. It was largely the operation of this principle that Adam Smith had in mind when he employed the unfortunate metaphor that a free economy works as though it were guided by an invisible hand.

In the United States production is carried on by several million independent business enterprises, each of which is concerned with nothing but its own profit. Knowing this, and knowing nothing about economics, one might easily be led to think of such conditions as an “anarchy of production,” which is how Karl Marx described them. One might easily be led to expect that because production was in the hands of a mass of independent, self-interested producers, the market would randomly be flooded with some items, while people perished from a lack of others, as a result of the discoordination of the producers. This, of course, is the image conjured up by those who advocate government “planning.” It is the view of most advocates of socialism.

The uniformity-of-profit principle explains how the activities of all the separate business enterprises are harmoniously coordinated, so that capital is not invested excessively in the production of some items while leaving the production of other items unprovided for. The operation of the uniformity-of-profit principle is what keeps the production of all the different items directly or indirectly necessary to our survival in proper balance. It counteracts and prevents mistakes leading to the relative overproduction of some things and the relative underproduction of others.

To understand this point, assume that businessmen make a mistake. They invest too much capital in producing refrigerators and not enough capital in producing television sets, say. Because of the uniformity-of-profit principle, the mistake is necessarily self-correcting and self-limiting. The reason is that the effect of the overinvestment in refrigerator production is to depress profits in the refrigerator industry, because the excessive quantity of refrigerators that can be produced can be sold only at prices that are low in relation to costs. By the same token, the effect of the underinvestment in television set production is to raise profits in the television set industry, because the deficient quantity of television sets that can be produced can be sold at prices that are high in relation to costs. The very consequence of the mistake, therefore, is to create incentives for its correction: The low profits—or losses, if the overinvestment is serious enough— of the refrigerator industry act as an incentive to the withdrawal of capital from it, while the high profits of the television set industry act as an incentive to the investment of additional capital in it.

Moreover, the consequence of the mistake is not only to create incentives for its correction, but simultaneously, to provide the means for its correction: The high profits of the television set industry are not only an incentive to investment in it, but are themselves a source of investment, because those high profits can themselves be plowed back into the industry. By the same token, to the extent that the refrigerator industry suffers losses or earns a rate of profit that is too low to cover the dividends its owners need to live on, its capital directly and immediately shrinks, and it is thereby made unable to continue producing on the same scale.

In this way, the mistakes made in the relative production of the various goods in a free market are self-correcting.

With good reason, the operation of profit and loss in guiding the increase and decrease in investment and production has been compared to an automatic governor on a machine or to a thermostat on a boiler. As investment and production go too far in one direction, and not far enough in another direction, the very mistake itself sets in motion counteracting forces of correction. Moreover, the greater the mistake that is made, the more powerful

are the corrective forces. For the greater the overinvestment and overproduction, the greater the losses; and the greater the underinvestment and underproduction, the greater the profits. Thus the greater the incentives and the means (or loss of means) to bring about the correction. In this way, the mistakes made in a free market are not only self-correcting, but self-limiting as well: the bigger the mistake, the harder it is to make it.

Further, in a free market, most of the mistakes that might be made in determining the relative size of the various industries and the relative production of the various goods are not made in the first place. This is because the prospect of profit or loss causes businessmen to weigh investment decisions very carefully in advance and thus to avoid mistakes as far as possible from the very beginning. In seeking to avoid losses, businessmen necessarily aim at avoiding overinvestment and overproduction. In seeking to make the highest possible profits, they necessarily aim at providing the market with those goods in whose production they do not expect other businessmen to invest enough. This last fact, incidentally, makes each businessman eager to invest sufficiently in his own industry, lest the opportunities he does not seize be seized by others instead.

In addition, the free market performs a constant process of selection with respect to the ownership of capital. Capital gravitates, as it were, to those businessmen who know best how to employ it and is taken away from those who do not know how to employ it. For those who invest in providing goods that are relatively more in demand make high profits and are thereby able to increase their capitals, and, consequently, their influence over future production; while those who invest in producing goods that are relatively less in demand earn low profits or suffer losses, and are correspondingly deprived of capital and of influence over future production. At any given time, therefore, capital in a free market is mainly in the hands of those who are best qualified to use it, as demonstrated by their past performance in investing. For this reason, too, most of the mistakes that might be made in determining the relative production of the various goods are avoided in the first place in a free market.

The Power of the Consumers to Determine the

Relative Size of the Various Industries

The uniformity-of-profit principle explains not only how a free market prevents and counteracts mistakes in the relative production of the various industries, but also how the consumers in a free market have the power of positive initiative to change the course of production. All the consumers need do to cause production to shift is to change the pattern of their spending. If the consumers decide to buy more of product A and less of product B, the production of A automatically becomes more profitable and that of B less profitable. Capital then flows to A and away from B. The production of A is thus expanded, and that of B contracted, until, once again, both A and B afford neither more nor less than the general or average rate of profit.

Of course, businessmen do not sit back and passively wait for the consumers to shift their demand. On the contrary, businessmen seek to anticipate changes in consumer demand and to adjust production accordingly. In addition, of course, they constantly seek to introduce whatever new or improved products they believe will attract consumer demand once the consumers learn of the product. Businessmen will produce anything for which they believe the consumers will pay profitable prices, and they will cease to produce anything for which the consumers are unwilling to pay profitable prices. In this sense, business is totally at the disposal of the consumers—the consumer is king, as the saying goes. In total opposition to the misguided efforts of the Marxists to contrast production for profit with “production for use,” the fact is that production for profit is production for use. It is production for the use of the consumers, as determined by the value judgments of the consumers themselves. It is the way production for use takes place in the context of a division-of-labor society, in which the producers produce for the needs of others, whose needs are conveyed to them by means of profit and loss.

i. The “Consumer Advocates” Versus the Consumers

It should not be difficult to see that the real advocates of the consumers—their virtual agents—are businessmen seeking profit, not the leaders of groups trying to restrict the freedom of businessmen to earn profits. Such groups, called, ironically, the “consumer movement,” seek to force businessmen to produce things the consumers do not want to buy, like seat belts and air bags in automobiles before they are sufficiently improved in comfort and reliability and reduced in cost to be attractive to many people. At the same time, the socalled consumer movement seeks to prohibit businessmen from producing things the consumers do want to buy, like breakfast cereals that are enjoyable to eat, and full-sized automobiles. As von Mises has pointed out, inasmuch as what is produced in a free economy is, in the last analysis, the result of the free choices of the consumers, the demands of the consumer advocates are comparable to efforts arbitrarily to overturn the results of a free election when one does not like the outcome. The dictatorial character of such demands should be obvious. 2

Of course, whenever they can be gotten to admit that it is actually the choices of the consumers they wish to overturn, not any arbitrary decisions of businessmen, the

THE PRICE SYSTEM AND ECONOMIC COORDINATION 175

“consumer advocates” are almost certain to argue that they are nonetheless justified in their activities, on the grounds that they merely force the consumers to act “for their own good.” Here the “consumer advocates” lose sight of the fact that the fundamental basis of achieving the individual’s good is his guidance by his own judgment. They show absolutely no respect for the character of the consumers as rational beings, who must be persuaded by facts and logic, not compelled as though they were brutes, in the name of something allegedly more valuable than their free judgment and their dignity as rational beings.

It may well be the case that using seat belts saves lives and that if left to their own free choice, the consumers would not have used them as fast as they have been made to use them through compulsion. But what saves infinitely more lives than seat belts is the acceptance of the principle that each human being, as the possessor of reason, is valuable and competent and should be free to run his own life and pursue his own happiness. The use of any specific case as the pretext for overturning this principle opens the floodgates to unlimited destruction through the use of physical force to overrule people’s judgment and thus to prevent them from achieving their wellbeing or to compel them to act against their own wellbeing. Ayn Rand has rightly compared the use of force in the name of achieving a man’s good to an attempt to give him a picture gallery at the price of cutting out his eyes. 3 ii. Consumer Safety and Pressure Group Warfare

The fact of the matter is that the consumers cannot even properly be described as irrational in refusing to use seat belts, so long as their use had (or has) the effect of making every automobile trip a physically uncomfortable experience. It cannot reasonably be claimed that the remote possibility of an accident automatically outweighs any possible physical discomfort that would have to be experienced on every trip in order to safeguard against it. Let the use of seat belts be made comfortable enough, their cost low enough, and knowledge of their benefits widespread enough, and there is no doubt that consumers will freely use them, because in such circumstances they really would benefit from their use. But when compulsion is introduced into the picture, it is an entirely different story.

Thus, even if the “consumer advocates” have succeeded in compelling the use of seat belts—by means of the threat of fines and possibly jail terms for failure to use them—what remains is the fact that the consumers have been compelled to endure what in their judgment is a chronic physical discomfort (and/or too high a cost). This cannot be justified if one values the free judgment

of the human mind and thus elementary human dignity. In sharpest contrast, under freedom, such an affront would not only have been avoided, but it might well have been avoided while people still gained the benefit of seat belts. When based on compulsion, the use of seat belts does not have to be comfortable and sufficiently economical—it is simply compelled, whether the consumers like it or not. When based on freedom, the use of seat belts does have to be comfortable enough and economical enough, because the consumers have to both like using them and value them above their price if they are to buy them. On a free market, these are the kind of seat belts the consumers would have to have obtained.

Only a free market can rationally decide such questions as whether or not seat belts, and now air bags, should be installed in automobiles. In a free market, if air bags, for example, represented a major advance in automobile safety, one of the consequences would be that their presence would so reduce the costs of insurance companies in the settlement of injury claims that the insurance companies would be in a position significantly to reduce the premiums of whoever owned a car which had one. This saving in insurance premiums, coupled with the personal benefits of reduced likelihood of serious injury, would then be weighed by the consumers against the cost of having air bags installed, or the additional cost of buying an automobile that came with an air bag in comparison with one that came without an air bag. The greater the reduction in physical injuries, and the financial costs associated with them, that air bags achieved, and the lower the cost of installing air bags, the greater would be the demand for air bags. Depending on these data, the potential quantity of air bags demanded would exist on a continuum ranging from none at all, in the event the advantages were deemed insufficient by everyone relative to the additional cost, down through high-cost luxury add-on or option, down through widely chosen add-on or option, down through standard feature on some or most new models, down through standard feature on all new models.

Things are very different in a hampered market economy, such as today’s socalled mixed economy, with its pressure-group warfare. In such conditions, each pressure group seeks to violate the rights of others for its own benefit, either for its own aggrandizement or in order to make good the depredations of others that have been inflicted on it. Thus, the automobile insurance industry— itself made to bear the skyrocketing medical costs caused by government intervention into health care (insofar as it must pay the medical bills of the victims of automobile accidents), bled white by jury awards based on the notion that any large corporation is fair game for anything, and the victim of government interference to the point of

being rendered incapable of controlling the automobile repair costs it must pay—forms into a pressure group and joins the “consumer advocates” in demanding that the automobile industry install air bags. It acts in the hope that the reduction it expects to have in its own costs will serve as a reprieve. As cover, it waves the banner of consumer safety, while making no mention of the higher prices that consumers will have to pay for automobiles. Ironically, at the same time, on the basis of their own accumulated grievances, automobile owners join in demands for rate rollbacks for the insurance companies.

And while this goes on, the “consumer advocates” lead an ignorant public to believe that the costs imposed on the automobile industry in the name of safety, fuel economy, pollution control, and whatever are somehow just at the expense of the automobile companies and have nothing whatever to do with raising the cost of production and price of automobiles. The fact is, of course, that such legislation has already added several hundred dollars to the cost of the average new automobile that is sold in the United States. The paradoxical effect of this has actually been to work to reduce automobile safety! To the extent that new automobiles are made more expensive than they need to be, people are compelled to operate their cars longer. Since older cars as a rule are not as safe as new cars, this means that people are forced to drive in automobiles that are not as safe as they would be in the absence of automobile safety legislation and allied legislation. Thus, the introduction of physical force into the issue of automobile safety (and anywhere else in the market) actually has the perverse effect of operating to reduce safety. 4

The Impetus to Continuous Economic Progress

The uniformity-of-profit principle explains how the profit motive acts to make production steadily increase in a free market. It explains how the profit motive becomes an agent of continuous economic progress.

In order to earn a rate of profit that is above average, it is necessary for businessmen to anticipate changes in consumer demand ahead of their rivals, to introduce new and/or improved products ahead of their rivals, or to cut the costs of production ahead of their rivals. I say, “ahead of their rivals,” because as soon as any innovation becomes general, then, in accordance with the uniformity-of-profit principle, no special profit can be made from it. For example, the first firms that produced shoes by machinery rather than by hand, or put zippers in clothing, or found a way to sell a cigar for ten cents, or whichever, were able to make above-average rates of profit by doing so. But once such things became general, no special profit could any longer be made from them. They became the ordinary standard of the industry and were taken for granted. Sooner or later, virtually every innovation does become general. This implies that for any firm to continue to earn an above-average rate of profit, it must repeatedly outdistance its rivals; it must work as an agent of continuous economic progress.

Perhaps one of the most dramatic examples of this is provided by the career of the first Henry Ford. When the Ford Motor Company began, in the early part of the twentieth century, the automobile was a rich man’s toy. Extremely primitive models by our standards were selling for about $10,000—in the very valuable money of the time. 5 Henry Ford began to find ways to improve the quality of automobiles and at the same time cut the costs of their production. But it was not possible for Ford to make a single improvement or a single cost reduction and stop there, because it was not long before those innovations were generally adopted in the industry and, indeed, superseded. Had Ford stood pat, it would not have been long before his once profitable business was destroyed by the competition. In order for Ford to go on making a high rate of profit, he had to continuously introduce improvements and reduce costs ahead of his rivals.

The same is true in principle, in a free market, of any individual or firm that earns an above-average rate of profit over an extended period of time. What was good enough once to make a high rate of profit, ceases to be good enough as soon as enough others are able to do the same thing. In order to go on earning an above-average rate of profit, one must continue to stay ahead of the competition. By the same token, any business that stands pat is necessarily finished in a free economy, no matter how great its past successes. For the technological advances of any given time are further and further surpassed as time goes on. Think how absurd it would be in virtually any industry to try to make money today by producing with the most advanced, most profitable technology of 1900, 1940, or even 1980, and not bothering to adapt to the changes that have taken place since then.

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It is necessary to explain in more detail how the competitive quest for an above-average rate of profit expands the total of production.

If a firm is a leader in the improvement of production, it expands its sales revenues and profits at the expense of the sales revenues and profits of other firms that are less quick to improve. This is because it has something better or equally good but less expensive to offer than they do; and so buyers shift their purchases to it, thereby enlarging its sales revenues and profits and diminishing the sales revenues and profits of other firms.

(It is important to realize that this same result—the innovative firm’s gain in sales revenues and profits accompanied by a decline in the sales revenues and profits

of others, who are less innovative—occurs even in the exceptional case in which a business cuts its costs of production and yet keeps its selling price absolutely unchanged. In this case, it does not attract sales revenues from other sellers in the same industry, but it almost certainly attracts sales revenues and profits from sellers in different industries. Because to the extent that it saves, and reinvests its extra profit anywhere in the economic system, it will bring about an increase in production. This new production in some other line of business will take sales revenues and profits away from whichever sellers buyers now abandon in order to be able to purchase this new production. For example, imagine that a maker of razor blades, say, finds a way to cut his costs, and yet chooses not to cut his selling price at all. He will not reduce the sales revenues and profits of other razor blade manufacturers, but to the extent that he saves, and invests his profit in the production of some other product— whether it is an after-shave lotion, chocolate bars, or anything—he will increase the supply of that product and take sales revenues and profits away from somewhere else in the economic system, because to buy this additional product of his, people will have to restrict their expenditures for other things.)

Now the combination of an innovator’s higher profits and others’ lower profits or outright losses is what then impels these others to improve their production, too. These others may simply want to cash in on the high profits of the innovator and so duplicate his innovation for that reason. Or they may be in the position of having to duplicate his innovation in order merely to stay in business.

It cannot be stressed too strongly that under the freedom of competition, innovations must be adopted not only to make exceptional profits, but to be able to make any profits whatever. They must be adopted merely to be able to remain in business at all. This is true because sooner or later, as the result of the freedom of competition, virtually all cost cuts are translated into price cuts, and whoever does not produce with the lower-cost method cannot cover his costs. Even in our present-day, highly inflationary environment, in which wages rise every year and prices hardly ever fall, it is necessary for all producers to adopt cost-cutting improvements. They must adopt them in order not to have to raise prices in full proportion to the increase in wages and so be in the untenable position of requiring price increases greater than their competitors’ in order to stay in business.

As indicated, there is probably no business in the United States today that would still be in business had it not adopted major innovations over the last generation and probably even over the last decade. It is not possible for a business to sell at the same prices as others and yet produce at substantially higher costs—not when its selling prices are governed by their lower costs. Nor is it possible for a business to sell a substantially poorer product than others at the same price they are asking for a better product. The penalty for falling too far behind either in efficiency or in quality of product is going out of business. The only way to avoid this penalty is by adopting the innovations before it is too late.

The fact that sooner or later competitors do adopt innovations not only enables them to increase their own profitability, or at least to restore it and thus to survive (which of these it is depends on how much sooner or later they adopt them), but it also takes away the special profits of the innovators. The fact that the special profits of innovating do tend to disappear, because competitors catch up, is what necessitates that everyone who wants to go on making an exceptional rate of profit over an extended period of time introduce repeated innovations. If he is to prevent the loss of all his special profits to competitors who are catching up, he must make fresh advances over them. In this way, the combination of the profit motive and the freedom of competition leads successful producers to seek continuous improvements. That is the only way they can sustain an exceptional rate of profit; they cannot rest content merely with their past successes.

In connection with the freedom of competition, it should be realized, moreover, that the ranks of businessmen are open to everyone, including penniless newcomers. Those who have a valuable idea, but lack the funds to implement it themselves, can offer a partnership to others who do have capital; and further capital can be borrowed. In a capitalist society, there is an enormously large number of possible sources of financing for any new idea. It is equal to the number of individuals or combinations of individuals who possess the amount of capital required. For example, if a million dollars is the sum required, there are as many potential sources of financing as there are individuals or combinations of individuals who possess a million dollars or more.

This situation guarantees that every new idea has many possible chances for being implemented. If the innovator does not possess the necessary capital himself, he can turn to as many separate sources of financing as there are individuals or groups who do possess the necessary capital. It is not necessary for him to convince everyone, a majority, or even a significant-sized minority of his fellow citizens that his idea is valuable before he can put it into practice. If he owns the necessary capital himself, he can go ahead without convincing any other person at all. If he does not own the necessary capital himself, then he needs to convince only a minority consisting of possibly just one other person, and in no case

of more than a relative handful of people who in combination possess the necessary capital.

The importance of this fact cannot be overestimated. Not only are new ideas always the product of individual minds, known at first to just one individual member of the whole human race, but also, no matter how sound or important they are, their value is often not recognized for a considerable time by the overwhelming majority of other people. To confirm this fact, one has only to recall the difficulties even of such giants of progress as Columbus, Pasteur, Edison, Ford, the Wright brothers, and Goddard in obtaining recognition and support for their profoundly important innovations. Columbus had to spend years attempting to raise funds for his voyage, and was very lucky finally to succeed in doing so. Pasteur’s theory that germs cause diseases was denounced by the French Academy of Sciences as a fraud. Edison’s claim that he could produce electric light was denied by most of the physicists of his day. Ford and the Wright brothers were widely regarded as cranks. Goddard’s ideas on rocketry and space flight were dismissed with contempt by such prominent publications as The New York Times. In the absence of a wide range of chances for new ideas being tried, the great majority of valuable innovations are unlikely to be tried, and, in the face of that prospect, unlikely even to be arrived at in the first place. In order for new ideas to flourish, it is essential that a sufficient number of opportunities for their implementation exist so that innovators can above all find ways around the prevailing “mainstream” views—that is, the views of the then current “experts.” As von Mises often pointed out, the “experts” are always experts merely on the state of knowledge up to their time, never on the subject of new knowledge, which in the nature of the case has not yet entered the “mainstream” and is often at odds with the “mainstream.”

Thus, in connection with the operation of the uniformity-of-profit principle, a capitalist society provides the incentive of profit to introduce continuous innovations and the incentive of avoiding losses to adopt the innovations of competitors. At the same time, it opens the possibility of introducing innovations to everyone in the entire society and provides an enormous number of possible sources of financing for innovations. It is impossible to imagine an economic system that could be more conducive to economic progress.

As for the translation of this process of innovation into terms of physical increases in production, it is probably self-evident that the introduction of new and/or improved products constitutes an increase in production or is a source of an increase in production. One has only to think of such cases as the automobile replacing the horse and buggy, or the automobile with the self-starter replacing the hand-cranked automobile, or such cases as the tractor bringing about a vast increase in the production of agricultural products, or the electric motor bringing about a vast increase in the production of all kinds of manufactured goods. It may be less obvious, however, how the day-by-day attention of businessmen to costs, and their constant efforts to reduce the costs of production, are an equally important source of the increase in production. Still less obvious is the role in increasing production that is played by correct anticipations of changes in consumer demand. Therefore, let us briefly consider the contribution of these factors to increasing production.

Reducing the costs of production means, for the most part, that one finds a way to produce the same amount of a good with less labor. This acts to increase production because it makes labor available to produce more of this good or more of other goods, somewhere else in the economic system. The saving of labor is clearest in the case in which the businessman achieves the cost reduction by employing labor-saving machinery. But even if the cost reduction is achieved by finding a way to use less of some material or a less costly material, labor will also be saved. If less of a material is required, less labor is required to produce the smaller quantity of the material. If a less costly material is required, it is probable that labor will be saved, since it is probable that the less costly material is less costly because less labor is required to produce it. To this extent, then, saving costs means saving labor and, therefore, making the means available for increasing production.

Even if a saving in the quantity of labor is not involved in a cost reduction, the ability to produce something with a less costly material, or with less costly labor for that matter—say, unskilled labor in place of skilled labor— still brings about a net increase in total production. What happens in these cases is that the more costly material or labor is released to expand the production of something else which is comparatively important, while the less costly material or labor that replaces it is withdrawn from the production of something else which is comparatively unimportant.

The principle here is perhaps best illustrated by the case of employing nurses and other aides for many of the tasks that would otherwise have to be performed by doctors. What is gained is the added work that can only be performed by doctors and which otherwise would have been impossible for lack of availability of doctors’ time. What is lost is only the work that the nurses or whoever might have performed as secretaries, bookkeepers, or whatever. Every substitution of less costly labor for more costly labor is comparable to this case in its effect. The same applies to the substitution of less costly for more costly materials. In this way, a net economic

gain, equivalent to an increase in production, takes place, because the production of something more important, that is, something with higher marginal utility, is increased at the expense of the production of something less important, that is, something with lower marginal utility. As far as labor goes, the ability to substitute unskilled for skilled labor and achieve equal results can also be viewed as the equivalent of increasing the intelligence and ability of workers, which in the very nature of the case must increase production. 6

The correct anticipation of changes in consumer demand is also a necessary part of the process of increasing production. To understand this point, it must be realized that increases in production are one of the most important causes of wide-ranging changes in the pattern of consumer spending. For example, the steady improvements in agriculture and the consequent drop in the proportion of people’s income that has had to be tied up in buying food has made possible a continuously growing demand for the whole range of industrial goods. Similarly, the introduction and development of the automobile brought about far-reaching shifts in demand: it made possible the development of the suburbs and a whole host of new businesses from gas stations to motels; expanded the demand for other businesses, such as ski resorts; reduced the demand for passenger railroads and horses; and virtually destroyed the businesses of buggymaking and blacksmithing. Every improvement in production exercises a similar, if less dramatic, effect on the demand for other goods.

In order for these shifts in demand to be accompanied by corresponding shifts in production, it is necessary for wide-ranging changes in the investment of capital to occur. Thus, to continue with the examples of agriculture and the automobile, capital had to be diverted from agriculture to industry, from cities to suburbs, from railroads, horsebreeding, buggymaking, and blacksmithing, to automaking, gas stations, motels, and ski resorts. To the extent that the appropriate shifts of capital did not occur, or occurred with undue delay, the benefit from the improvement in production was lost. For example, to the extent that capital was not shifted out of farming rapidly enough—as a result of government farm subsidies or the inertia of many farmers—the effect of the improvements in agriculture was limited to a relatively unwanted increase in agricultural production and correspondingly less of an increase in much more desired industrial production. Similarly, to the extent that capital would not have been shifted rapidly enough out of buggymaking and horsebreeding, the benefits from the automobile would have been held down: capital would have been wasted in buggymaking and horsebreeding which could have been employed with infinitely greater benefit in any of the new or expanding industries brought about by the automobile. In all such cases, to fail to make the appropriate shifts of capital is to lose some or all of the benefit of the improvement in production. For this reason the correct anticipation of changes in consumer demand is an integral part of the process of increasing production.

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I have established that the effect of the quest for an above-average rate of profit in the face of the operation of the uniformity-of-profit principle is to bring about the steady improvement and enlargement of production. The inescapable implication of this fact is a powerful tendency for prices to fall from year to year. It is necessary to reconcile this implication with the fact that based on the experience of almost everyone now living the reality appears to be that prices rise virtually every year.

The fall in prices that the profit motive has actually achieved can be clearly seen if prices are calculated not in terms of depreciating paper money, but in terms of the amount of labor that the average worker must perform in order to earn the means of buying any given quantity of goods. Today, the average worker performs perhaps forty hours of labor in a week and is able to obtain the goods that constitute his present standard of living. As we look back in time, however, we see that the hours of work that had to be performed were greater, and the goods constituting the average worker’s standard of living were less. Thus, as time has gone on, and the average worker has come to receive more and more while working less and less, the quantity of goods he can obtain for each hour of his labor has increased. To say the same thing in different words, the amount of labor he must perform in order to obtain a unit of goods has steadily decreased. In this sense, prices—calculated in terms of the quantities of labor that must be performed in order to buy goods—actually have fallen steadily as the result of the operation of the profit motive.

The fact that in terms of paper money, prices have risen is the result of the fact that while prices of goods really do tend to fall because of the operation of the profit motive, the value of the paper money tends to fall still faster. When falling prices are expressed in a standard that itself falls even more rapidly (which is the case with paper money), they have the appearance of having risen. The following illustration will make this point obvious. In the early 1970s a primitive four-function pocket calculator sold for about $400. At the same time, a fairly primitive video tape recorder sold for about $2,400. Thus, at that time, it took 6 pocket calculators to represent the price of one video tape recorder. Today, the price of a much improved video tape recorder is about $400— which certainly represents a radical drop. But today, the price of a comparable pocket calculator is only about

$10. Thus, today, it takes 40 pocket calculators to equal the price of a video tape recorder instead of only 6. When the lower price of the video tape recorder is expressed in terms of pocket calculators, it appears to have risen instead of fallen, because the price of the pocket calculators has fallen so much more.

Exactly this principle applies to the rise in prices in terms of paper money. While the profit motive operates to reduce the prices of the mass of commodities and does in fact succeed in reducing them when expressed in any kind of reasonably fixed standard of value, the value of paper money falls even more rapidly and so gives the appearance that things have become more expensive instead of less expensive.

This result can be further understood if we realize that paper money is actually among the cheapest goods in the world to produce in the first place. It starts out with a virtually zero cost of production. If its production were open to the freedom of competition, so that anyone in possession of the appropriate paper and printing plates was allowed to manufacture it, its value would quickly be driven down to the value of goods with a comparable cost of production, such as pieces of note paper and pins. Indeed, its value would even be less, because it would not have the actual physical utility of such goods, and the need to carry vast quantities of it to buy other goods would destroy its usefulness as money. In other words, under the freedom of competition, the profit motive would soon make paper money absolutely worthless. All other goods would be worth an infinite quantity of it.

The value of paper money is not destroyed this quickly, because its creation is a monopoly privilege of the government. But even so, as we shall see, the government has powerful incentives to increase the quantity of paper money at a substantially more rapid rate than the scientists, inventors, businessmen, and savers and investors are able to increase the supply of goods. 7 The result is that while the productive work of these most intelligent and ambitious members of society may succeed in an average year in increasing the supply and thus tending to reduce the prices of goods by, say, three, four, five percent, or whatever, the government is easily able to outstrip their performance and increase the quantity of money and volume of spending in the economic system by a larger amount, with the result that prices rise instead of fall.

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To summarize the discussion of the price system thus far: The desire of businessmen to earn profits and avoid losses, and to earn higher profits in preference to lower profits, brings about a tendency toward a uniform rate of profit on capital invested in all the different branches of industry. The operation of this tendency counteracts, delimits, and largely prevents mistakes from being made in the relative production of the various goods. Because of it, consumers have the power of positive initiative to shift the course of production simply by changing the pattern of their spending; because of it, businessmen are made to act virtually as the consumers’ agents. The operation of the tendency toward a uniform rate of profit requires that high profits be made by continuously introducing productive innovations in advance of competitors. These innovations are the base of a continuous increase in production, whether they take the form of new and improved products, reduced costs of production, or correct anticipations of changes in consumer demand. As such, they operate continuously to raise the average standard of living. They steadily enlarge and improve the goods available while reducing not only the amount of work that must be performed in order to produce any given quantity of goods but also the amount of work that must be performed in order to buy any given quantity of goods. In other words, they make possible progressively improved products at prices corresponding to progressively falling real costs of production.

On the basis of the foregoing, we must conclude that the profit motive and the price system of capitalism have been responsible for virtually all of the economic progress of the last two hundred years or more. They have ensured the maximum possible effort to introduce innovations and to extend their application as rapidly as possible, with the result that in comparatively short periods of time revolutionary improvements have become commonplace. Because of this and because of the rapid adaptation they assure to all changes in economic conditions, they have rendered every crisis, from natural disasters, to wars, to absurd acts of government, a merely temporary setback in a steady climb to greater prosperity.

Profits and the Repeal of Price Controls

What we have learned about the free market can be applied to a number of cases in which the free market does not or for a time did not exist in our country. A brief consideration of these cases will both illustrate the principle of the tendency of the rate of profit toward uniformity and provide a demonstration of the value to be gained by extending the free market.

Consider the case of government farm subsidies. Let us imagine that the government stopped buying up farm products to be stored or given away, and at the same time reduced taxes by the amount of money it saved in abolishing the farm subsidy program.

The effect would be a drop in the demand for farm products. But since the taxpayers would now have the money previously used to pay the subsidies, there would be a rise in the demand for a host of other products—

products which the taxpayers judged would satisfy the most important of their needs or wants which previously had had to go unsatisfied, such as an extra room added on to a house, a newer or better car, extra education, and so on, depending on the needs and desires of the various individuals concerned. The immediate effect of this shift of demand would be to depress prices and profits in farming and to raise them in these various other industries. The further consequence would be a withdrawal of capital and labor from farming and their transfer to the production of these other goods.

The movement of capital and labor out of farming would take place until the rate of profit in farming was raised back up to the general level, and the rate of profit earned on the various goods in additional demand by the taxpayers was brought down to the general level. Until this result was achieved, incentives would exist for a further movement of capital and labor out of farming and into these other fields. When the process was finally completed, therefore, the rate of profit earned in farming would be on a par with the rate of profit earned everywhere else. In accordance with the uniformity-of-profit principle, it would simply not be possible for the rate of profit in farming to be permanently depressed.

It follows from this analysis that in the long run those who remained in agriculture would tend to earn, on average, the same level of income they had earned before the repeal of the subsidies. Even the incomes of ex-farmers would, on average, come to be on a level comparable to what they had been initially. This would be the case as soon as the former farmers acquired industrial skills on a level comparable to those they had possessed in agriculture and so could take appropriate advantage of the new employment opportunities created by the expansion in the demand for industrial goods. The one permanent difference that would now exist and which would be of benefit to everyone, farmers and ex-farmers included, would be that the taxation of everyone’s income would be smaller and everyone would be enabled to buy more of the goods he himself desired. Instead of everyone being forced to spend a part of his income, through the government, for the purchase of farm products to be uselessly stored or given away, he would be able to spend that part of his income for industrial goods of value and importance to his life. And those goods would be produced by the capital and labor previously employed in producing the farm products.

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In sharpest contrast to the beneficial effects the uniformity-of-profit principle brings to the abolition of farm subsidies, are the further harmful effects it leads to if farm subsidies are retained. Insofar as the subsidized prices are above the costs of producing additional agricultural output by more than is necessary to provide the going rate of profit, the incentive is created to increase production. The incentive is created to increase production all the way to the point that any further increase would have to be carried out under conditions of such diminishing returns and need to resort to land of inferior quality, that higher costs of production would finally offset the receipt of the artificially higher farm product prices and bring the rate of profit in agriculture down to the general level in this way. To reach this point, the government would have to purchase and store truly immense quantities of agricultural commodities. It would not only run out of grain elevators, as it did, but also probably run out of caves and the holds of mothballed ships, to which it has actually turned for use as supplementary storage facilities. And, not to be overlooked, its budget would be thrown substantially further out of balance.

To avoid these consequences, the government is led to seek ways to limit the increase in production its policy of farm subsidies makes profitable. Thus, it restricts the number of acres that can be planted. It may require that the growers have a special license in order to grow a crop. To a large extent the effect of this policy is to allow inefficient, high-cost producers to go on producing while prohibiting production by more efficient, lowcost producers. In a free market, the lowcost producers would expand production, drive the price down, and force the high-cost producers out of business. But this cannot happen when the price is prohibited from falling and the government restricts production. 8 This added policy of restricting production, of course, represents a blatant infringement of the right of people to use their own property as they see fit. And it has even taken such bizarre forms as imposing fines on farmers for growing food to feed to their own animals. The rationale for this outrage is that such food production makes it possible for the farmers in question to avoid buying feed and thus with the same feed production reaching the market imposes on the government the need to make additional purchases to maintain the price of crops used as feed. Thus individual liberty is sacrificed in order to hold down government expenditures which are absurd in the first place. In effect, the government begins by playing the role of a fool and ends by becoming a tyrant.

As a result of farm subsidies, until very recently a major portion of agricultural output was worse than wasted—it was used to sustain Communist regimes around the world through being given away to them for nothing under such programs as “Food for Peace,” or in exchange for funds provided to the Communist regimes by private banks under loans whose repayment was guaranteed by the U.S. government. In sustaining these regimes, which would otherwise have fallen many years

ago from a lack of food supplies caused by the inherent nature of socialism, the farm subsidy program perpetuated the need for largescale defense spending, in order to be able to provide security against the permanent policy of aggression of such regimes. It thereby operated to multiply the burden of taxation far beyond its own, direct cost.

A related consequence of the existence of agricultural surpluses which would otherwise rot, and which the government’s restrictions on production have served merely to diminish, not eliminate, has been the encouragement of public dependency and unemployment in the United States. These are results of the food stamp program, which provides large numbers of American citizens with the ability to obtain free food, and thus acts as a major public welfare program, enabling many people to live without working.

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I chose the example of farm subsidies mainly to illustrate how the free market reacts when the profitability of an industry is initially rendered low. Farm subsidies, however, represent a form of price controls different from the kind we shall predominantly be concerned with in the first half of this book. Farm subsidies are a way the government achieves artificially high prices. They are an illustration of legal minimum prices—that is, prices below which the government prevents the producers from selling. They are comparable in their effects to minimum-wage legislation. They cause unsaleable surpluses—which, in the case of labor, means unemployment. We will deal with such price controls further and at length in the second half of this book, in the discussion of unemployment and depressions. The kind of price controls that we want to focus on first, because they are most directly relevant to the subject of the dependence of the division of labor on capitalism, are controls designed to keep prices artificially low—that is, legal maximum prices or ceiling prices, namely, prices above which one is not allowed to sell.

Thus let us take as a second major illustration of the effects of the repeal of price controls, the consequences that would follow if rent controls were repealed.

To simplify this discussion, let us assume that the entire supply of rental housing in a given locality has been under controls. In this case, the first effect of the repeal of controls would simply be a jump in all rents. As a result of the jump, however, rental housing would again become profitable—in fact, as a result of previously inadequate building due to rent controls, extremely profitable. However, it is impossible that the rental housing industry should be permanently more profitable than other industries. The high rate of profit would be the incentive, and would itself provide much of the means, for expanded investment in the rental housing industry. There would be a building boom in rental housing. As a result, the supply of rental housing would be stepped up and the rents and the profitability of rental housing would begin to fall and would go on falling until the rate of profit in rental housing was no higher than the rate of profit in industry generally. The longrun effect of the repeal of rent controls, therefore, would simply be an increase in the supply of rental housing. Rents themselves in the long run would be no higher than corresponded to the costs of constructing and operating apartment houses, with profits only enough to make the industry competitive, by providing the going or average rate of profit. 9

Exactly the same effects would follow the repeal of price controls on crude oil, natural gas, or any other good. There would be a temporary surge in price and profit, followed by expanded production and a reduction in price and profit to the point where the price corresponded to the good’s production cost and allowed only enough profit to make the good’s production competitive. The repeal of the price controls on domestically produced oil and oil products in the United States in 1981 provides an excellent illustration of this proposition. After a temporary surge in its profitability, followed by a major expansion in domestic production and fall in the price of oil and oil products, the American oil industry ceased to be extraordinarily profitable.

Of course, it should not be forgotten that once a price control is repealed, the dynamic effects of the uniformity-of-profit principle take over. As we have seen, if someone wants to make an above-average rate of profit on a free market, he must strive to reduce his costs of production and improve the quality of his products, and repeatedly succeed in doing this ahead of his rivals. This means that in the absence of controls, costs and prices tend steadily to fall—if not in terms of a depreciating paper money, then nevertheless in terms of the time people must spend to earn the money to buy goods. Once controls are repealed and a free market established, the free competitive quest for high profits causes prices to fall further and further below the point at which they were controlled, while the quality of goods rises higher and higher.

It should be obvious that the repeal of rent controls would act to end New York City’s housing shortage and make possible an enormous improvement in the quantity and quality of housing for the average person in New York City, and continuing improvements thereafter. It should be equally obvious that the repeal of price controls on crude oil and on natural gas, if not sabotaged by such measures as the government’s physically closing off the sources of an expanded supply of energy, act to set the stage for growing supplies of these goods and thus

for a return to America’s traditional abundance, indeed, growing abundance, of energy supplies.

In sum, it should already be clear, even at this stage of our knowledge, that the problems we have experienced in these areas have been the result of government controls and that the solution lies with the extension of economic freedom and thus, among other things, of the ability of the profit motive and the price system to operate to achieve their benevolent consequences. More broadly, the solution lies with the intensification of the capitalist elements that have traditionally characterized the economic system of the United States, and which have been increasingly restricted.

Of course, the ability of the profit motive and the price system, and other essential elements of capitalism, such as saving and capital accumulation, to achieve continuous economic progress, should not be thought to be hindered in any fundamental way by a possible lack of natural resources. Nor should such economic progress be thought to be dangerous or undesirable by virtue of “harming the environment.” I have already demonstrated in Chapter 3 how capitalism operates continuously to increase the supply of economically useable natural resources along with the supply of products. In the same place, I have also shown how the inherent nature of production is to make the chemical elements provided by nature, and which constitute the totality of the physical world, stand in an improved relationship to man—that is, to improve his environment. 10

The Effect of Business Tax Exemptions and Their Elimination

The uniformity-of-profit principle sheds light on the effect of business tax exemptions and their elimination. For example, for many years prior to 1975, the U.S. oil industry, along with other extractive industries, was able to deduct from its taxable income a depletion allowance based on the value of the oil it extracted, and thus to reduce its overall effective rate of taxation. The effect of the depletion allowance was not to make the oil industry permanently more profitable than other industries, however.

It is true that the initial effect of such a tax advantage is to raise an industry’s aftertax rate of profit relative to that of other industries. But the higher aftertax rate of profit then results in the attraction of additional capital to the industry, and itself provides such additional capital, with the result that the industry’s rate of profit falls back toward the general, average aftertax level. The effect is that the industry is larger, its production is greater, and the price of its product is lower. It does not permanently earn a higher rate of profit.

This principle applies even if the industry is totally tax exempt. Then the effect is simply that the industry’s expansion is carried that much further, but not that its rate of profit remains permanently above the going or average rate. The total exemption from the federal income tax of bonds issued by state and local governments provides an excellent illustration of the principle. Because of their tax exemption, these bonds are purchased to the point that the rate of return they afford is on a par with the aftertax rate of return of bonds that are fully subject to the federal income tax.

By the same token, of course, repeal of a tax exemption, once it has been incorporated into the pattern of investment, is tantamount to a reduction in an industry’s rate of profit. If its effect is to reduce the industry’s rate of profit below the general rate, then the consequence will be a withdrawal of capital and a reduction in the size of the industry, until the smaller industry that remains can once again earn the going rate of profit—by charging a higher price for its product. (If the rate of profit of the industry is not pushed below the going or average rate, because of the presence of some factor such as an increase in the demand for the industry’s product, the effect will be that the industry will grow less than it otherwise would have, and the price of its product will not fall to the same extent that it otherwise would have.)

In the 1970s, in the midst of a widely proclaimed “energy crisis,” the U.S. government, in addition to imposing price controls on oil, acted to further restrict oil company profits, and thus oil industry investment, by punitively increasing their rate of taxation precisely by first reducing and then totally abolishing the customary depletion allowance on crude oil. The effect was a further blow to domestic oil production.

Additional Bases for the

Uniformity-of-Profit Principle

Before leaving the uniformity-of-profit principle, it must be pointed out that in addition to changes in the selling prices of products resulting from changes in the amount of capital invested in an industry, other factors also operate to establish a uniform rate of profit among the different branches of production. One of these has already been indicated in the discussion of the effects of repealing or maintaining farm subsidies. There it was pointed out that as agricultural output is increased, unit costs rise as the result of the operation of the law of diminishing returns and the need to resort to land of inferior quality. The same factors operate on unit costs in the case of mining. And obviously they operate in reverse when it is a question of reducing the production of agricultural commodities or minerals. Thus, in cases of this kind, the investment of additional capital operates to reduce the rate of profit by virtue of bringing about a

combination of lower selling prices and higher unit costs of production, not simply lower selling prices alone. By the same token, the withdrawal of capital in such cases operates to raise the rate of profit by virtue of a bringing about a combination of higher selling prices and lower unit costs of production, not simply higher selling prices alone.

A second, similar factor, which is of relevance throughout the economic system, is a possible rise or fall in the prices of the factors of production used in an industry, as the capital invested in the industry, and thus its level of output, increases or decreases. As later discussion will show, factors of production such as labor and many raw materials exist at any given time in a given supply. The prices of such factors of production are determined by the combination of their given supply and the prevailing demand. 11 Thus insofar as changes in capital investment change the relationship between the demand for such factors of production and their supply, they change the prices of such factors of production.

Thus, for example, if the demand for one product rises and the demand for another product falls, and if the labor or raw materials used in the production of the products cannot be transferred from the one to the other, then changes in the prices of these factors of production will occur. For example, if the demand for a product made of iron rises and the demand for a product made of cotton falls, no part of the supply of cotton can be used to meet the additional demand that will result for iron ore. Nor can the land that produces cotton be used in the production of additional iron ore. As a result, the effect will be a rise in the price of iron and a fall in the price of cotton. Similarly, if the demand for a product requiring one type of labor skill rises while the demand for a product requiring a different type of labor skill falls, the result will be a rise in the wage rate of the one kind of labor and a fall in the wage rate of the other kind of labor.

In all such cases, the industry whose product is in greater demand and whose rate of profit has been elevated above the average, will, as before, experience an influx of capital investment. In these circumstances, the effect of the additional capital investment will be not only to increase the supply and reduce the selling price of the product, but also to raise the demand relative to the supply of one or more of the factors of production the industry uses. This will raise the price of those factors of production and thus the industry’s unit cost of production. Thus, in this case too, the industry’s rate of profit will fall toward the general level both because of a fall in its selling price and a rise in its costs.

By the same token, the industry whose product is in decreased demand and whose rate of profit has been depressed below the general level, will, as before, experience an efflux of capital. The effect will be both to reduce the supply of its product and the demand for one or more of the factors of production it uses. Thus, while the selling price of its product tends to rise, the prices that constitute its costs of production tend to fall. Its rate of profit, therefore, tends to be restored to the general level as the result of both of these phenomena.

It should be realized that this discussion implies that the uniformity-of-profit principle operates even in circumstances in which it is physically not possible to increase the production of a product because one or more of the necessary factors of production simply does not exist. For example, if there is an increase in demand for a particular wine, which must be made from grapes that can be grown only on a small quantity of land on which very special growing conditions exist, the first effect will be a rise in the price of the wine and in the rate of profit to be made in producing the wine. As usual, additional capital will now tend to be invested in producing the item, but the effect of the additional investment in this case will simply be to raise the price of the grapes and the vineyards. The rate of profit in this case will be brought down to the general level without an increase in supply and fall in the price of the product. It will be brought down by virtue of the rise in the prices of the factors of production and in the amount of capital that must be invested in order to earn any larger amount of profit. The winery will not be able to go on making an above-average rate of profit, because it will have to pay a correspondingly higher price of grapes. The vineyard, that receives the higher price of the grapes, will not be able to go on making a higher rate of profit, because the value of the vineyard will increase to the point that its larger amount of profit, earned on the more valuable grape crop, is divided by a correspondingly larger amount of capital that must be invested in order to purchase such a vineyard. If, of course, the demand for the wine later falls, the result will be a fall in the price of the grapes and in the value of the vineyard, which will once again tend to establish a rate of profit on a par with the general rate.

Still another factor working to establish a uniform rate of profit is changes in the percentage of capacity at which plant and equipment are operated, or, for short, changes in the operating rate of firms. Indeed, it is possible, within limits, that this factor can work even in the absence of changes in the price both of the product and of the factors of production used to produce it.

Whenever there is an increase in demand for the product of an industry which possesses unused plant capacity, the effect is to make that industry operate at a higher level of capacity. By the same token, the effect of a decrease in demand is to cause the industry to operate at a lower level of capacity. Even if the price of the

product does not change, the change in the extent to which plant capacity is utilized makes the average profit margin in the industry vary in the same direction as the change in demand. This is because utilizing plant capacity at a higher rate spreads such fixed costs as depreciation quotas over more units of product and thus reduces unit costs. Thus the profit per unit and the average profit margin increase. Furthermore, in causing a higher operating rate at unchanged selling prices, the rise in demand also causes a rise in the rate of capital turnover, inasmuch as a larger physical volume of goods sold at the same prices represents greater sales revenues. While sales revenues are markedly greater, the size of the capital invested in the plants operating at higher rates increases only by the necessary increase in working capital—that is, the capital invested in such things as inventory and work in progress. This means that the increase in capital almost certainly takes place in much smaller proportion than the increase in sales revenues. Thus, on the strength both of a higher profit margin and higher capital turnover ratio, the rate of profit on capital invested in the industry necessarily increases as the demand for its products rises. 12 Of course, for the same reasons as just given, but working in reverse, the rate of profit on capital invested in an industry necessarily falls when a fall in demand causes operation at a lower level of capacity.

On the basis of such facts, a rise in the demand for a product may be accompanied by an above-average rate of profit simply by virtue of a rise in the operating rate of the industry, without a rise in the selling prices of its products. In response to this higher rate of profit, additional capital is invested, and the effect of the additional investment is to reduce the rate of profit of the industry, back toward the general level, merely by virtue of the consequence being a reduction in the rate of capacity utilization. Similarly, the withdrawal of capital from an industry with a below-average rate of profit can restore the rate of profit merely by virtue of raising the operating rate of the plant and equipment that remains. This mechanism of adjustment can exist in an industry which normally maintains the same selling prices so long as it operates within some defined range of capacity, and which experiences a pronounced tendency toward a rise or fall in its average rate of operations due to changes in demand. Before the rise in demand is such as to outstrip its ability to meet it at the prevailing prices of its products, it adds to its capacity and meets the now higher level of demand with additional capacity. The advantage to the firms which do this is that it forestalls the possibility of competitors or potential competitors seizing the opportunity of meeting the additional demand. In that case, not only would the rate of profit of the firms which undertake the expansion come back down, but their share of the market would be reduced as well. Likewise, before a declining demand goes too far, it may be accompanied by decisions not to replace plant and equipment otherwise coming due for replacement.

Thus, changes in demand may result in changes in the rate of profit leading in the usual way to changes in investment and a resulting movement of the rate of profit back to the going rate without the necessity of changes in the price of the product. 13

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It must be stressed that the uniformity-of-profit principle describes a tendency, never an actually existing state of affairs. This is because before a uniform rate of profit can be achieved in all branches of production, new changes occur, requiring a different pattern of investment of capital in the economic system if such uniformity is to be achieved. And before the relative size of the various industries can be adjusted to conform with that pattern, still further changes occur, requiring yet another pattern of investment of capital, and so on without end. Thus, the economic system never comes to rest in an actual state of final equilibrium, whose existence is an essential condition of the existence of a uniform rate of profit. The economic system is merely tending toward such an equilibrium, which is itself constantly changing. 14

The final equilibrium toward which the economic system tends constantly changes because of continuous changes in such phenomena as the state of technology and supply of capital equipment, population and its distribution in terms of age and sex, climate and weather conditions, usefulness of various areas for mining, and so on. 15 The uniformity-of-profit principle is nonetheless fully real. Its reality is confirmed by the fact that definite changes must occur in order to prevent its realization. Among the most important of such changes, of course, is, as we have seen, the continuous innovation required to stay ahead of competitors, whose emulation of one’s earlier improvements would, in fact, drive one’s profits down to the average rate if one did not continue to innovate.

Permanent Inequalities in the Rate of Profit

In addition to the fact that there is constant change in the final state of equilibrium toward which the economic system tends, there are factors operating to create permanent inequalities in the rate of profit even in a state of unchanging final equilibrium. In a sense, inequalities in the rate of taxation can be described as such a factor, in that in order to earn equal aftertax rates of profit, the more-heavily-taxed industries will require a higher pretax rates of profit than the less-heavily-taxed industries.

If a branch of business is subjected to any other form of legal disability, in particular, if it is simply made

altogether illegal, then that fact will operate to make it earn a permanently higher rate of profit than other branches of business. This is because no one will engage in that line of business unless, over and above the going or average rate of return, the profits provide compensation for the risk of incurring the legal penalties imposed. Thus, the illegalization of such activities as gambling, prostitution, and narcotics, for which, however regrettably, a substantial portion of the population is ready to pay, has the ironic effect of enabling those who are prepared to engage in them and who, in addition, are willing to break the law, to earn premium incomes.

Apart from all government intervention, there is also the fact that in many cases the profits earned must compete with the wages and salaries that the businessmen involved could have earned by working elsewhere, as employees. This phenomenon is especially important in the case of small, unincorporated business firms, in which much or even all of the physical labor performed is performed by the owners. When expressed as a percentage of the capital invested, the profits of such firms tend to constitute a far higher percentage than the profits of larger-sized firms, in which comparable labor is performed by paid employees. Thus, for example, a drug store chain, with pharmacists and branch managers who are paid employees, will tend to earn the same rate of profit as the average department store chain, automobile company, or steel company. But a small, independently owned drug store, in which the owner performs the labor of a pharmacist and manager, will tend to earn a rate of profit that is high enough to include compensation that is comparable to what the owner could earn in these capacities if he worked as the paid employee of a chain. The same principle, of course, applies to all other small businesses in which the owner performs labor that elsewhere is performed by paid employees. 16 It is possible that because of the satisfaction derived from owning one’s own business, the profits in these cases, while substantially higher in terms of a rate of profit, nevertheless fall somewhat short of fully compensating for the wages or salary that could be earned working elsewhere.

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A permanent inequality in the rate of return on capital invested can exist between the rate of profit in the narrower sense and the rate of interest.

Whenever the rate of profit is spoken of, without qualification, it should be understood as reflecting profit gross of interest payments—that is, prior to deduction of interest payments. The prospective rate of profit in this sense is what determines whether or not it is worthwhile to pay any given rate of interest. For example, in deciding whether or not it pays to borrow a million dollars at a 10 percent rate of interest, a businessman will wish to know what rate of profit he can make by investing that million. It will pay to borrow only if the prospective rate of profit is somewhat greater than 10 percent.

The rate of profit in this sense, or, as it is often called, the rate of return on capital invested, can be calculated in any given case simply by adding interest payments back to profits net of interest, and then dividing by the total of the invested capital that is owned by the business itself plus the borrowed capital the business uses. By the same token, a rate of profit in the narrower sense can be found by dividing the profit net of interest exclusively by the invested capital that is owned by the business itself.

The following example makes these distinctions clear. If a business borrows $1 million at a 10 percent rate of interest, and already has $1 million of invested capital of its own, and earns a profit gross of interest of $220 thousand, its rate of profit—its overall rate of return on the total capital invested of $2 million—is 11 percent. At the same time, its rate of profit in the narrower sense of profit net of interest, divided only by its own invested capital, is 12 percent.

We should view the relationship between the rate of profit in the narrower sense and the rate of interest in the light of the following: Equity investors and lenders, or, in a corporate structure, stockholders and bond and noteholders, come together as classes of partners, each with special ownership rights, and jointly invest their capitals in enterprises. The lenders agree to receive a fixed and limited return on their capitals on condition that the capital of the equity investors serve as a buffer between them and any below-average profits or outright losses which the enterprise as a whole might suffer. The equity investors agree to allow their capital to serve as such a buffer, and have claim to everything the enterprise may earn after meeting its contractually fixed obligations to the lenders. The total investment in the enterprise may then earn the average rate of profit, an above-average rate of profit, or a below-average rate of profit, including an outright loss. As a rule, any above-average rate of profit earned on the investment as a whole will accrue to the equity-capital investors; and when considered as a part of the rate of return on the equity capital, will magnify this rate of return to the degree that the equity capital represents a smaller percentage of the total capital, i.e., to the extent that it is leveraged. To the extent that the investment as a whole fails to earn as much as the average rate of profit, the failure is borne first by the equity investors, who may not only earn no return whatever, but may also lose the full amount of their capitals, and only then by the lenders. And this reduction in the rate of return to the equity capitalists will be magnified to the degree that the equity capital represents a smaller fraction of the total capital, that is, to the extent that it is leveraged.

As these remarks suggest, while the rate of profit gross of interest is the determinant of the rate of interest, it is not necessary that the two be equal. It is likely that the greater degree of certainty and safety attaching to loan capital and its return will depress that return somewhat below the average rate of profit inclusive of interest. Indeed, in conditions of rapid economic progress and keen competition in the process of improvement, the rate of profit in the narrower sense tends to be significantly and permanently higher than the rate of interest. In such conditions, the general rate of profit on capital as such may be relatively high, for reasons to be explained in Chapter 16. Yet high rates of profit are available only to those who are capable of introducing improvements or at least rapidly adapting to them. All others, if they are prudent, will be content to accept a much lower and, for them, much more secure rate of return, in the form of interest.

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In the light of the preceding discussion, the frequent complaint that one can borrow money only to the extent that one already has it, appears absurd. Nothing could be more natural or reasonable than that one must have money in order to borrow money. This is because if one is to acquire the funds of others at a fixed, limited rate of return, one must have the means of ensuring that these funds and the promised return are protected. In essence, all loans are margin loans. Only to the extent that the borrower himself possesses capital can he provide a margin of safety on a larger total capital. It is thus no less absurd to complain that people cannot borrow funds except to the degree that they already possess funds than it would be to complain that one cannot speculate on the stock exchange beyond the degree that one can provide the necessary margin. Every entrepreneur must himself be a capitalist or he must find a capitalist who is willing to be his partner in entrepreneurship. In every venture in which lenders have capital there must also be equity capital. To secure more borrowed capital, there must be more equity capital.

2. The Tendency Toward a Uniform Price for the Same Good Throughout the World

A second principle of price determination, similar and closely related to the uniformity-of-profit principle, and which also plays a major role in coordinating the division of labor, is that in a free market there is a tendency toward the establishment of a uniform price for the same good throughout the world.

The basis of this principle is the fact that any inequality in the price of the same good between two markets creates an opportunity for profit. In order to profit, all one need do is buy in the cheaper market and sell in the dearer market. The very fact of doing this, however, acts to reduce the inequality in price. For the additional buying raises the price in the cheaper market and the additional selling lowers it in the more expensive market. The process tends to continue until the inequality in price between the two markets is totally eliminated and a uniformity of price achieved.

The reason that uniform prices among different geographical markets are not actually established is mainly the existence of transportation costs. The existence of these costs means that before a price discrepancy between two markets becomes profitable to exploit, it must exceed these transportation costs. These costs, however, then set the limits which geographical price discrepancies do not tend to exceed. Or, to put it positively, the price of the same good tends to be uniform throughout the world except for transportation costs between markets.

(In the case of goods sold by a single seller, such as those with brandnames or under patent protection, the principle may take the form that the wholesale price in the market that imports tends not to exceed the retail price in the market that exports, plus transportation costs. So long as the good is publicly available to all comers at the retail level in any given country, its wholesale price in a free market cannot for long be greater elsewhere by more than the costs of transportation. Thus, for example, in a free market, while American pharmaceutical manufacturers might charge less for various patented drugs in Mexico than in the United States, because of the lower incomes and thus smaller demand for drugs in Mexico, they would not be able to do so for very long by more than corresponded to this variant of the principle.)

The significance of the principle of the tendency toward a geographic uniformity of prices is very great. Its operation explains, for example, why local crop failures in a free market do not result even in significant scarcities, let alone famines. The effect of a failure of the local grain crop, say, is to begin raising the price of grain in the local market. Once the local price of grain exceeds prices in outside markets by more than transportation costs, it becomes profitable to buy in those outside markets and sell locally. The effect is that the reduction in the local supply is almost entirely made good by drawing on the production of the rest of the world. Consequently, instead of a disastrous reduction in the local supply and an enormous rise in the local price, there is a modest reduction in the world supply and a modest rise in the world price of grain.

A good analogy to what happens is provided by the physical principle that water seeks its level. Imagine that you have just filled an ice tray—the kind in which water

is able to flow around and underneath the plastic or metal insert that marks off the separate compartments for the ice cubes. If you now remove water from one compartment of the tray, you will not reduce the water level in that compartment by the amount of water you take from it. You will reduce the water level in that compartment and in the whole tray very slightly, because the loss from the one compartment will be spread over the whole tray.

In just the same way, if half the wheat crop of France were lost, the supply of wheat in France would not fall by half. On the contrary, the supply in France and in the whole world might fall by 2 or 3 percent—or however much of a decline the French loss represented in the world supply.

Water seeks its level by virtue of the force of pressure. It moves from places of higher pressure to places of lower pressure. Commodity supplies seek their level by virtue of the attraction of profits. They move from places of lower prices to places of higher prices, in the process equalizing prices as the movement of water equalizes pressure.

It should be realized that the principle of the tendency toward a geographical uniformity of prices is not only descriptively analogous to a law of physics, but, as far as the ability of governments to act is concerned, has the same existential status as a law of physics. (And so, incidentally, do all the principles of economics.) 17 That means it is impossible even for the world’s most powerful governments to annul its operation. Governments can frustrate its operation, but even in the cases in which they do so, they cannot annul its operation. The existence of the principle is confirmed by the very attempts to frustrate it, because to frustrate it, definite means must be adopted, which are necessary only because the principle exists, and is working. For example, governments may adopt tariffs, or they may prohibit imports or exports altogether, and in that way stop the equalization of prices. But why must they resort to such measures? The answer is because the principle does exist and is at work even in a controlled economy. Controls of a specific kind are needed to counter it. There is no difference here between economics and the example of water seeking its level. We can make ice trays in which each compartment is totally insulated from the others. That does not contradict the principle that water seeks its level. It confirms it, because the insulation is required only because water does seek its level, and for some reason one wishes to stop it from doing so. It is the same way with all economic laws and government attempts to frustrate them.

Why the Arab Oil Embargo Would Not Have Been a Threat to a Free Economy

The principle that in a free market there tends to be a

uniform price for the same good throughout the world has major application to the Arab oil embargo of 1973– 74. The principle shows that if the United States had had a free market in oil when the Arabs imposed their embargo, our oil supplies could not have been seriously jeopardized.

Let us think back to the time of the embargo, and imagine that everything else is the same except that the United States has a free market in oil.

The Arabs now launch their embargo. The immediate effect is that a large part of the oil supplies of the northeastern United States—the major importing region and the one dependent on the Arabs—is cut off.

In a free market, no sooner would this have happened, than the price of oil and oil products in the Northeast would have begun to rise. Once prices in the Northeast came to exceed those in the rest of the country by more than the costs of transportation, supplies would have moved from the rest of the country to the Northeast. The effect would have been largely to replenish supplies in the Northeast and to reduce supplies somewhat in the rest of the country. The reduction in imports from the Arabs, in other words, would have been spread over the whole country instead of being concentrated in the Northeast, where it threatened to cripple the economy of the region. In this way, its impact would have been minimized. Prices in the Northeast would have been held down by the inflow of the new supplies, and those in the rest of the country raised up by the shipments to the Northeast.

In fact, the higher level of oil prices in the Northeast and in the country as a whole would have acted as a magnet to supplies of oil from outside the country. The same motives that would have impelled a Southern or Midwestern oil producer to send additional supplies to New York or Boston would also have impelled a Venezuelan or Nigerian producer to do so. In fact, additional imports could have come from the most remote places. As the rise in prices in the Northeast pulled up prices in the rest of the country, it could very well have become profitable to start shipping additional supplies to the West Coast from oil-producing areas like Indonesia, thereby freeing more of domestic production for supplying the Northeast.

Indeed, the United States could have gone on benefitting from Arab oil! This would have occurred simply as a result of expanding the import of refined petroleum products made from Arab oil in places not subject to the Arab embargo. For example, if the Arabs continued to supply Spanish refineries, say, and the price of refined products had risen in the United States, those refineries would have diverted more of their output to the United States.

It thus becomes apparent that within a fairly short time

an embargo by the Arabs against oil shipments to the United States would have had very little effect on the supply of oil in the United States. To the extent that the United States had been importing Arab oil, it would, for the most part, merely have changed importers, and, for much of the rest, it would even have continued to benefit indirectly from Arab oil, in the form of importing refined products made from Arab oil in non-Arab countries.

The reason the Arab embargo did threaten us was the existence of our price controls on oil and oil products. These price controls had been imposed by President Nixon in August of 1971, as part of a temporary general price freeze, and then remained in force after almost all of the other price controls were removed. Thus, when oil supplies to the Northeast were cut off by the embargo, price controls prohibited the people in the Northeast from bidding up oil prices. The people in the Northeast were therefore made powerless to bring about the shipment of additional supplies from the rest of the country. In the same way, price controls prohibited the people of the United States as a whole from biding up prices, with the result that it was not possible to bring about stepped-up imports from non-Arab sources. The effect of our controls was to cause the reduction in imports from the Arabs to be experienced with full force at its initial point of impact and to make it impossible to obtain replacement imports. Our price controls paralyzed us—they made it impossible for us to take the actions needed to deal with the situation.

Indeed, because of our price controls, we were not only prevented from finding replacement imports for the loss of Arab imports, but were forced to lose imports from non-Arab sources as well! This happened because other countries in the world, such as West Germany, became better markets in which to sell oil than the United States. As a result, our non-Arab foreign suppliers were led to sell more of their oil to those countries and less to us. Because of our price controls, we tied our hands in the international competition for oil, and made it possible for countries far poorer than ourselves to outbid us for oil we had normally consumed.

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There is more to say about why a free American economy would have had nothing to fear from an Arab embargo.

In late 1973 and early 1974, the Arabs were apparently threatening to cut off oil supplies to the world. There was near panic over whether they would do so. There seemed to be no solution except either to give in to their demands, whatever they might be, or go to war with them.

If we had had a free economy, the only lasting effect of any embargo the Arabs might have launched against the rest of the world would have been to strengthen our oil industry at the expense of their oil industry.

To understand this point, let us assume that the American economy had been free of all price controls in 1973 and that the Arabs had launched their embargo with the serious intention of cutting off their supply of oil to the world. Let us assume that the worst fears people had at the time came true and that the Arabs simply stopped selling oil to anyone, in an effort to blackmail the world into doing their bidding.

The effect, of course, would have been a skyrocketing of the price of oil.

But observe. The Arabs wouldn’t have gotten the benefit of the higher price, because they wouldn’t have been selling any oil.

The benefit of the higher price of oil would have gone to the non-Arab producers, mainly to the producers in the United States.

The American oil companies in that case really would have made fabulous profits. They might have made profits at a rate fast enough to double their capitals in a single year, or less. They would have made the kind of money the Arabs made.

In the face of the Arabs’ withdrawal from the market, a tendency would have set in to reestablish the United States as an oil exporter, because Western Europe and Japan would have had to turn to us. However much prices skyrocketed here, they would have skyrocketed still more there. Instead of our high prices pulling oil in, we would have begun to ship oil out, in response to their still higher prices. Billions of dollars would have begun to flow from Western Europe and Japan to the United States, not to Iran or Saudi Arabia.

With vast profits starting to pour in from the rest of the world and, of course, from American buyers too, huge sums would have become available for every kind of oil and energy project in the United States. It would not have taken long, with such profits, for the domestic oil industry to have been entirely rejuvenated and established on an enormously larger scale than ever before, and who knows what other new sources of energy along with it.

Now consider the Arabs. While the American oil producers would have been making money hand over fist, the Arabs would have been starving for lack of income. In this context, it would have been virtually certain that the Arab alliance would soon have broken up. The less fanatical Arab countries would soon have resumed the sale of oil in order to cash in on the profits. Probably, in very short order, all of them would have begun selling again. So, in fact, the supply of oil in the world would almost certainly not have been drastically reduced for very long, despite whatever intentions the Arabs may originally have had. And, therefore, the United States would not, in fact, have had to switch for very

long, if at all, from the role of an oil importer to the sudden role of an oil exporter. But to whatever extent the Arabs had delayed in resuming the sale of oil, the effect of their action would have been to impoverish themselves while enormously enriching the oil industry in every other country, especially the United States.

In the years that followed, the American oil industry would have been bigger and richer. American oil production and the production of other forms of energy in the United States would have been expanded because of the additional profits that American firms had earned. Very possibly, a year or two after the embargo, the price of oil would have fallen below its level in the period before the embargo, because of expanded American production. The oil industry at that point might have run at losses for a while. The American firms would have been able to cover their losses out of the profits the Arabs had handed them. The Arabs would not have been able to cover their losses as easily. Consequently, the effect of the whole process would have been a larger American oil industry and, quite possibly, a smaller Arab oil industry.

This is what economic freedom would have accomplished.

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The question might be raised of just how high oil prices could have gone during the Arab embargo if we had not had price controls. It is impossible to answer such a question with any accuracy. Perhaps for a brief period we might have had very high prices of oil and oil products. While they lasted, such prices would certainly have represented a hardship for many people, the author of this book included. But later we would have had lower prices than we had, thanks to a larger domestic oil industry and energy industry in general. Indeed, the preceding discussions make clear that the rise could not have been very great for very long, and that in a short time, oil prices would have begun to fall, just as has turned out to be the case since the repeal of the price controls. Furthermore, as we will see, even while a high price lasts, the real problem is not the high price, but the scarce supply. No one’s hardship is alleviated by a low price for goods he cannot buy, which is always the effect of price controls. If we in fact have a scarcity, and consumption must be restricted, then, as will be shown, the high price is necessary and positively beneficial, because it leads people to restrict their consumption in the ways that are least damaging to themselves.

The policy of price controls on oil during the embargo, therefore, cannot even be said to have sacrificed our longrun economic wellbeing to our short-run economic wellbeing. It sacrificed both our longrun and our short-run economic wellbeing.

Tariffs, Transportation Costs, and the Case for Unilateral Free Trade

The existence of tariffs modifies the operation of the principle that the price of a good tends to be the same throughout the world in exactly the same way as does the existence of transportation costs. Namely, it allows the prices of goods to differ between two markets by a wider margin, equivalent to the existence of additional transportation costs—that is, by the sum of transportation costs between the two markets plus the amount of the tariff. Now, only when the price of a good in one market comes to exceed its price in another market by more than the sum of transportation cost plus tariff, does it pay to buy in the cheaper market and sell in the dearer market. This, of course, operates to drive the discrepancy in price to the point where it no longer exceeds the sum of transportation cost plus tariff.

The fact that tariffs have the same effect on price differentials between markets as do transportation costs, and can be analyzed as the equivalent of additional transportation costs, implies that a country must benefit from a policy of free trade even if it adopts that policy unilaterally, with its citizens having to go on selling their goods in countries that continue to maintain tariff barriers. For a policy of unilateral free trade is analytically equivalent in its effects to a fall in inbound transportation costs while outbound transportation costs remain the same.

In the nature of the case, the inhabitants of a territory must benefit from the fact that the cost of transporting goods to them is as low as possible. The fact that it is lower than the cost of transporting goods from them to other areas can make no difference. If, for example, they were fortunate enough to live in a territory toward whose coast the predominant winds blew or the ocean current flowed and which, accordingly, found itself with correspondingly low inbound transportation costs, they would benefit from that fact, even though inbound transportation costs were thereby rendered less than outbound transportation costs. The fact that it is not equally less costly for their goods to reach others does not take away the advantages to them of others’ goods being able to reach them more cheaply. It would be the height of absurdity on their part to demand that inbound freight be rendered artificially more costly, say, by requiring inbound ships to carry extra ballast, in order to equalize the transportation costs of inbound and outbound freight.

The situation is exactly the same with regard to a policy of unilateral free trade or a country having tariffs lower than the tariffs of the countries with which it trades. To insist that one’s own country have tariffs so long as the countries its citizens sell to have tariffs, or have tariffs that are as high as the tariffs of those countries, is to

demand the equivalent of raising inbound transportation charges merely because they happen to be lower than outbound transportation charges. 18

3. The Tendency Toward Uniform Prices Over Time: The Function of Commodity Speculation

In a free market there is a tendency toward the equalization of the price of a good in the present with the expected price of that good in the future. For example, there is a tendency for the price of wheat or crude oil or whichever, today, to be equal to the expected price of wheat or crude oil or whichever next month, six months from now, or next year. This principle applies to any good that is capable of being held in storage.

The basis of this principle is the familiar fact that any discrepancy in price creates an opportunity for profit, the exploitation of which reduces the discrepancy. If, for example, wheat is expected to be more expensive six months from now than it is today, then speculators begin to buy wheat at today’s comparatively low price for the purpose of storing it and later selling it at the comparatively high price that is expected to exist in the future. The effect of their action is to raise the price of wheat in the present, and, by enlarging the supply available in the future, reduce the price of wheat in the future. As a result, the present and expected future prices are brought closer together.

The present and expected future prices will never actually be equalized, for two important reasons. First, there are costs of storing any commodity. In addition, since every business must yield the going rate of profit, if it is to continue in existence, it is necessary to earn as good a rate of profit in storing commodities as in any other line of business. Consequently, the actual relationship between present and future prices is that they tend to differ by no more than the costs of storage plus an allowance for the going rate of profit on the capital that must be invested in the storage.

The practical significance of this principle can be seen in the following example. Assume that the wheat harvest is one-twelfth below the size of the average annual harvest. It is therefore necessary to stretch what would normally be an eleven months’ supply of wheat over twelve months. If the price of wheat did not rise at harvest time, the consumption of wheat and wheat products would go on at the usual rate, requiring a more severe restriction of consumption later on. Imagine that the price did not rise until after ten months had gone by, during which consumption had occurred at the usual rate. In that case, two months would be left to go until the next harvest, and it would be necessary to stretch the remaining supplies, equal to only one month’s usual consumption, over that period. By the rise in price being delayed this long, one month’s supplies would have to be made to do the work of two, instead of eleven months’ supplies doing the work of twelve. The rate of consumption would have to be cut in half instead of merely by one-twelfth. It is the same in principle for all shorter periods during which the rate of consumption is excessive. Always, an excessive rate of consumption in the earlier months must be balanced by a more severely reduced rate of consumption in the later months.

The existence of speculation on future prices prevents such calamities and minimizes all such imbalances in the rate of consumption. Speculators anticipate the future prices of commodities and buy or sell the commodity in question for the purpose of profiting from every discrepancy between the present price and the prices they expect to exist in the future. In our example, the activity of the commodity speculators would serve to bring about the minimum necessary restriction in the rate of wheat consumption. For if they see that in the absence of their activity prices will reach famine levels in the future, or levels reflecting a severe scarcity, or even any level whatever that exceeds the present price by more than the costs of storage and the going rate of profit, they begin to buy the commodity in question for the purpose of profiting from the future high price. Their additional buying raises the price of the commodity in the present and thus restricts the rate of its consumption. Later, as the future unfolds, the goods in the hands of the speculators constitute a larger supply and serve to reduce prices in comparison with what they would otherwise have been. The activity of the speculators therefore serves to transfer supplies from a period in which they are less urgently needed, as indicated by their lower price, to a period in which they are more urgently needed, as indicated by their higher price. In this way, it brings about the optimum rate of consumption of limited supplies.

Speculative activity, of course, is not limited to anticipating just future scarcities. Rather, it seeks in general to balance consumption and production over time by accumulating stocks of commodities and regulating their rate of consumption. If it is anticipated, for example, that a future harvest will be larger than originally forecast, and thus that the price of wheat in the future will be lower than originally expected, the activity of the speculators will bring about a lower price immediately. In anticipation of the lower future price, some of the speculators will begin to sell their holdings of the commodity now, in order to find a more profitable employment for their capitals. As a result of their sales, the price begins to fall right away. As a consequence of the lower price, the rate of consumption in the present is expanded. In this case, the effect of speculative activity is to permit present

consumption to expand in the knowledge that larger future production than originally expected necessitates the holding of smaller present stocks.

Much speculative activity occurs on organized commodity exchanges. However, only a relatively small number of basic commodities are traded on the exchanges—principally various agricultural commodities and nonferrous metals. For the rest, speculation is largely limited to those who are engaged in the actual production or use of the commodity.

It should be realized that every businessman is a commodity speculator when he decides what size inventory to hold of his product or materials and whether it is a good time to increase or decrease the size of his inventory. For he is basing his decision on a comparison of present prices and the prices he expects to exist in the future. In the same way, every consumer engages in commodity speculation when he decides to buy more or less than his normal requirements on the basis of a comparison of present prices with the prices he anticipates in the future.

The speculative activities of businessmen and consumers serve to equalize present and future prices in additional ways than the one we have considered. For example, if, in anticipation of higher prices, businessmen simply hold back on selling their inventories, they are decreasing the supply available in the present and increasing the supply available in the future, which, of course, acts to narrow the discrepancy in price. By the same token, if businessmen or consumers step up their purchases in the present, in anticipation of higher prices in the future, then, to that extent, their demand for the item in the future will be less because it will already have been provided for. In this case, a larger present demand and smaller future demand act to reduce the discrepancy in price.

Like almost every economic activity that goes beyond manual labor, commodity speculation is frequently denounced. Because speculation transmits the higher prices expected to exist in the future to the present, it is denounced as the cause of the higher prices. What is overlooked in this accusation is that the supplies accumulated as a result of speculation must ultimately be used, and at that time they necessarily act to reduce prices—because either they are put on the market and sold, thereby increasing the supply of the commodity, or, by sparing their owners the need to purchase, they reduce the demand for the commodity. Moreover, if the speculators are mistaken—if they raise the present price and there is no independent cause of a higher price in the future— they pay the penalty for their mistake: they have bought at high prices and must later sell at low prices; or they have stocked up at high prices when they might later have bought at low prices; or, in holding back their supplies in the hope of selling at higher prices, they end up having to sell at lower prices than they could have obtained by not holding back. 19

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It is necessary to point out that the connection between present and expected future prices is broken in conditions of increases in production and declines in price. In such conditions, the ability to reduce prices in the present by selling out of accumulated stocks reaches its limit once those stocks have been reduced to their necessary minimum. At that point, if prospective future prices are lower still, no mechanism remains which is capable of driving present prices down any further and thus coming back into correspondence with the prospective future prices. (There is no basis for a decline in demand in cases in which the item needs to be used in the present, such as food. There is also no basis for any general or widespread decline in demand insofar as the falling prices that are expected to result from increased production will enable people’s incomes to go further, for this gives them the prospect of being better off in the future. In these conditions, people are in a continually better position to buy.) Thus it becomes possible for prospective future prices to fall below present prices by almost any amount. This in fact is regularly the case with respect to agricultural commodities in the months preceding the harvest. Their prospective prices during the coming harvest are almost always sharply below their current prices, precisely because of the inability to make significant further sales out of accumulated stocks, which stand at their low point in the period before the harvest. And the very fact that the stocks do stand at a low point is also responsible for the prices in the months just prior to the harvest standing at a high point.

The connection between present and future prices is established mainly by the accumulation of stocks to take advantage of prospective higher prices in the future. Declines in present prices based on the anticipation of lower future prices occur in a context in which the holding of significant supplies for the future is still necessary, but in which it is possible for the magnitude of the supplies held to be less.

Rebuttal of the Charge That the Oil Shortages of the

1970s Were “Manufactured” by the Oil Companies

Our knowledge of speculation can be applied to the charge that the oil shortages of 1973–74 and 1979, were “manufactured” by the oil companies. This was an accusation which was repeated again and again in the press and on television in those years. The accusation represents a classic case of economic ignorance, and is thus well worth analyzing. 20

The proof offered that the oil companies were artificially creating the oil shortage was the allegation that their storage depots were full of oil. I remember one television news story in the 1973–74 crisis, filmed at an oil company tank farm, in which the reporter pointed to the tanks, said he had personally seen that they were full, and, therefore, that there could be no real shortage of oil, but just an “artificial” one created by the oil companies.

The reporter, his editor, station, and network evidently forgot, or did not know, the major news item of the time, which was the prospect that in the coming months the United States would be deprived of a significant part of its customary imports of oil, while having to meet the possibility of a long, severe winter. The tanks and storage depots most certainly should have been full, in anticipation of that terrible prospect. Any fullness of the tanks and depots was not, as the news media claimed, a proof of the abundance of oil, but of its prospective scarcity. (The reader should imagine what it would mean if the day ever came when he thought it necessary to fill every spare inch of his kitchen with food. His large stockpile would not be a proof of the abundance of food, but of the prospective scarcity of food.)

Apparently, the media were simply unaware of the need to hold supplies of oil for future sale. For it appears that they would have been satisfied with the genuineness of the shortage only if their reporters had visited the tank farms and found them empty. By that time, however, it would have been too late: millions would have died from the lack of oil.

The unfortunate fact was, however, that the oil company storage depots and tank farms were not full. The media erroneously inferred from their observation of a large quantity of oil at some tank farms that there must be a large supply of oil in the country. Their logic was the same in principle as that of someone travelling to an impoverished country like India and seeing a few warehouses full of food, and then concluding that there is a large quantity of food in the country. In reality, because of price controls, the stocks of crude oil, gasoline, and residual fuel oil in the United States in the period from October 31, 1973, to April 1, 1974—the time of the oil crisis—were all substantially less in most months than their respective averages had been for that period of the year over the preceding five years; distillate fuel (home heating oil) was the only major oil product whose stock had been increased. Overall, that is, if one simply adds up the number of barrels of crude oil and of the various kinds of oil products, stocks were significantly lower in all but two months, when they were very slightly higher. 21

The fact that stocks of oil in storage were actually below average in 1973-74 should not be surprising. Such a result is to be expected from price controls. It is implied in our example of the deficient wheat harvest in which the price does not rise. It is only necessary to realize that price controls not only induce buyers to buy up commodities too rapidly for supplies to last, but also induce sellers to sell them too rapidly. Sellers are led to sell too rapidly because it is more profitable to sell goods at the fixed, controlled price in the present rather than in the future. By selling in the present, a seller saves storage costs and can earn profit or interest by investing the sales proceeds. If he is going to have to sell at the controlled price, it pays him to sell as soon as possible and simply put the money in the bank if necessary. 22

The only reason that stocks of distillate oil were built up in the crisis period was that the government ordered it. Distillate stocks had declined sharply in early 1973, as the result of price controls, with the result that shortages began to appear even then. The government feared vastly worse shortages in the winter of 1974: it feared the prospect of people freezing to death.

It should be understood that if we had not had price controls, any build-up in stocks of oil that would have occurred, would not have caused a shortage, even though it reduced the supply of oil currently available. In the absence of price controls, the build-up would have raised the current price of oil. At higher prices, people would have economized on their use of oil products to whatever extent it was necessary to reduce current consumption. Of course, higher prices would also have pulled in supplies from other markets, making the necessary reduction in current consumption that much less. As will be shown in later discussion, anyone able and willing to pay the higher current prices would have been able to buy whatever oil products he wished. There would have been no shortage in the sense of people being able and willing to pay the asking price of oil but unable to obtain it. Thus, even if there had been a build-up of stocks of oil, as the media claimed, it could not have caused a shortage of oil in the absence of price controls.

In charging the oil industry with “manufacturing” the oil shortage by holding large stocks of oil, the media displayed ignorance in four respects. First, they were ignorant of the fact that, with the exception of distillate, stocks of oil were not actually large, but significantly below normal. Second, they were ignorant of what large stocks of oil would have signified had they existed (or, in the case of distillate, what the large stock did signify)—i.e., proof not of abundance, but of prospective scarcity. Third, they were apparently ignorant even of the fact that it is necessary to hold stocks of oil in the first place, for their attitude was, it seems, that so long as oil was on hand, there could be no problem of a lack of it. Fourth, they did not know that in the absence of price controls, no accumulation of a stock could cause a short—

age in the current market.

In their treatment of the oil shortage, the media functioned on the level of men without the ability to think conceptually. They proceeded as though they were unable to make distinctions between quantities that are perceptually large, that is, between a tank farm full of oil, and an adequate national supply. They proceeded as though they were unable to think beyond the range of the immediate moment, that is, to realize the need to hold supplies for future sale. They proceeded as though they were incapable of understanding connections among concrete events, namely, the connection between the prospect of the loss of imports and the need to build up stocks of oil. They proceeded, in short, as though they had never heard of, and were incapable of grasping, a single principle of economics. Only because they functioned at this incredibly low mental level, was it possible for the media to assert that the oil shortage was “manufactured” by the oil companies.

I will have much more to say about this accusation in the pages that follow. I will show that it is correct to say that the oil shortage was “manufactured” and “artificial,” only if one realizes that it was manufactured by the government, through price controls, not by the oil companies and their perfectly natural and praiseworthy desire to earn profits.

4. The Tendency Toward Uniform Wage Rates for Workers of the Same Degree of Ability

In a free market there is a tendency toward an equalization of wage rates for workers of the same degree of ability.

The basis of the tendency toward equality is the fact that men prefer to earn a higher income rather than a lower income, and therefore seek higher-paying jobs in preference to lower-paying jobs. The movement of labor into the higher-paying fields and out of the lower-paying fields reduces wage rates in the higher-paying fields and raises them in the lower-paying fields. The stopping point is an equality of wage rates.

This is not to say that forty-or fifty-year-old workers suddenly give up their work of many years to change to a brand-new occupation in response to a 5 or 10 or even 20 percent difference in wages. No. In view of the costs and the various other problems such workers would have to incur in the learning of new skills, it would not pay them to switch occupations except in cases of extremely large differences in wages—brought about, for example, by their previous jobs being rendered obsolete through technological progress.

The movement of labor from occupation to occupation in response to less-than-gross differences in wage rates is accomplished in a different way. It is accomplished by virtue of the fact that each occupation continually loses members through death or retirement and must continually be resupplied with young workers. Changes in the flow of young workers into the various occupations produce the same effect as an actual movement of labor between occupations. Where the number of young workers entering an occupation exceeds the number of old workers dying or retiring, the supply of labor in that occupation rises. Where the number of young workers entering an occupation is less than the number of old workers leaving, the supply of labor in that occupation falls.

Now by the time young people are ready to begin preparing themselves for a career, there are very marked differences in their ability and willingness to learn. And, for this reason, the labor force necessarily assumes a hierarchical structure, with the tendency toward an equalization of wage rates being operative only within the respective levels of this structure, not throughout the structure as a whole.

Those with the greatest ability and willingness to learn are potentially capable of performing practically any job. For example, the young man who is capable of learning to be a surgeon is also certainly capable of learning to be a printer. In turn, the young man who is capable of learning to be a printer is also certainly capable of learning to work on an assembly line. Everyone, in other words—the potential surgeon, the potential printer, and the potential assembly line worker—is capable of learning the work of the assembly line worker. But only the potential surgeon and the potential printer are capable of learning the work of the printer. And only the potential surgeon alone is capable of learning the work of the surgeon.

In conformity with the principle contained in this example, let us think of the young people ready to prepare for a career as divided into three broad groups: those capable of entering the professions, those capable of learning to do skilled work, and those capable of learning to do no more than unskilled work.

Such a division of the potential labor force necessarily prevents any tendency toward a general equalization of wage rates. No matter how high the wage rates of the professions may climb in relation to those of skilled and unskilled labor, it is simply impossible for young people who lack the necessary capacity, to go into the professions instead of skilled or unskilled labor. Similarly, no matter how high the wages of skilled labor may climb in relation to those of unskilled labor, there is, again, no way for the young people who lack the necessary capacity, to enter the field of skilled labor instead of unskilled labor. On the other hand, the wages of skilled labor are limited

in relation to those of professional-level labor. For as soon as the wages of skilled labor begin to exceed those of professionals, it is possible for young people capable of the professions to enter the field of skilled labor. In the same way, the wages of unskilled labor are limited in relation to those of skilled labor. For as soon as the wages of unskilled labor begin to exceed those of skilled labor, it is possible for young people capable of skilled labor to enter the field of unskilled labor.

It is because of this hierarchical division of the total pool of human talent—of the fact that ability can flow downward to lower channels, but not upward to higher channels, so to speak—that we observe in actual life that the wages of professionals markedly and permanently exceed those of skilled workers, while those of skilled workers, in turn, markedly and permanently exceed those of unskilled workers. And we observe that the wages of the highest-paid skilled workers cannot get very far ahead of the wages of the lowest-paid professionals, nor the wages of the highest-paid unskilled workers very far ahead of the wages of the lowest-paid skilled workers.

This explains inequalities in wages. Let us return to the question of why wage rates for any given level of ability tend to be equal.

Let us consider the wage rates of a number of skilled occupations, for example, the various building trades, such as carpenters, electricians, and plumbers, and other skilled occupations, such as printers, draftsmen, mechanics, and locomotive engineers. All of these occupations, and others of a similar nature, require the same basic level of intelligence and education on the part of the workers. As a result, they are all potentially capable of being performed by the same people. All of them, in effect, can be supplied with labor that is drawn from a pool of human talent on the same basic level. Because of men’s preference for a higher income over a lower income, this pool of talent naturally runs more heavily into those occupations which offer higher wages and less heavily into those which offer lower wages. As a result, there is a tendency toward an increase in the supply of labor in the better-paying kinds of skilled work and a decrease in the supply of labor in the poorer-paying kinds of skilled work. Since the effect of the increases in the supply of labor in the initially higher-paying fields is to reduce wages in those fields, while the effect of the decreases in the supply of labor in the initially lower-paying fields is to raise wages in those fields, the discrepancies in wages among the different kinds of skilled labor are narrowed, and thus these wage rates tend toward equality.

In exactly the same way, there is a tendency toward a uniformity of wages among the various unskilled or low-skilled occupations, such as assembly line workers, machine tenders, truck and bus drivers, clerks, stevedores, and so on. There is a tendency toward a further uniformity of wage rates among the various professions, such as doctors, lawyers, scientists, engineers, professors, and so on. In these cases, too, the original pool of talent flows into the various channels on its level in accordance with the wages to be made; and, in flowing more or less heavily, lowers or raises those wages, thereby reducing the discrepancies among them and driving them toward equality.

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There are, of course, important differences in wages of a permanent nature even within the three broad groups of workers that I have delineated. At each level, there is a tendency for some particular occupations to earn more than others—for example, for doctors to earn more than professors, and for stevedores to earn more than clerks. There are also important differences in earnings within each occupation, especially at the professional level. For example, there are always some doctors or lawyers who earn five or ten times as much as the average of their profession, and there are some printers or mechanics who earn significantly more than others.

These differences are due in part to the existence of further categories of division in human ability. There are those who have the ability and willingness to learn how to be a doctor or lawyer, and others who have the ability and willingness to learn how to be a great doctor or lawyer. In other cases, willingness and ability to learn is not the sole criterion of division. Other factors have to be added. For example, in many types of work, especially unskilled work, it is necessary to possess a significant degree of physical strength. Those who have it are in a narrower category than those who do not and, accordingly, tend to be higher paid. In other cases, workers are differentiated by the special development of other physical or psychological potentials—such as muscular coordination, an ear for music, special visual acuity, and so on. In the case of great athletes, opera singers, musicians, and actors—all the really star performers—the combination of special characteristics is such as to make the labor of these persons virtually unique. As a result, when they are in demand, their earnings do not have any fixed limit in relation to the earnings of others, because no one is able to increase the supply of what they are offering.

For the rest, the differences in wages within the various broad groups are the result of the fact that considerations other than money income are associated with each job. There are such considerations as how interesting or uninteresting is the work, how pleasant or unpleasant are the conditions of the work, how safe or dangerous is it, how regular is the employment, how long and how expensive is the special preparation required, and, perhaps, still other, similar considerations. Considerations

of this kind explain, for example, why scientists tend to earn less, and tax lawyers more, than is commensurate with their respective levels of ability. In the one case, the work itself may be the highest pleasure in life to those who perform it; in the other, it is more likely to be experienced as painfully dull. As a result, those with the necessary ability to be scientists are willing to enter the field even to the point of accepting substantially lower wages in comparison with what they could earn elsewhere. By the same token, people would cease to enter such a field as tax law as soon as that field no longer offered significant monetary advantages over other fields they might enter. The principle that emerges is that any occupation which offers advantages other than income tends to offer correspondingly lower wages, while any occupation that imposes special disadvantages of any kind tends to offer correspondingly higher wages. These discounts and premiums in wages balance the special advantages and disadvantages of the various occupations.

In sum, in a free market there are at least three principles of wage determination at work simultaneously. One is a tendency toward a uniformity of wages for labor of the same degree of ability. A second is a tendency toward unequal wage rates for labor of different degrees of ability—primarily intellectual ability, but also other abilities as well. And a third is a tendency toward the inclusion of discounts and premiums in wages as an offsetting element to the special advantages or disadvantages of the occupations concerned. The combined operation of these three principles helps to explain the full range of the various wage rates we observe in actual life.

Now, as far as it operates, the principle of the uniformity of wage rates is similar in its consequences to the uniformity-of-profit principle. That is, it serves to keep the various occupations supplied with labor in the proper proportions. Too many people do not rush into carpentering and not enough go into printing, say, because the very effect of such a mistake is to reduce the wages of carpenters and raise those of printers. This acts to delimit and counteract the mistake. In addition, the operation of this principle gives to consumers the ultimate power to determine the relative size of the various occupations. If, to continue with the same example, the consumers buy more printed matter and fewer products made of wood, then the effect of the change is to cause the demand for printers to rise and that for carpenters to fall. As a result, the wages of printers rise and more young men are induced to become printers, while the wages of carpenters fall and fewer young men become carpenters.

It should be realized, as this example of the printers shows, that in seeking to earn the highest wages, the individual worker is seeking to do the kind of work the consumers most want him to do. This is true of every individual who seeks to take the best-paying job he can find at any given level of ability or who seeks to raise his level of ability. For what enables any job to pay more is only the fact that the consumers want its products sufficiently. Let them decide to reduce their demand for its products, and the wages it pays will tend to fall, while if they raise their demand for its products, the wages it pays will tend to rise still higher.

In a free market, within the limit of his abilities, each person chooses that job which he believes offers him the best combination of money and nonmonetary considerations. In so doing, he simultaneously acts for his own maximum wellbeing and for that of the consumers who buy the ultimate products his labor helps to produce.

Equal Pay for Equal Work: Capitalism Versus Racism

The uniformity-of-wages principle must be understood as implying the existence of a powerful tendency under capitalism toward equal pay for equal work. Despite the prevailing belief that capitalism arbitrarily discriminates against such groups as blacks and women, the fact is that the profit motive of employers operates to eradicate all differences in pay not based on differences in performance. Where such differences persist, they are the result of government intervention or private coercion that is sanctioned by the government. 23

Where the profit motive is free to operate, if two kinds of labor are equally productive, and one is less expensive than the other, employers choose the less expensive, because doing so cuts their costs and raises their profits. The effect of choosing the less expensive labor, however, is to raise its wages, since it is now in greater demand; while the effect of passing by the more expensive labor is to reduce its wages, since it is now in lesser demand. This process goes on until the wages of the two kinds of labor are either perfectly equal or the remaining difference is so small as not to be worth caring about by anyone.

As illustration of the fact that even very small differences in wage rates could not be maintained under capitalism, consider the following example. Assume that white workers of a certain degree of skill are paid $5 per hour. Assume that black workers of identically the same degree of skill can be hired for just 5 percent less, that is, for just 25¢ an hour less. Assume that a factory must employ 500 workers of this degree of skill. With a 40-hour week, over a 50-week year, this slight difference in hourly wage rates results in a saving of labor cost and a corresponding extra profit per year of $250,000 if the factory owner employs 500 blacks rather than 500 whites (for 25¢ x 500 x 40 x 50 = $250,000).

Even in the case of a small establishment employing

only 10 workers, the annual saving in labor cost, and thus the extra profit attaching to the employment of blacks, would be $5,000 (since 25¢ x 10 x 40 x 50 = $5,000)— enough for the owner to afford a new car every other year or to make significant improvements in his business.

It is doubtful that there are many employers so bigoted as to be willing to indulge their personal prejudice in favor of whites at a cost of $250,000 per year, or even $5,000 per year. The clear implication is that even slight differences in wage rates would make the employment of blacks in preference to whites virtually irresistible. Not only would a 5 percent differential in wages not be sustainable, but neither would a 2 percent or even a 1 percent differential. Every such differential would lead employers to hire blacks in preference to whites, and would thus bring about a further rise in the wage rates of blacks and a further fall in the wage rates of whites, until a virtually perfect equality was achieved.

Indeed, profit-seeking employers qua profit-seeking employers are simply unconcerned with race. Their principle is: of two equally good workers, hire the one who is available for less money; of two workers available for the same money, hire the one who is the better worker. Race is simply irrelevant. Any consideration of race means extra cost and less profit; it is bad business in the literal sense of the term.

It should be realized that one of the great merits of capitalism is that by its very nature employers are virtually compelled to be oblivious to race. The freedom of competition under capitalism ensures this result. For even if, initially, the majority of employers were so fanatically bigoted as to be willing to forgo extra profits for the sake of their prejudice, they would be powerless to prevent a minority of more rational employers from earning these extra profits. (“Rationality” in this context means not passing moral judgment against a person on the basis of his racial membership and not allowing such a judgment to outweigh the desire for profit. Such a judgment represents a logical contradiction in that morality pertains only to acts open to choice, while a man’s racial membership is not open to his choice. The irrationality is then compounded by the sacrifice of one’s own objective good—the earning of a profit—for the sake of the irrational judgment.) Because of their higher profits, the more rational employers would have a relatively greater income out of which to save and expand their businesses than the irrational majority. Moreover, since they operated at lower costs, they could afford to charge lower prices and thus increase their profits still further by taking customers away from the irrational majority. The result of these factors would be that the more rational employers would tend to replace the less rational ones in economic importance. They would come to set the tone of the economy, and their attitudes would be transmitted to all other employers, who would seek to emulate their success. In this way, capitalism virtually guarantees the victory of rationality over racial bigotry.

This discussion also provides a rebuttal to the accusation that under capitalism the skills and abilities of groups such as blacks are not utilized. For it follows that the unhampered profit motive leads employers to place the members of all groups in the highest positions for which their skills and abilities qualify them. Consider the following example. Assume that a skilled lathe operator must be paid $15 per hour, and that black workers who have been taught this skill in a trade school are presently employed as janitors at $5 per hour. The black workers would almost certainly be willing to change their jobs for a raise to, say, $10 an hour. Any employer who hired them as lathe operators at $10 per hour would thereby add $5 to his profits for every hour of their work, as compared with employing whites. Over the course of a year composed of 50, 40-hour weeks, his extra profit would amount to $10,000. And this would be on the labor of just one man.

It is obvious that under capitalism, if the skills and abilities of blacks or any one else are being wasted in low-skilled, low-paying jobs, it is to the financial self-interest of employers to change the situation, indeed, to seek out such workers, and in many cases even to incur substantial costs in training them. And it follows that the greater the extent to which a group’s skill or ability is wasted, the greater is the profit to be made by rectifying the situation. For example, if a black with the ability to do the work of a $100,000-a-year company vice president is working as a $20,000-a-year clerk, it is even more to the interest of an employer to seek him out and rectify the situation than in the case of the lathe operator working as a janitor. In this case, the employer could double the black worker’s salary to $40,000, and at the same time add $60,000 to his own profits by employing him in a capacity commensurate with his skill and ability.

Of course, just as in the initial case, the wages and salaries of blacks brought into the more skilled and higher-level jobs would more and more tend to match those of the white workers performing these jobs. Because as employers competed for blacks, their wages would rise, while, in order to be competitive with the black workers, the white workers would have to accept reductions. Indeed, once the first few blacks or members of other groups in a comparable situation are brought into an occupation in which they were previously unrepresented and succeed in proving their ability by actual satisfactory performance, a dynamic effect ensues. The breaking of the taboo, followed by the visible proof of its lack of rational foundation, changes the way in which such individuals are viewed. The demand for their ser—

vices then greatly increases. (The history of major league baseball provides an excellent illustration. Once the taboo on the admission of blacks was broken with the employment of the very able Jackie Robinson, all barriers to the admission of blacks soon fell.)

In connection with the fact that free competition with members of socalled minority groups can entail a fall in the wage rates of the average member of the groups already established, most notably, white male workers, it should be realized that any such reductions in wage rates would take place as part of a process operating to raise the real wages—the actual standard of living—of the average member of all groups. For it would be accompanied by reductions in the prices of consumers’ goods greater than any reduction in aftertax money incomes experienced by the average member of the groups already established. This conclusion is conclusively demonstrated in later chapters of this book. 24

Of course, none of the above developments can occur if they are stopped by the initiation of physical force. If, for example, the local Ku Klux Klan is able to burn down the factory of an employer who employs blacks instead of whites, because it knows it will go unpunished by the law; or if local government officials are capable of suddenly finding all kinds of violations of building, health, and safety codes on the part of such an employer, to the point of crippling his operations, then employers will not seek to take advantage of the lower wages of blacks, and thus the wages of blacks will not be raised to parity with those of whites of equal skill.

Although not motivated by racial prejudice, what is also capable of aborting the advance of blacks (and women), particularly at the higher levels of employment, is a system of taxation that takes away the greater part of the additional profits that might be made by defying custom and making the necessary innovations of bringing them into fields of employment in which they were previously not represented. Indeed, industries whose profits are limited by the government, such as public utilities, or whose output is purchased on a cost-plus basis, such as that of defense contractors, have no financial incentive whatever to make such innovations. And, of course, in an environment in which destructive government regulations can be unleashed at any time on virtually any business, or in which valuable government favors or outright government subsidies can be obtained—in an environment, therefore, in which it does not pay to have enemies, or to offend any significant group, or, as the saying goes, in which it does not pay “to rock the boat”— businessmen will not be very quick to make such controversial innovations in employment. 25 Ironically, such measures as equal-employment-opportunity laws directly rule out the very possibility of employing blacks or women at lower wages for the same work as whites or men. They thus directly prevent businessmen from finding the employment of blacks or women in the higher positions to be unusually profitable—profitable enough to begin defying traditions and customs based on nothing more than empty stereotypes.

Later discussion will show the especially destructive effects of minimum-wage and prounion legislation on blacks, in aborting the very possibility of their gaining significant advancement. 26

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The uniformity-of-profit principle implies that along with equal pay for equal work, capitalism operates to supply the members of all groups on equal terms in their capacity as consumers. As a demonstration of this fact, assume that blacks had to pay monthly rents just 5 percent higher than those of whites, while the landlord’s costs were the same in both cases. This 5 percent premium would constitute a major addition to a landlord’s profits. If a landlord’s profit margin—his profit as a percentage of his rents—were normally 10 percent, a 5 percent addition to his rents would constitute a 50 percent addition to his profits. Even if his profit margin were initially as high as 25 percent, a 5 percent addition to his rents would constitute a 20 percent addition to his profits.

In response to such premium rates of profit, housing construction for blacks would be stepped up, and a larger proportion of existing housing would be rented to them. The effect of this increased supply of housing, of course, would be to reduce the rental premium paid by blacks. And because a mere 1 percent premium would mean significant extra profits in supplying blacks with housing, even a premium of this small size could not be maintained. Thus, blacks would pay no higher rents than whites, and obtain housing equal in quality to that obtained by whites.

Likewise, assume that merchants in black neighborhoods charged higher prices than the same goods would bring in other neighborhoods, while the merchants’ costs of doing business were the same in both places. The higher prices in such a case would constitute a clear addition to profits. With higher profits to be made in black neighborhoods than white neighborhoods, merchants considering the location of new stores would choose the black neighborhoods. The influx of new stores, of course, would lower selling prices in the black neighborhoods; and the process would go on until the prices and the profits to be made in those neighborhoods were no higher than elsewhere. (Regrettably, today it is often the case that retail prices in black neighborhoods are substantially higher than for the same goods in white neighborhoods and, at the same time, merchants are

moving out of the black neighborhoods rather than moving in. This situation is the result of the existence of higher costs of operation in the black neighborhoods— caused by such phenomena as higher rates of burglary, pilferage, and arson—coupled with the inability in many cases to raise prices sufficiently to cover such higher costs, which inability results from the fact that prices are limited by competition with stores in surrounding areas. The obvious solution is to reduce the crime rate. Despite all the rhetoric to the contrary, the economic self-interest of the average black is allied with that of the merchants who supply him, not with that of the criminals who impoverish and destroy the merchants.)

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Moreover, under laissez-faire capitalism racial segregation would disappear, even though it would be legally permissible on private property. It would disappear because it is fundamentally incompatible with the requirements of profit-making and because it is irrational.

The businessman seeking profit is vitally dependent on the patronage of customers. This dependency is expressed in such popular sayings as “the customer is king” and “the customer is always right.” Blacks are customers, and, as they rose economically, would be more and more important customers. It is absurd to believe that businessmen would want to turn customers away by denying them access to their premises or by humiliating them with such requirements as separate drinking fountains. The businessman’s desire for profit makes him put aside all such malice. It does not matter that he personally may not like blacks. All he has to like is their money. Competition with other businessmen for the patronage of blacks then does the rest.

It might be objected that despite the willingness of businessmen to abolish segregation when doing so is profitable, the attitudes of white customers might prevent such action from being profitable. For example, it would obviously not be profitable to gain five poor black customers and lose ten good white ones as a result of desegregating.

Cases such as this could exist, in places such as the deep South of previous generations. But they could exist only in an ever-diminishing sphere. Even in the deep South of the past, there were many whites who positively desired equal treatment for blacks, and many more who did not oppose it strongly enough to withdraw their patronage from a business which desegregated. As a result, in the absence of government intervention, and the threat of private violence sanctioned by local governments, there would have been many businessmen in the South who would have found that, while they might lose some white customers by desegregating, they would by no means lose all, and would gain more black customers than they lost whites. This would have been certain to occur in areas where the population was relatively concentrated—that is, lived in cities or large towns—and in which the proportion of blacks was relatively high. In such areas, a businessman who desegregated would have been able to count on a relatively large black market to more than compensate him for his loss of white customers. For example, imagine a mass merchandiser, such as Sears, in a Southern town where there were two other such stores. If this store abolished segregation, it would certainly not have lost all of its white customers. Not that many Southern whites were so bigoted that they would have refused to shop there just because the store no longer humiliated blacks. Desegregating, however, would have enabled this store to gain a large number of black customers from the other two stores, for the blacks would have flocked to where they were treated as human beings. Desegregation would thus have been profitable for this store.

This case would have been repeated throughout the South. From practically the first day of freedom from government intervention and government sanctioned private coercion, there would have been voluntarily unsegregated stores, restaurants, hotels, and other establishments. The existence of these unsegregated establishments in their midst would then have acted to change the attitude even of those whites who had initially refused to deal with them. They would have seen with their own eyes that others were not contaminated by contact with blacks and that they would not be either. Thus, as time went on, fewer and fewer whites would have been prepared to withdraw their business from establishments which desegregated. The result would have been that businessmen would have had less and less to lose by desegregating; and the rising earning power, and thus growing buying power, of blacks would have given them more and more to gain. Finally, segregation would have come to be regarded as eccentric and then have ceased to exist altogether.

In this way, even such barriers as racially restrictive covenants in real estate would have been overcome. Property free of such restrictions, and therefore open to a wider market, would have become more valuable than property which carried them. Such covenants would have fallen into disuse and have been eliminated by voluntary consent.

Thus, even in areas such as the deep South, the extension of the economic freedom of capitalism to racial matters would have meant a significant measure of immediate integration, followed by an accelerating growth in integration. And it would all have been achieved voluntarily, in the pursuit of self-interest, in a spirit of mutual good will. 27

5. Prices and Costs of Production

In a free market the prices of products tend to be governed by their costs of production.

This principle follows directly from the uniformity-of-profit principle, and we have already glimpsed it in discussing the longrun consequences of repealing price controls. The uniformity-of-profit principle implies that the prices of products tend to equal their costs of production plus only as much profit as is required to afford the going rate of profit on the capital invested. If prices exceed costs by more than this amount of profit, then there is a tendency toward expanded production and lower prices (and possibly higher unit costs). If they fail to exceed costs by as much as this amount of profit, then there is a tendency toward reduced production and higher prices (and possibly lower unit costs). The stopping point is, as I say, where prices equal costs of production plus the amount of profit required to yield the going rate of profit on the capital invested.

Now there are two ways that cost of production governs prices. One way is indirectly—through variations in the supply of the good, as above. The other way is directly—through the decisions of the sellers of the good in setting their prices.

Let us consider first the cases in which the role of cost is indirect—for example, all or most agricultural commodities. In any given year, the price of wheat, or potatoes, or cotton, or whatever, is determined simply by supply and demand. Over a period of years, however, the price of such a good tends to gravitate about its cost of production. This is because whenever the price begins to exceed cost by more than what is required to afford the average rate of profit to the industry, additional capital will be invested, supply will be expanded, and the price and profit will decline. If the price fails to provide the average rate of profit to the industry, capital will be withdrawn, supply will be reduced, and the price and profit will be restored. What ties price to cost in such a case is variations in supply.

However, there is a vast category of cases in which the connection between price and cost is far more direct. This is the case of most manufactured or processed goods. In these cases, the sellers typically maintain inventories of their goods and have plant capacity available to produce more. In such a situation, a rise in demand, provided it is not too large, is met out of inventories, and before the inventory is exhausted, production is stepped up from plant capacity held in reserve. Similarly, when a fall in demand occurs, inventory is temporarily allowed to build up, and production is cut back. Provided the changes in demand are not of major proportions, there is little or no change in price. It can be observed, for example, that the price of bread, automobiles, newspapers, restaurant meals, paper clips, and countless other goods does not change with every change in demand. A change in demand must be fairly substantial to raise or lower the price of these goods. In cases in which the demand changes are not too substantial, they are simply accompanied by corresponding changes in production, while the price of the product remains the same.

In cases of this kind, it is not correct to say that the price of the product is determined simply by supply and demand. On the contrary, the price of the product determines the quantity of the product the buyers buy, and the quantity that the buyers buy determines the quantity the sellers produce and sell.

The prices themselves in these cases are set by sellers on the basis of a consideration of costs of production. It is not that each seller sets his price on the basis of his own costs. But some seller in an industry—usually, the most efficient large firm and one that is in a position to expand its production significantly from existing capacity—sets its price on the basis of a consideration of costs, and the other firms are forced to match its price. The other firms cannot exceed its price, because it has the additional production capacity required to supply many of their customers if they should try to sell at higher prices. Nor, as a rule, can the other firms undercut its price, because it is the lowest-cost, most efficient producer, and sets its price accordingly.

The cost of production on the basis of which such a firm sets its price is not primarily its own cost of production, but the costs of production of its less efficient competitors or, if it has no current competitors, the costs of production of potential competitors. It sets its price in such a way as to prevent its competitors from earning too-high profits, because it does not want them to accumulate the capital that would enable them to become more efficient and to expand at its expense. Nor does it want to invite new firms into its field. It wants to avoid creating a situation in which it makes it possible for others to make inroads into its business, which, once started, might lead to its own downfall. It therefore tries to set its price in such a way as to prevent this, which means it tries to set its prices not very far above their costs—as a maximum. At the same time, of course, it strives to reduce its own costs of production even further, so as to be able to expand its own profits and to be able comfortably to meet any price reductions inaugurated by competitors that in the meanwhile may have grown more efficient. It is only when the demand for the product becomes so strong that it is not possible to meet it at a price determined in this way, that the price rises to permit high profits to all in the field.

In the case of manufactured and processed goods,

therefore, the direct determinant of price is cost of production. 28

However, as should already be clear from Chapter 5, if we examine costs of production, we find that they are reducible to two things: to the physical quantities of the means or factors of production employed to produce a good and to the prices of those factors of production. 29 For example, the cost of producing an automobile equals the quantity of each type of labor employed in turning out a car times the wage rates of that labor, plus the quantity of steel used times the price of that steel, and so on. Now the prices of these factors of production are themselves directly determined either by supply and demand or by cost of production. For example, the wage rates are determined by supply and demand, while the price of steel is determined by cost of production. 30 Now the costs of producing steel and all the other elements of an automobile whose prices are determined by cost are themselves resolvable in the same way as the cost of producing an automobile. That is, they in turn are based on prices directly determined by supply and demand and prices directly determined by cost of production.

It should be observed that as we keep pushing the matter back and back, the cumulative role of prices directly determined by supply and demand becomes greater and greater. In the case of our automobile, the production cost of an automobile ultimately depends on the wages of auto workers, the wages of steel workers, the wages of iron miners, and so on, all of which are determined by supply and demand. And, along the way, the prices of some of the materials, such as the copper and zinc the auto companies may have to buy, the raw rubber the tire manufacturers buy, the scrap metal the steel producers need—these prices, too, are directly determined by supply and demand. Ultimately, therefore, as far as it rests on prices, cost of production itself is determined entirely by supply and demand.

Consequently, when prices are determined by cost of production, what they are ultimately determined by is still supply and demand, but supply and demand operating in a wide context—that is, by supply and demand operating in the context of the labor market and in certain broad commodity markets, not in the relatively narrow market of the individual product itself. 31

The analysis of cost of production into elements which are themselves determined by supply and demand brings us full circle. We began the analysis of price determination in Part B of Chapter 5 with a discussion of supply and demand, and now we must return to supply and demand, in order to explain prices determined on the basis of cost of production. For, as we have seen, insofar as cost of production rests on prices, those prices are ultimately determined by supply and demand. Thus, if we want an ultimate explanation of prices determined by costs, we must explain prices determined by supply and demand. This will be our task, at a more advanced level than before, in the next part of this chapter, as we complete the presentation of the free market’s laws of price determination.

PART B

ALLOCATION PRINCIPLES

1. The General Pricing of Goods and Services in Limited Supply

The determination of price by supply and demand applies to all goods and services whose supply is a given fact and therefore limited for a longer or shorter period of time to come. As we have seen, it also applies indirectly (via determining the prices that constitute their costs of production) to products whose supply can be immediately varied in response to changes in demand.

It is necessary to consider a kind of catalog of goods and services in limited supply, in order to understand concretely the range of application possessed by the principle of supply and demand.

The most important item in this list is, of course, human labor, which is always limited by the number of people able and willing to work. Furthermore, the labor of each person is limited by his need for rest and relaxation. And, as the general level of real wages—that is, the quantity of goods a worker can buy with his money wages—goes up, the fewer are the hours that people are prepared to work. This occurs because to the degree that people can earn a higher standard of living from any given number of hours of labor, their need for the additional real income that extra hours could provide is less intense. In addition to this, of course, the supply of skilled labor is always still further limited, and that of professional-level labor even more so; and, at any given time, the supply of labor in each occupation and each location is very narrowly limited.

After labor services come materials whose supply is temporarily limited, such as agricultural commodities between harvests. Housing and buildings of all kinds are in a state of temporarily limited supply, because considerable time is always required before their supply can be increased through new construction. Any material, any product whatever, is capable of being in limited supply temporarily, if the demand for it outruns the ability to supply it from existing facilities at a price based on cost of production.

Land sites are in the category of goods in limited supply on a longrun basis, insofar as there is anything

special or unique about them that makes them superior to other land, such as their superior location or superior fertility. 32

In a few cases, the products of such land sites are also in the category of goods in limited supply on a more or less permanent basis: for example, wines of a special flavor that can be produced only from grapes grown on a soil of a very limited extent, or caviar found in sturgeon beds located only in a few places.

Goods such as paintings and statues by old masters, first editions, rare coins, and so on, are in the category of goods in limited supply on an absolutely permanent basis, because their production is necessarily past.

Finally, all second-hand goods are in a state of limited supply.

The prices of all goods and services in limited supply are determined in an essentially similar way in a free market and have a similar significance. One basic determinant is the quantity of money in the economic system. As previously indicated, the quantity of money determines aggregate demand. 33 It can do this, of course, only in determining at the same time the demand for the various individual goods and services. We will not go too far wrong if we assume that once the economic system becomes adjusted to a change in the quantity of money, the effect of the change is to change the demand for everything more or less to the same degree. For example, in the long run, if the quantity of money doubles, and everything else remains the same (including such things as the rate at which the money supply increases and is expected to go on increasing), the demand for each individual good and service in the economic system should also tend to double. With a doubled quantity of money, we should expect that eventually the demand for shoes, baseballs, zinc, skilled and unskilled labor, and all other goods and services should all just about double. This means that, in the long run at least, we can regard the quantity of money as acting more or less equally on the price of everything. 34

The second major determinant of the prices of goods and services in limited supply is the value judgments of the consumers with respect to the various goods and services on which they spend the quantity of money. The value judgments of the consumers determine, in effect, how the aggregate demand that is made possible by any given quantity of money is distributed among the products of the various industries and among all the different goods and services in limited supply. The value judgments of the consumers determine, for example, how much is spent for shoes versus shirts, and indirectly, therefore, how much is spent for leather versus cloth, cowhides versus cotton, and grazing land versus cotton land; similarly for the labor services at each stage. In determining the relative spending for all the different consumers’ goods, each with its own requirements for labor of specific types, the consumers determine how much is spent in the economy as a whole for each type of labor in relation to every other type of labor, both in terms of specific occupations and in terms of wide groups of occupations, such as skilled labor versus unskilled labor. The same applies to all other goods and services in limited supply, such as diamonds versus wheat, real estate in New York City versus Des Moines, Iowa, and so on. In this way, the value judgments of the consumers ultimately determine the prices of all goods and services in limited supply in relation to one another. It is the value judgments of the consumers that ultimately determine how much more professional-level labor must be paid relative to skilled labor, and how much more skilled labor must be paid relative to unskilled labor.

In sum, the quantity of money determines the absolute height of the prices of goods and services in limited supply, and the value judgments of the consumers determine their relative heights. The value judgments of the consumers are, of course, judgments with respect to marginal quantities, and one may say that the relative prices of goods and services in limited supply are determined by their relative marginal utilities, or, in the case of factors of production, the relative marginal utilities of their final products to the consumers. 35

2. The Pricing and Distribution of Consumers’ Goods in Limited Supply

For our purposes, the most important characteristic of the price of a good in limited supply is the fact that in a free market it always tends to be set high enough to level down the quantity of the good demanded—that is, the quantity of it that buyers are seeking to buy—to equality with the limited supply of it that exists.

For the sake of simplicity, consider the case of a rare wine, for example. It may be that, potentially, millions of people would enjoy drinking this wine and would be prepared to buy tens of millions of bottles of it every year. But because of the limitation of the special soil on which the necessary grapes can be grown, no more than, say, ten thousand bottles of the wine can be produced in an average year. What happens in this case is that the price of the wine rises to such a point that the great majority of potential buyers are simply eliminated from the market. They look at the high price and say to themselves, “This wine is simply too expensive for me, however delicious it may taste.” In fact, in the knowledge that this would be their decision, the very existence of such a wine would probably never even be called to the attention of the great majority of people. As for those who do buy the

wine, the high price probably makes almost all of them restrict the amount of it that they consume. At fifty dollars a bottle, say, even millionaire wine lovers probably drink it much less often than they would at, say, ten dollars a bottle.

The case of apartment rentals is essentially the same. In a free market, rents go high enough to level down the quantity of rental space demanded to, or somewhat below, equality with the limited supply of it that exists. The only difference is that in an economy like that of the United States, no one need be excluded from the rental market entirely. Everyone is always able to afford to rent some space, even if it is only half of a room he must share with someone else. 36

Always, a freemarket price acts to level the quantity demanded of any good or service in limited supply down to equality with the supply that exists.

This characteristic of a freemarket price has a major implication. It implies that shortages cannot exist in a free market, even in cases of the most severely limited supply. That is because, however limited the supply may be, a freemarket price always rises high enough to level down the quantity demanded to equality with the supply available. In a free market, limited supplies do not cause shortages, but high prices. At the high price, there is no shortage.

In order further to prove this point, let us take an extreme example—one that is very unfair to the free market, namely, the case of the gasoline shortage of 1973–74. In a variety of ways, the government was responsible for vastly reduced supplies of gasoline, especially in the Northeast. Let us start with these artificially low supplies of gasoline and imagine that at that point the government had simply repealed its price controls on gasoline.

Whoever went through the experience should think back to the sight of service stations faced with multiblock-long lines of cars waiting for gasoline. Let us imagine a service station that has 1,000 gallons of gasoline in its own tanks and is confronted with a line of cars whose drivers are seeking 2,000 gallons of gasoline for their tanks. This is a case of 1,000 gallons of gasoline available, 2,000 gallons demanded. Even in this case, a free market would have equalized the quantity demanded with the supply available. If the owner of the gas station had been free to set his own price, he would have set a price high enough to make those drivers reduce the quantity they demanded by 1,000 gallons. Such a price undoubtedly existed. If the reader doubts this, he should imagine the gas station owner simply auctioning his gasoline off to the highest bidders. As the price at the auction rose, more and more bidders would have restricted the quantities they bid for, and some would have dropped out of the bidding altogether. At some point, the quantity of gasoline demanded would have been cut back to equality with the 1,000 gallons available. It makes no difference, of course, if instead of conducting an auction, the service station owner had simply set his price where such an auction would have set it. In either case, people who previously were prepared to buy 2,000 gallons of gasoline would have found that they could not afford more than 1,000 gallons and would have limited their purchases accordingly.

In fact, things would have gone further than this. A service station owner not restricted by price controls would have considered not only the demand of the drivers of the cars presently in line, but also the demand of all the drivers of the cars that might have shown up later in the day, or the next day, or any time before his next deliveries were to arrive. He would not have been willing to sell gasoline to someone presently in line if he expected that someone else would show up later willing to pay more. The price he set, in other words, would have corresponded to the price set in an auction market that extended over time and represented future bidders as well as present bidders.

The effect of the owner’s pricing gasoline in this way would have been not only further to reduce the quantity demanded on the part of those presently in line, thereby reducing the waiting line further, but actually to make gasoline available at all times at his service station. Since all other service station owners would also have been pricing gasoline in the same way, motorists would soon have realized that gasoline was in fact available whenever they wished it and in whatever quantity they wished it—provided they were willing to pay the price. There would have been no shortage and motorists would have known that they did not have to fear a shortage; they would have ceased to be afraid to drive with less than a full tank of gasoline. (It should be realized that this is largely a description of what actually happened later on. Shortages ended in the spring of 1974 because the controls on oil prices were substantially relaxed, and totally eliminated as far as imported oil was concerned.)

Of course, in the case of a good like gasoline, a rise in price to the freemarket level not only restricts the quantity demanded, and eliminates the need to hoard, but also pulls in supplies from other geographical areas. As we will see, it also causes oil refineries to step up the production of gasoline at the expense of other petroleum products, if necessary. And, in the long run, it increases the total production of oil products. In these ways, a free market not only balances the demand and supply of gasoline, but does so at the point of large and, indeed, continuously growing supplies.

However, the crucial point here is that even in the case

of goods in strictly limited supply, there are no shortages, no waiting lines, in a free market. Whoever has the price is always able to buy as and when he wishes, and as much as he wishes.

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There is a further very important point that follows from our discussion. This is the fact that in the context of limited supplies, it is not only to the self-interest of the sellers that prices rise when conditions make it necessary, but, no less, to the self-interest of the buyers. It is simply not true, as most people seem to believe, that the interests of buyers are always served by low prices. On the contrary, it is to the self-interest of buyers of goods in limited supply that prices be high enough to exclude their competitors from the market.

To grasp this point in the clearest possible way, imagine an art auction, with two bidders for the same painting. One of them is willing to go as high as $1,000; the other, as high as $2,000. The man whose limit is $2,000 would certainly like to pay as little as necessary. He would be glad to pay just $100, or less, if he could. But given the fact that someone else at the auction is prepared to bid up to $1,000, it would be very foolish for this man to insist on paying any preconceived figure below $1,000. If he arbitrarily insisted on bidding any amount below $1,000, the effect of his action would simply be to allow the painting to go to his rival. If he bid exactly $1,000, and refused to bid any more, he would make it a matter of accident to whom the painting went—if the other bidder bid the $1,000 first, it would probably go to that other bidder. In either case, by refusing to outbid the other bidder, he would prevent himself from getting the painting he wants and which he really values above the other bidder’s maximum of $1,000 for the painting.

There is absolutely no difference as far as this man is concerned if, instead of his having to appear personally at an auction and outbid his rivals, the art dealer who possesses the painting anticipates the strength of his bid, and simply sets a price on the painting in his gallery that is high enough to deter other potential buyers and thus to reserve it for him. From the standpoint of the rightly understood self-interests of this man, it is a positively good thing that the art dealer asks more than $1,000, because if he did not, someone else would buy the painting and it would be gone by the time our man got around to trying to buy it.

The only difference between the cases of the art auction and the art dealer and that of all other commodities in limited supply is simply one of size. Instead of it being a unique painting that is put up for auction or for sale and which is of interest to a relatively small number of bidders or potential buyers, it is more common to have millions of units of the same good offered in the market and sought after by large numbers of bidders or potential buyers. Just as in the case of the painting, in all these cases, too, the fact that a price is high enough to level down the quantity of the good demanded to equality with the limited supply of it that exists is very much to the interest of all those buyers who are willing and able to pay that price. That price is their means of eliminating the competition for the good from other bidders or potential buyers not willing to pay as much. It is their means of being able to secure the good for themselves. In our example of the wine, for instance, the price of fifty dollars a bottle—if that is the price necessary to level the quantity demanded down to equality with the supply available—is in the interest of everyone who values the wine at or above fifty dollars. If the price were any lower, the wine would be within reach of other potential buyers, who did not value it so highly, and it would, therefore, to that extent, not be available to those who did value it so highly. In the same way, whatever price of a square foot of rental space, or any other good, is required to level the quantity demanded down to equality with the supply available, that price is to the interest of all those who value that space or that good at that price or any higher price. If the price were any lower, they would simply lose their ability to secure the good for themselves—the good would be bought up by those not able or willing to pay as much, and to that extent it would be unavailable to those who did value it sufficiently.

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There are two possible misunderstandings of what I am saying that I want to anticipate and answer before going any further.

First, I want to stress that the ability to outbid others for the supply, or part of the supply, of a good is by no means the exclusive prerogative of the rich. The fact is that absolutely everyone exercises this prerogative to the extent that he earns an income or has any money to spend at all. Even the very poorest people outbid others, and the others whom they outbid can include people who are far wealthier than themselves. Of course, this is not true in a case such as our example of the rare wine, where the entire supply is obviously consumed by those who are quite well-to-do.

But it is true in a case such as rental space, or housing in general, where everyone succeeds in obtaining some part of the supply. In a case of this kind, a wealthier family will obtain a larger share of the supply than a poorer family, but what stops it from obtaining a still larger share is the fact that the poorer family outbids it for part of the supply. For example, a wealthier family may rent an eight-room apartment, while a poorer family rents only a four-room apartment. The reason that the wealthier family does not rent a nine-room apartment is

the fact that the poorer family is able and willing to pay more for its fourth room than the wealthier family is able and willing to pay for a ninth room.

This competition, of course, does not take place at an actual auction, but the result is exactly the same as if it did. If, for example, apartments are renting at some given figure per room, such as $300 a month, and the poorer family decides it can afford a four-room apartment, while the wealthier family decides it cannot afford a nine-room apartment, the implication is that the poorer family values a fourth room above $300, while the wealthier family values a ninth room below $300. In effect, the poorer family outbids the wealthier family for the marginal room. If this poorer family wants to be sure of obtaining its four rooms, it is just as important to it that rents be high enough to level the quantity of space demanded down to equality with the supply available, as it is to the richer family.

If the price were any lower than the necessary equilibrium price, then while some poorer families might be able to afford a fifth room, wealthier families would just as often be able to afford a ninth room. And as often as poorer families succeeded in grabbing off a fifth room at the expense of a wealthier family’s eighth room, a wealthier family would succeed in grabbing off a ninth room at the expense of a poorer family’s fourth room. The same results apply to any good that is universally consumed: an artificially low price permits the “rich” to expand their consumption at the expense of the “poor” just as often as it permits the poor to expand their consumption at the expense of the rich.

Thus, the setting of prices at levels high enough to achieve equilibrium between the quantity demanded and the supply available is to the rational self-interest of everyone, irrespective of his income. Moreover, a harmony of interests exists in a free market even in those cases in which the price totally excludes some people from the market for particular goods. It exists on a remoter plane. For example, the price of Rembrandt paintings excludes the author of this book from the market for those paintings entirely and without question. Nevertheless, it is to my self-interest that if someone must be excluded, it be me, and not an industrial tycoon. For if his vastly greater contribution to production did not enable him to live at a better level than I do, I would be in serious trouble. To put this another way, if an industrial tycoon can have his art collection and other super-luxuries, then I can have all the food I want, a house, an automobile, and so on, and more and better all the time. If I were to be able to compete on equal terms with him for the super-luxuries, he would have no motive to conduct production in such a way that I am assured of all the necessities and lesser luxuries.

In order to avoid a second possible misunderstanding about the interest buyers have in prices being sufficiently high, I want to stress that I am not saying that people should simply welcome higher prices and be glad to pay them. Obviously, rising prices impose major hardships on large numbers of people, and they cannot simply look on stoically and be glad of their ability to pay those prices. However, there are two separate things here that must be very carefully distinguished, namely, the fact of the rise in prices and the cause of the rise in prices.

Our example of the art auction will serve to make this distinction clear. Assume that the losing bidder, whose maximum bid was previously $1,000, is now placed in a position in which he is able to bid as high as $1,500. In order to outbid him, our man will now have to bid above $1,500, whereas before he only had to bid above $1,000. Obviously, this is not a pleasant development for our man. But nevertheless it is still to his interest to bid a price that is sufficiently high to secure him the painting. Our man should, indeed, still value the opportunity to outbid his rival. His sorrow should be directed only at that which now makes it more difficult for him to do so.

In the same way, even in periods of rising prices people should, indeed, still value the opportunity to outbid their rivals and the fact that sellers set prices high enough to achieve this objective for them. Their anger should be directed only at that which makes it more and more difficult for them to accomplish this overbidding. What they should be angry about is not the existence of a market economy and the way the market economy works but at the presence in the market of a vast gang of dishonest bidders and dishonest buyers, a gang that bids and spends dollars created out of thin air in competition with their earned dollars. As later discussion will show, the source of these dollars created out of thin air is none other than the government. And the dishonest gang consists of it and of everyone else who demands and receives such fiat money. 37

In other words, it is inflation and the pressure-group demands for inflation that the victims of rising prices should denounce, not the market economy or the opportunity it affords them for outbidding their rivals. It is the entry of newly created money into the economy that they should seek to stop, not the registry of that newly created money in the form of higher prices. Instead of, in effect, calling for the closing of the market, they should simply call for an end to the government’s inflation of the money supply, and thus for the establishment of a fully free market—a market free of this as well as the government’s imposition of price controls.

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On the basis of the way their prices are determined, the distribution of consumers’ goods in limited supply—

in the sense of who actually ends up with them—always tends to take place in a free market in accordance with two criteria: the relative wealth and income of the various potential buyers and the relative intensity of their need or desire for the good in question. The wealthier a buyer is, the more of any good he can afford to buy—obviously. But wealth is not the sole criterion of distribution. Where two buyers possess the same wealth, the one who needs or desires a good more intensely will be willing to devote a larger proportion of his wealth to its purchase, and he will therefore be able to outcompete an equally wealthy buyer who values the good less intensely. And, of course, in many cases a buyer who possesses a sufficiently strong desire will be able to outcompete a wealthier buyer, sometimes even a substantially wealthier buyer. In our example of the wine, for instance, a wine connoisseur of relatively modest means might very well be willing to pay prices that a millionaire would not. Or, because of their relative preferences, some poorer families might outcompete some wealthier families not just for a marginal room, but for an equal-size apartment by devoting a sufficient proportion of their income to rent.

In a free market, therefore, consumers’ goods in limited supply are distributed in accordance with purchasing power directed by needs and desires, or, equivalently, in accordance with needs and desires backed by purchasing power. Everyone consumes these goods in accordance with a combination of his means and his needs and desires.

3. The Pricing and Distribution of Factors of

Production in Limited Supply

All that we have learned about the prices of consumers’ goods in limited supply applies to the prices of factors of production in limited supply, that is, to the prices of materials, labor, machinery, and anything else that is bought for business purposes and that is in limited supply.

The price of a factor of production in limited supply is also determined in such a way that the quantity of it demanded is levelled down to equality with the limited supply of it that exists, just like a consumers’ good in limited supply. What pushes the price to the necessary height is, once again, a combination of the self-interests of the sellers and the buyers. The immediate buyers, directly concerned, are, of course, businessmen. Businessmen desire a factor of production not for the satisfaction of their own personal needs or wants, but in order to secure the means of producing goods for profit. Nevertheless, it is just as much against the interests of businessmen to try to pay too little for a factor of production as it is for a consumer to try to pay too little for something he buys. Like a consumer, a businessman must be willing to pay prices that are high enough to secure him the things he wants. This means that he must be willing to pay prices that outbid what other businessmen are prepared to offer for the same part of the supply. (It follows that the doctrine that self-interest drives employers arbitrarily to pay subsistence wages is as absurd as the belief that self-interest drives the bidder at an art auction to offer scrap-paper prices for a valuable painting. Employers who would arbitrarily decide to pay too-low wages would simply enable other employers to hire away their labor. The employer who wants labor must be willing to pay wages that are high enough to make that labor too expensive for all its other potential employers. 38 )

The only complication that is introduced by the price of a factor of production in limited supply is that it does double duty, so to speak. It not only levels down the quantity of the factor that is demanded to equality with the supply available, but, indirectly, the quantity of all the various products of the factor as well.

Let us consider first a simple case, such as cigarette tobacco, whose only product is cigarettes. The price of cigarette tobacco not only levels down the quantity of cigarette tobacco that is demanded, but, as a major part of the cost of producing cigarettes, it carries through to the price of cigarettes and also levels down the quantity of cigarettes demanded. The price of cigarette tobacco thus adjusts the demand for cigarettes to the supply of cigarette tobacco. Observe just how this happens. As the price of cigarette tobacco rises, the cost of producing cigarettes rises, which, in turn, raises their price. As the price of cigarettes rises, the quantity of cigarettes demanded falls. In fact, it is this fall in the quantity demanded of cigarettes, as their price rises, that necessitates a fall in the quantity demanded of cigarette tobacco, as its price rises. As the price of cigarette tobacco rises, businessmen purchase less of it because they know that they cannot sell as many cigarettes at the higher prices that are necessary to cover the resulting higher costs of production. In this way, therefore, the price of cigarette tobacco levels down the quantity demanded both of cigarettes as well as cigarette tobacco to equality with the supply of cigarette tobacco available.

Nothing is changed if we now consider the somewhat more complicated case of wheat or any other factor of production that has a variety of products, such as skilled labor. As the price of wheat rises, the cost of production and prices of all products made from wheat—such as bread, crackers, macaroni, whiskey, and wheatfed cattle and chickens—also rise. The rise in the prices of wheat products reduces the quantity of the various wheat products demanded, and this reduces the quantity demanded of wheat. Again, as the price of wheat rises, businessmen

cut back their purchases in anticipation of the fact that they will not be able to sell as many wheat products at the higher selling prices necessary to cover the higher cost of wheat. In this way, therefore, through its effect on the cost of production and the selling prices of all the various wheat products, the price of wheat equalizes not just the quantity of wheat demanded, but also the quantity demanded of all wheat products as a group, with the supply of wheat available.

There is a further important similarity between what is accomplished by the price of a factor of production in limited supply and the price of a consumers’ good in limited supply. If we look at the whole range of products of such a factor as forming a single group, we can observe the same essential principle of distribution with respect to the factor that we previously observed with respect to a consumers’ good in limited supply. Namely, the benefit of the factor, as conveyed by its various products, is distributed to the various individual consumers in accordance with their relative purchasing power and in accordance with their relative desire for products of that type. For example, the benefit of the supply of wheat is distributed to the ultimate consumers in accordance with a combination of their relative wealth and relative preferences for products made of wheat. Other things being equal, richer buyers obtain the benefit of more of the supply of wheat than poorer buyers. Not that richer buyers eat more bread—they probably eat less of it—but they eat more meat, which requires the use of far more wheat to make possible its production pound for pound (in the feeding of cattle) than does bread. In the same way, a buyer with a relatively strong preference for wheat products, such as a buyer who especially likes steak and scotch, is able to obtain a larger share of the benefit of the wheat supply than a buyer of equal wealth who values these things less.

The benefit of the supply of crude oil, skilled and unskilled labor, and all other factors of production in limited supply is distributed to the ultimate consumers in just the same way.

Thus far, it is evident that the prices of factors of production in limited supply have the same characteristics and the same significance as the prices of consumers’ goods in limited supply. The great difference between them pertains to the fact that there is an added dimension to the distribution of the factors of production. Not only is the benefit of a factor of production distributed to different persons, in accordance with their relative wealth and relative preferences, but the factor itself must be distributed to different concrete uses in production. Its benefit goes to the persons only by means of those specific uses. For example, consumers do not buy the benefit of wheat or skilled labor as such, but the various specific products of wheat or skilled labor. The supply of the factor must be distributed among its various specific products—in order to produce them.

This distribution of a factor of production among its various products is the result of a further process of mutual bidding and competition among the consumers. Only this time, it is not merely one consumer bidding against another consumer, but the different needs, desires, or purposes of one and the same individual consumers bidding against each other, as well. For instance, there is a competition for wheat between its use for baking bread, its use for making crackers, its use for making whiskey, feeding meat animals, and so on. There is a competition for crude oil between its use for making gasoline, its use for making heating oil, and so on. And there is a competition for the labor of each ability group among all of its various possible employments. Since the same individual consumers consume most or all of the various products of these factors of production, the competition is, as I say, ultimately largely one between the competing needs, desires, or purposes of the same individuals.

In order to grasp the nature and the importance of this competition, let us consider the question of why just so many bushels of wheat—to continue with that example—are devoted to each of its specific uses. Why aren’t a million bushels, say, withdrawn from making crackers and added on to baking bread? The reason this does not occur is that the consumers of the quantity of crackers requiring the million bushels in question are perfectly willing and able to pay a price for the crackers that makes it profitable to cracker manufacturers to produce them at the current price of wheat. The consumers of the crackers, in other words, are willing to allow the producers of the crackers to pay the present price of wheat. But suppose that a million bushels of wheat were used to produce additional loaves of bread. In order to find customers for the additional bread, its price would have to be reduced. In fact, in a country like the United States, where, as a rule, even the very poorest people can already buy all the bread they desire to eat, the price would probably have to be cut so drastically as to induce people to feed the extra bread to pigeons. Conceivably, the extra bread might not be saleable at any price. In any case, it is clear that the bakers of bread would not be able to buy any additional wheat except at a lower price of wheat. And that means that the bread industry, in effect, bids less for the million bushels of wheat in question than the cracker industry. The cracker industry gets the wheat by outbidding the bread industry. And this happens because ultimately the consumers of crackers are outbidding the consumers of bread for the benefit of that wheat.

For the same reasons, the reverse situation does not

occur either—that is, a million bushels of wheat are not withdrawn from the bread industry and added on to the cracker industry. For the consumers of the present quantity of bread are willing to pay prices for that quantity that allow the bread industry to be profitable at the present price of wheat. But the consumers of crackers would only be willing to buy a larger quantity of crackers at a lower price. In order for crackers to be profitable at a lower price, the price of wheat would have to be lower. As a result, the only way the cracker industry could buy an additional quantity of wheat would be at a lower price of wheat than the bread industry is willing to pay for it. Thus, the bread industry outbids the cracker industry for this particular quantity of wheat. Again, ultimately it is the consumers of the one product outbidding the consumers of the other product for the benefit of the quantity of wheat in question. And since it is the same people who consume both products, it is really one kind of need, desire, or purpose of the same individuals outcompeting another.

In exactly the same way, any other such transfer of wheat from one use to another is prevented by the fact that in its changed employment the quantity of wheat in question could only be employed profitably at a lower price than in its present employment. In other words, the present employments outbid the potential changed employments, and thus they get the wheat. And the reason they outbid them is because of the fact that the ultimate consumers are willing to allow more for the use of wheat in its present employments than in its changed employments.

In this way, the distribution of wheat to its various uses is determined by a process of competition among those uses, which in turn reflects a process of competition among the needs, desires, and purposes of one and the same individual consumers.

We can substitute any factor of production for wheat, and the results will be the same. If we ask why a million manhours of unskilled labor are not withdrawn from one industry and added on to another, the answer again is that the consumers are willing to pay product prices in its present employments that enable businessmen to employ that labor profitably at its going wage rate; if the labor were shifted, however, the consumers would only buy the resulting products at prices that would require lower wage rates for their production to be profitable. These products, therefore, are unable to compete for the necessary labor. They are unable because of the choices and value judgments of the consumers, which enable the existing employments to outbid them.

A principle which emerges from our discussion is that in a free market a factor of production in limited supply always tends to be distributed to its most important employments, as determined by the value judgments of the consumers themselves. In our example of the distribution of wheat, it was more important for the million bushels to be employed in producing crackers that people wanted—as demonstrated by their willingness to pay for them—than additional bread that people did not want or wanted less. It was more important for a million bushels to be retained in producing bread that was desired than to be added on to producing crackers that were less strongly desired—as manifested, this time, in the willingness of consumers to allow more for wheat used to produce bread than for wheat used to produce additional crackers.

It is this way in every case. A factor of production in limited supply is employed in those uses that can afford to pay the highest prices for it. And that is determined by the willingness of the consumers to pay prices for the resulting final products. Every factor of production in limited supply is distributed to those employments where the consumers are willing to allow the most for it in the prices of the goods they buy. That is, it is distributed to those employments which the consumers regard as the most important to their own wellbeing.

It must be stressed that the concept “the most important employments of a factor of production” is a variable range that expands or contracts with the supply of the factor of production available. What it means is the most important employments for which the supply of the factor suffices. 39 For example, if the supply of the factor is extremely limited, the most important employments for which the supply suffices might be as important as life itself. If the supply is very great, the most important employments can extend downward to include many luxury uses. The case of wheat again provides a good example. In a country like India, or medieval France, devoting wheat to its most important employments means, essentially, producing as much bread as possible to ward off starvation. In a country like the present-day United States, devoting wheat to its most important employments ranges downward through totally satisfying the desire for products such as bread and pasta, heavily satisfying the desire for such things as cakes and cookies made from wheat, substantially satisfying the desire for alcoholic beverages made from wheat, and partly satisfying the desire for wheatfed meat.

A second major principle follows from this discussion. Namely, the price of every factor of production in limited supply, and thus the prices of all of its various products, is determined by the importance attached to the least important of the employments for which its supply suffices; that is, by the importance attached to its marginal employments. In our example of wheat, for instance, the price of wheat in the present-day United States is determined by the importance attached to the use of wheat in feeding meat animals—its marginal employment in the context of our economy. This results

from the fact that the price of wheat has to be low enough to permit its use to be profitable in all of its employments. If it is to be used in feeding meat animals, its price has to be low enough to make that use profitable at prices consumers are willing to pay for wheatfed meat. However, there is only one uniform price of wheat in the same market at the same time. As a result, the bread industry pays no more for wheat than the cattle-raising industry. And because the price of bread is determined by its cost of production, the price of bread in the United States is actually determined not by its own importance, which may be as great as the stilling of hunger, but by the relatively low importance attaching to the use of wheat in producing meat.

Or, to take another example, the price of surgical instruments, on which countless lives may depend, is not determined by the importance of the needs they serve directly. It is not even determined by the importance attached to the marginal employments of iron and steel, but by the importance attached to the marginal employments of the ability groups of the labor that produces iron, steel, and surgical instruments. For the price of the surgical instruments is determined by their cost of production. And the wage rates which constitute that cost are low enough to make the employment of the different ability groups of labor profitable in their marginal employments. To put it another way, the price even of surgical instruments is no higher in relation to the wages of the ability groups of labor employed to produce them than the marginal products of such labor, which may be a quantity of razor blades or even magazines or chocolate bars or who knows what.

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To summarize our discussion of factors of production in limited supply, we have seen that all the principles apply that we developed in relation to consumers’ goods in limited supply, plus two others: First, that factors are distributed to their most important employments through a process of the different needs, desires, and purposes of the same individual consumers bidding against one another. And second, that the prices of the factors are determined with respect to the least important among the employments for which their supply suffices. Determination of price by cost, we have seen, therefore, ultimately means determination with respect to the consumers’ value judgments concerning the marginal products of factors of production. 40

4. The Free Market’s Efficiency in Responding to Economic Change

On the basis of the way their prices are determined, every change in the demand or supply of a factor of production in a free market tends to be dealt with in the most rational and efficient manner possible—that is, in a way that maximizes gains and minimizes losses.

To understand why this is so, imagine that the demand for one product in the economic system rises, while the demand for another product falls. For the sake of simplicity, assume for the moment that the two products are produced with the same factors of production. Washing machines and refrigerators are a good illustration of such products, because both of them require just about the same overall proportions of skilled and unskilled labor in their production, use largely the same materials, and can probably be produced in the very same factories without great difficulty. If the demand for one of these products increases while the demand for the other decreases, there will probably be little or no change at all in the demand for factors of production that cannot be matched by an immediate corresponding shift in their supply. Essentially, all that occurs in this case is that more of the same kinds of factors are employed in one capacity, and less in another. In accordance with a change in consumer demand, the production of the one item is expanded while the production of the other item is contracted. In this case, there is obviously no tendency toward a change in the prices of the factors of production.

But now let us consider a more complicated case, which will bring out an important new principle of the free market. Assume that a change in fashion occurs which dictates that the average person own one extra wristwatch, and which, at the same time, encourages him or her to own one less suit or dress. I choose this example because the labor used to produce clothes cannot be transferred to the production of watches, due to the enormous skill differences involved. Here, therefore, we have a case of changes in the demand for factors of production that cannot be matched by offsetting shifts in their supply. Let us see what happens in such a case in a free market. 41

The wage rate of watchmakers and the cost of production and price of watches, of course, will rise; while the wage rate of garment workers and the cost of production and price of clothing will fall. However, the effects will not be confined to these initial areas of impact. A rise in the wages of watchmakers will begin to attract other workers into the field, say, some workers who would have gone into instrument making, optics, jewelry making, and so forth—that is, whatever fields employ labor of a kind that can be used to make watches. A fall in the wage rates of garment workers, on the other hand, will begin to push some of these workers out of that field and into other fields. As a result, a tendency develops toward widening and diffusing the initial impact of the change in demand.

As workers leave fields such as instrument making and optics to go into watchmaking, the wage rates and thus the production costs and product prices in these fields will begin to rise. Thus, the rise in demand for watches will raise not only the cost and price of watches, but also the cost and price of instruments, optical goods, and so forth—all products that use the same kind of labor as watchmaking. Conversely, as workers leave the garment industry and begin to enter other fields for which they possess the necessary skills, the wage rates, production costs, and product prices in those fields will begin to decline.

The question we want to ask is: what principle determines which industries among those that employ the same kind of labor as watchmaking actually release additional labor for watchmaking, and to what extent? And which industries among those potentially capable of absorbing the labor released from the garment industry actually absorb it, and to what extent? To arrive at the answer, we must realize that at the higher prices of the various goods that use the same kind of labor as watches, the consumers will reduce their purchases of those goods. It is these decisions of the consumers to restrict their purchases, that determine which of the industries release labor for watchmaking and to what extent. For example, if the consumers decide to go on buying an unchanged quantity of optical goods at their higher price, but a reduced quantity of jewelry and various instruments, none of the labor will come from the optical goods industry, and all of it will come from the jewelry and instrument industries. Obviously, the labor will come from these various industries in accordance with whatever proportions the consumers decide to curtail their purchases of the various products at their respectively higher prices.

Clearly, what occurs in this case is an indirect bidding for the use of labor between the buyers of wristwatches and the buyers of all other products employing the same kind of labor. The buyers of wristwatches cause a bidding up of the price of the wider category of labor that produces both wristwatches and all the other products I have named. As a consequence of this intensified bidding for labor, the buyers of these other products—jewelry, instruments, optical goods, and so forth—are confronted with higher product prices and so must restrict their purchases. To the degree that they restrict their purchases, they release labor to the watch industry and make possible its expansion.

Now to the extent that the consumers are rational, the products whose purchase they discontinue at the higher prices will be the least important among the ones they previously purchased. That is, the consumers will discontinue their previously marginal purchases. For each consumer who buys these various products will cut back his purchases in the way that hurts him least in his context and in his judgment. Thus, if he needs eyeglasses, he will certainly go on buying a pair of eyeglasses, but perhaps forgo the purchase of a telescope for his hobby, say. If he was previously in a position to buy several pairs of eyeglasses and a telescope and some jewelry, then, when he is confronted with higher prices for all of them, he may decide to go ahead with the telescope but cut back on an extra pair of sunglasses and some jewelry. The effect on the quantities demanded of these goods in the whole economy is, of course, simply the aggregate of all such individual decisions. In this way, it can be seen that in a free economy the labor released for watchmaking will come from its previously marginal employments— that is, from the employments where all the various individual consumers in the market judge they can best spare it.

By the same token, the labor released from the garment industry will be absorbed in those employments which are the most important of the employments for which the supply of that type of labor did not previously suffice; that is, it will be absorbed in the most important of its previously submarginal employments. This conclusion follows from the fact that the workers released will be seeking to earn the highest incomes they can and that these incomes will be found in producing those goods for which the consumers are willing to allow the highest prices over and above the allowance for the other costs entailed in producing them. The displaced garment workers will enter whatever fields can absorb them with the least fall in wage rates. These are the fields whose products the consumers are willing to buy in additional quantities at the least fall in prices. They offer the displaced garment workers the highest wages now available to them. I have not attempted to enumerate these other employments because the skills involved are so common that the labor released would probably be absorbed to some degree in a vast number of industries. For example, some of the former garment workers might end up as office workers, taxi drivers, metal workers, or who knows what.

Everything we have seen concerning the source of labor for additional watches applies in principle to the source of any factor of production in limited supply for an expansion of the production of any good. Always, the process is one of an intensified bidding for the factor by businessmen acting as agents of the consumers of one or more of its particular products against businessmen acting as agents of the consumers of its other products. This bidding drives up the price of the factor, the costs of using it in production, and the prices of all of its various products. Supplies of the factor are always released, in accordance with the choices of the consumers, from the

production of its previously marginal products—from the products where the consumers decide they can best spare it. In the same way, everything we have seen concerning the absorption of labor released from the garment industry applies to the absorption of any factor in limited supply released from any industry. Always, the factor is absorbed in the most important of its employments previously unprovided for, in accordance with the judgment of the consumers, as manifested in what they are willing to pay the most for.

The identical reasoning that we have applied to changes in the demand for a factor of production in limited supply applies to changes in the supply of such a factor. If the overall supply of a factor should increase, the addition goes to provide for the most important of the employments of the factor previously unprovided for. For example, an increase in the supply of wheat in the present-day United States would be used to expand the production of such things as wheatfed meat and aged whiskey. If the supply of a factor should decrease, the reduction is taken out on the least important of the employments previously provided for. In the case of wheat in the context of the present-day United States, this would mean a reduction in the production of such things as wheatfed meat and aged whiskey. In other words, an increase in the supply of a factor goes to the most important of its previously submarginal employments; a decrease is taken out on its previously marginal employments.

The principle that emerges from this discussion is that in a free market if a factor of production is in reduced demand or additional supply, the portion of it that becomes newly available is channelled to the most important of its previously submarginal uses; if the factor of production is in additional demand or reduced supply, the portion of it that is no longer available is taken from the least important of its previous uses, that is, from its previously marginal uses. In other words, as stated, every change in the demand or supply of a factor of production in a free market is dealt with in a way that maximizes gains and minimizes losses; which is to say, it is dealt with in the most rational and efficient manner possible.

A Rational Response to the Arab Oil Embargo

The above principle has major application to such economic disruptions and pretenses for price controls as the Arab oil embargo. It enables us to understand in yet another respect how a free market would have minimized the impact of any reduction in the supply of oil that the Arabs might have been able to impose on us, and would minimize any other such disruption that might occur in the future.

If we had had a free market, the price of crude oil and the production costs and prices of all oil products would have risen during the embargo. The consumers would have decided where the reduction in the use of crude oil was to be effected and to what degree, by the extent to which they cut back on their purchases of the various oil products at the higher prices. Where the use of an oil product was important, consumers would have paid the higher price, and oil would have continued to be used for that purpose. Only where the use of an oil product was not worth its higher price, would the use of oil have been cut back or discontinued. For example, consumers would have paid a higher price for the gasoline required to drive to work and for the heating oil required to keep them warm. They would not have been as ready to pay higher prices for the gasoline required for extra shopping trips or for heating oil to keep their garages warm.

The crucial point is that in a free market the more important employments of oil would have outbid the less important ones, and the reduction in the supply of oil would have been taken out exclusively at the expense of the marginal employments of oil—that is, at the expense of the least important employments for which the previously larger supply of oil had sufficed.

But, of course, we did not have a free market. We had price controls. Price controls prevented the more important employments of crude oil from outbidding the less important employments. They prevented the most vital and urgent needs for oil from outbidding the most marginal. For example, during the oil shortage 1973–74 one could read stories in the newspapers about truck drivers not being willing to deliver food supplies to southern Florida for fear of being unable to obtain fuel for the return trip up the length of the Florida peninsula. There was even a story about the operation of oil rigs off the Louisiana coast being threatened as the result of an inability to obtain supplies of certain oil products needed for their continued functioning.

Now it is simply insane that such vital activities should suffer for a lack of oil—that even the production of oil itself should be threatened. In a free market, this could never happen. Such vital uses of oil would always be able to outbid any less urgent employment for all the oil they required. But under price controls even these most vital employments were prohibited from outbidding any other employment that could pay the controlled price.

Price controls simply paralyze rational action. In effect, they bring together at an auction for the use of oil a trucker needing fuel to deliver food supplies and a housewife needing gasoline to take an extra shopping trip to the supermarket, and they prohibit the trucker from outbidding the housewife. They bring together oilmen needing lubricants for their wells and homeowners seeking oil to heat their garages, and they prohibit the oilmen

from outbidding the homeowners. In a word, price controls make it illegal to act rationally.

5. The Economic Harmonies of Cost Calculations in a Free Market

We can now understand even more fully than was possible earlier how in a free market the production of each good is carried on in a way that is maximally conducive to production in the rest of the economic system. For we are now in a position to understand more fully how the concern with costs of production promotes the production of other goods every time it leads to the substitution of lower-priced factors of production in limited supply for higherpriced ones, such as the use of unskilled labor where skilled labor was previously required, or the use of a less expensive quantity of aluminum where a more expensive quantity of copper was previously required, and so on. All we have to do is keep in mind that the less expensive factors in limited supply are less expensive because the importance of their marginal products to the consumers is less. To substitute less expensive factors for more expensive ones, therefore, is to make it possible for the consumers to obtain products to which they attach greater marginal importance at the expense of products to which they attach smaller marginal importance. For the more expensive factors are released to uses of greater importance than those from which the less expensive factors are withdrawn.

Thus, the fact that in a free market production is carried on at the lowest possible cost that businessmen can achieve means that the production of each thing is carried on not only with the least possible amount of labor, but with those specific types of labor and other factors of production in limited supply whose use represents the least possible impairment of the satisfaction of alternative wants.

We can observe the operation of this principle in every cost calculation that businessmen make. To take some examples, let us assume that a railway company is contemplating the extension of its line across a body of water or that an electric company is contemplating the construction of additional generating capacity. In these cases, and in practically every other case, alternative methods of production are possible. The railway could build a bridge across the water, it could tunnel under the water, build a ferry, or, perhaps, detour around the body of water. In each instance, a variety of further alternatives are possible, such as where to construct the bridge, what materials and design to use, and so on. In the same way, the electric company could build a coal-powered plant, a water-powered plant, an oil or gas-powered plant, or an atomic-powered plant. Again, major variations are possible in each of these alternatives.

Now each method of production and each variant of any given method requires some different combination of factors of production in limited supply. Each of these factors of production has its own alternative uses in various other employments. For example, the bridge requires workers with the special skills required to build bridges. These workers could be employed in building bridges elsewhere or in building skyscrapers, or, of course, in a variety of lesser jobs. The tunnel requires the special skills of sandhogs. These men may first have to be trained, and then a long period of time will go by during which they are unavailable to produce a different variety of goods than the bridge builders. Again, different methods require different combinations of materials that may themselves be in limited supply or require different combinations of labor skills or limited materials in their own production.

The point here is that the selection of any given method of production has its own unique impact on the rest of the economic system in terms of withdrawing factors of production from possible alternative employments. The fact that businessmen select the lowest-cost methods of production means that they try to produce each good with the least overall impairment of the production of alternative goods. Because to produce at the lowest cost means to use that combination of factors of production in limited supply that has the lowest total marginal significance in alternative employments.

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Not only is the production of each good harmoniously integrated with the production of all other goods in a free market, but so too, not surprisingly, is the consumption of each good. As we have seen, insofar as any good is produced by factors of production in limited supply, its price reflects the competitive bidding of the consumers of all the products of those factors. For example, the price of bread in a free market reflects the competitive bidding of the consumers of all wheat products for the use of wheat; the price of gasoline in a free market reflects the competitive bidding of the consumers of all oil products for the use of crude oil; and so on. Going still further, the price of wheat and wheat products relative to the price of oil and oil products reflects the competitive bidding of the consumers of all wheat products relative to the competitive bidding of the consumers of all oil products. Indeed, the prices of all factors of production in limited supply and of their respective products reflect the relative utilities of the respective marginal products to the ultimate consumers. The consumer buyers of any of these products, therefore, when they take account of their prices, are led to pay the same regard to the rest of the economic system as businessmen when they make cost calculations.

More on the Response to the Oil Embargo

The above facts about the harmonious integration of the production and consumption of each good into the rest of the economic system also have application to how a free market would have responded to the Arab oil embargo.

If we had had a free market, the response to the reduction in the supply of oil would have been based on the exercise of the intelligence and judgment of each and every individual businessman and consumer in the economic system.

As the price of oil and oil products rose, each individual businessman and consumer would have decided where and to what extent to cut back on the use of oil by consulting his own individual circumstances. Those businessmen would have cut back who had lower-cost alternatives available. For example, businessmen with the alternative of switching to coal or shipping by rail or barge instead of truck would have done so. And more and more would have done so, more and more rapidly, as the price of oil and oil products rose higher, because the comparative savings in doing so would have become greater. In the same way, some firms might have concentrated their production in fewer days to conserve fuel. Some might have concentrated production more heavily in plants in warmer parts of the country. Some might have reduced or stopped production entirely, because of an inability to sell as many goods at the higher prices necessitated by higher costs of fuel and transportation. The point is that there would have been as many individual responses as there were separate business firms and even subunits within business firms. The response in each case would have been based on a consideration of costs and alternatives in the individual case.

Similarly, each individual consumer would have decided where and to what extent to cut back on the basis of the individual circumstances confronting him. What would have decided in each case was the importance of the particular oil product, as determined by the individual consumer’s personal needs and desires dependent on that product, and the extent of his wealth. For example, no one to whom time was essential would have been forced to reduce his driving speed. Nor would a wealthy person have been forced to give up driving his Cadillac. By the same token, no one whose only means of getting to work was an automobile would have gone without gasoline. He would have chosen to go without other things first and to spend the money he saved from somewhere else, to buy the necessary gasoline. Anyone in such a position would have been assured of all the gasoline he required, because he would certainly have been willing and able to pay more for gasoline for the purpose of getting to work than most other people would have been willing to pay for it for any lesser purpose. To obtain gasoline for getting to work, one would merely have had to outbid other people seeking gasoline for pleasure trips, marginal shopping trips, and so on.

More broadly, since more gasoline can always be produced from crude oil made available by producing less of other oil products, an individual needing gasoline to get to work would merely have had to outbid other people requiring the use of crude oil for any lesser purpose than one comparable to that of getting to work. For example, he would have been able to obtain gasoline by outbidding even people far richer than himself who previously used oil to heat their swimming pools, or, perhaps, who previously consumed vegetables or flowers grown in hothouses with the aid of large quantities of oil.

The specific ways in which oil would have been economized are far too numerous to name. It is impossible even to learn them all. They would have depended on an enormous number of individual circumstances, in many cases known only to the individuals directly involved, whoever and wherever they might have been.

The essential fact is that oil would have been economized in ways that affected each individual as little as possible. Each individual—businessman and consumer—would have dealt with the problem in the way best suited to his own business or personal context, and at the same time his efforts would have been harmoniously integrated—through the price of oil and oil products— with the like efforts of everyone else. Each would have acted on the basis of the price of oil and oil products, and the circumstances and judgments of each would have determined just how high those prices would have had to go before the quantity of oil and oil products demanded was levelled down to equality with the reduced supply of crude oil available. In other words, in a free market, the oil crisis would have been met by the conscious planning of each individual, harmoniously integrated with that of every other individual.

Of course, this is not what occurred—because of price controls. All considerations of individual context were dropped. The intelligence and planning of the individuals were paralyzed, as we have already seen. The government’s solution was a sledgehammer approach that disregarded all individual circumstances and context. It arbitrarily curtailed the use of oil and oil products for whole categories of employments. For example, it declared that the airline industry would operate on 80 percent of its previous year’s fuel, that farmers would have to make do with so much less propane, and that everyone would have to drive at no more than fifty-five miles per hour and set his thermostat at no more than sixty-eight degrees. This absurd approach simply ig—

214 CAPITALISM nored which industries and which specific firms and individuals could really afford to cut back on oil, and just where. It disregarded such elementary facts as that lower truck speeds would require proportionately more trucks and manhours to haul the same amount of freight, so that to arbitrarily save a few gallons of gasoline, whole trucks and untold man hours to operate them would be wasted. It disregarded the fact that thermostat settings of sixty-eight degrees in some places and for some people can be tantamount to freezing and cause pneumonia. But more of such consequences of price controls soon enough.

Appendix to Chapter 6: The Myth of “Planned Obsolescence”

A popular fallacy—advanced in full contradiction of the uniformity-of-profit principle and its implications for economic progress—holds that businessmen engage in the practice of “planned obsolescence,” that is, they allegedly plan for their products to wear out more rapidly than is necessary, in order to create an additional, replacement demand for them. 42 According to Vance Packard, one of the leading popularizers of this fallacy: “Even the best of products, of course, wears out sometime. Therefore a company cannot be legitimately criticized for estimating the death date of its product. It is vulnerable to criticism, however, if it sells a product with a short life expectancy when it knows that for the same cost, or only a little more, it could give the customer a product with a much longer useful life. In such situations one may properly wonder about the company’s motives.” 43

Despite the prevalence of such beliefs, the fact is that in all cases in which a more durable product can be produced at the same cost of production as a less durable one, the profit motive acts as an inducement to produce the more durable product. Indeed, the profit motive acts as an inducement to produce the more durable product even when its cost of production is substantially greater, provided that the extra durability is sufficiently great.

A simple example will demonstrate why this must be so. Assume that there are two light bulbs costing $1 each to produce. One lasts 10 times as long as the other. The manufacturers are presently producing the less durable bulb and selling it at a price of $1.25. Assume that they are presently selling 100 million of these bulbs per year and that if they introduced the longer-lasting bulb, they would sell only 10 million of them per year. The question must be asked: Is it less profitable to sell 10 million longer-lasting bulbs than 100 million of the present bulbs?

The supporters of the planned obsolescence doctrine believe that the answer is yes. But the answer is no.

At present, the manufacturers have sales revenues of $125 million—$1.25 per bulb times 100 million bulbs. They have a total cost of $100 million—$1 per bulb times 100 million bulbs. Their present profit, therefore, is $25 million. Now assume that they introduce the 10-times-longer-lasting bulb. Such a bulb could certainly be sold for 5 times as much as the present bulb. (If it is, the customer is far better off, for he pays only half as much per unit of service life of a bulb as he did before. In fact, he gains at any price below 10 times as much). A price 5 times as high is $6.25. This price times 10 million bulbs sold, gives sales revenues of $62.5 million. The manufacturers’ total costs are now $1 per bulb times 10 million bulbs, or $10 million. Profits, therefore, go to $52.5 million—more than doubling from their present level!

Manufacturers can increase their profits by introducing the longer-lasting product even if its unit cost is higher, provided that the higher cost is less than proportionate to the product’s longer life. For example, even if the 10-times-longer-lasting bulb cost 9 times as much to produce, or $9, the manufacturers could still increase their profits substantially. If they offered the bulb at a price of $12, which would still represent a saving to the consumers, they could increase their profits by $5 million. They would have sales revenues of $120 million and total costs of $90 million, leaving them with a $30 million profit instead of a $25 million profit.

As a rule, the only time it would not pay to introduce a longer-lasting good is if it has a higher cost which is more than in proportion to its longer life. For example, it would be absurd to introduce a 10-times-longer-lasting bulb which cost 50 times as much to produce. There are exceptions to this rule, however. In some cases, the convenience of not having to replace a product as often could be so significant as to outweigh a cost more than in proportion to its longer life. Thus, a light bulb lasting 10 times as long and which could be profitable only at a price of 11 times as much, might be successful simply because it would save time in changing bulbs, reduce the risk of falling from ladders, and so on. On the other hand, an automobile which would last twice as long and which had to be sold at twice the price would not make economic sense. Such an automobile would require that people tie up twice the sum of money (and, if they bought on credit, pay twice the interest) and not derive any compensating advantage. A 2-times-longer-lasting automobile would only make sense if it could be sold profitably at a price significantly less than double, perhaps 1.8 or even 1.7 times the price of the present car. (Interest rates would play a major role in determining how large

THE PRICE SYSTEM AND ECONOMIC COORDINATION 215 the saving had to be.)

What the above examples demonstrate is that not only consumers but also manufacturers derive a gain from the introduction of longer-lasting products, provided only that such products are not disproportionately more expensive to produce. The fact that manufacturers might sell a smaller number of units of longer-lasting goods because of the reduced need to replace them, is altogether irrelevant. Any profits which they must forgo as a result of reduced volume can easily be made up in the price of the quantity they continue to sell, together with a major increase in their profits. To understand the principle involved, it is only necessary to realize two things. First, as an upper limit, the price of the longer-lasting product can be raised approximately in proportion to its greater durability. Second, only a relatively small price increase is required to make up for the profits lost on the quantity no longer produced. Any price in between these limits represents both a saving to the consumer and additional profits to the producer.

To make this clear, let us return to our example of the light bulbs. If the present light bulb is sold for $1.25, a 10-times-longer-lasting one could be sold at a potential upper limit of $12.50. At any price lower than $12.50, the consumers have a clearcut gain. While the manufacturer’s volume is cut to one-tenth of its initial level, the profit he loses is only 25¢ on each bulb. Since he no longer sells 9 bulbs for every one which he continues to sell, he must be compensated to the extent of $2.25 in the price of the longer-lasting bulbs. If the longer-lasting bulb costs $1 to produce, then the manufacturer needs a price of only $3.50 to make as much profit on one-tenth the quantity of bulbs as he did on the initial quantity. At any price greater than $3.50, his profits increase. Any price greater than $3.50 and less than $12.50 thus represents a gain to both the consumers and the producers. (If the longer-lasting bulb costs $9 to produce, the manufacturer must have a price greater than $11.50 to come out ahead.)

Consider wider illustrations. Profits are only a small percentage of sales—5 percent, 10 percent, on rare occasion 20 percent. Assume profit is 20 percent of sales—for example, a manufacturer has costs of 80, profits of 20, and sales of 100. If his physical volume were to be cut in half, while his unit cost and selling price remained the same, he would have costs of 40, profits of 10, and sales of 50. His profits could be restored to 20, however, if he could raise his price by 20 percent, thus raising his sales revenues from 50 to 60. If the halving of his sales volume is the result of a doubling of his product’s life, there can be no doubt about his ability to raise his price by 20 percent—the upper limit by which he could raise it is 100 percent. Observe. In this case, the manufacturer only needs a price rise in excess of 20 percent to come out ahead, while the conditions of the case permit a price rise as high as 100 percent. Suppose the manufacturer’s sales volume is reduced to a third of its initial level, as a result of his introducing a product which lasts 3 times as long. The potential upper limit of his price increase is now 200 percent. But all he needs to come out ahead is a price increase of 40 percent—40 percent more on a third of his initial volume will give him the same profits he made on the other two-thirds, if his initial profit margin was 20 percent. Similarly, if his volume is cut to a fourth of its initial level, as a result of quadrupling his product’s life, then while the upper limit of the price rise goes to 300 percent, the manufacturer only needs a price rise in excess of 60 percent to come out ahead.

If we change the assumed profit margin to 10 percent, then a mere 10 percent rise in price restores profits when volume is cut to a half of its initial level, a 20 percent rise restores profits when volume is cut to a third of its initial level, and so on. With a 5 percent profit margin, a 5 percent rise in prices restores profits when volume is cut to a half, and a 10 percent rise in prices restores profits when volume is cut to a third of its initial level, and so on. The upper limits by which prices might be raised in these cases, however, continue to be 100 percent, 200 percent, and ever more, to the degree that volume is cut as a result of the introduction of longer-lasting products.

The principle which emerges is the following. The consumers are willing to pay an increase in price equal to as much as one less than the multiple of durability times the product’s initial price. (For example, if the product is made 10 times more durable, the consumers are willing to pay an increase in price equal to 9 times the product’s initial price.) To come out even, however, the manufacturers require a price increase equal merely to one less than the multiple of durability times the product’s initial profit margin—for example, 9 times 20 percent, 9 times 10 percent, or 9 times 5 percent. Between a multiple of the initial price and an equal multiple of the initial profit margin is an enormous field for mutual gain to both consumer and producer. This field is so great that any necessary writeoffs of existing plant and equipment could easily be compensated for along with profits forgone on lost volume. 44

Perhaps the best and simplest way to regard longer-lasting products in comparison with less-durable products is in terms of the comparative costs of producing equivalents. If one better light bulb lasts 10 times as long as a present light bulb, it is the equivalent of 10 of the present light bulbs. If the cost of production of both types of bulb is $1, then what we have is a $1 cost of production versus a $10 cost of production of the same equivalent. If the cost of production of the better bulb is $9, then we

216 CAPITALISM have a case of $9 versus $10 as costs of production of the same equivalent. The issue of whether or not manufacturers will introduce longer-lasting products can thus be seen to reduce to the question of whether or not they prefer lower-cost methods of production to higher-cost methods of production. They will introduce longer-lasting products whenever the longer-lasting products represent a reduction in the cost of producing equivalents. And they will do so with a rapidity and enthusiasm in direct proportion to the cost reductions to be achieved. To ask if GE would introduce a 10-times-longer-lasting light bulb, or GM a 2-times-longer-lasting car, having the same unit cost of production as the present light bulb or car, is to ask the equivalent of: Would GE introduce a light bulb costing one-tenth as much to produce? Would GM introduce a car costing half as much to produce? The answer to both questions is obviously yes.

Thus far, I have deliberately understated the case. I have assumed that the reduction in the quantity of a good demanded would be in full proportion to its greater durability. In fact, this would usually not be so. If a 10-times-longer-lasting light bulb or a 2-times-longer-lasting automobile can be sold at less than 10 or 2 times the price, the quantity demanded will not fall to a tenth or a half, but to some amount greater than a tenth or a half. (Indeed, in some cases, the quantity of the good demanded might even increase, if the demand for it is sufficiently elastic.) The reason, of course, is that in terms of a unit of service life the good is made less expensive and thus tends to be used in larger quantity. This tendency of the quantity demanded to fall less than in proportion to the product’s greater life would be powerfully reinforced in every case in which the producer of the longer-lasting product was faced with competitors producing the shorter-lived product. In all cases of this kind, the firm introducing the more durable product would have the entire existing market of its competitors as a potential field for its own expansion. It thus might very well succeed in increasing its physical volume by a substantial multiple.

The fact is that business does not produce less-durable goods in preference to more-durable goods, but the contrary. Nor does it foist undesired fashion changes on the public, or dribble out over time improvements which it has the ability to introduce all at once. These beliefs rest on the fallacy that profitability depends exclusively on the physical volume of goods sold. In fact, in all these cases, any profits lost as a result of diminished volume, could more than be made up by a relatively modest rise in price on the remaining volume. Consumers would benefit at the same time, because they would save the expense of buying unnecessary units. 45

Despite the fact that the profit motive leads businessmen to try to produce the highest-quality, longest-lasting products per dollar of cost, it can, of course, be the case that over time the quality of products deteriorates and their life shortens. This is because the beneficial effect of the profit motive can be outweighed by the contrary effect of government interference. For example, prounion legislation can deprive firms of the ability to fire careless workers. Taxation can deprive them of the funds to buy the quantity and quality of the labor, materials, and machinery they would otherwise employ in producing a given quantity of goods. Above all, price and wage controls can lead to a deterioration in the quality and life of products by creating shortages of means of production and by eliminating all the normal, competitive incentives to high-quality production. 46 The essential point is not that deterioration in the quality and life of products cannot exist, but that the profit motive always acts to improve the quality and lengthen the life of products insofar as it is allowed to operate.

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It is conceivable that the objection might be raised to the preceding analysis that it is mistaken in assuming that manufacturers of more-durable products are in a position substantially to increase the prices of such products and thus make up for any reduction in physical volume they might suffer. The objection might be made that freedom of competition would quickly put prices at the same level as they were to begin with. The answer to this objection is that under capitalism whoever introduces a significant improvement in production normally enjoys patent protection, which would secure his ability to obtain the higher price for a sufficient period of time to make the improvement worthwhile.

The doctrine of planned obsolescence is merely one more groundless assault on the profit motive and the pursuit of self-interest. If it does not represent “planned error”—that is, outright malice—it represents such a degree of thoughtlessness as to constitute reckless disregard of facts and logic.

THE PRICE SYSTEM AND ECONOMIC COORDINATION 217

Notes

1.The rate of profit on capital invested should not be confused with the concept of profit margin. A profit margin is profit taken as a percentage of sales revenues, not capital invested. Because of technical factors centering on the periods of time which must elapse between outlays of capital and receipts of sales revenue, different industries tend to earn permanently unequal profit margins, even though they tend to earn equal rates of profit on capital invested. Thus, for example, a retail grocery business, which has a substantial portion of its capital invested in merchandise of the kind that is sold within days of purchase, or even on the very same day, may have annual sales revenues equal to five times its capital. A steel mill, on the other hand, may have annual sales revenues that are merely equal to its capital. An electric utility may have annual sales revenues that are equal to only half of its capital. Because of these very different rates of capital turnover—i.e., ratio of sales to capital—namely 5:1, 1:1, and 1 ⁄ 2 :1, very different profit margins must exist if equal rates of profit on capital invested are to exist. Thus, the profit margin in the retail grocery business would have to be just 2 percent; that of the steel mill, 10 percent; and that of the electric utility, 20 percent, in order for all of them to earn a rate of profit on capital invested of 10 percent.

2. Cf. Ludwig von Mises, Socialism (New Haven: Yale University Press, 1951), p. 535; reprint ed. (Indianapolis: Liberty Classics, 1981). Page references are to the Yale University Press edition; pagination from this edition is retained in the reprint edition.

3. See Ayn Rand, Capitalism: The Unknown Ideal (New York: New American Library, 1965) pp. 15–16.

4. See above, p. 118, n. 80, for a reference to the fact that the validity of this principle has found important recognition within the U.S. government.

5. At that time, $10,000 represented approximately 500 ounces of gold. To estimate the equivalent in terms of today’s money, one should multiply 500 oz. of gold by the currently prevailing price of gold.

6. For elaboration and related discussion of these points, see below, pp. 206–214.

7. See below, pp. 925–927.

8. Cf. Henry Hazlitt, Economics in One Lesson, new ed. (New Rochelle, N. Y.: Arlington House, 1979), pp. 114–115.

9. I must point out that it is an error to assume that the repeal of rent controls would create any kind of insuperable problems of short-run hardship. Indeed, I will demonstrate later on that even before sufficient time went by to make possible the construction of any additional new housing, the overall effect of the repeal of rent control would be to improve the conditions of more people than it worsened and to impose no greater hardship on those who had to give up their rent-controlled apartments than was already being experienced, and had been experienced for many years, by just as many other people precisely as the result of rent controls. On this point, see below, pp. 252–254.

10. See above, pp. 63–66 and 90–91.

11. See below, pp. 201–202.

12. See above, n. 1 of this chapter, for an explanation of the relationship between the rate of profit on the one side, and the rate of capital turnover and the profit margin on the other.

13. Of course, the absence of price changes is possible only if the changes in demand are within certain limits. If increases in demand are so great as either completely to outstrip the ability of the industry to meet them from existing capacity, or to require the use of older, substantially less efficient, higher-cost capacity, product prices must rise. It is only a question of by how much. Similarly, if the fall in demand is so substantial that one or more firms finds that the quantity of their products demanded is insufficient to enable them to operate even their most efficient lowest-cost capacity at an adequate rate, while other firms are still using substantially less efficient, higher-cost capacity, then it will be to the interest of such firms to cut prices below the operating costs of others’ less efficient capacity. This will enable their efficient capacity to displace the others’ less efficient capacity. The price cut in these circumstances will be profitable to the firms which make it, because continued operation of high-cost capacity by others is thereby made unprofitable, with the result that the price-cutting firms secure substantial additional business that is profitable to them. See below, p. 436, for the application of this point to a critique of the doctrine of pure and perfect competition and the Marshallian doctrine of the representative firm.

14. Cf. Ludwig von Mises, Human Action, 3d ed. rev. (Chicago: Henry Regnery Co., 1966), p. 245.

15. Ibid.

16. It is standard practice in contemporary economics to consider the portion of the profits of small businessmen which is comparable to the compensation they could earn as wage earners as though it actually were wages. For a critique of this practice, see below, pp. 459–462.

17. This has already been indicated in connection with the uniformity-of-profit principle. See above, p. 185.

18. For an analysis of the actual process of adjustment in wages and prices that would follow the adoption of a policy of unilateral free trade or unilateral tariff reduction, and of the consequences if other countries simply refused to allow the goods of the country in question into their territory while it pursued a policy of free trade, see below, pp. 535–536.

19. The fact that speculators must lose in the absence of an independently caused rise in the demand for and price of the commodity they speculate in is confirmed by the following supply-and-demand diagram. The diagram shows that initially, in the absence of speculators, the price of a commodity is p 0 , resulting from the demand DD and the supply SS. The general public buys the entire supply, equal to quantity 0A, at the price

P

S

D ′

D p 1 _ _ _ _ _ _ _ _

_ p _

0 _

_ D ′

_

_ D

_ S

0 _ Q

B A

218 CAPITALISM p 0 . Now speculators appear on the scene, and when their demand is added to that of the general public, the total demand for the commodity rises from DD to D′D′. The result is that the price rises from p 0 to p 1 . At the higher price, the general public reduces its purchases from the full supply, 0A, to the part of the supply represented by 0B. The speculators buy up the part of the supply represented by AB. If the speculators bought the quantity AB all at once, they would have to pay a price of p 1 for it. In the absence of an increase in demand on the part of the general public, the speculators would then have to sell back their supply at a price of p 0 , if they sold it back all at once. The fact that they would probably buy the quantity AB in increments and sell it back in increments changes nothing fundamental, because the purchase and sale of each increment is described by exactly the same analysis. In addition, there is the further problem of a likely movement of the quantity supplied to somewhere to the right of the line SS, in response to the rise in price. For further discussion of why speculators must lose in the absence of an independent cause of higher future prices, see below, pp. 224–225.

20. Indeed, in 1991, the attorneys general of several states renewed the accusation in new lawsuits that they brought against various oil companies.

21. See George Reisman, The Government Against the Economy (Ottawa, Ill.: Jameson Books, 1979), pp. 29–30, Table 1. 22. For an important exception to the principle that sellers are led to sell too rapidly, see below, pp. 225–226.

23. The substance of the following discussion concerning the opposition between capitalism and arbitrary discrimination has been excerpted, with minor modification, from my pamphlet Capitalism: The Cure for Racism (Laguna Hills, Calif.: The Jefferson School of Philosophy, Economics, and Psychology, 1992). The pamphlet originally appeared as a six-part article in The Intellectual Activist in 1982.

24. See below, pp. 367–371, 584–585, and 663–664. See also Capitalism: The Cure for Racism, pp. 6–8.

25. On these points, see George Reisman, Capitalism: The Cure for Racism, pp. 12–14. What is described here is government-inspired bureaucratic management taking the place of profit management. On this subject, see Ludwig von Mises, Bureaucracy (1944; reprint ed., New Rochelle, N. Y.: Arlington House, 1969), pp. 64–73. See also below, pp. 304–305.

26. On this subject, see below, pp. 382–385.

27. For an account of the precise nature of all the government intervention that has blocked the benevolent operation of capitalism on behalf of blacks in their capacity both as wage earners and as consumers, not only in the South but also in the North, see George Reisman, Capitalism: The Cure for Racism, pp. 10–28. See also below, pp. 375–376 and 382–385.

28. This accords with the views of the great classical economist David Ricardo. See David Ricardo, Principles of Political Economy and Taxation, 3d ed. (London, 1821), chap. 30 especially; reprinted as vol. 1 of The Works and Correspondence of David Ricardo, ed. Piero Sraffa (Cambridge: Cambridge University Press, 1962).

29. See above, p. 168.

30. Wage rates are explainable in terms of supply and demand analysis even in cases in which they are imposed arbitrarily by labor unions or governments. For in such cases, an essential part of the process is an artificial restriction of the supply in the face of a given demand.

31. As previously indicated, this analysis of the relation between cost of production and supply and demand is the work of the great economist Eugen von Böhm-Bawerk, one of the founders of the Austrian school of economics. Very similar ideas are also propounded by John Stuart Mill, the last major representative of the British classical school. Cf. Eugen von Böhm-Bawerk, Capital and Interest, 3 vols. (South Holland, Ill.: Libertarian Press, 1959), 2:168–176 especially, but also 2:248–256 and 3:97–115; John Stuart Mill, Principles of Political Economy, Ashley ed. (1909; reprint ed., Fairfield, N. J.: Augustus M. Kelley, 1976), pp. 442–468. As previously noted more than once, a lengthy quotation from Böhm-Bawerk, expressing the substance of his views on the relationship between cost of production and prices appears below, on pp. 414–416.

32. Submarginal land, such as most deserts and mountains, is limited from a mathematical point of view, but stands beyond the limit of the supply of economically useable land. Its limitation in this latter sense provides it with no economic value, for it has zero marginal utility.

33. See above, pp. 152–169 passim, especially p. 158, and below, pp. 219–220. See also below, pp. 503–505.

34. While the economic system is in process of adjusting to a change in the quantity of money, the demand for the various goods and services is affected unevenly. Cf. von Mises, Human Action, pp. 412–414; idem, The Theory of Money and Credit, new ed. (1953; reprint ed., Irvington-on-Hudson, N. Y.: The Foundation for Economic Education, 1971), pp. 137–141. Von Mises argues that there are also permanent effects on the relative demands for the various goods and services, and thus on their relative prices. 35. See above, p. 169.

36. Of course, government intervention can deprive people of the ability to rent space they can afford to rent, by declaring such space to be substandard and its rental illegal. Such government intervention causes homelessness. See below, pp. 384–385. 37. See below, pp. 503–526 and 895–963 passim.

38. For elaboration of this vital fact and of its significance, see below, pp. 613–618 and 618–664 passim.

39. Cf. above, pp. 49–50.

40. This insight is one of the great contributions of Böhm-Bawerk. See above, p. 52 and the present chap., n. 31.

41. The results that will be derived from the present case could also be derived from the case of opposite changes in the demand for products of iron and products of cotton that was used earlier in connection with establishing additional causes of the tendency toward a uniform rate of profit. See above, p. 184. 42. This appendix, with minor revision, is drawn from the author’s article of the same title which originally appeared in Il Politico 38, no. 3 (September 1973). It appears by permission of the publisher.

43. Vance Packard, The Waste Makers, Giant Cardinal ed. (New York: Pocket Books, Inc., 1963), p. 49.

44. For a demonstration of this fact, see my above-referenced article from which the present discussion is drawn, pp. 485–486. 45. For elaboration on these points, see ibid.

46. On these destructive effects of price controls see below, pp. 219–264 passim.