Chapter V: The World of Goods and the Flow of Production

“The world is like a shop stocked full of goods. They are on sale for work—toil may buy them.”^*

FRIEDRICHVON LOGAU (1604-1655)

1. The Social Product and the National Income

Now that we have studied the structure of the division of labor and discovered in money the indispensable auxiliary of that division of labor, let us go a step further and examine more closely the process which unfolds on these bases, namely, how goods are supplied and distributed.

Let us emphasize at once that the concept “economic good” must be understood in a very broad sense; i.e., it includes all those things which serve as means for satisfying wants. In our economic system these are things for which, as a rule, a price must be paid. Hence, this concept embraces not only material goods as such, but also a wide variety of services (a lawyer’s counsel, a physician’s examination, a scholar’s lecture, a singer’s concert) and a final category that may be grouped under the loose designation of “rights and relationships” (right to use a dwelling, patents and copyrights, a physician’s practice, the “goodwill” of a firm, etc.). The criterion of price does not always suffice to characterize an economic good. This is especially true in respect to those collective goods which, as in the case of measures taken to ensure internal and external security (e.g., protection against epidemics), satisfy a collective need. These goods the state “produces” and distributes according to the system of collective economy. Thus the work done by a civil servant is an economic good albeit there is no “market” for it. Indeed, it is because of this very circumstance, as we have shown previously (Chapter II, Note 5), that we cannot always be sure that such a “good” answers to a general need.

A procedure which proves useful on several counts is to consider, in concrete terms, the total output of goods and services produced by the nation in a given period of time, say a year. This total yearly output we may term the social product (or gross national product), a helpful abstraction of which we shall make use frequently henceforth. It should be remarked that the total of available goods is not identical with the total of consumable goods. A large part of the gross national product is composed not of consumption goods, but of producer goods (capital) which serve for the maintenance of the apparatus of production (renovation, replacement) and also for the extension of that apparatus (expansion, net investment, accumulation of capital). To determine the net national output (i.e., the supply of commodities and services which constitute a real addition to the national economy and which are over and above those required to maintain the productive apparatus intact), we must subtract from the total output (gross product) those goods and services needed for replacement purposes. This subtraction we may designate as “the costs of doing business.” Anyone who has ever figured out an income tax will know what this means. An economy in which reserves are not built up to the necessary extent would “eat” its capital; it would “feed on its own substance.” Its productive apparatus would fall, bit by bit, into a state of disrepair and, as a consequence, national output would become smaller and smaller in the future. This, in fact, is what occurred in many countries during and after both World Wars.

Just as we designate as personal income what remains at our disposal after subtracting our costs of doing business, so too may we regard national income. If this national income is represented in terms of goods and not of money, it is identical with the net national output. Hence, national income may be determined from a study of gross output statistics. In practice, however, it is customary to calculate the national income in another way, viz., by adding together personal incomes, a fact which gives rise to several instructive considerations. For example, do the monthly allowances given to students by their parents figure in the national income? Obviously not, since what may be included under national income are only those incomes arising from the actual production of goods, services, and utilities of whatever kind. Such incomes are a kind of monetary reflection of a corresponding addition to the total of real goods (original income). Clearly, we may not include in the total income those incomes which represent merely transfers of original income (derived income). Otherwise, we would be making the mistake of counting the same thing twice. On the same reasoning, we would not be counting the same thing twice were we to include in the national income the incomes of the household domestic and the government clerk since these incomes result from the “production” of immaterial goods, proof of the demand for which is the fact that they have been paid for.¹ These reflections underscore the broad interpretation which must be given to such concepts as “good” and “productive” if we wish to grasp the essence of economics.

2. The Essence of Production

Of the many heads under which we can classify goods, there is one which takes precedence over all others. The essential note of an economic good is its scarcity in the sense with which we have now become familiar. For certain goods, this scarcity is immediately given, viz., for those goods which cannot be increased by production. Such are the paintings of the old masters or rare vintage wines. The true significance of this category of scarce goods will become clear to us when we consider that it includes such important and irreplaceable goods as land (though pedants might insist that land can be increased in quantity by building dikes to wrest it from the sea). And then there is the most important and productive good of all-human labor power. Certainly, it cannot be “produced” in the ordinary sense of the word. In contradistinction to these goods whose scarcity is immediately and unalterably given, there is the great mass of goods which can be increased by production, a circumstance which, as we have seen, does not preclude their possessing the quality of scarceness, but is of sufficient importance to merit our close study.

If the concept “good” must be understood in a very broad sense, so also must the concept production. This point must be particularly insisted upon since the layman is always quick to classify as unproductive every activity which does not immediately serve for the production of material goods, especially trade and transportation. To make this point unambiguously clear, let us consider the following: production is never a new creation of matter, but only the creation of a “good,” just as consumption is never the annihilation of matter but only the annihilation of a “good.” Production cannot add a single atom to the existing quantity of matter but only transforms matter in such wise that it is capable of satisfying a given want. Hence, all production is really only the transformation, the refinement, and the combining of matter, and this applies not only to so-called primary production (agriculture, fishing, forestry, mining, etc.) but also to commercial-industrial production. What is after all the purpose of mining if not to transport to a suitable place material found in an unsuitable place—in other words, to change its location? Hence production is, broadly interpreted, the process of making economic goods available; its quiddity is economic, not technical. The railroad “produces” as does also the merchant, the hotel-keeper, the clerk, the actor. Even a speculator is a producer insofar as he fulfills an economically useful function, and is not to be confused with the unproductive individual who merely exploits the available opportunities for reaping unearned profit.²

These considerations are illustrated in the following example. We have seen that the production of coal is nothing else, at bottom, than a change in its location. Coal is of no use to the inhabitants of West Virginia so long as it has not been brought to the surface. Nor is West Virginian coal which has been brought to the surface of any use to the inhabitants of Pittsburgh until it has been transported to that city. What mysterious difference is there between the vertical and the horizontal movement of coal? To satisfy a want, a good must not only exist as such, but it must be in the place where it is demanded. Moreover, it must be in that place at the time when it is demanded. And there are a number of other requirements which we as consumers ordinarily expect “goods” to meet: we prefer goods to be available in a wide range of choices; we expect not to have to become connoisseurs in order to be able to rely on the quality of the goods we buy; and we attached increasing value to customer conveniences, to elegant shops, courteous service, attractive packaging, home deliveries, and many other things. All these things, of course, the manufacturer can undertake to do and, in fact, often does (shoe shops run by shoe manufacturers). Nevertheless, in these instances as elsewhere, the principle of the division of labor has proved its worth: most such accessory operations are better performed by enterprises specialized for the purpose. Trade, transportation, and speculation fulfill these intermediate “service” functions. Their apparently autonomous character should not be permitted to obscure the fact that they are really “producing” utilities and services without which the material goods would have for us little or no value. Such enterprises are, indeed, no less “productive” than those concerned with producing material goods. To wax indignant over the difference between the factory price and the retail price (“retail markup”) is no more rational than to complain of a “manufacturing markup,” i.e., of the increase in the value of the product added within the factory. This does not exclude the possibility that in both cases avoidable costs and wasteful practices will be present, but these are defects which can be most effectively eliminated by competition of greater or lesser degree. If, in recent years, the retail markup has noticeably increased in many sectors of the economy, this merely expresses the fact that we attach increasing value to such ancillary activities.

Much confusion is generated on the above point by continually contrasting the distribution function of trade with production per se. The distinction is certainly not fallacious but it must not be forgotten that the distribution of goods appertains equally to production, since it represents a function which is distinct and separate from others and is compensated as such. Unfortunately, the word distribution is also used in quite another sense, namely, in the sense of a distribution of income, i.e., the distribution of individual claims on the social product by way of the formation of income. The distribution of goods by trade is a part of production, but, in consequence of the income which he acquires thanks to his distribution function, the merchant, as all other producers, participates in the process of income formation and income distribution. Since we are here dealing with two entirely different things, it would seem preferable to employ different expressions for them and to find some other word for the less abstract concept of goods distribution.³

3. The Economic Process as a Whole

We have now managed to marshal practically all the data which we need to acquire understanding of the individual parts of the economic process. By making a number of simplifying assumptions, in particular, that the social division of labor and the price system are the dominant features of the economic system and that we are concerned with a “closed economy” (one, i.e., without foreign trade), we may picture the operation of the economy in global terms as follows. There is, first, production in the broad sense of that activity which makes available the largest quantities and most numerous kinds of goods possible. Following our previous assumption, this total output is then exchanged on the several markets and its value determined by means of price formation (circulation of goods). The formation of prices, in turn, determines by way of the formation of income that share of the total output which accrues to each individual (distribution). Finally, these shares are used or consumed by the individual economic units. What we have done thus far is to list the several parts of the economic process in their logical order, a procedure which does not imply their successive occurrence in time. We do not suggest, for example, that during a given period of time goods are produced, are later apportioned to the recipients by circulation and distribution, and are finally consumed. In reality, all of these operations take place simultaneously. The economic process is thus a simultaneous process and one in which all the parts are intimately connected to each other and conditioned by each other. This network—which represents a major difficulty in the understanding of theoretical economics—will become even more apparent in the course of the subsequent analysis.

To simplify our inquiry, we have thus far admitted a number of hypotheses, the first of these being that the total output (gross national product) of the economy equals the total supply of the economy in a given time period. This follows naturally from our admission that the whole of production enters the market. But since the producers buy each other’s products, the gross national product (i.e., total supply) must, in a state of equilibrium, also equal total demand. If in any considerable degree this is not the case, we are then faced with that total disturbance of the economy known as a crisis. It is a truism, moreover, that the gross national product is always equal to the gross income of the economy during the period in question. The latter we may define, initially, as the sum of the various money incomes, incomes which are converted into real goods only by the exchange of “vouchers” acceptable in the “general store” of the national economy; in other words, incomes are converted into goods by market demand. We must, therefore, distinguish between the formation of income and the use of income. But here again we must reckon with the possibility of a twofold disturbance. In the first place, the expenditure (use) of income may be retarded because income earners may hesitate a long time before spending their money (deceleration of the speed of circulation of money, hoarding, deflation) . Secondly, the expenditure of income may not correspond to the actual composition of output. In such case, the producers have produced at cross purposes. In this connection, it is necessary to direct attention to the three ways in which income may be used: (1) to obtain goods for immediate use (consumption); (2) to obtain producer goods for the maintenance of the productive apparatus (replacement); (3) to obtain producer goods for the purpose of expanding the productive apparatus (accumulation of capital). This division of the different kinds of income use must correspond, in a state of equilibrium, to the composition of the national output. Otherwise, we shall again have to reckon with the emergence of a state of disequilibrium (crisis). But this is a discussion we have reserved for a special chapter.

One of the most fruitful results of the above analysis will have been to put us on our guard against regarding any one part of the economic process as autonomous and given. All the components of this process are joined together, all are interdependent: supply and demand, producers and consumers, production and purchasing power, the formation and the use of income. For the beginner, nothing is more difficult than to visualize this total process in concrete terms; nothing is more difficult than the job of making it clear to him and, by the same token, nothing is more important than the understanding of this process.⁴

The analysis of the total economic process by manipulation of the gross magnitudes of the economy—macroeconomics as it is now termed in contrast to microeconomic theory which will concern us in the following chapter on “Markets and Prices”—is as old as economics itself. Heavy emphasis on macroeconomics is a characteristic mark of the economic thought of recent decades, a result primarily of the experience of the Great Depression (1929-1933). The ever greater refinement of macroeconomic concepts and the rise of a self-contained national income theory has been accompanied, as well, by an increasingly successful use of statistics to measure the actual global movements of the economy in the course of a year. The usefulness of such calculations is undeniable. But there are also unmistakable dangers connected with the use of the new techniques. They can be avoided only where there is awareness of the limitations of this kind of analysis.⁵

In our analysis of the economic process thus far, we have assumed a “closed economy”; that is to say we have deliberately ignored the actual connection of the domestic economy with the rest of the world. If we now relax this assumption, we find that the domestic economy is joined to the world economy by a multitude of transactions and activities involving the exchange of goods and services, and of a corresponding number of payments made to foreign countries and received from them. This connection may be clearly seen and statistically measured by grouping the various foreign transactions and payments of a nation under several principal headings, somewhat in the manner of a firm’s balance sheet. The balance of payments of a country is so constructed as to show payments (in domestic currency) received from abroad on the plus or credit side of the balance, and payments to foreign countries on the debit or minus side of the balance. The principal categories of such a balance of payments are: (1) the savings account which shows the net total yield (+ or—) of (1) the merchandise account (the “balance of [visible] trade”), (2) the services account (tourism, transportation, insurance, banking services, copyright payments, etc.), (3) the investment income account (dividends and interest received from abroad or paid to abroad), (4) unilateral transfers (receipts or payments); (II) the investment account which shows the total of capital investments by foreigners in the domestic economy and total investments by domestic residents in other countries; (III) the cash account which shows the increase or decrease in a country’s holdings of foreign exchange and/or gold. This yields the following scheme in which the plus or minus sign in each case indicates whether the transaction in question is to be assigned to the credit or debit (active or passive) side of the balance of payments.

I. The Savings Account

1. The balance of trade (visible)

(a) merchandise exports (+)

(b) merchandise imports (–)

2. The services account

(a) services of residents to foreigners, also called “invisible exports” (+)

(b) services of foreigners to residents, also called “invisible imports” (–)

3. The investment income account

(a) dividends and interest received from abroad (+)

(b) dividends and interest paid abroad (–)

4. Unilateral transfers (aid and gifts)

II. The Investment Account

1. Capital imports (+)

2. Capital exports (–)

III. The Cash Account

1. Increase of monetary reserves (–)

2. Decrease of monetary reserves (+)

It is clear that a net surplus yielded by the algebraic sum of the items in any of the above categories may be offset by a net deficit in another category (or categories). Thus in the balance of payments of Switzerland for the year 1959, the large net deficit in the (visible) trade balance was offset by a still larger net surplus yielded by the other items in the Savings Account so that this account as a whole showed a substantial surplus (+ 758 million Swiss francs). This surplus in turn was offset partly by a net debit in the investment account (excess of capital exports over capital imports) and partly in an increase of Swiss monetary reserves. Different was the situation yielded by the West German balance of payments for 1960 in which both the Savings Account and the Investment Account closed with large net credits. The Savings Account was “active” because of the extremely large (favorable) balance of (visible) trade which more than offset the large deficit on services account. The Investment Account yielded a net surplus because of the substantial excess of capital imports over capital exports. The net surplus resulting from the sum of the Savings Account and the Investment Account was offset in turn by a debit on cash account, that is, by a correspondingly large increase in Germany’s monetary reserves (of almost DM 8 billion [about $2 billion]). In this growth of German monetary reserves was reflected the aforementioned (p. 106) “imported inflation.”

It is evident that in the evaluation of the balance of payments position, the greatest caution is indicated. The “activity” or “passivity” of the individual items in the several accounts signify relatively little, as we have seen; what is significant is the net position yielded by the sum of all the accounts. But here too circumspection in passing judgment is required.⁶ Even to speak of an “active (favorable) or passive (unfavorable or adverse) balance of payments makes for difficulty since such a balance, like a firm’s balance sheet, always balances in the sense that the algebraic sum of the credits and debits necessarily equals zero (for every credit there must be an offsetting debit, and vice versa).

To qualify the balance of payments as active or passive has meaning only to the extent that we abstract from the balance of payments as an accounting device and omit certain accounts (the offsetting ones) in order to focus attention on the disposition of others. Customarily, the cash account is neglected in determining whether the balance of payments is active or passive; it is said to be active (or in surplus) when the algebraic sum of all the accounts except the cash account yields a net surplus, and passive (or in deficit) in the converse case in which the sum of all the accounts except the cash account yields a net deficit. Alternately, one may focus attention solely on the cash account, qualifying the balance of payments as active when monetary reserves increase and passive when they decline. But even here it is not necessarily true that an active balance of payments is something good and a passive balance something bad. Indeed, an active balance of payments can represent a danger for the economy as shown in the example of the imported inflation in West Germany and in other European countries at the present writing (1962). Conversely, a passive balance of payments of a certain duration and amount can serve to restore a disturbed equilibrium of international payments.

It is under no circumstances permissible, however, to see in an active balance of payments the proof of the riches and capital wealth of a country nor in a passive or deficitary balance of payments proof of the poverty and capital insufficiency of an economy. The activity or passivity of the balance of payments involves merely the external equilibrium of an economy (which is, in turn, primarily dependent on monetary factors), not the quantity of commodities and real capital of which it disposes. For years West Germany achieved balance of payments surpluses because it was a comparatively cheap country, but West Germany was made not one penny richer on that account. The United States has suffered for years from a balance of payments deficit, thanks chiefly to the wage policies of American labor unions, and has become a comparatively expensive country. But the United States is today far richer than it was when the world still suffered from a “dollar shortage.” France, too, was not poor and insolvent because it suffered from a passive balance of payments thanks to the financial mis-economy of the Fourth Republic. And France did not become rich and solvent overnight merely because the De Gaulle government changed the international value of the franc, put an end to inflation, and thereby converted the balance of payments deficit into a surplus.

4. The Factors of Production

Our admonition to regard the economic process as a whole made up of many parts is the more justified in view of the close relationship between the act of production and the act of exchange (circulation) . In this connection, the Silesian poet Logau, in the candid aphorism which we have selected as motto for this chapter, happened 300 years ago upon an economic truth which it was left to modern theory to elucidate: production is, at bottom, nothing else than a perpetual exchange transaction with Nature by which we seek to exchange on the most advantageous terms our efforts against the produced commodities. It is a transaction in which the concept of marginal utility finds just as pertinent application as in exchange in the narrower and more usual sense.⁷ Conversely, it may be said that exchange is nothing else than production, i.e., the procuring of goods through the making of corresponding sacrifices. Production and exchange are similar in that both require certain expenditures to obtain a good: indeed, the whole meaning of the social division of labor resides in this, that it permits each of us to choose the most economical way of procuring needed goods. That is the whole secret of the division of labor, especially of the international division of labor, which many find it so hard to understand.

Of what then do the expenditures made in production consist? If we push our inquiry still farther back, we find that all these expenditures may be traced finally to three categories of production elements (factors of production) which in turn are not further divisible: labor, land, and capital.

Of these three factors of production, labor requires the least explanation. There is no need to define it for it is clear to everyone that labor is the really active and directing element in production. So preeminently important is this factor that it is easy to understand the constantly repeated efforts to make it the sole factor of production and of costs. At all events, we must keep ever in mind that the concept “labor” is to be taken in a sense sufficiently large to encompass all human activity, intellectual as well as physical, directive as well as directed. Thus, the activity of an entrepreneur must be there included. It follows further that the labor factor of production will fall into numerous sub-classes, each of these possessing its own market, its own wage scale, its own special features. Moreover, these individual labor markets will not necessarily stand in close relationship to one another.⁸

Similarly, little difficulty is experienced in comprehending the significance of land (or Nature in general) as a factor of production. Its role in production is characterized by the fact that it serves simultaneously as a location (cf. Chapter III, Note 1) and as a reservoir of the raw materials and the energy which lie dormant in the land. The latent energy and the raw materials of the earth, to the exploitation of which primary organic production (agriculture, forestry, fishing) and primary inorganic production (mining) are devoted, comprise the final and most basic sources of mankind’s supply of goods. In common with the labor factor of production, land exhibits the special characteristic of not forming a homogeneous mass but of falling (according to its location or to its varying content of raw materials) into innumerable sub-classes. The location of the land is of especial importance because, in contrast to the other factors of production, land is immovable: Mohammed must, in truth, always go to the mountain.

Labor and land are things easily grasped, their importance is self-evident and their role in production is clear. Everyone knows that they are indispensable, that they represent ultimate elements of production which are not reducible to any further common denominator. But what about the factor of production we call capital? Here begin the difficulties.

Let us start with a fairly simple situation in which capital will figure—the production of grain. When we say that for this purpose we require capital in addition to land and labor, what do we mean? Concretely, we visualize the following requirements: tools, draft animals, seed, fertilizer, farm buildings, machines, and lastly, a supply of foodstuffs (subsistence fund) to be consumed during the time which elapses between sowing and harvesting. This is a roundabout way of expressing the fact that man cultivates the land not only with the bare strength of his arms but with all sorts of auxiliary means as well. But what is the justification for regarding these auxiliary means as a third independent factor of production? Cannot all such items be subsumed under labor and land? For example, a plough contains wood and iron and its manufacture requires the expenditure of a certain amount of labor. The truth is, however, that the plough contains still a third component whose presence, though not immediately visible, can be ascertained by a process of deduction. Let us assume that the farmer makes the plough himself and that in consequence he will have to employ a part of his time in the production of a plough instead of in the production of food. For the farmer, this entails a diminishment of his current supply of consumption goods. As long as he is engaged in making the plough, either he will eat less or he will live from a supply of foodstuffs which he has previously stored up. Should he choose the latter alternative, he will still have had, during some former period, to reduce his consumption in an amount corresponding to his present stock of such foodstuffs. This restriction of consumption pays for itself in the future, however, for a plough, compared with primitive forms of cultivation, will result in an enormous increase in yield. Thus we see that the production of a plough requires not only the combined services of land and labor but a further essential condition—the restriction, in one form or another, of consumption. It is only after this current sacrifice is compensated in the future by the larger yield obtained thanks to the plough that the balance, so to speak, is struck. Until then, the farmer is obliged to wait for the rewards due to his work and to his restriction of consumption. We arrive at the same result if we come somewhat closer to reality and assume that the farmer does not make the plough himself but orders it made by the smith. The smith is then paid in money which the farmer could otherwise have used to buy consumption goods.

By this renunciation of complete enjoyment at the present moment in favor of the future, i.e., by “waiting,” capital acquires the character of an independent factor of production, a factor which cannot be subsumed under either land or labor. Since present supplies can be diminished in favor of the future only within fixed limits, the capital factor of production is always scarce. This is a point of the greatest importance and one which has to be borne constantly in mind. Were it not for this fact, it would be difficult to understand why all the scythes in the world have not long since been replaced by mechanical reapers, all the sewing needles by sewing machines, all bicycles by automobiles, and all streetcars by subways. Hence it is that we are obliged to pay a price for this scarce “something” just as we do for butter or for string, and this price is nothing other than interest.

“Waiting,” the essential ingredient of the capital factor of production, may take different forms. The form it takes in the case of the (purchased) plough is clear. The money which has been “put” into the plough has been withheld from current consumption uses and the farmer must wait until the extra yield obtained with the plough offsets the amount of his investment. The same principle is involved in building a house where the landlord must wait until the sum of his rents equals the costs of constructing the house. In either case we have to do with that kind of “waiting” which is associated with the investment of capital (fixed capital). The purpose of this capital investment is to provide means of production which are to be used over several production periods. But the farmer must take into account still another kind of waiting. Between the plowing and the seeding of the soil and the sale of the harvest stretches a period of several months: in autumn, there are expenditures for labor, seed, and fertilizer which are recovered only after the sale of crops in the summer of the following year. In the meantime, the farmer and his family must live; he must, therefore, have either a supply of consumption goods in reserve or a sum of money for the purchase of such consumption goods. Here again, a period of waiting is involved, but waiting of a different character than that which we observed in the first instance. The farmer must await repayment (for the duration of the period of production) not only for the labor, raw materials, and auxiliary equipment used in the process of production but also for the consumption goods required during this process (subsistence fund). Waiting of this type involves the use of what is termed working capital (circulating capital). The relation of fixed capital to working capital is the same as that of a meat-grinding machine to the meat which is put through it.

Naturally, it is not required that the producer himself do the “waiting.” By obtaining a loan he can, in effect, shift the burden of waiting onto the shoulders of some other person, the latter receiving his indemnification in the form of interest. Depending upon the kind of “waiting” involved, the credit thus obtained is either an investment credit or an operating credit. The possibility of obtaining such a credit obviously changes nothing with respect to the fact that for the capital thus supplied someone must undergo a period of “waiting,” of adjournment of his consumption irrespective of whether this occurs in some sector of the national economy or—as in the case of an international transfer of capital—of the world economy.

We can now see from the very fulness of explanation which it requires that capital is set off from the other two factors of production by a number of peculiarities. It is these peculiarities which make the analysis of capital one of the most difficult problems of economics.⁹ Part of the difficulty derives from the circumstance that capital, differently from land and labor, is subject to quantitative changes effected by human decisions and economic considerations. The quantity is increased in a process known as the formation of capital and is diminished by the consumption of capital.¹⁰ Here it should be observed that a certain fixed amount of capital is available to the economy at any given moment; this amount can be increased within a given period of time, but only within certain limits. There is a way, of course, of stretching these limits and of forcibly increasing the quantity of capital, viz., through credit expansion. But an increase of capital which is effected by such a radical method is ordinarily purchased at the cost of a subsequent crisis.¹¹

Finally, we must touch briefly on that aspect of capital which renders it so repugnant to the adversaries of our capitalist system, the socialists, and one to which we too cannot remain indifferent. This is the circumstance that capital is not only an elementary factor of production but, in its current context, also a source of private income for which apparently no services are rendered in return. Both notions must be kept rigorously distinct, however. Saying that capital is an indispensable factor of production does not imply that we are taking a position on the question of who should own this factor of production. The first point is uncontested whereas perennial controversy rages around the question of the ownership of capital. Naturally, even a socialist state cannot do without capital as a factor of production since in a socialist state, as in any other, it will be necessary to economize so that worn-out machines can be replaced and new ones built. The Russian Five Year Plan is nothing if not such a socialist method of creating capital on a colossal scale. It is not the use of capital which distinguishes the socialist from the capitalist economy, but only the fact that this capital, under socialism, belongs to the state. But we must not imagine that we have refuted socialism simply because we can show that capital is necessary even in a socialist state. No serious socialist questions the necessity of capital; what he demands is that it belong to the “community.” Whether this demand is reasonable or not is a question we have reserved for discussion in another place.

5. The Combination of the Factors of Production

Under present conditions, it is usual to find the three factors of production combined with one another in every type of production. What is of especial significance in this connection is the fact that it is possible, in considerable degree, to substitute one factor of production for another (substitution of the factors of production). Agriculture, for example, can be carried on by combining a given area of land with little labor and capital (extensive agriculture) or with much labor and capital (intensive agriculture). Labor and capital, in turn, may be substituted for one another; there are many tasks which we may choose to entrust either to manual labor or to the machine. Every housewife who buys a washing machine substitutes capital for labor. Careful reflection on her part is required before deciding whether she should or should not make such a purchase. Two motives can influence her decision, one of which has already engaged our attention. We found that the purchase of a machine is warranted only insofar as there exist sufficient opportunities for its use. In calculating whether her laundry is regularly of a sufficient quantity to require the full use of a washing machine, the housewife is unconsciously employing a general principle of great significance designated commonly as the law of mass production. Using our household laundry as example we may explain this law as follows. The costs of using a washing machine fall into two large groups: the costs which increase or diminish with the amount of laundry (electricity, water, attention required, soap) and those which are given once for all as a fixed amount (interest and amortization on the washing machine). The more clothes there are to wash (the mass or amount of production) the smaller will be the costs of laundering per piece of laundry since the fixed costs are distributed over a greater number of production units.¹² The last piece of laundry is thus the cheapest to do as the last passenger to board a train is, from the point of view of the railroad, the cheapest to transport. Hence the dominant consideration in purchasing a washing machine is that the household regularly furnish a sufficient amount of soiled laundry. To artificially soil the laundry for this purpose, as a kind of harmless family sport, would hardly be the ideal of good housekeeping. It would be well if this point could be driven home to those numerous individuals who strive by equally artificial means to extend the system of mass production throughout the economy.

In deciding whether to buy a washing machine, our housewife will be guided by still another consideration—the relation between the prices of the two factors of production. Where labor is less costly as compared to capital (i.e., where wages are low and interest rates high), the washing machine would prove uneconomical. Where these conditions are reversed, it will pay to use such a machine. This explains why in America many more machines are used—in the home as well as in industry and everywhere else—than in Europe, and why in Europe more machines are used than in Asia. It is for the same reason that in American agriculture, labor is much more sparingly used in relation to land and capital than is the case in Europe. In most Asian countries, labor is the cheapest of the factors while land and capital are the dearest; in the United States, labor is the dearest of the factors and land and capital the cheapest. In China, human labor is so cheap that it figures as an important source of motive power in the public transportation system (ricksha coolies). No further explanation is needed to show that in all these cases the price relationships existing among the several factors of production reflect the supply relationships of these factors in the national economy: that factor of production which is at a given moment the “scarcest” is also the dearest, and since it is the dearest it is used, perforce, sparingly. A socialist economy must be guided by similar considerations if it wishes to dispose economically of the several factors of production. A principle of primordial importance is herewith revealed, one which not only enables us to understand how the prices of the factors of production are formed (the wages of labor, the rent of land, and interest) but which also shows that the optimum combination of the factors in a given country is determined by the individual economic structure of that country. Once again we observe that what may be technically impressive is by no means always what is best economically.

It is now clear that one of the chief tasks of the organizer of production—the one who in industry is called the entrepreneur—consists in a continual search for the most advantageous combination of the factors of production. Since all producers tend to aim at this objective, they all collaborate in the formation of the prices of the factors of production. The optimum combination at any given moment is decisively influenced by the fact that the quantity of one of the factors cannot be continually increased without ultimately causing a fall in the yield due to such increase. It is this process which is meant when in agriculture we speak of a “law of diminishing returns.” This means that if to a given area of land we apply ever greater amounts of labor and capital, there occurs a fall in the rate of yield following an initially over-proportionate increase of yield. Here is a truth which everyone can verify experimentally by subjecting some hapless tomato plant to ever heavier doses of artificial fertilizer. This law applies generally to the whole of production in the sense just illustrated, viz., that the continual addition of new increments of one of the factors of production to fixed quantities of the others produces an increased yield which is at first over-proportional and then under-proportional. This is such a commonplace and undisputed principle that cooks make use of it daily. The first dose of salt that is put into a given quantity of potatoes greatly enhances their taste while the utility of succeeding doses becomes increasingly doubtful. The cook knows that there is an optimum combination of potatoes and salt. Thus we arrive at the momentous principle that for every type of production the factors must stand in a harmonious relationship to one another, since otherwise the yield of the one will develop disproportionately to the yields of the others. The average office can certainly benefit by the employment of at least one stenographer, but if the manager of that office hires a second he soon becomes aware that she is by no means as indispensable as the first, that a third stenographer would be even less valuable, etc. Their productivity declines and it is clear that the productivity of the last stenographer hired—the “marginal productivity” of this species of productive factor called labor—can hardly be higher but also hardly lower than her wage.

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^*The original German verse runs as follows:

“Die Welt ist wie ein Kram, hat Waren ganze Haufen,
Um Arbeit stehen sie feil and sind durch Fleiss zu kaufen.”

NOTES

1. (p. 120) National Income and National Wealth

Calculation of the national income is an uncertain procedure at best; even greater uncertainty enters into the calculation of national wealth. It must be emphasized, to begin with, that we lack any really accurate means of evaluating those items of the national wealth for which there are no markets. At what figure should the streets and canals be assessed? To evaluate them on the basis of their costs of construction would be incorrect inasmuch as their final value to the community may have no relation to these original costs. But there is a further fundamental difficulty here and a highly instructive one. If, as the result of some natural disaster, a country’s supply of water is suddenly and drastically diminished, water would figure as an item in the national wealth even though in real terms the country would have suffered an impoverishment. These few observations may serve to show the minimal value of calculations respecting the national wealth. Cf. Colin Clark, National Income and Outlay (London, 1937); Colin Clark, The Conditions of Economic Progress (2nd ed.; London, 1950); J. R. Hicks, The Social Framework (2nd ed.; Oxford, 1952); see also the literature listed under Note 5.

2. (p. 121) Speculation

The word speculation has such unpleasant connotations that most people have great difficulty in associating it with any useful function. To properly evaluate the role of speculation, however, we have only to reflect on the fact that, given the uncertainty of the future, there is a speculative element in every economic act. Every undertaking involves the assumption of risks and an element of gambling and a businessman is, at bottom, only a specialist in the weighing of probabilities. The fact that certain individuals make a profession of computing future risks manifests merely the usefulness of the division of labor. Just as the merchant relieves the manufacturer of the specific functions of merchanting, so the speculator relieves him of the risks of speculation. In this connection see: W. Röpke, article “Spekulation,” Handwörterbuch der Staatswissenschaften (4th ed.); F. H. Knight, Risk, Uncertainty, and Profit (Boston, New York, 1921). The above literature also examines the circumstances in which speculation is unproductive and even harmful (as is popularly held to be the case, in an unjustified generalization, with respect to all speculative activity). Speculation may be effectively controlled by ensuring that speculators are provided with as few opportunities as possible of engaging in parasitic business practices. Thus, the evils of the black market, which are common to all command-type economies, could be far more effectively combated by reestablishing a free economy than by police interventions. A particularly serious view must be taken of speculation in urban real estate. Speculation of this type may be curbed by purposeful city planning, by a forward-looking land policy, by taxation, and by the adoption of certain legal measures. Here we encounter the special characteristics of land rent which we have reserved for discussion in another place (pp. 195 ff.). Cf. H. Sieber, “Die Bodenspekulation und ihre Bekämpfungsmöglichkeiten,” Wirtschaft und Recht, No. 2, 1957. On stock exchange speculation see: A Hunold, Die schweizerischen Effektenbörsen (Zurich, 1949); F. W. Hirst, The Stock Exchange (London, 1949).

3. (p. 122) Production and Distribution

A proposal that merits consideration is one made by Franz Oppenheimer (for the first time in his Theorie der reinen und politischen Oekonomie (Berlin, 1910) to employ the expressions “production” and “distribution” in the technical senses illustrated in our text. The term “production” would then be equally applicable not only to the production of material goods (primary production, manufacturing) but to trade, transportation, and other activities as well.

4. (p. 124) The Economic Process

For further clarification of the economic interrelationships discussed in the text, consult the diagram shown below. Cf. C. Bresciani-Turroni, Economic Policy for the Thinking Man (London, 1952), Chapter II. See also J. R. Hicks, The Social Framework, op. cit., and the literature listed under Note 5.

5. (p. 125) Macroeconomics

From the voluminous literature in this field may be mentioned: Wilhelm Krelle, Volkswirtschaftliche Gesamtrechnung (no date); Erich Schneider, Einführung in die Wirtschaftstheorie, I. Teil, Theorie des Wirtschaftskreislaufs (8th ed., 1960); Werner Hofmann, Die volkswirtschaftliche Gesamtrechnung (1954); H. C. Edey-A. T. Peacock, National Income and Social Accounting (London, 1954). A special type of macroeconomics is the “input-output” analysis developed by the American economist Wassily Leon tief (The Structure of the American Economy [New York, 1953]) which seeks to measure the flows of commodities entering and leaving the process of production.

For the limits and problems of the macroeconomic approach, see: W. Röpke, A Humane Economy, op. cit., p. 252 ff.; F. Machlup, Der Wettstreit zwischen Mikro- und Makrotheorien in der Nationalökonomie (1960); S. Schoeffler, The Failures of Economics: A Diagnostic Study (Cambridge [Mass.], 1955).

6. (p. 127) The Balance of Payments

For further discussion and literature see my book International Order and Economic Integration, op. cit., pp. 194 ff. See also my article “Zahlungsbilanz und Nationalreichtum” in W. Röpke, Gegen die Brandung (2nd ed.; Zurich, 1959) pp. 306 ff.

7. (p. 128) The World–“this shop”

One of the most important of latter-day theorists has written: “La nature n’est autre chose qu’un grand bazar à prix fixes ou bien une série de machines automatiques. Voulez-vous du charbon, du fer, des fruits, de la viande? Vous pouvez avoir tout ce que vous voulez; vous n’avez qu’à passer à la caisse, c’est-à-dire, vous n’avez qu’à vous soumettre aux conditions, aux prix fixes qu’elle réclame” (M. Pantaleoni, Du caraclère logique des différences d’opinions qui séparent les économistes [Geneva, 1897], P. 34)

8. (p. 129) The Heterogeneous Character of the Labor Market

It is well known that a shortage of one type of labor (or of professionally trained individuals) can persist simultaneously with an oversupply of another type. The transition from one category (of labor) to another is extraordinarily difficult, as much for one who has already been trained for a certain occupation as for his children. The several categories of labor thus form groups among whom competition is more or less frustrated (“noncompeting groups” in the terminology of J. E. Cairnes, Some Leading Principles of Political Economy [London, 1874]).

9. (p. 132) The Theory of Capital

We have to do here with a problem which was the leading concern of the economists of the last century and which is once again the center of a lively controversy. Among the most recent books on this subject the following deserve to be noted: F. A. von Hayek, Prices and Production (2nd ed.; London, 1949); W. Eucken, Kapitaltheoretische Untersuchungen (1934); R. v. Strigl, Kapital und Produktion (Vienna, 1934); J. R. Hicks, Value and Capital (London, 1939).

10. (p. 132) Capital Formation and Capital Consumption

The formation of capital can follow several modes as suggested by the following scheme (W. Röpke, Die Theorie der Kapitalbildung [1929]):

I. Capital formation in a natural economy, termed also the direct formation of capital. Here capital is formed without resort to the detour of money. Example: the farmer who makes his own plough. Similarly illustrative of the formation of capital in a natural economy is the farmer who refrains from selling his young animals and instead raises them to maturity in order to increase the number of his own livestock. Thus, even in the contemporary money economy, this method continues to play an important role in the domain of agriculture. For the rest, however, capital formation at the present time takes place indirectly, i.e., by the detour of money.

II. Capital formation in a money economy:

(1) Formation of capital through saving, i.e., some portions of income are voluntarily set aside and put at the disposal of the capital market. This is and remains the principal method of capital formation in the free world.

(2) Formation of capital by the entrepreneur which occurs when profits accruing from operations within the firm are used for the purchase of new equipment (“self-financing”, corporate saving).

(3) Formation of capital through fiscal policy, e.g., the state may divert taxes to the construction of factories, the building of railroads, etc. In contrast to the preceding, there is an element of compulsion involved in this mode of capital formation (“fiscal forced saving”).

(4) Bank formation of capital which is a consequence of the banks’ power to create credit. The process involved is the following: when the banking system grants additional credits to businessmen for the construction of factories, the general demand for goods is increased, but without a corresponding increase in supply. The result is a more or less perceptible rise in prices (boom). This compels consumers to restrict their consumption. As before, the restriction of consumption necessary to the formation of capital has occurred, but with this difference, that it takes place “from behind” as it were, and compulsorily (“monetary forced saving”). With the development of the modern banking system, this type of capital formation has become extremely important.

11. (p. 132) Credit Expansion as a Cause of Crisis

That the expansion of credit is an act of violence to the economy which, after the initial boom, is avenged in the crisis and depression which follow, is a fundamental part of all theories of the business cycle. Thus, the last world crisis (1929-32) was preceded by a gigantic expansion of credit in the economically advanced countries. Further discussion of this subject will be found in the special chapter reserved for it (Chapter VIII).

12. (p. 134) The Law of Mass Production

The relationships involved in this law may be roughly set forth: if we let k stand for the cost of production per unit of output, p for the quantity of output, g for fixed (general) costs, and s for variable (special) costs, the following equation holds:

But since the variable costs (s) per unit of output remain the same regardless of the quantity of output, the costs per unit (k) must constantly diminish as the quantity of output (p) increases, since in this case the quotientwill become constantly smaller. Hence, unit costs approach, asymptotically, variable costs. In reality, the relationships involved are considerably more complex than this. Thus, the assumption that the variable costs (per unit of output) remain constant will rarely be realized; more often, in fact, variable costs will be found to have a slightly degressive character. We must be especially on guard against accepting the law of mass production as one of limitless application. There are several circumstances which put effective limits to its use, sooner or later. In the case of the washing machine, for example, it is clear that if the volume of laundry is continually increased, the original washing machine will no longer suffice, so that a new and larger machine must be procured. But there are obviously limits to the dimensions which such a machine can assume in the ordinary household. In this case, too, then, there exists an optimum. Where this optimum lies for each of several different sizes of machine can be determined only by technical investigation. Probably, it lies at a lower level, on the average, than most people think. Also, with the increasing size of operations, other difficulties appear which raise costs. Chief among these are the increasing cumbersomeness of the coordinating and supervising functions of management and the increasing need for ever greater uniformity of operations. On these matters, see E. A. G. Robinson, The Structure of Competitive Industry (London, 1935); Colin Clark, The Conditions of Economic Progress, op. cit.

For the rest, we must be careful not to confuse the law of mass production with the law of diminishing returns. The widely held opinion that industry falls under the law of increasing returns and agriculture under that of decreasing returns ignores the fact that we are here contrasting two wholly different things. The extremely complex interrelationships involved in these phenomena hold a large place in recent (cost) theory. The reader who desires a thorough understanding of these matters should consult P. H. Wicksteed, The Common Sense of Political Economy, Vol. 2 (London, 1933); pp. 527 ff. See also: F. X. Weiss, article “Abnehmender Ertrag,” Handwörterbuch der Staatswissenschaften (4th ed.); O. Morgenstern, “Offene Probleme der Kosten- und Ertragstheorie,” Zeitschrift für Nationökonomie, March 1931; J. M. Clark, Studies in the Economics of Overhead Costs (Chicago, 1923); E. Schneider, Theorie der Produktion (Vienna, 1934); H. v. Stackelberg, Grundlagen einer reinen Kostentheorie (Vienna, 1932).