I. The Scope of the Inquiry

The central aim of this study is to make a systematic survey of the interrelations between the different parts of the material structure of the process of production, and the way in which it will adapt itself to Alms and Umllatlons changing conditions. In so far as these of the Investigation complex problems have been explicitly discussed in the past they have been treated as part of the theory of capital and interest. Here they will be treated from a some what different viewpoint. Our main concern will be to discuss in general terms what type of equipment it will be most prQfitable to create under various conditions, and how the equipment existing at any moment will be used, rather than to explain the factors which determined the value of a given stock of productive equipment and of the income that will be derived from it. As will appear presently, there are in this field a number of fairly 3 4 Introductory . PT. I important and difficult problems which fall into what is usually regarded as the sphere of equilibrium analysis, but which have not 'yet received adequate attention. By far the greater part of the present investigation will be confined to that part of the subject which belongs to equilibrium analysis proper. A full treatment of the economic process as it proceeds in time, and of the monetary problems that are connected with this process, is outside the compass of this book. The discussion in justification of the distinction that is involved here, and of the methodological issues underlying it, will be reserved for the two following chapters. All that I wish to explain at this point is why the task of merely putting those elements of the theory of capital which are commonly treated as belonging to general equilibrium analysis into a form in which they will prove useful for the analysis of the monetary phenomena of the real world, is important enough to merit a separate study.

It may at first be somewhat disconcerting to be told that the theory of a subject which has been so widely and so vigorously discussed right from the beginning of Wh 'h bl economic science as the theory of capital, y • ose pro ems discussed here were should need almost complete recasting as negle.ted In the past • I' soon as we try to use Its resu ts III the analysis of the more complex phenomena of the real world. But there are very good reasons why the theory of capital in the form in which it now exists has proved less useful than we should wish for the purposes for which we now need it. The fact is that the problems of capital as here understood, that is, the problems arising out of the dependence of production on the availability of" capital" in certain forms and quantities, have hardly ever been studied for their own sake and importance. And, as we shall see, the theory of stationary equilibrium, within which they were treated, did not really offer any oppor tunity for their explicit discussion. Such analysis as they have received has been almost entirely subordinate to CR. I The Scope of the Inquiry 5 another problem, the problem of explaining interest.

And the treatment of the theory of capital as an adjunct to the theory of interest has had somewhat unfortunate effects on its development. This for two reasons. Firstly, it was carried only just so far as seemed necessary for the main purpose of explaining interest, and this explanation aimed at illustrating a general principle by the simplest imaginable cases rather than at providing an adequate account of the interrelationships under more complex conditions. Secondly, and this is even more important, the attempts to explain interest, by analogy with wages and rent, as the price of the services of some definitely given " factor" of production,! has nearly always led to a tendency to regard capital as a homogeneous substance the" quantity" of which could be regarded as a " datum" , and which, once it had been properly defined, could be substituted, for purposes of economic analysis, for the fuller description of the concrete elements of which it consisted. It was inevitable in these circumstances that different authors should have singled out different aspects of the same phenomenon as the relevant ones, and the consequences of this were those unending dis cussions about the" nature" of capital which are among the least edifying chapters of economic science.

There were of course praiseworthy exceptions, the most notable of which are to be found in the works of Jevons, Bohm-Bawerk, and Wicksell, who did at least begin with the analysis of the process of production Attempts In the right and the role of capital in it, instead of with direction were stullllied by the treatment a concflpt of capital defined as some quasi-of capital as a single homogeneous magnitude. But even these faclor authors and their followers used this analysis only in order 1 Cf. Armstrong, 1936, p. 3: " ... the treatment of capital ... as a factor of production on a par with land and labour has led to many erroneous conclusions". (The full titles of the publications referred to in this manner will be found in the Bibliography at the end of this volume.) 6 Introductory PT. I to arrive ultimately at some single definition which, for the purposes of further analysis, lumped together as one quasi-homogeneous mass all or most of the different items of man-made wealth; and this definition was then used in the place of the fuller description from which they had started.

As we shall see, it is more than doubtful whether the discussion of" capital" in terms of some single magnitude, however defined, was fortunate even for its immediate Th. proper starling point Is a full descrip tion of the component parts of the capital structure purpose, i.e. the explanation of interest. And there can be no doubt that for the understanding of the dynamic processes it was disastrous. The problems that are raised by any attempt to analyse the dynamics of pro duction are mainly problems connected with the inter relationships between the different parts of the elaborate structure of productive equipment which man has built to serve his needs. But all the essential differences between these parts were obscured by the general endeavour to subsume them under on~ comprehensive definition of the stock of capital. The fact that this stock of capital is not an amorphous mass but possesses a definite structure, that it is organised in a definite way, and that its composition of essentially different items is much more important than its aggregate" quantity", was systematically disregarded. Nor did it help much further when it was occasionally emphasised that capital was an " integrated organic conception" ,1 so long as such hints were not followed up by a careful analysis of the way in which the different parts were made to fit together.

This concentration on a particular capital concept to the neglect of all the multitudinous meanings which attach to the word capital in everyday speech has a further disadvantage. It is not only that the term capital in any of its "real" senses does not refer to a homogeneous substance. There is the further difficulty 1 Knight, 1935a, p. 83.

CR. I The Scope of the Inquiry 7 that even if we describe physically all the items of which the real structure of production is composed we have not described all the factors which will dictate their mode of utilisation. The various meanings ConcenlratIon On of the term capital in everyday speech are single capital concepts also caused an unconscious tribute to the complexity neglect or Important of the problem, and it has been unfortunate aspects oUh. problem that the majority of authors seem to have assumed that somewhere or other there was some single substance corresponding to the singleness of the term which had discharged so many functions. In fact there are at least two kinds of relevant magni tudes or rather proportions which must be taken into account if we want to understand the working of the price mechanism in this field; neither of Th' I' e .wo re evan. them is a simple " quantity", and neither quanlltatlve relallonof them stands in a unique relationship to ships the rate of interest except through its relation to the other. The first is the dimensions of the real structure of productive equipment, describing how it is organised for, or capable of, yielding various quantities of final output at different dates. The second is the proportional demands, or the relative prices, which are expected to rule for these different quantities of output at different dates. The first of these two quantitative relationships describes the proportions between the existing quantities of concrete resources in terms of their relative costs, while the second describes the relative demand for the two kinds of resources. But only together do these two sets of quantitative relationships or proportions determine what is usually regarded as the supply of capital in value terms.

The treatment of the capital problem in terms of the demand for and supply of one single magnitude is only possible on the assumption that the proportions just described stand in a certain equilibrium relationship to one another. On this assumption the result of a 8 Introductory PT. I given supply of concrete capital goods meeting an exactly corresponding demand for them could be represented as a single-value magnitude, a quantity of capital in ThesedllIereneeshavo the abstract which could be set against boen disregarded be-a marginal productivity schedule for cause Ibey disappear In stationary equi-capital as such; and in this sense there IIbrlum would be a unique correlation between " the" quantity of capital and the rate of interest. As a first explanation of the rate of interest, theconsidera tion of such an imaginary state of ultimate equilibrium may have certain advantages. There can be little doubt that the traditional theories of interest do little more than describe the conditions of such a long-term stationary equilibrium. Since this ('oncept of long-term equilibrium assumes that the quantities of the individual resources measured in terms of costs are in perfect correspondence with their respective values, the descrip tion of capital in terms of an aggregate of value is sufficient. Even for the purposes of what is sometimes called" comparative statics", that is the comparison of alternative states of stationary equilibrium, it is still possible to assume that the two magnitudes move in step with each other from one position of equilibrium to another, so that it never becomes necessary to distinguish between them.

The problem takes on a different complexion, however, as soon as we ask how a state of stationary equilibrium can ever be brought about, or what will be the reaction For dynamic analysis Ihe twoeoneepts must, however, be earelully distinguished of a given system to an unforeseen change. It is then no longer possible to treat the different aspects of capital as one, and it becomes evident that the "quantity of capital" as a value magnitude is not a datum,l but only a result, of the equilibrating prooess. With the 1 Cf. Wicksell, Lectures on Political Economy, vol. i, p. 202: "But it would clearly be meaningless - if not altogetJ;!er inconceivable - to maintain that the amount of capital is already fixed before equilibrium between production and consumption has been achieved".

OH. I The Scope of the Inquiry 9 disappearance of stationary equilibrium, capital splits into two different entities whose movements have to be traced separately and whose interaction becomes the real problem. There is no longer one supply of a single factor, capital, which can be compared with the productivity schedule of capital in the abstract: and the terms demand and supply, as referring to magnitudes which affect the rate of interest, take on a new meaning. It is the existing real structure of productive equipment (which in long-term equilibrium is said to represent the supply) which now determines the demand for capital; and to describe what constitutes the supply, writers have usually been compelled to introduce such vague and usually undefined terms as "free" or "disposable" capital. Even those writers who at earlier stages of their exposi tion have most emphatically decided in favour of only one of the meanings of the term capital, and that a " real" capital concept, later find it necessary either to use the word " capital" in another sense, or to introduce some new term for something which in ordinary language is also called capital. The consequent ambiguity of the term capital has been the source of unending confusion, and the suggestion has often been made 1 (and in one or two instances even put into practice 2), that the term should be banned entirely from scientific usage. But much as there may be to be said in favour of this procedure, it seems on the whole preferable to use the expression as a technical term for one of the magnitudes in question, without, however, ignoring the other magnitudes which are sometimes denoted by this term. As will be more fully explained below (Chapter IV), we shall use the term capital as a name for the total stock of the nonpermanent factors of production.

We cannot go into too many details at this stage. 1 E.g. by Schumpeter, Handw6rterbuch der Staatswissenschaften, 4. Auti., vol. 5, p. 582. • 2 E.g. by Cannan, Elementary Political Economy (l888).

10 Introductory PT. I But it may be helpful to add a few words, by way of illus tration, about the reasons for the general failure seriously to take account of the essentially non-homogeneous nature Some causes and COn-of the different capital items, and about sequen •• soHh.treal- . the consequences of this failure. Two meni 01 real capital as a homogeneous ideas in particular have had a very harmful quaniliy effect on the whole theory of capital. The first is the idea that particular capital items represented a definite value independently of the use that could be made of them, a value which was apparently thought to be determined by the amounts" invested" in these items. This idea is a remnant of the old cost-of-production theories of value whose influence has lingered longer in the theory of capital than perhaps anywhere else in economic theory.1 The second is the conception that additions to the stock of capital always mean additions of new items similar to those already in existence, or that an increase of capital normally takes the form of a simple multiplica tion of the instruments used before, and that consequently every addition is complete in itself and independent of what existed previously. This treatment of capital as if it consisted of a single sort of instrument or a collection of certain kinds of instruments in fixed proportions - a treatment which has won favour from the fact that it has sometimes been used explicitly as a supposed simplification - is perhaps more than anything else responsible for the idea that capital may be regarded as a simple, physically determined quantity, and that the rate of interest may be explained as a simple (decreasing) function of this quantity. It would of course follow from these assumptions that the rate of interest must steadily and continuously fall in the course of economic progress since every addition to the stock of capital would tend to 1 cr. Knight, 1935c, p. 45: "Historically, this notion goes back to the classical theory of capital as the product of labour, hence is an indirect consequence of that fountainhead of error, the labour theory of value."

CR.! The Scope of the Inquiry 11 lower it; and t,he familiar fact that the rate of interest fluctuates widely over comparatively short periods would appear to be without any foundation in the real facts and would therefore have to be ascribed entirely to the influence of monetary factors. The organisation of the structure of real resources corresponding to any expected aggregate value of the existing stock of· capital will of course depend on the kind of productive technique that is Thl 1 d t s ea soan overpossible with that amount of capital. And slmpUOed theory of th t · th t d ·l·b . derived demand e asser IOn a un er equl I rlum conditions a different structural organisation will be associated with a different value of the stock of capital means that changes in the supply of capital will bring about changes in the productive technique. The widely held idea that capital consists of (or is) a definite collection of instru ments combined in fixed proportions, and the corollary of this idea, that there is at anyone time only one prac ticable productive technique (which is supposed to be determined either by the state of technological know ledge or by the already existing durable instruments) leads to another fallacy. This fallacy, which may be con veniently described as the" theory of derived demand", has played an important role in recent discussions of trade cycle problems.

The error inherent in this view is of course not the mere assertion that the demand for productive equipment is derived from the expected demand for consumers' goods, which is quite correct, but the idea that the amount of productive equipment which is required in order to satisfy an additional demand for consumers' goods is uniquely determined by the " existing state of technique ". If the productive technique to be employed were fixed by extra economic factors, and particularly if it were assumed to be independent of the rate of interest, then a given change in the demand for consumers' goods would indeed auto matically be transmitted at a given rate to the earlier 12 Introductory l'T. I stages of production, and be transformed there into a demand for a uniquely determined quantity of equipment. This is a conclusion uniformly arrived at by authors who are able to think of an increase of capital only in terms of a simple duplication of equipment of the type already in existence,! and who completely disregard the changes in productive technique connected with the transition from less to more" capitalistic" methods of production and vice vers~. This view has become widely known in the discussion of trade cycle problems as the" accelera tion principle of derived demand". It derives a certain specious plausibility from the fact that under certaiI\ lnonetary conditions things may for a time work in accordance with it. 2 But, as ,ve shall see, the fact that monetary influences lnay sometimes temporarily obscure, or even reverse, the more permanent influences of the underlying real factors, is one of the main reasons why it is essential to make a systematic study of the significance of these real factors.

A last instance may be mentioned of the unfortunate effects which these simplified ideas on capital have exerted on the analysis of dynamic phenomena such as The concept of net industrial fluctuations. I refer to the crude Investment distinction which is commonly made between current production and new investment, or between the reproduction of the existing stock of capital and addi tions to that stock, and the even cruder distinction between the gross production of capital goods and the production of consumers' goods. Here too the idea that the growth of capital takes place in such a form that new items of a 1 Although a great deal of the current discussion of trade cycle problems is to some extent affected by this idea, there is probably no other book by a reputable economist where it is used so crudely as in H. G. Moulton's Formation of Capital (Washington, 1935), a book which is also, apart from this parti~ular point, a veritable treasure-box of most of the current fallacies connected with capital.

2 See Part IV below, and Hayek, 1939, where the significance of the " acceleration principle of derived demand" is discussed in some detail.

CB. I The Scope of the Inquiry 13 similar nature to those previously in existence are added to an otherwise unchanged stock, has been responsible for a good deal of confusion in contemporary discussion. The same applies to the cognate idea that for purposes of analysis the whole capital problem can be adequately dealt with by dividing industries into two groups, those pro ducing consumers' goods and those producing investment goods. But the problems involved here are obviously too complex to allow more than a mere mention at this stage. They are to some extent connected with the distinction between long and short periods, and the various concepts of equilibrium, which will be discussed in the next chapter.