§3. Cost of Production as a Determinant of Capital Value

The criticism that my views as to the relation of cost of production and capital value are invalid because of the use of land as typical of capital has been advanced by several writers.90 In its most concrete form, it applies to the example which I presented of the case where an orchard was held to be worth $100,000 because this sum represented the discounted value of the expected income from the orchard of $5,000 per annum. But even if we change the orchard to machines, houses, tools, ships (that is, "produced means to further production") the principle that the value of anything is the discounted value of its Edition: current; Page: [461] expected income stands unrefuted. This is not to say cost of production does not have an influence. But past costs have no influence on the present value of a capital good, except as those costs affect the value of the future services it renders and the future costs. Future costs influence this value more directly by being themselves discounted at the current rate of discount. It is certainly true that if the reproduction cost of the capital goods is lowered, their production will be stimulated, the supply of services they render will be increased, the valuation of these services, i.e., the income from these capital goods per unit will be lowered, and, therefore, quite aside from any effect on the discount rate, the capitalization of this reduced income will tend to be lowered. Furthermore, this fall in the value of the capital goods will be brought down to a point, through the operation of the opportunity principle, where it is brought into conformity with the new cost of production of the capital good plus a margin to represent the amount of interest.

But, although it is true, it is objected, that under the supply and demand analysis, an increase in the supply of a single commodity will lower its value, the same does not follow when applied to all goods. "Exchange values and prices are relations among goods. Increase the supply of one good and the ratio at which it exchanges for others or for money will change to its disadvantage. If, however, you increase at the same time the supplies of all goods, including gold, the standard money material, you affect simultaneously both sides of all ratios of exchange and consequently the ratios should remain substantially as before. It is just such an increase of goods of all sorts and descriptions that is denoted by Böhm-Bawerk's phrase, 'the technical superiority of present over future goods', Edition: current; Page: [462] or by the more familiar phrase 'the productivity of capital'. Admitting the physical-productivity of capital (and Fisher does not question it), the value-productivity of capital or, more accurately, an increase in the total value product as a consequence of the assistance which capital renders to production seems to me to follow as a logically necessary consequence.... Since there is nothing in the assumption that the productivity of all instruments is doubled that involves any serious change in the expense of producing the instruments, the productivity theorist certainly would claim that under these conditions there must be, if not a doubling, certainly a very substantial increase in the rate of interest."91

I can perhaps do no better than to repeat in part the reply which I made to this criticism in 1914.92 "But the increased productivity of capital will entail a decreased price, or value per unit, of the products of that capital. And in addition there may be an increase in the expense of producing the capital, if, for instance, it is reproducible only under the laws of diminishing returns or increasing costs. Evidently it does not follow that the net return on capital-value will be permanently increased. In short, the expenses of production, on the one hand, and the price of the product of the capital multiplied by the increased product itself, on the other hand, will tend to adjust themselves to each other and to the rate of interest. But this rate of interest, according to my philosophy, instead of being permanently raised, will be ultimately lowered, for to double the productivity of capital will mean ultimately a much larger income to society than before, and Edition: current; Page: [463] this larger income tends to lower the rates of impatience of those who own it. So long as the rate of interest does not fall to correspond with the lower rates of impatience, there will continue to be profit in reproducing the productive capital until adjustment is attained—whether by decrease in the price of the products or by increase in the cost of the capital, or both, does not matter. In any case this adjustment must be by lowering and not by raising the rate of interest, for the rate of interest cannot be raised if the rates of impatience are not raised, and the rates of impatience cannot be raised if, as is assumed, the income stream is increased in size without being altered in other respects."

Very possibly, Professor Seager and I may have been arguing at cross purposes, for, of course, in the transition period while productivity is being doubled, the rate of interest may be raised. This is amply provided for in my theory. But even during the transition period something more is required than increased productivity in order that the rate of interest shall rise; the cost of making the change must be reckoned with and deducted from the income stream. Mere physical productivity will not suffice.

Having stated my views, it will serve to present clearly the difference of opinion to quote an illustration which Professor Harry G. Brown has furnished me of his views on the matter.

"Smith is a fisherman. His boat (capital necessary to his business) is wearing out and will last little longer. He catches, in general, 40 halibut a week, which he sells for $1 each, or $40 a week. He is also a good carpenter and can make himself a boat in a week's time. But to do so, he must give up the $40 worth of fish he could catch, or the $40 for which he could sell them. For him the cost of building a boat is $40. That is its cost in the sense of the sacrifice Smith Edition: current; Page: [464] must make in other products (fish) of his labor, if he builds the boat.

"Jones offers to sell him an exactly similar boat already built for $150. Smith refuses to pay over $40. Since other fishermen do the same, the demand for boats is such that Jones can't get $150. The fact is that the income Smith could get from his fish, which he expects to catch this week ($40) affects the price Jones can charge (value) for a boat (capital good) already built. This $40 worth of fish is not income from the boat we are about to value. It certainly is not the value of that income or its discounted value. And it is not a future cost of the to-be-valued boat.

"The cost you are thinking of as 'included' in your formulation (discount principle of capital value) is, for example, the expected cost (say 5 years hence) of replacing a worn-out or broken seat, broken oarlocks, etc., and the annual cost of painting. But the $40 which measures the cost to Smith of duplicating Jones' boat will make Smith unwilling to pay $150 even though your formulation, taken by itself, would let him—for he must have some boat. And Smith would have a curious mind if the $40 cost affected him only through first making him think of more plentiful and therefore less valuable future services. It has a direct effect on his price offer, not an effect consequent solely on a revaluation of expected future services.

"You can't make the psychology of the fisherman, Smith, fit into your formula. It's better to make a formula that fits what Smith's mind really does."

I accept all of Professor Brown's reasoning and conclusions except his application to me. His contention that the cost of duplicating existing capital will influence the value of that capital is perfectly correct, but so is the discount formula.

The two are not inconsistent. If they were, by the same logic, the generally accepted formula by which the value of a bond is calculated in every broker's office is contradicted every day whenever a cheaper bond is available. The first axiom in economics is, naturally, to get anything Edition: current; Page: [465] the cheapest way whether that way is to make it oneself, buy a substitute or otherwise, for in Professor Brown's reasoning it is solely the existence of an alternative cheaper way which makes the supposed disturbance.

The reasoning proves too much. Suppose Jones offers Smith a bond at one price and Smith refuses because he can get another just like it for less. He would choose the cheaper and he would have a "curious mind" if the cheaper cost affected him only through first making him think elaborately of the discount process. All he needs to know is that if Jones' bond is worth the price offered the cheaper one is even more clearly worth while. And Jones will sit up and take notice, possibly reducing his price.

The cheaper bargain thus has in Professor Brown's sense a "direct" effect on the price of Jones' bond, not an effect solely on a revaluation of expected services. But we cannot here conclude that the usual mathematical formula for the price of a bond was incorrect.

There is no more definite and universally accepted formula in the whole realm of economics and business than that referred to. It is used every day in brokers' offices. It gives the price of a bond in terms of the interest basis, the nominal interest and the time of maturity. It is the type, par excellence, of the capitalization principle both in theory and practice. It is not impaired by any undercutting of the market.

The boat is, economically, a sublimated bond. If Jones offers it to Smith for $150, while Smith can get it cheaper the discount principle is not invalidated. There is simply a readjustment in the boat as in the bond market. Moreover in an individual transaction where there is no marginal point reached by repeating the transaction—only one boat, not a series—there are wide limits within which Edition: current; Page: [466] the buyer gets his consumer's surplus and the seller his producer's surplus. Only when there is a series of successive boats or bonds do we have a full fledged example of the margin where consumer's rent disappears and an equality replaces inequalities.

In the isolated case we should be content to say that Smith will not pay more than the capitalized value. In the case of the conventional series of boats, the marginal boat will be such that the capitalization principle and the cost principle will both apply. The seventh boat, let us say, will cost Smith $100 whether to make or to buy. Jones and other boat owners will have reduced their price from $150 and Smith will have found that to make so many boats will have cost $100 instead of $40, to say nothing of the important fact that he would have to wait much more than a week.

All these points are covered in my presentation, for Professor Brown's example is only one of the myriad examples of alternative opportunities. Smith, like everybody else, will use the cheapest way in the sense of choosing the income stream of labor and satisfaction having the maximum present worth at the market rate of interest.

Professor Brown has his eyes on the opportunity part of the picture and no one has stressed that part more than I. But interwoven with it and consistent with it, in the analysis of a perfect market in which the individual is a negligible factor, is the principle that every article of capital is valued at the discounted value of its expected services and costs.

I do not intend to underestimate the importance of the cost concept. The importance it holds in my mind is not to be measured by the number of pages devoted to it Edition: current; Page: [467] in my books, the main purpose of which was to study capitalizations of income. I believe that the position on cost which was taken by Professor Davenport93 is in general the correct one. What I attempted to point out was that those double-faced events, which I have called interactions, and which always have a double entry, a positive and negative entry, in social bookkeeping, are not ultimately cost any more than they are ultimately income. I also tried to emphasize that cost enters into capitalization on equal terms with income, when the cost is future. Past cost does not affect present valuations except indirectly, as it affects future expected income and cost.

No one would maintain that obsolete machinery, even in good condition, could be appraised on the basis of its cost. The only cases in which cost (with interest) is equal to value is where this value is also equal to the estimate of worth on the basis of future expectations; when, in other words, cost is superfluous as a determinant of value. That cost does influence value by limiting supply, thereby affecting the quantity and value of future services, cannot be questioned. It is natural that business men should not follow this roundabout relation, but connect directly cost with value. This, however, is no reason for economists to fail to analyze the relation in all its complications.