Download Production Theory:

Production Theory:
In recent years it has been a mainstay of economics textbooks to emphasize
production possibility curves (PP). What stands behind this analysis is the assumption
that decisions made about: What to produce? How to produce it? and For whom is it to be
produced? is the price system. Acs and Gerlowski (1996. Managerial Economics and
Organization) have stated that:
Economists refer to the collection of related markets in a capitalistic economy as
the price system. The price system achieves coordination by answering three
basic questions concerning what to produce, how to produce it, and for whom to
produce it. One basic criterion used in determining the adequacy of the price
system is whether the allocation of resources obtained by the price system happens
efficiently. (88, emphasis in original)
Put very simply, efficiency is the process of getting more for less. … An economy
is efficient when it is impossible to get more output from existing resources.
Efficiency is what all economic systems strive for whether they are individuals,
organizations, or countries. …
The study of the interrelationship of all markets is known as general equilibrium
theory. (89, emphasis in original)
The most common reasons for markets not achieving efficient coordination are
market power, imperfect information, increasing returns in production, and
externalities. When any of these conditions prevail, the market may be inefficient.
When people found that markets were inefficient in coordinating economic
activities, they often organized firms. Remember the functional component in the
definition of firms – they organize economic activity. (89, emphasis added)
Notice the ‘most common reasons for markets not achieving efficient coordination’ –
Market power – results from market structures and pricing decisions – the
more participants in a market, the lower the degree of market power
exercised by any party (Competition). If there are few sellers and
many buyers, the sellers are able to set prices at higher levels than
would have been the case if the were many sellers. Similarly, if there
is a single buyer of a resource, the buyer is able to dictate a lower
price than would have been the case with many buyers bidding for
the resources. [Incomplete markets]
Imperfect information – Acs and Gerlowski have observed: “The
competitive model assumes that firms and households are well
informed. Imagine knowing every good and service sold at every
store and the price at which they sold. If information were perfect –
complete and accurate – problems of how to allocate resources
would be relatively easy to solve. But information is imperfect –
less than complete and accurate – and costly to acquire.” (109,
emphasis added) They continue: “Imperfect information can flaw
the tendency toward an efficient equilibrium such as predicted in the
standard competitive model.” (109) “Imperfect information regarding
prevailing wage rates for labor (or rental rates for capital) can also
create problem leading to inefficient production.” (110)
A situation ‘… is often referred to as one with asymmetric information.
That is, the seller has more information than the buyer. One of the
consequences of asymmetric information is that there may be relatively
few buyers and sellers, far fewer than there would be with perfect
information. (111)
Increasing returns in production – Alfred Marshall defines ‘increasing returns’
as: “… we say broadly that while the part which nature plays in
production shows a tendency to diminishing return, the part which man
plays shows a tendency to increasing return. The law of increasing return
may be worded thus: -- An increase of labour and capital leads generally
to improved organization, which increases the efficiency of the work of
labour and capital.” (265)
Marshall further observes: “… the two tendencies towards increasing and
diminishing return press constantly against one another. In the production
of wheat and wool, for instance, the latter tendency has almost exclusive
sway in an old country, which cannot import freely. In turning the wheat
into flour, or the wool into blankets, an increase in the aggregate volume
of production brings some new, but not many ; for the trades of grinding
wheat and making blankets are already on so great a scale [economies of
scale] that any new economies that they may attain are more likely to be
the result of new inventions than of improved organization. In a country
however in which the blanket trade is but slightly developed, these latter
may be important ; and then it may happen that an increase in the
aggregate production of blankets diminishes the proportionate difficulty of
manufacturing by just as much as it increases that of raising the raw
material. In that case the actions of the laws of diminishing and of
increasing return would just neutralize one another ; and blankets would
conform to the law of constant return. But in most of the more delicate
branches of manufacturing, where the cost of raw material counts for little,
and in most of the modern transport industries the law of increasing return
acts almost unopposed. (266)
In a footnote to this last paragraph, Marshall comments, additionally:
In an article on “The Variation of Productive Forces” in the Quarterly
Journal of Economics, 1902, Professor Bullock suggests that the term
“Economy of Organization” should be substituted for Increasing Return.
He shows clearly that the forces which make for Increasing Return are
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not of the same order as those that make for Diminishing Return :
and there are undoubtedly cases in which it is better to emphasize
this difference by describing causes rather than results, and
contrasting Economy of Organization with the Inelasticity of
Nature’s response to intensive cultivation. (Emphasis added)
Notice the wording, “… the inelasticity of nature’s responses to intensive
cultivation…” This represents a continuation of the mistakes made by the Rev.
Thomas Malthus – who permitted population to grow geometrically, and by
holding technology constant, results in holding resources to grow at an arithmetic
rate – allowing technology to grow at a fixed rate. This is given lie to by
analyzing data from USDA’s Agricultural Statistics for both corn and wheat
[yield/acre] during the last three-quarters of the Twentieth Century and the
opening years of the 21st Century. The dramatic expansion in per-acre-yields
through time is attributable to changes in technology, e.g., the development of
hybrids custom designed to maximize output based on environmental conditions.
Similar results have been accomplished by the International Rice Institute [funded
by that dirty capitalist institution – the Rockefeller Foundation] – IR 8 hybrid
variety in the Philippines, which more than doubled the per-acre-output over
traditional varieties. This is the essence of ‘increased productivity’ – more from
the same or less!
As a transition to externalities, it is important to review what Marshall has called
the Economies of Production [seeking Cost Minimization] and its correlates:
Many of those economies in the use of specialized skill and machinery
which are commonly regarded as within the reach of very large
establishments, do not depend on the size of individual factories. Some
depend on the aggregate volume of production of the kind in the
neighbourhood; while others again, especially those connected with the
growth of knowledge and the progress of the arts, depend chiefly on
the aggregate volume of production in the whole civilized world. And
here we may introduce two technical terms. (220)
We may divide the economies arising from an increase in the scale of
production of any kind of goods, into two classes – firstly, those
dependent on the general development of industry ; and secondly, those
dependent on the resources of the individual houses of business engaged
in it, on their organization and the efficiency of their management. We
may call the former external economies, and the latter internal economies.
Externalities – Before explaining externalities, it is helpful to remember one of
The associated factors of the Law of Scarcity – what Milton Friedman
called TANSTAAFL, or ‘There ain’t no such thing as a free lunch.” In
addition, it should be noted production economies – the economies that
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arise “… from an increase in the scale of production of any kind of goods,
may be divided into two categories: -- “firstly those dependent on the
general development of the industry; and, secondly, those dependent on
the resources of the individual houses of business engaged in it , on their
organization and the efficiency of their management. We may call the
former external economies, and the latter internal economies. (Marshall,
221, emphasis in original) It was A.C. Pigou who seized upon the negative
externalities in his well known book, The Economics of Welfare (1920)
declaring it a ‘market failure’ requiring government intervention to protect
the third parties and it was Ronald Coase who pointed out that it was
simply a ‘transaction cost’ that, under the correct circumstances, could be
eliminated by negotiations. (“The Problem of Social Costs,” Journal of
Law and Economics, 1960)
According to Acs and Gerlowski: “Externalities arise when an individual
or firm takes an action but does not bear all the costs or receive all the
benefits…. Therefore, the market fails to guide their allocation. …This
failure is especially likely when there are significant scale economies in
some production process, so that it is less expensive to produce many units
than to produce few.” (111) These provide the logic for the connection
between ‘externalities’ and ‘increasing returns of production’.
The notion of externalities is associated with the recognition that both
production (producer) and consumption (consumer) activities may give
rise to harmful (negative) or beneficial (positive) effects that are not borne
by parties to the activities, but rather are externalized onto others, i.e.,
third parties. Sometimes these are referred to as ‘spillover’ effects. These
‘third party’ effects may be classified into four categories:
external economies (positive effects) of production;
external diseconomies (negative effects) of production;
external economies (positive effects) of consumption; and
external diseconomies (negative effects) of consumption.
External diseconomies of production are uncompensated costs imposed on
a third party (non-participant) in the activities of a production unit, e.g.,
acid rain produced by the burning of sewerage sludge at the Buckman
Plant on Tallyrand that damages the pained finish on imported
automobiles.
External economies of production are uncompensated benefits that are
bestowed upon to some third party as a result of the production activities
of a firm, e.g., expansion of output by one firm may require ‘supplier
firms’ located in the same area (least cost transportation location, LCTL)
to also expand their production to meet demand – Anheiser-Busch plant
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and bottle, can and packaging materials suppliers – creating addition jobs
and household incomes for workers in Jacksonville. (Marshall, 279: and
Alfred Weber, 1909)
Similar results are associated with expected for consumption activities and their
uncompensated costs imposed and unrewarded benefits bestowed on third parties
as the result of consumption activities.
When viewed from the perspective of the nature, structure and cost of obtaining
information, and their consequences insights are gained regarding the allegations
of economic inefficiencies and the presumed need for government intrusion and
intervention into free markets. The economic inefficiencies allegedly associated
with incomplete markets (the exercise of market power), less than perfect
information, increasing returns, and externalities are society operating inside its
production possibility frontier. This represents levels of resource use (less than
full employment of resources) and production below the economy’s potential. The
combined effects of the situation are underproduction (un- or underemployed
resources and lower returns to the owners of ‘factors of production’) →
increased relative product scarcities (and associated higher prices for
underproduced goods) → reduced satisfaction of human needs and wants
(lowered levels of ‘social welfare’) → need, according to A.C. Pigou, for
government intervention to correct the so-called ‘market failure,’ by stimulating
consumer demand and ‘full resource employment,’ especially of labor – however
‘full employment’ is defined.
Consider the diagram below:
Unemployed Resources
Problem:
á la A.C. Pigou
Problem:
á la R.H. Coase &
J.M. Buchanan
‘Market failure’
‘Government failure’
- “inefficient regulations’;
- “when a command economy is
subject to arbitrary decrees
by inept bureaucrats”
- “riddled with monopoly”
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Remember that Acs and Gerlowski have identified four basic factors responsible for the
failure of competitive markets:
- imperfect information
- missing or incomplete markets (exercise of market power)
- existence of externalities
- presence of increasing returns
It is worth mentioning that a fifth factor that that contributes to the failure of both a free
market and the failure of government: ‘rent-seeking’ behaviors on the part of members
of special interest group in the private sector and government bureaucrats. At this
juncture it is appropriate to quote Acs and Gerlowski’s comments of ‘rent-seeking’:
Up to this point we have examined how rents can have a positive
influence on organizations. In other words, they can be used to
increase efficiency. There is also a negative side to the existence
of quasi-rents in organizations. The presence of rents in an
organization can create incentives to attempt to reallocate these
rents. Quite often these attempts at reallocating rents do not increase
total value and may decrease it. Economists consider such activities
as pure costs. Activities that no serve social function other than to
transfer rents or quasi-rents have come to be called rent-seeking
behaviors and directly unproductive activities (DUP). (234,
emphasis in original; emphasis added)
The terms ‘rent’ and ‘quasi-rent’ may not be unfamiliar to many. The concept of
‘economic rent’ goes back to writings of David Ricardo [“Essay on the Influence of a
Low Price of Corn on the Profits of Stocks.”] According to Robert Formaini’s analysis
of Ricardo [“David Ricardo: Theory of Free International Trade,” Economic Insights, 9
(2); @ www.dallasfed.org/research/ei/ei0402.html.] is revealing. He has noted that the
Corn Laws (1815):
… forbade the importation into England of food grown elsewhere and
sought to maintain the rising prices for British agricultural products
that had occurred during the Napoleonic wars, when the French navy
had embargoed British ports. Facing the loss of food imports, Britain
had to use more of its own land to feed its population. This caused crop
prices, and hence, land rents to rise at rapid rates during the war period.
(emphasis added)
Several things are at work here: First, less fertile land (lower productivity) had to be
pressed into agricultural production. The use of less fertile land under cultivation, created
a ‘surplus value’ on the more productive land, i.e., ‘economic rent’. Second, owners of
the most fertile land have a vested interest in maintaining agricultural commodity prices
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high (self-serving, rent-seeking behavior). Third, provides a template for the same ‘rentseeking behaviors’ in contemporary American markets – in which ‘special-interest
groups’ (sugar cane and tobacco growers, steel and auto producers, textile manufacturers,
etc.) seek rents through government intervention in ‘free international markets’ and the
erection of trade barriers – tariffs, quotas, voluntary export restraints, and content
requirements). Trade restrictions benefit small, well organized and funded, special
interests at the expense of the consumer and results from collusion between these
special interests and government. Interestingly, Robert J. Carbaugh (International
Economics, 3rd Ed,) has concluded:
U.S. protection policy is determined by special interest groups that
represent producers. This is because consumers generally are not
organized, and their losses due to protectionism are widely dispersed.
But the gains from protection are concentrated among well-organized
producers and labor unions in the affected sectors. Those harmed by a
protectionist policy absorb individually a small and difficult
Many people view members of the bureaucracy as ‘self-less public servants.’ Such a
view strains credulity, since each and every individual, despite their protestations
otherwise, are in fact self-interested, pursuing the gratification of their own wants and
needs. Government failure is associated with ‘rent-seeking’ behavior (using the powers
of government to obtain that which has been denied to them through free competitive
markets) and the existence of inefficient regulations –
Consider the following quotations from Alan Greenspan’s paper: “Antitrust,” given at the
Antitrust Seminar of the National Association of Business Economists, Cleveland,
September, 1961; published by Nathaniel Branden Institute, New York, 1962. Reprinted in Ayn Rand. 1967, Capitalism: The Unknown Ideal, 63-71.
The world of antitrust is reminiscent of Alice’s Wonderland: everything
seemingly is, yet apparently isn’t, simultaneously. It is a world in which
competition is lauded as the basic axiom and guiding principle, yet ‘too
much’ competition is condemned as ‘cutthroat.’ It is a world in which
actions designed to limit competition are branded as criminal when taken
by businessmen, yet praised as ‘enlightened’ when initiated by the
government. It is a word in which the law is so vague that businessmen
have no way of knowing whether specific actions will be declared illegal
until they hear the judge’s verdict – after the fact. (63)
Greenspan then acknowledges that:
Americans have always feared the concentration of arbitrary power in the
hands of politicians. Prior to the Civil War, few attributed such power to
businessmen. It was recognized that government officials had the legal
power to compel obedience by the use of physical force – and that businessmen had no such power. A businessman needed customers. He had to appeal
to their self-interest. (63)
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There are several arresting points in this quotation: first, (i) there was once a
‘fear’ of ‘arbitrary power’ wielded by politicians; second, (ii) the Civil War was
a benchmark – ‘few’ attributed the abuse of power to the private sector [remember
that Karl Marx released the Communist Manifesto in February 1848, which was
followed by the outbreak of revolutions throughout Europe] … now the alleged
venality of the capitalist class was uncovered … and spread to the United States
(see: www.age-of-the-sage.org/ philosophy/ communist_ manifesto.html); third, it
was government workers that wielded the monopoly-legal power to coerce
individuals to obey their dictates [remember Lincoln’s actions against judges who
insisted on the ‘rule of law’ by placing them under house arrest … see: Thomas J.
DiLorenzo. 2006. Lincoln Unmasked: What You’re not Supposed to Know
About Dishonest Abe.]; and fourth, as noted by Adam Smith (1776): “…
businessmen had no such power…. (they) needed customers …. (have) to appeal
to their self-interest.”
Greenspan continues his analysis:
This appraisal of the issue changed rapidly in the immediate aftermath of
the Civil War, particularly with the coming of the railroad age. Outwardly,
the railroads did not have the backing of legal force. But to the farmers of
the West, the railroads seemed to hold the arbitrary power previously
ascribed solely to the government. The railroads appeared unhampered by
the laws of competition. They seemed able to charge rates calculated to keep
the farmers in seed grain – no higher, no lower. The farmers’ protest took
the form of the National Grange movement, the organization responsible for
the passage of the Interstate Commerce Act of 1887. (63-4, emphasis added)
The industrial giants, such as Rockefeller’s Standard Oil Trust, which were
rising during this period, were also alleged to be immune from competition,
from the law of supply and demand. The public reaction against the trusts
culminated in the Sherman Act of 1890. (64, emphasis added)
Notice Greenspan’s words which have been emphasized – seemed, appeared, and
alleged – reflects his questioning of intent. He continues:
It was claimed then – as it is still claimed today – that business, if left free,
would necessarily develop into an institution vested with arbitrary power.
Is this assertion valid? Did the post-Civil War period give birth to a new
form of arbitrary power? Or did the government remain the source of such
power, with business merely providing a new avenue through which it could
be exercised? This is the crucial historical question.
The railroads developed in the East prior to the Civil War, in stiff
competition with one another as well as with the older forms of
transportation – barges, riverboats,, and wagons. By the 1860’s there
arose a political clamor demanding that the railroads move west and tie
California to the nation: national prestige was held to be at stake. But
the traffic volume outside of the populous East was insufficient to draw
commercial transportation westward. The potential profit did not warrant
the heavy cost of investment in transportation facilities. In the name of
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‘public policy’ it was, therefore, decided to subsidize the railroads in their
move to the West. (64, emphasis added)
The contrast between the economic realities in the East and the West that
Greenspan has drawn is revealing – in the East there were ‘competitive forces’
that were lacking in the West [‘with one another’ and ‘older forms of
transportation’ (barges, riverboats, and wagons’)]. He then describes ‘a political
clamor’ – i.e., individuals who would benefit directly from the railroads (ranchers,
farmers and land-owners and political wanna’ be’s) – in a disgusting display of
‘rent-seeking’ behaviors – explaining the reasons that these ‘special interest
groups’ went to government to obtain the results that they wanted! The market
demand for transportation services – ‘traffic volume’ (manifest as ‘potential
profit’) in the West was insufficient to attract risk-taking, private sector
entrepreneurs to the westward expansion of the transportation system – the
railroads. The answer was expansion of government powers! In order to satisfy
the ‘needs’ and ‘wants’ of the ‘special interest groups’ in the West, (short-term
profits from the ability to tap into the eastern markets for meat and grain)
government intervention was necessary – the ‘subsidization of the railroads.’
Between 1863 and 1867, close to one hundred million acres of public lands
were granted to the railroads. Since these grants were made to individual
roads, no competing railroads could vie for traffic in the same area of the
West. Meanwhile, the alternative forms of competition (wagon, riverboats,
etc.) could not afford to challenge the railroads in the West. Thus, with the
aid of government, a segment of the railroad industry was able to ‘break
free’ from the competitive bounds which had prevailed in the East.
As might be expected, the subsidies attracted the kind of promoters who
always exist on the fringe of the business community and who are constantly
seeking an ‘easy deal.’ Many of the new western railroads were shabbily
built: they were not constructed to carry traffic, but to acquire land grants.
(64, emphasis added)
Notice the form of the subsidy – 100 million acres of public lands taken out of the public
domain and given to ‘special interests’ … alternating ‘square-mile blocks’ for each linear
mile of track laid … including subsurface mineral rights, including oil and natural gas!
Additionally, the lack of competition from other roads and other forms of transportation,
created what Edward H. Chamberlain referred to as a ‘spatial monopoly’:
Let us apply the reasoning to the second phase of differentiation mentioned
above, – that with respect to the conditions surrounding a product’s sale. An
example is the element of location in retail trade. The availability of a
commodity at one location rather than at another being of consequence to
purchasers, we may regard these goods as differentiated spatially and may
apply the term ‘spatial monopoly’ to that control over supply which is a
seller’s by virtue of his location. (1933. The Theory of Monopolistic
Competition: A Re-orientation of the Theory of Value, 62-3)
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His observations apply not just to retail establishments, but extend to other sectors of the
economy, see: Appendix D, “Urban Rent as a Monopoly Income,” 266-69.
Greenspan’s discussion of railroad expansion in the West focuses on the consequences of
‘special interest rent-seeking’ and government intervention into the ‘free-market’:
The western railroads were true monopolies in the textbook sense of the
word. They could, and did, behave with an aura of arbitrary power. But
that power was not derived from a free market. It stemmed from government subsidies and government restrictions. (65, emphasis added)
The source of the monopoly-power was NOT the forces of free-markets, but government
intervention, which had eliminated competitive interactions and supported the creation of
monopoly pricing. Greenspan continues:
When, ultimately, western traffic increased to levels which could support
other profit-making transportation carriers, the railroads’ monopolistic
power was soon undercut. In spite of their initial privileges, they were
unable to withstand the pressure of free competition.
In the meantime, however, an ominous turning point had taken place in
our economic history: the Interstate Commerce Act of 1887.
That Act was not necessitated by the ‘evils’ of the free market. Like
subsequent legislation controlling business, the Act was an attempt to
remedy the economic distortions which prior government interventions
had created, but which were blamed on the free market. The Interstate
Commerce Act, in turn, produced new distortions in the structure
and finances of the railroads. Today, it is proposed that these
distortions be corrected by means of further subsidies. The railroads
are on the verge of final collapse, yet no one challenges the original
misdiagnosis to discover – and correct – the actual cause of their
illness.
To interpret railroad history of the nineteenth century as ‘proof’ of the
failure of a free market, is a disastrous error. The same error – which
persists to this day – was the nineteenth century’s fear of the ‘trusts.’
(65, emphasis added)
Greenspan then proceeds to analyze the ‘trusts’ and the passage of the Sherman Act
(1890), beginning with Standard Oil:
What observes failed to grasp, however, was the fact that the control
by Standard Oil, at the turn of the century, of more than eighty percent
of the refining capacity made economic sense and accelerated the
growth of the American economy.
Such control yielded obvious gains in efficiency, through the integration
of divergent refining, marketing, and pipeline operations; it also made
the raising of capital easier and cheaper. Trusts came into existence
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because they were the most efficient units in those industries which, being
relatively new, were too small to support more than one large company.
(65-6, emphasis added)
Greenspan’s observations may force us to consider the path of many ‘high technology’ industries
today – transistors/semiconductors, software, biotechnology, and information technologies – the
so-called ‘new economy’ industries. Here, once again, the ideas of ‘increasing returns’ and
‘technological lock-in,’ expressed by Kaldor, David and Arthur, along with ‘transaction costs’
developed by Coase find application.
More specifically, Greenspan, details the economic development processes of industries:
Historically, the general development of industry has taken the following
course: an industry begins with a few small firms; in time, many of them
merge; this increases efficiency and augments profits. As the market
expands,new firms enter the field, thus cutting down the share of the
market held by the dominant firm. This has been the pattern in steel, oil,
aluminum, containers, and numerous other major industries. (66)
The observable tendency of an industry’s dominant companies eventually to
lose part of their share of the market, is not caused by antitrust legislation,
but by the fact that it is difficult to prevent new firms from entering the field
when the demand for a certain product increases. Texaco and Gulf, for
example, would have grown into large firms even if the original Standard
Oil Trust had not been dissolved. Similarly, the United Steel Corporation’s
dominance of the steel industry half a century ago would have been eroded
with or without the Sherman Act..
It takes extraordinary skill to hold more than fifty percent of a large industry’s
market in a free economy. … The rare company which is able to retain its
share of the market year after year and decade after decade does so by means
of productive efficiency – and deserves praise, not condemnation.
The Sherman Act may be understandable when viewed as a projection of the
nineteenth century’s fear and economic ignorance. But it is utter nonsense in
the context of today’s economic knowledge. … (66)
The error of the nineteenth-century observers was that they restricted a wide
abstraction – competition – to a narrow set of particulars, to the ‘passive’
competition projected by their own interpretation of classical economics. As a
result, they concluded that the alleged ‘failure’ of this fictitious ‘passive
competition’ negated the entire theoretical structure of classical economics,
including the demonstration of the fact that laissez-faire is the most efficient
and productive of all possible systems. …. (67)
Greenspan next contemplates what most people, today mistakenly perceive as
MONOPOLY …
A ‘coercive monopoly’ is a business concern that can set its prices and
production policies independent of the market, with immunity from
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competition, from the law of supply and demand. …
The necessary precondition of a coercive monopoly is closed entry – the
barring of all competing producer from a given field. This can be accomplished only by an act of government intervention, in the form of special
regulations, subsidies, or franchises. …. (68, emphasis added)
The ultimate regulator of competition is a free economy is the capital market.
So long as capital is free to flow, it will tend to seek those areas which
offer the maximum rate of return. …
… What it [a free capital market] does guarantee is that a monopolist
whose high profits are caused by high prices, rather than low costs, will
soon meet competition originated by the capital market. (68, emphasis in
the original)
The analysis is then extended to the aluminum industry of the United States – and ‘the
history of the Aluminum Company of America’ or ALCOA before the Second World
War. In this section, he notes:
In analyzing the competitive processes of a laissez-faire economy, one must
recognize that capital outlays (investments in new plant and equipment either
by existing producers or new entrants) are not determined solely by current
profits. An investment is made or not made depending upon the estimated
discounted present worth of expected future profits. Consequently, the issue
of whether or not a new competitor will enter a hitherto monopolistic
industry, is determined by his expected future returns.
The present worth of the discounted expected future profits of a given
industry is represented by the market price of the common stock of the
companies in that industry. (69, emphasis in the original)
The churning of the nation’s capital, in a fully free economy, would be
continuously pushing capital into profitable areas – and this would
effectively control the competitive price and production policies of
business firms, making a coercive monopoly impossible to maintain. It
is only in a so-called mixed economy that a coercive monopoly can
flourish, protected form the discipline of the capital market by
franchises, subsidies and special privileges from governmental
regulators. (70, emphasis added)
Perhaps the most damning of Greenspan’s observations and social costs of antitrust
policies are saved for last, and includes a silly quote from the former Supreme Court
Judge:
To sum up: The entire structure of antitrust statutes in this country is a
jumble of economic irrationality and ignorance. It is the product: (a) of
a gross misinterpretation of history, and (b) of rather naïve, and
certainly unrealistic, economic theories.
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… No one will ever compute the price that all of us have paid for that Act
(Sherman) which, by including less effective use of capital, has kept our
standard of living lower than would otherwise have been possible. …..
Those who allege that the purpose of the antitrust laws is to protect
competition, enterprise, and efficiency need to be reminded of the
following quotation from Judge Learned Hand’s indictment of
ALCOA’s so-called monopolistic practices. (70)
It was not inevitable that it should always anticipate increases in
the demand for ingot and be prepared to supply them. Nothing
compelled it to keep doubling and redoubling its capacity before
others entered the field. It insists that it never excluded competitors;
but we can think of no more effective exclusion than progressively
to embrace each new opportunity as it opened, and to face every
newcomer with new capacity already geared into a great organization,
having the advantage of experience, trade connections and the elite of
personnel.
ALCOA is being condemned for being too successful, too efficient, and
too good a competitor. Whatever damage the antitrust laws have done to
our economy, whatever distortions of the structure of the nation’s capital
they may have created, these are less disastrous than the fact that the
effective purpose, the hidden intent, and the actual practice of the antitrust laws in the United States have led to the condemnation of the productive and efficient members of our society because they are productive
and efficient. (70-1, emphasis in the original)
So there you have it! Government as the ‘protector’ of the consumer and society from the
rapacious business community ultimately makes businesses less efficient by retarding
innovation, mal-allocates scarce resources, limits output, and drives prices higher than
they would have otherwise have been – absent the Interstate Commerce Act (1887) and
the Sherman Act (1890). One can only imagine the costs of other government
interventions into the free market on Americans’ standard of living.
Back to Production and Its Implications
Hopefully, the material abstracted from Alan Greenspan’s article, “Antitrust,” will
provide insights into the textbook issues championing business innovation (the
development of new products, the adoption of more efficient organizational structures,
and investment in new processes). It raises concern over the Government’s Sword of
Damocles that hangs over the heads of the of the entrepreneur – the risk of being savaged
by the very bureaucrats pursuing their own self-interest at the expense of the national
welfare that they have been charged to protect – for more on this issue, read: Formaini’s
description of James Buchanan’s contributions to ‘public choice’ economics at:
www.dallasfed.org/research/ei
13
Acs and Gerlowski, then call attention to differences between ‘resource-based’ industry
[the old economy or ‘rust-belt industry] and ‘knowledge-based’ segments of the economy
[the ‘new’ economy]. Examples of the former include – iron and steel, automobiles,
textiles, food processing, while the later includes: semiconductors, software, computers,
photo-voltaic, nanotechnologies, biotechnology, robotics. Firms in the former industries
tend to be labor and capital intensive and experience diminishing returns, while the latter
are characterized by ‘intellectual’ capital [protected by patents, copyrights, trademarks
(federal level) and trade secrets (state-level)] created by research and development
(R&D) activities – and tend to experience increasing returns. Several scholarly articles
may be referred to formulate an understanding of the nature, structure and attributes of
the so-called ‘new’ economy:
N. Kaldor. 1972. The Irrelevance of Equilibrium Economics. Economic
Journal, 82, 1237-1255.
P.A. David. 1985. Clio and the Economics of QWERTY. American Economic
Review: Papers and Proceedings, 75, 2, 332-337.
W.B. Arthur. 1990. Positive Feedbacks in the Economy. Scientific American,
262, 2, 92-99.
W.B. Arthur. 1989. Competing Technologies, Increasing Returns, and Lock-in
by Historical Events. Economic Journal, 99, 1, 116-131.
D.E. Booth. 1986. Long Waves and Uneven Regional Growth. Southern
Economic Journal, 53, 2, 448-460.
As noted previously, the following articles are significant in the interpretation of the
‘knowledge-based’ economy:
The role of private property and property rights:
T.L. Anderson and P.J. Hill. 1983. Privatizing the Commons: an Improvement?
Southern Economic Journal, 50, 2, 438-450.
The possible organizational/management structures:
R.H. Coase. 1937. The Nature of the Firm. Economica, 4, 386-405.
Problems of the Pigovian approach and an alternative:
R.H. Coase. 1960. The Problem of Social Cost. Journal of Law and
Economics, 3, 1-44.
More on the nature, structure and benefits of private property rights:
H. Demsetz. 1967. Toward a Theory of Property Rights. American
Economic Review, 57, 2, 347-359.
The special case of ‘intellectual property rights’:
Thomas A. Stewart. 1994. “Your Company’s Most Valuable Asset: Intellectual
Capital,” Fortune,
__________. 1997. “Why Dumb Things Happen to Smart Companies.” Fortune,
June 23, 159-60.
14
Additionally, several books are also helpful:
A.P. Carnavale. 1991. America and the New Economy. San Francisco: Jossey
Bass.
Thomas A. Stewart. 1997. Intellectual Capital: The New Wealth of
Organization. New York: Doubleday/Carraway Books.
It’s important to note that Alfred Marshall, devoted extensive material devoted to the
issue of ‘increasing returns’
Technological Change: Shift from Muscle- to Brain-Power
In the research and development-intensive, knowledge-based industries large investments
of capital and brain-power (advanced degrees in the ‘hard’ sciences) are required. In
such industries, as production expands, unit costs continue to fall, while profits increase.
This shift is best seen in the concept of Schumpeter’s ‘perennial gale of creative
destruction’ resulting in the (Nikolai) Kondratiev or 55-year business cycle. Additionally,
as Acs and Gerlowski have noted:
… experience gained with one product or technology can make it easier
to make new products incorporating similar or related goods. In these
cases, the competitive market fails. (111)
It ‘fails’ in the Pigovian (A.C. Pigou. 1920. The Economics of Welfare) sense of the
term. Robert L. Formaini and Thomas F. Siems [“Ronald Coase – The Nature of Firms
and Their Costs,” Economic Insights, (Dallas Federal Reserve), 8 (3)] have reported what
Pigou had concluded, that:
… government regulations enhance efficiency by correcting for claimed
imperfections, which Pigou called market failure.
Acs and Gerlowski has stated:
Market failure is defined as a malfunction in the market mechanism
that results in a misallocation or an unproductive use of resources.
(111-2, emphasis in original)
Once it is explicitly acknowledged that all resources are scarce, any misallocation via ‘a
malfunction of the market mechanism’ reduces the total level of social welfare … less is
produced, prices are higher and consumers deprived of potential satisfaction of needs and
wants. Acs and Gerlowski, then point out:
One approach is to try to reproduce the conditions of the competitive
model in the economy. Therefore, you break up large firms – AT & T,
IBM, GM – to create ones with less market power. Most traditional
15
textbooks [and University professors] take this approach. This book
takes a different tact. Since we are unlikely to replicate the competitive
model, we should concentrate on how to deal with [alleged] market
failure. For example, the information problem is at the heart of understanding how organizations function. (112, emphasis added)
One of the chief reasons for the need for organizational coordination, a la Coase’s “The
Nature of the Firm,” finds its roots in the division of labor (specialization of task), which
simultaneously, reduce production costs and increasing transaction costs! Clearly, the
attainment of efficient outcomes must involve tradeoffs.
Buchanan – A Defense of Property Rights
An interesting take on this may be found in James M. Buchanan’s short, but penetrating
book: Property as a Guarantor of Liberty (1993). Buchanan provides an alternative
defense for the existence of private property – it is not simply justifiable on the basis of
economic efficiency (minimization of negative externalities), but the defense of private
property rights adds both to productivity improvements, but, perhaps more importantly,
also supports individual freedom (or liberty). He begins his argument with an analysis of
the Hobbesian jungle – where there is no separation of that which is ‘thine’ and what is
‘mine’. In such a state, the
…life of any person is described to be ‘poore, solitary, nasty, brutish,
and short.’ (4)
Under such conditions, individuals would value security (of person and property)
sufficiently to voluntarily surrender:
… authority to an emergent sovereign who promises subsequent
protection.
Such trade-offs would not be made, if the individual expected to be worse off than before
the relinquishment of authority to the sovereign.
Quite often the starting point for an analysis of social relations is the so-called ‘tragic
commons’ (See: Garrett Hardin. 1968. “The Tragedy of the Commons,” Science, 162,
1243-8 – a very disturbing article justifying government fertility control, even by
draconian means), where land (or other value-generating resource) is held and used in
common is ultimately degraded as each individual seeks to use the land first and most
intensively (the maximization of individual self-interest, at the expense of the greater
whole or society). Each individual is governed by self-interest (the desire to maximize
that individual’s returns from his/her actions) and the quest to ‘capture’ as much value
for him/her own advantage as possible. This is as Adam Smith had described things in his
famous The Wealth of Nations (1776) ……………………….
16
The result of this unfettered competition for the use of the scarce resource (land) is ‘overuse’ of the land … declining fertility, de-forestation, over-fishing or soil erosion. The
message is that ‘private choice is combined with common access,’ results in over
exploitation, e.g.:
… each participant’s behavior, at the relevant margin of use, imposes
external diseconomies on the well-being of others in the sharing group
(5)
or society. Under such conditions:
… all participants can be made better off, as signaled by their own
agreement under some collectively chosen constraints on private
choice. (5)
This solution is beset by two problems – (i) minority views; and, (ii) the need for
enforcement of the collective will … there is always the temptation for the majority to
force its will on others and, ultimately, their willingness to employ coercion employing
some collective mechanism of enforcement. Yet, there is a simpler solution, one that does
not involve government – the establishment of well-defined private property rights that
are easily enforced and transferable.
Buchanan has noted that:
… one implied means of internalization of the relevant externalities is
the partitioning of the shared resource among the separate users, the
replacement of common usage by private and separated property in
specifically assigned parcels. (6)
This represents, “… a movement toward independent and private usage” of resources.
The tension that exists between privatization and the implied social contract is described
by Buchanan:
The privatization of the commons [i.e., the creation of private property
rights] suggests that productive reform lies in the direction of increasing
individual independence (reducing interdependence), whereas agreement
among individuals in the contract with the emergent Hobbesian sovereign
suggests that productive reform lies in the direction of increasing individual
interdependence through membership in the commonly-shared institution
of the sovereign [government]. (6, material in brackets added)
In fact, there is no conflict between these approaches, rather a difference in emphasis.
The tragic commons focuses on the assignment of separated, ‘specifically assigned
parcels’, accompanied by ‘rights of exclusion’ [the ability of the individual owner to gain
exclusive rights to the land and appropriate all the rents for his/her own benefit, by
excluding others]. This begs the issue of enforcement of private property rights. The
defense of private property is based on the efficiency criterion, assuming “that political
authority acts benevolently.” (7, emphasis added)
17
The Hobbesian jungle places emphasis on the need for enforcement and protection of
private property rights [role of the sovereign (or government), enforcement of contracts].
This provides a “theory of legitimacy for a coercive political-legal order,” based on the
consent of the participants. This raises a thorny issue for the sovereign (or government):
What if the participants withdraw their consent? What happens to the ‘legitimacy for a
coercive political-legal order’? Is the sovereign or government, then induced to arbitrarily
exercise coercion? If it does, then is the sovereign or government acting illegitimately?
It seems that the socialists (or as Hayek and Mises refer to them – the ‘statists’) have a
better intuitive understanding of the nexus between enforceable private property rights
and the liberty of the individual property owner. This helps explain their willingness to
severely curtail and circumscribe ‘private property rights’, justifying it as being
undertaken in the ‘interest of the welfare of the social whole’. Perhaps, a more
reasonable, though unstated reason is that when the individual property owners have
their rights protected and enjoy liberty and freedom of use, the political class is always in
danger of their withdrawal of consent. It is in the interest of the political class to reduce
the sanctity of private property rights, limit the freedoms (liberties) that go along with
them, and increase individuals’ dependence upon the sovereign or government. Nowhere
has this been more clearly seen than in the former
Buchanan emphatically states that the partitioning of the commons involves the
establishment of “… well defined limits or boundaries…” by some initial agreement. It is
not enough for there to be ‘well-defined’ property rights, those rights must be enforceable
and exchangeable, in order for liberty (or freedom) of the individual to be assured! He
then goes on:
This initial agreement [contract between the sovereign and the property
owners or ‘participants’] establishes the law of property and defines
violations of this law to occur when [the limits or] boundaries are crossed.
(10)
Much of the legal framework has been codified in ‘common law,’ e.g., the ‘Law of
Capture’ applied to fluid resources – water, petroleum, and natural gas.
Buchanan continues by noting that initially, there are no advantages to be derived from
‘specialization of task’ or the ‘division of labor,’ except along age and sex lines—based
on the individual and the family-unit, which produces all ‘goods and services’ that are
needed by that unit – they are economically ‘self-sufficient’ units (autarchic), operating
independently of others. Individual autarchy (economic self-sufficiency) represents
maximal independence of the individual or family-unit and maximal efficiency of
resource use:
The individual’s well-being, in his or her own reckoning, depends not
at all on the behavior of others. (10)
18
However, such independence has an obvious opportunity cost, the incremental value of
goods and services that could have been produced and would be available for consumption through the miracle of division of labor (or specialization of task).
Interindustry Linkages & the Instantaneous Assumption
In the traditional simple circular flow model, the firm is typically represented as a box on
the right-hand side of the diagram. Inputs (factors of production, i.e., land, labor, capital
and entrepreneurship) flow into the firm from households (resource or factor owners),
while a compensatory flow of payments for the use of those resources (rents; salaries,
wages and other forms of labor compensations; returns on capital; and profits) flow from
the firm to the factor owners or households. The summation of all returns to factor
owners represents an ‘income estimation’ of GDP. Simultaneously, within the firm the
firm a transformation takes place, wherein the factor inputs are converted into semifinished or final goods and services. With the successes of firms pursuing ‘outsourcing,’
and increasing adoption of this ‘buy’ model by highly integrated firms, as opposed to ‘inhouse’ production components or ‘make’ approach, the number of specialized, subcontracting firms producing semi-finished components, can be expected to increase.
Within limits, this specialization results in increasing returns and economies of
production. The sum of all value of all producers of goods and services (as expressed by
the prices consumers pay) is the ‘Output’ method of expressing gross domestic product
(GDP). This should provide insight into the basic fact that there is an overlap between
microeconomics and macroeconomics – they are NOT separate and distinct, but, as Mises
and Hayek have noted, that there are ‘real-couplings’ through the existence of the
activities of the firm taking place through time – the short- and the long-run.
Perhaps a more innovative, as well as a more revealing approach to the economic issue of
production is to be found in what has come to be known as the Hayekian Triangle,
named after Frederick Hayek who developed the view in the 1930s. His approach must
be contrasted with the Keynesian model with its focus on the ‘short-run’. Hayek’s view
considered, what Roger Garrison refers to as, a ‘real coupling’ between the ‘short-run’
and the ‘long-run’. At the heart of the Hayekian view is a ‘capital theory’ –
… the theory of a time-consuming, multi-stage capital structure envisioned by
Carl Menger [Principals of Economics, 1871] and developed by Eugen von BöhmBarwerk [Capital and Interest, 1889]. Decades before macro- economics emerged as
a recognized subdiscipline, Böhm-Barwerk had modeled the fundamental Mengerian
insight into macroeconomic theory to account for the distribution of income among
the factors of production. (2001. Time and Money: The Macroeconomics of Capital
Structure, 4, emphasis added)
Garrison continues:
Dating from the late 1920s, Hayek [“Das Intertemporale Gleichgewichtssystem der
Preise und die Bewegungen des Geldwertes,” 1928; and Prices and Production, 1935],
19
following the lead provided by Ludwig von Mises [The Theory of Money and Credit,
1912], infused the theory with monetaryconsiderations. He showed that credit policy
pursued by a central monetary authority can be the source of economy-wide
distortions in the intertemporal allocation of resources and hence an important
cause of business cycles. (4, emphasis added)
Oh, my! Notice what is being said and the implications …. ‘credit policy’ of the Federal
Reserve Bank … can ‘distort’ the inter-period allocation of resources [what von Mises
refers to as ‘malinvestment’, not simply ‘misinvestment’] and therefore is ‘an important
cause of business cycles.’ Hummm … the Fed is the cause of the very thing that it is
supposed to be preventing! This is expressed clearly by Garrison:
Hayek’s focus [1935] on a money-induced artificial boom reflects the fact that, as an
institutional matter and as an historical matter, money enters the economy through
credit markets. Hence, it impinges, in the first instance, on interest rates and affects
the intertemporal allocation of resources. (5, emphasis added)
He concludes this section by stating:
There is a real coupling between the short run and the long run …. Identifying
the relative-price effects (and the corresponding quantity adjustments) of a
monetary disturbance, as compared with tracking the movements in macroeconomic aggregates that conceal those relative-price effects, gives us a superior
understanding of the nature of a cyclical variation in the economy and points the
way to a more thoroughgoing capital-based macroeconomics. (5, emphasis in
original)
Before returning to the nature of production and the Hayekian Triangle, several salient
realities must be pointed-out. First, the explicit recognition of the significance of ‘time’
[t-n → t0 →
tn] and the ‘intertemporal allocation of resources’ in the analysis of
economic relationships, i.e., the ‘real’ coupling of short run and long run. This contrasts
starkly with Keynes’ driven focus on the short-run (“In the long run we’re all dead.”) and
the supposed preoccupation of classical economics with the long run (said to be the result
of devotion to Say’s Law – “Supply creates its own demand.”) Garrison argues that:
… Hayek’s writings – and those of modern Austrian macroeconomics – can be
comprehended as an effort to reinstate the capital-theory ‘core’ that allows for
a ‘real-coupling’ of short-run and long-run aspects of the market process. Hayek
was simply observing an important methodological maxim, as later articulated by
Mises (1966, 296):
[W]e must guard ourselves against the popular fallacy of the drawing a sharp
line between short-run and long-run effects. What happens in the short run is
precisely the first stages of a chain of successive transformations which tend
to bring about long-run effects.
Additionally, according to Sean Corrigan (2002. “Say’s Law for Our Time,”
www.mises.org), Keynes’ model is based on the identity:
20
Income = Consumption plus Investment, +/- Net Exports and Government
A careful review of the structure of the data in Table B-1 Gross Domestic Product, 19592005; and Table B-2 Real Gross Domestic Product, 1959-2005 available in the
Economic Report of the President, confirms this observation:
GDP = PCE + GPDI + NX + GCE & GI
where:
GDP
PCE
GPDI
NX
GCE&GI
- Gross Domestic Product;
- Personal Consumption Expenditures;
- Gross Private Domestic Investment;
- Net Exports; and
- Government Consumption Expenditures &
Government Investment.
Corrigan continues:
… let us assume that what makes us rich is not consumption ….
Clearly, it is production that matters, for this is what ultimately lifts us out of
savagery. That this should be controversial shows how far we have fallen from
the good common sense of our forefathers.
For we can play Oliver Twist all we like, importunately holding up our plates
for more, but unless we offer something in return, we are unlikely to be able
to rely on our portion being replenished at will.
This simple observation sounds very much like a quote from Adam Smith (1776. An
Inquiry into the Nature and Causes of the Wealth of Nations ):
Clearly, production is important (it is the sources of goods and services and of the
incomes necessary to attract resources), additionally, production provides the means by
which ‘specialization’ can be accomplished – it is the source of the wherewithal of
households to purchase product outputs, rather than having to provide them for himself.
Adam Smith’s parable of pin-factory helps in understanding the efficiency improvements
of ‘division of labor’ and the concomitant decline in costs and product prices. (See:
www.divisionoflabour.com/archives/000006.php.)
The Hayekian Triangle lays out the structure of the production processes, explicitly –
from ‘early stages’ (extractive and refining processes and manufacturing) through the
‘late stages’ (distributing and retailing). [See below] This diagrammatic
21
OUTPUT
OF
CONSUMER
GOODS
EARLY
STAGES
LATE
STAGES
mining
manufacturing
retailing
refining
distributing
STAGES OF PRODUCTION
PRODUCTION TIME (t0 → tn)
framework and its labeling accentuate the intertemporal linkages [t-n → t0 →
tn]
that are assumed away by traditional economic models – both macro – (Keynesian and
neo-Keynesian) and micro – (normatively exemplary perfectly competitive) models.
Garrison has noted:
Attention to the intertemporal structure of production is unique to Austrian
macroeconomics. (45, emphasis added)
Garrison observes:
Capital-based macroeconomics gives play to both the value dimension and the
time dimension of the structure of production. The relationship between the final,
or consumable, output of the production process and the production time that the
sequence of stages entails is represented graphically as the legs of a right triangle.
In its strictest interpretation, the structure of production is conceptualized as a
continuous-input/point-output process. The horizontal leg of the triangle represents
production time. The vertical leg measures the value of the consumable output of
the production process. Vertical distances from the time axis to the hypotenuse
represent the values of good-in-process. The value of a half-finished good, for
instance is systematically discounted relative to the finished good – and for two
reasons: (1) further inputs are yet to be added; and (2) the availability of the
finished good lies some distance in the future. Alternatively stated, the hypotenuse
represents value added (by time and factor input) on a continuous basis. (46)
Keep in mind that Gross Domestic Product (GDP) can be estimated in several ways – the
summation of values of all incomes (Households) and the summation of the values of all
final outputs or products (Firms). A third way of estimating GDP is the summation of all
Values Added, i.e., at each and every stage of production.
Perhaps more importantly, Garrison notes, revealingly:
22
… the Hayekian triangle has a double interpretation. First, it can depict goods
in process moving through time from the inception to the completion of the
production process. Second, it can represent the separate stages of production,
all of which exist in the present, each of which aims at consumption at different
points in the future…. The double labeling of the horizontal axis … is intended
to indicate the double interpretation: ‘Production Time’ connotes a timeconsuming process; ‘Stages of Production’ connotes the configuration of the
existing capital structure.
… as long as we think in terms of the employment of means, and the achievement of ends, and the time element that separates the means and the ends, the
Hayekian triangle remains applicable.
The continuous-input/point-output process that is depicted by the Hayekian
triangle takes time into account but only as it relates to production. (47)
It might be noted that the Hayekian triangle serves as a compliment to Alfred Weber’s
theory of location (1909. Location of Industries) – wherein mining activities and
production of the of final product are separated by geographic space, this separation can
be overcome, but only at a cost (transportation costs), as well as, time (t0 → tn). The
output from mines must be processed then this product must be moved to new locations
for further processing and, ultimately fabricated into final products that must be
distributed to final consumers (or final demand). All of these activities cannot be
accomplished ‘instantaneously,’ both processing and transporting are time-intensive.
Garrison provides a straight-forward explanation of Hayek’s triangle:
… the vertical and horizontal dimensions of the triangle are intended to
represent value and time separately, the relevant time dimension measures
the extent to which variable resources are tied up over time. Production time
itself, then, has both a value dimension and a time dimension.
… it is intended to indicate the general pattern of the allocation of resources
over time and the general nature of changes in the intertemporal pattern. (49)
This explicit recognition of the importance of time permitted the Austrian School to
interpret:
…the rate of interest to reflect a systematic discounting of future values –
whether or not capital was involved in creating them or money was involved
in creating them or money was involved in facilitating their exchange…capital
or, more pointedly, the intertemporal structure of capital – is the primary focus.
The centrality of the interest rate derives from its role in allocating resources –
and sometimes in misallocating them – within the economy’s capital structure.
(Garrison, 6)
If further pushing toward a fuller macroeconomic understanding is to pay, it
may well involve paying attention to the economy’s intertemporal capital
23
structure. (6)
Clearly, adjustments in the economy are NEVER instantaneous, nor are they perfect.
Second, notice the FULL title of John Maynard Keynes’ well-known book: The General
Theory of Employment, Interest and Money – in it there is no mention of capital, but, as
put by Garrison, “… its shadow, interest, does.” Garrison notes that:
Classical economists saw the rate of interest, also known as the rate of profit,
as the price of capital. Keynes, who clearly rejected this view, was involved in
creating them or money was involved in facilitating their exchange. (6, emphasis
added)
But, perhaps more importantly, Keynes’ model is a “demand-dominated model,” one has
to ask: “What is the role of supply or production and its need for investment?” Garrison’s
full comments on Keynes and the so-called ‘general theory’ are:
Keynes (1936: 378), whose demand-dominated theory offered us nothing in the
way of a ‘real coupling,’ simply refocused the profession’s attention on the shortrun movements in macroeconomic magnitudes while paying lip service to the
fundamental truths of classical economics: “ if our central controls succeed in
establishing an aggregate volume of output corresponding to full employment as
nearly as is practicable, the classical theory comes into its own again from this
point onward.” This comes immediately after his claim that the “tacit assumptions
{of the classical theory} are seldom or never satisfied.” (4)
It’s necessary to go back to basics – the factors of production are: land, labor, capital and
entrepreneurship … Notice how Alfred Marshall [Principles of Economics, 8th Ed.,
1920] has put it:
The agents of production are commonly classed as Land, Labour, and Capital.
By Land is meant the material and the forces which Nature gives freely for man’s
aid, in land and water, in air and light and heat. By Labour is meant the economic
work of man, whether with the hand or the head. By Capital is meant all stored-up
provision for the production of material goods, and for the attainment of those
benefits which are commonly reckoned as part of income. It is the main stock of
wealth regarded as an agent of production rather than as a direct source of
gratification.
Capital consists in great part of knowledge and organization : and of this some
part is private property and other part is not. Knowledge is our most powerful
engine of production; it enables us to subdue Nature and force her to satisfy our
wants. Organization aids knowledge; it has many forms, e.g. that of a single
business, that of various businesses in the same trade, that of various trades
relatively to one another, and that of the State providing security for all and help
for the many. (115)
Later in the book, in Book V, “General Relations of Demand, Supply and Value;”
Chapter III, ‘Equilibrium of Normal Demand and Supply,’ Marshall observes:
24
… It is for instance often sufficient to take the supply price of the different kinds
of raw materials used in any manufacture as ultimate facts, without analyzing
these supply prices into the several elements of which they are composed;
otherwise indeed the analysis would never end. We may then arrange the things
that are required for making a commodity into whatever groups are convenient,
and call them its factors of production. Its expenses of production when any
given amount of it is produced are thus the supply prices of the corresponding
quantities of its factors of production. And the sum of these is the supply price
of that amount of commodity. (283)
Mises (1998) calls attention to the obvious, but all too often ignored production
relationships whenever there are MORE than, a single activity taking place:
Other things being equal, the more the production of a certain article increases,
the more factors of production must be withdrawn from other employments in
which they would have been used for the production of other articles …. (340)
He then emphasizes the forward looking perspective of the ‘entrepreneur’:
The planning entrepreneur is always faced with the question: To what
extent will the anticipated prices of the product exceed the anticipated
costs? If the entrepreneur is still free with regard to the project in
question, because he has not yet made any inconvertible investments
for its realization, it is average costs that count for him. But if he has
already a vested interest in the line of business concerned, he sees
things from the angle of additional costs to be expected.. (340)
Information
Perfect Information – the perfectly competitive market is the ‘gold-standard’ of market
structures. In their ‘Glossary,’ Acs and Gerlowski have defined Perfect
Information in the following manner:
Every participant (and potential participant) in a market becomes aware
of every price, product specification, and buyer and seller location at no
cost. (446)
The atomistic participants have access to perfect information, thereby abolishing
uncertainty and risk. The term ‘market structure’ is employed to describe the
whole environment (physical, economic, social, and political), within which
households and businesses conduct their myriad transactions. James V. Koch
25
(1976. Microeconomic Theory and Applications. Boston: Little, Brown and
Company) has suggested that perfect competition may be interpreted as a parable
[a short fictitious story that illustrates a moral attitude or religious principle],
since the conditions assumed for its fulfillment have never existed. Economists
then argue that it functions as a norm or yardstick by which markets are to be
evaluated. Hummm …. Frank Knight, while noting that virtually every business is
a partial monopoly, expressed amazement that: “… the theoretical treatment of
economics has related so exclusively to complete monopoly and perfect
competition.” (1921 Risk, Uncertainty and Profit, 193). Again, Acs and
Gerlowski, in their ‘Glossary,’ have defined Perfect Competition, as:
An arrangement of buyers and sellers in which there is perfect
information, a homogeneous product, similar firms, and free entry
and exit. (446)
What then are these assumptions which have never existed? The key assumption
upon which perfectly competitive markets are based is that all parties to
transactions or exchanges have access to perfect information. Additionally:
- a large number of both buyers and sellers;
- no market participant (buyer or seller) has the ability to
influence the market price;
- each firm’s product is homogeneous and indistinguishable,
i.e., there are no means of product (or service differentiation)
in the market … labels, packaging or trademarks;
- there are no barriers to either entry to or exit from the market in the
long run, e.g., licenses or zoning regulations designed to keep
new firms out and preserve the monopoly power of existing firms
and ‘sold to the public’ as a means to protect health and safety;
- all factors of production are perfectly mobile; there are no
impediments to resources moving to uses in activities and locals
with highest returns (and away from lower rates of returns),
in summary, all activities take place at a single point in space;
- adjustments are instantaneous; and
- firms seek to maximize profits (the spread between total revenue (TR)
and total cost (TC).
The implications of perfect information and perfect competition are that there are
some mystical forces that impel markets toward an efficient equilibrium.
Imperfect Information – introduces the notion that it is impossible for market participants to have access to flawless information. It is not possible to foretell the future
or to fully anticipate the actions or re-actions of other market players. Imperfect
information involves several factors – information will always be incomplete and
less than totally accurate. Additionally, and perhaps even ore importantly from an
economic perspective, information is not costless to acquire. Acs and Gerlowski
have reported:
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The firm may not know exactly what the marginal products of its inputs are.
Further, attempts at estimating them may be flawed for a number of reasons.
Imperfect information regarding wage rates for labor (or rental rates for
capital) can also create problems leading to inefficiencies in production.
(110)
When one market participant has more and/or better information than other
participants, such ‘informational asymmetries,’ create the potential for
opportunism. According to Acs and Gerlowski:
The policy of taking advantage of an informational asymmetry in your
behavior; is a central assumption of transaction cost economics. (446)
Less than perfect information enables one or the other participant to a market
transaction to engage in ‘opportunistic behavior’. Once again, Acs and Gerlowski
have defined the concept:
Action taken when one party to an agreement acts in his or her own
selfish interests, even at the expense of other parties involved in the
agreement. (446)
It is well to remember the definition of a firm: “A bundle of contracts …” or
agreements’, that ‘sticky stuff’ that tends to bind disparate interests together to
accomplish efficient production, distribution and consumption based on mutual
advantage.
There are a number of manifestations of ‘informational asymmetries’ in markets:
Moral Hazard – “An ex post contracting situation and source of transaction
costs that occurs when one party’s actions are imperfectly observable
and when the incentives of the parties may be less than perfectly
aligned.” (Acs and Gerlowski, 446)
Incomplete Contracts – “Agreements that fail to fully specify actions under
every conceivable course of events.” (Acs and Gerlowski, 444)
Ex ante Opportunism – “Prior to signing the contract, the parties involved
(at a minimum) must reach a consensus as to what contingencies the
agreement governs. There are said to be information asymmetries
when the amount and quality of information held by each party
differs or is believed to differ.” (Acs and Gerlowski, 171)
Incomplete
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Private Information – Information asymmetries are associated with the existence
of ‘private information’. Information is never costless, it must be
acquired research, investigation (collection of ‘raw data’), processing
(organization and interpretation), and communication. Each of these
activities involve costs or the expenditure of scarce resources. Such
information is private when it is acquired by participants in the private
sector (members of businesses and households). These data are
protected by:
Copyrights
Patents
Trade Secrets
Copyrights and patents (private ownership rights) are protected by the
Federal Government, as mandated by the U.S. Constitution; Trade Secrets are
protected under state legislation.
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