“Capitalism – A Treatise on Economics” by George Reisman – A Review

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It is not often that the present author is moved to review any particular publication by a specific author, let alone one that was published nearly twenty years ago. However, Capitalism by George Reisman, at more than one thousand pages long, is the first major treatise that is at least related to the “Austrian” tradition since the publication of Murray N Rothbard’s Man, Economy and State in 1962.

Although Reisman is a contemporary of Rothbard and a fellow student of Ludwig von Mises, Reisman’s approach to economics is markedly different from either. Indeed, armed solely with knowledge of his pedigree one might be forgiven for wondering why more attention has not been directed towards to Reisman’s work from within “Austrian” circles. It is only after having read this treatise that one can see why. Although Reisman claims that Mises is his primary intellectual influence, there is very little of this treatise that could be regarded as distinctly Misesian. Rather, Reisman’s direct influences are the classical economists (especially Smith, Ricardo and J S Mill, upon whom he relies for support to an extent far beyond his reliance upon Mises) and Ayn Rand. Reisman specifically rejects the categorisation of economics as the science of human action, and prefers, instead, to regard it as “the science that studies the production of wealth under the division of labour”. He therefore willingly abandons any analysis of individual values, means, ends, and choices, and restores economic theory to the study of holistic aggregates; indeed we might say that his definition of economics, which views wealth as an entity possessing some kind of objectively determinable magnitude, demands such a restriction. Reisman positions the businessman, rather than the consumer, as the centre of the economic system, stating that consumers (as a whole) are largely dependent upon businessmen (as a whole) rather than vice versa. While, according to Reisman, consumers provide the direction of economic activity (i.e. the precise direction of resources to fulfilling specific industries), businessmen and capitalists are responsible for its extent, i.e. the limits of saving and capital investment. In other words, it is the decisions of capitalists that determine the extent of “economic progress” (a term Reisman prefers to “economic growth”) rather than those of consumers. A corollary of this is that production and producers are reinstated as the keystones of economic activity rather than consumption and consumers (there is at least an implication in parts of the treatise that production is good and proper whereas consumption is bad and wasteful, although this is much muted compared to the same in Reisman’s classical influences). Furthermore, it is clear that Reisman does not regard his approach to economics as a wertfrei science and, instead, believes his economic theory to be a rigorous promoter and defender of the capitalist system – an attitude that cannot be avoided by his definition of economics as the study of the accumulation of wealth under the division of labour, a division that he says is only possible under private ownership of the means of production. Thus, in Reisman’s world, a discussion of economics is a discussion of capitalism which, presumably, explains the book’s title.

What can we say about Reisman’s approach? Without beating about the bush we must state at the outset that Reisman, who is thoroughly acquainted with “Austrian” economics, has jettisoned a tremendous degree of sound theoretical understanding from the science. Although Reisman, who self-identifies as an “Austro-classical” economist, endeavours to restore to economics many of the (in his opinion) sound doctrines of the classical economists that were allegedly rejected following the discovery of the law of marginal utility and the backlash against Marxism, we must conclude that the result is something of a retrogression rather than a synthesis of two, hitherto quite disparate, schools of thought. In Reisman’s world, the achievement of all ends and their associated costs never advance deeper than the objective measurement of exchanges for money. He never advances any exposition of individual ends and subjective costs (indeed, he explicitly rejects the doctrine of opportunity cost). Hence the entire purpose of the economic system as serving the needs of individuals and the types of decisions that individuals must make in order to achieve these ends is missing, subsumed by the supposedly limitless need of man as a whole to accumulate “wealth” in perpetuity. In other words, Reisman’s restoration of the primacy of the production of “wealth” overlooks the fact that all production is ultimately aimed at providing for consumers and that it is the ends of consumers to which the economic system is geared. It is perfectly consistent to state, as does the wertfrei “Austrian” school, that the purpose of all economic endeavour is to provide for consumption while on the other hand remaining firm that the means of achieving this consumption can only be served by increased production. Therefore, while we can hold that the desire for consumption is the ultimate cause of economic progress, we can also state that production is the proximate cause. Thus, while Reisman’s categorisation of economic theories under the headings of either “productionism” or “consumptionism” – the former of which involves the promotion and encouragement of increased production as the means towards economic progress, the latter the promotion and encouragement of increased consumption – provides an instant and convincing cognitive aid, it obscures the clarity afforded by this insight of the “Austrian” school.

Furthermore, Reisman’s repositioning of the capitalist/businessman as the driver of economic progress relies upon capitalists providing the bulk of investment funds, i.e. that it is the consumption/saving decisions primarily of businessmen that determines the extent of economic progress. He argues that the wages of labourers do not provide a significant source of investment funds and are usually consumed either immediately or are saved in order to purchase durable consumer goods such as housing or automobiles. Any investment saving that labourers do happen to undertake is likely to be wholly disinvested at retirement, thus netting out the saving of younger generations. However, there is no reason for Reisman to think that this this must be the case. It is just as possible for investment funds to come from the savings of everyday individuals that are then lent to businessmen for them to deploy in their enterprises via a conduit such as bank savings accounts (and such a view would greatly undermine any opinion that capitalism keeps the masses in servitude as wage labour). The distinctive role of the businessman is that he provides entrepreneurial talent in order to generate economic progress by directing those saved funds to where they are most urgently desired by consumers. Yet Reisman’s treatise lacks any extensive theory of entrepreneurship and only passively recognises the need for superior decision-making in order to fulfil the ends of consumers. This lacuna in Reisman’s theory means that in order to position the businessman as the driver of economic progress he has to paint him as the primary provider of investment funds. This contrasts greatly with Reisman’s mentor, Mises, who makes entrepreneurship a hallmark of Human Action, thus giving us an insight into the economic significance of the businessman that extends far beyond the fact that he simply didn’t consume his wealth. (Some of Reisman’s views on what determines an individual’s consumption/investment preferences, which inform his theory here, are also incorrect and we will explore these below). In any case, however, Reisman seems to support his theory through a blurring of economic categories, such as labourers, consumers, capitalists, etc. (something which, irritatingly, is done all too frequently). In reality, all individual people in the economy participate in different categories at different times – a man is clearly a labourer when he goes to work, a consumer when he spends his wages in the shops, and a saver when he buys a corporate bond. However, when we are discussing, for the purposes of conceptual clarity, the roles of individuals in these economic categories, we isolate those specific roles from other categories and thus we always talk of labourers qua labourers and consumers qua consumers, etc. So even if it may happen be true that the particular people who are businessmen are responsible for the greater part of saving and investment, businessmen are consumers too and considering them as consumers qua consumers it is their decision to refuse to consume their wealth today in favour of accumulating greater wealth for consumption tomorrow that provides the source of investment funds. It is therefore true to state that it is the choices of consumers who determine both the direction and extent of economic progress. Moreover, as Mises also recognises, any consumer who is currently a wage earner can transform himself into a businessman, entrepreneur or capitalist by saving and investing his wages (while, equally and oppositely of course, any businessman who decides to consume his fortune may end up as a wage earner).

Finally, it is one thing to state that the preoccupation of the economic activity of any one (or even most) individuals may be with the accumulation and augmentation of their own wealth. But it does not follow from this that the science of economics itself concerns the accumulation of wealth. Animals preoccupy themselves with the need to attain food and shelter but this does not mean that the focus of zoology is with the achievement of these things.

Examining Reisman’s treatise on its own, non-wertfrei terms as a rigorous defence of the capitalist system, much of its earlier part is a detailed offence against the fallacies of socialism, collectivism, interventionism and environmentalism (and later, Keynesianism and inflationism). These devastating, if often heavy handed, critiques are likely to be viewed as by Austro-libertarians as Reisman’s greatest achievement in this work, even if some of it was previously published as The Government Against the Economy. A specific and lengthy chapter is possibly the most passionate assault against the ecology movement, a chapter that could easily be expanded and published as a separate treatise (Reisman’s stress of the anti-human zeal of environmentalism resonates with that of environmentalists, such as former Greenpeace Canada President Patrick Moore, who have become disillusioned with the movement). Reisman’s explanation of various forms of government intervention, such as price fixing, with reference to specific notable examples such as the oil recession of the 1970s, in which he traces out all of the effects (and effects of alternatives to) government meddling have rarely been matched. Yet much of the remainder of Reisman’s exposition does not in fact read as a promotion or a defence of the capitalist system; rather it is more akin to an aggregative, accountancy-laden explanation of what the capitalist system does, much like a description of some giant machine that swallows up inputs measured in numbers and churns out some kind of output, also measured in numbers. Reisman categorises an endeavour as productive according to its ability to earn money voluntarily through exchange. Hence all government functions, relying upon taxation, must necessarily be classified as consumption and not production. In other words, government can never produce and must always be a leech on the genuinely productive, capitalist system. Moreover, his excellent critique of socialism recognises that socialism must entail tyranny and a replacement of the ends sought by individuals with the ends sought by leaders. However, Reisman’s aggregative, accountancy approach never builds upon this insight. In the depths of the latter half of the treatise one almost forgets any connection between these accounting entries and how the capitalist economy serves the needs of individual people. One of Reisman’s stated aims in the treatise is to show how a proper understanding of the capitalist system should prevent one from feeling any kind of “alienation” from or subjugation by the capitalist system – something which Reisman comes closest to achieving through his analysis of the division of labour. Yet in the main it would appear that the Mises-Rothbard approach of detailing the economy as a network of bilateral, voluntary exchanges between individual people striving to meet their own needs through voluntary co-operation (and how these disparate and often conflicting goals and purposes nevertheless mesh into a harmonious, productive society) is much more conducive to achieving this than is Reisman’s aggregative, accountancy method. While it is true that the ability of capitalism to manifestly increase the standard of living and the degree of material wealth lends it a tremendous amount of moral weight, we can suggest here without too much elaboration that any rigorous defence of capitalism and, moreover, freedom can proceed only by focussing on the primacy of the needs of each individual person, not all of which can be measured or attained though objectively viewable exchanges for money. This omission in Reisman’s work also weakens the distinctly economic flavour of this treatise, as individual choices, desires, wants, decisions and actions do not seem to matter.

Turning now to some of Reisman’s theoretical contributions to the science of economics, there are two that stand out in particular. The first is his attempted demolition of the “conceptual framework” of the Marxist exploitation theory by asserting the primacy of profit rather than of wages. In Reisman’s view, critics of Marxism, including Böhm-Bawerk, have accepted the categorisation, originating with Adam Smith, of profits paid to capitalists as deductions from wages, and have sought explanations in order to justify this deduction. Reisman, however, asserts that wages, paid to labourers, are, in fact, a deduction from profits. If profits are calculated by subtracting business costs from business revenue, it is clear that if a person undertakes an enterprise to achieve, say, 100 units of revenue then every monetary outlay he expends in order to achieve that 100 units of revenue must count as a deduction from it. The fewer costs he has the more profit he is left with. Thus it is profits that represent the primary economic income, not wages. It is conceivable for the economic system to have profits but not wages in the event that every individual person operated as a sole trader and employed no other individuals. If, however, a businessman hires labourers to assist in his enterprise, the wages he must pay to these workers for their assistance are deducted from the ultimate sales revenues. Therefore, according to Reisman, wages only appear in the economic system on account of the help that other people provide to a businessman’s enterprise, and their help stakes a claim on his revenue. Thus it is wages that are deducted from profits, not vice-versa.

Whatever the merits of this view we must conclude that, to the dyed-in-the-wool Marxist, it is likely to be beside the point. The source of contention in the exploitation theory is that the businessman doesn’t do anything and simply leeches off the productivity of the worker; in other words by hiring labourers the businessman simply abdicates any participation in the act of production yet still gains an income. Reisman himself provides the answer to this by pointing out that labour is not the only source of productivity in a division-of-labour society and that it is, in fact, decision making, risk-taking, management and oversight that are also essential – in other words, entrepreneurship. And yet, as we noted, any extensive treatment of entrepreneurship is precisely what is missing from Reisman’s theory. Therefore, it must be submitted that an understanding of entrepreneurial profit and loss and the insulation of the labourer from business risk coupled with the time preference theory of interest provides a more effective demolition of Marxism than the primacy of profit theory which, if correct, provides only additional ammunition for it.

This brings us to Reisman’s next theoretical contribution which is his net-consumption/net-investment theory of aggregate profits, profits which he tries to explain in an environment of an unchanging supply and flow of money. The attempt to explain profit in terms of physical goods is relatively straightforward. Goods, of course, can increase or decrease and thus there can be absolutely more (profits) or fewer (losses) of them across society as a whole. We can also understand clearly, across the time structure of production, how the consumption of a smaller quantity of physical goods can be foregone today in order to produce a larger quantity of goods tomorrow. This is not so when it comes to accounting for profits and losses in terms of money which is assumed to be fixed in supply and flow. For every transfer of money that represents a credit to ones businessman’s income must show up as a corresponding debit to another businessman’s costs. Hence, while some individual businesses would earn profits and others would suffer losses, all profits and losses across the economy as a whole would net out and hence any question of aggregate profit would be impossible. The only method of solving this conundrum is to somehow, on the societal balance sheet, create a credit entry to income/equity without a corresponding debit entry to costs. It is the explanation of how this is possible that Reisman sets out to achieve.

The first element of aggregate profits – “net consumption” – derives from the fact that business revenues from consumption spending by labourers (and, as we noted, Reisman categorises all spending by labourers as consumption spending) shows up also as a business cost in the form of wage payments. Therefore, revenue and cost cancel each other out on the societal income statement. Similarly, business to business spending will be counted as both an equal and opposite revenue and cost and will net to zero. However, “the payment of dividends by corporations, the draw of funds by partners and proprietors from their firms, and the payment of interest by business firms” (which Reisman regards as “transfers”) to business owners, which provide the latter with a source of consumption spending, does not show up as a business cost yet does, once spent, show up as a business revenue. Thus the rate of profit is determined solely by the desire of the capitalists to consume. This element of profit has, Reisman claims, the ability of providing continued aggregate profits in an environment of unchanging money. For example, if the volume of spending is 1000 units of money each period, business costs could be 900 while business revenues could be 1000 and profits 100 in each and every period. (Reisman uses similar reasoning to explain how the rate of profit is increased by taxation as all taxation is consumption spending). The second element, “net investment”, derives from the fact that business spending on assets to produce business revenue are capitalised as assets and only later depreciated incrementally as a business cost. Thus, in an environment where the volume of spending is the same, business revenue exceeds business cost. For example, if 100 units of money are expended on capital assets, 800 units are spent on business costs, and there are 1000 units of business revenue, profits would be 200 as the 100 units spend on capital assets are not charged as a cost. Reisman believes that net investment provides a finite outlet for aggregate profit because, eventually, depreciation charges from assets previously capitalised will equal the value of new assets capitalised. For example, if 100 units of monetary spending on assets per year are capitalised and then depreciated at an uncompounded, annual rate of 10%, depreciation charges will be 10 units in year one, 20 units in year two, 30 units in year three, and so on until, in year 10, depreciation charges will exactly equal the 100 units of additional investment and so net-investment will provide no source of aggregate profit in that year. Thus, Reisman believes, only net consumption is capable of providing continuous, aggregate profits period after period. Net consumption and net investment are, however, joined at the hip. Reduced net consumption provides increasing funds for net investment to be capitalised on the balance sheet and charged as business costs only at increasingly remote points in the future.

What can we say about this theory? It should not be surprising to “Austrians” that Reisman’s theory is based upon net-consumption and net-investment as it those elements that are determined by the “Austrian” theory of time preference, which affects the rate of interest. (What Reisman refers to as “profit” is what most “Austrians” would refer to as “interest” – Reisman offers no explicit distinction between entrepreneurial profit and loss on the one hand and what “Austrians” would regard as interest on the other). Yet Reisman regards his theory as standing in opposition to the time preference theory and, moreover, the older productivity theory of interest. However, Reisman’s approach, characterised as simply a description of accountancy practices and the summation of money flows, does not challenge the time preference theory at all. The primary question of profit and interest that is answered by this latter theory is why do businessmen not impute the full value of the final product to the factors of production. In other words, why, even after businessmen are compensated for their managerial or oversight activities as a factor of production, is there always a further residual surplus that is not eliminated by competitive bidding amongst entrepreneurs? Why is there, to use Reisman’s terminology, a “going rate of profit” at all? The net-consumption/net-investment theory, while explaining that rises in net consumption will increase the rate of profit while reductions in them will lower it, only really explains how, from an accounting point of view, profits are possible. Reisman offers no extended treatment of the motivations of capitalists in paying (and of labourers in accepting) a sum lower than the total of business revenues and thus it is difficult to regard this as a distinctly economic theory. A more convincing explanation of his theory would detail how, with decreasing time preference, more funds are advanced to factors of production yielding revenue in the future, thus diminishing net consumption and the rate of profit, while these expenditures will be capitalised at increasingly higher amounts, depending on the time period when they come to fruition, relative to the ultimate business revenue that is earned. Thus Reisman’s accountancy-laden approach would, in this way, be fully reconciled with the “Austrian” approach to profit, or, rather, to what “Austrians” would call interest.

When Reisman does address the motivations that determine net-consumption and net-investment he does so erroneously. Reisman defines time preference as the determinant of “the proportions in which people devote their income and wealth to present consumption versus provision for the future.” It is Reisman’s link between this posited desire to provide for the future and net-investment that causes him to declare that net investment can provide only a limited contribution to net profit. To quote: “As capital and savings accumulate relative to income, the need and desire of people to increase their accumulated capital and savings still further relative to their income diminishes, while their desire to consume their income correspondingly increases”. In other words, the more saving and capital people possess the more they have provided for the future and thus productive expenditure will fall and consumption will rise, choking off net investment in the form of further additions to the asset side of the balance sheet. Thus depreciation charges begin to equalise new investments and aggregate profits from net-investment begin to fall. This view, however, is mistaken. Time preference has nothing to do with the desire of people to provide for the future. The need to provide for the future is always a present end just like any other and could be achieved by plain saving rather than investment. Time preference, rather, is the rate at which individuals prefer a larger quantity of goods available at some point in the future ahead of a smaller quantity of goods available today. It is perfectly possible for people to continue to invest sums of capital that will not produce consumer goods for well after they are deceased. Indeed, this is precisely why people have inheritances to bequeath. Many of the buildings, factories and infrastructure we have today were created not in our own lifetimes but were handed down to us from past generations. And it is further possible that capital accumulation and technological progress, which Reisman himself stresses enhances the ability to produce capital goods, will enable the production of capital goods that last further and further into the future. People would not even need to create capital goods that last so long with the purpose that they do so – in other words they could be perfectly limited in their own time horizons and yet still produce capital goods that yield a product well after the elapse of this time horizon. Let’s say, for example, that the current rate of time preference means that the produce from all assets appearing after thirty years hence is fully discounted to zero. In other words, only what the assets can produce in the next thirty years is valuable to present persons. If a capital good was created that could yield produce for sixty years, after the elapse of each year, another year’s discounted produce would be capitalised as this year is drawn into the thirty year time horizon. Therefore, such assets will provide a continued source of credits to business equity (and, thus, profits) without corresponding business costs. This is precisely the case with some of the most valuable patches of urban land which, for all intents and purposes, will go on producing well beyond the lifetimes and time horizons of any living person. Thus there is no reason for net-investment to be so limited in its contribution to aggregate profits in the environment of unchanging money. Moreover, we can see in this way how accumulating, aggregate profits that are capitalised for longer and longer periods is the hallmark of an economically progressing society – one where more and more capital is invested for longer – while the opposite, aggregate losses, represents retrogression through capital consumption.

Finally, as we noted above, there is no reason to discount saving by labourers a source of investment funds. This would divert spending from business revenue as the funds would be lent to businesses who would then spend it on “productive expenditure”. Without any corresponding business revenue the rate of profit would fall. (Thus we can see why increased funds that are made available for lending must be made at increasingly lower rates of interest).

There are one or two further disagreements we can cite here. First, “Austrian” business cycle theory, the jewel in the crown of “Austrianism”, is never explained at length and instead takes its place in a wider treatment of the effects of inflation. Second, his treatment of neoclassical price theory is too aggregative and does not explain how individual bidders and suppliers bring about a harmony between the quantity demanded and the quantity supplied. Third, as in his critique of the time preference theory of interest, Reisman often perceives differences or disagreements where there are none, such as that alleged between his productivity theory of wages and the marginal productivity theory of wages, the latter of which he describes incorrectly. And finally, in spite of having been the translator of Mises’ Epistemological Problems of Economics, Reisman has little to say concerning method – something which perhaps descends from his rejection of economics as the science of human action, which underpins Mises’ methodological dualism that divides economics from the natural sciences.

Overall, therefore, the question of whether Reisman’s approach to economics has successfully synthesised the “Austrian” and classical schools, and, moreover provided a progressive outlook for the science of economics must, regrettably, be answered in the negative. Rather, Reisman’s positive economic theory in this treatise comes across more as a restatement and re-polishing of classical economics (with some corrections to that school of thought), peppered with insights from neoclassicism and the “Austrian” school. Reisman’s rejection of the primacy of human action as the subject matter of economics has been at the expense of not only losing a great deal of theoretical understanding in the wertfrei science that this affords, but also weakening any positive promotion for capitalism and freedom.

Nevertheless, while this review has been mainly been critical of Reisman’s positive economic theory, we must end by celebrating the fact that our author has, in this treatise, many great things to say concerning socialism, environmentalism, interventionism, inflationism, Keynesianism and all other manner of false doctrines rejected by “Austrians” and libertarians alike. What Reisman has put to paper here are among the finest critical analyses of these areas ever written and, even if one cannot agree with Reisman’s specific, economic outlook, these contributions alone place Reisman in the top rank of economists whose work should be studied avidly.

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Prices and Cost of Production

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A major field of study in the science of economics is the pricing of consumer goods and their antecedent factors of production. The history of this area of thought provides an almost textbook example of the falsehood of the “Whig theory” of historiography – the idea that the knowledge of humanity progresses in an ever upward direction and that what we know now is better and more enlightened than what we knew before. For this area of study in particular is marked by progression, retrogression and progression once more, often with disastrous consequences.

The most serious case of retrogression in this regard was of, course the Marxian labour theory of value that stipulated that the exchange ratio of goods depended upon the quantity of labour time inherent in their production. This theory, together with its corollaries and associates such as the iron law of wages and the exploitation theory, was derived, so it was believed, directly from the largely pre-capitalist classical economics of Smith and Ricardo.

A basic “Austrian” response to this is to reject Marxism and its supposed classical parent by pointing out, of course, that costs are also prices. To explain prices in reference to prices, therefore, would appear to be a case of circular reasoning. Rather, the prices of the factors of production were derived from the value of the final good. Capitalists would bid up the factors of production according to the valuation of the final product. Thus the value of every factor was explained not according to the effort expended but, rather, according to its value in producing consumer goods.

Unfortunately, however, this basic understanding of the “Austrian” approach towards prices ignores the much richer theoretical tapestry inherent in the “Austrian” approach (especially that of Böhm-Bawerk) which, in fact, does not contradict many of the tenets of price theory in classical economics but, rather, armed with the law of marginal utility, provides a more powerful explanatory basis for them. Thus, one need not throw out the classical economics baby with the Marxist bath water and risk losing many of the important and true conclusions that were abused and distorted by Marx.

An immediate problem with the basic “Austrian” view is that the sequence of valuations from consumer good through the stages of production to the ultimate land and labour factors is the reverse of the temporal sequence of events. A product has to have been produced through all of its stages of production before a consumer can bid a price for it. Thus, the prices of the factors of production pre-date those of the consumer goods upon which the former are supposedly based. It is difficult to understand, therefore, how something can be derived from something else that does not yet exist. The more accurate view is, of course, that the prices of the factors of production are based upon the estimated selling prices of the future consumer goods. In a static equilibrium such as the evenly rotating economy the prices of the final goods are known in advance and hence the pricing of the factors of production will accurately reflect the value of the final consumer goods. But as helpful as this model may be in conceptualising the structure of production, it is woefully easy to draw from it the conclusion, so beloved of mainstream economists, that a boost in the value of consumption must necessarily result in a subsequent boost of the value of the factors of production. In other words that consumption feeds production. This, of course, is patently untrue. As John Stuart Mill said, “demand for commodities is not demand for labour”. Rather, to produce a commodity for purchase, labour (and all of the factors of production) must already have been demanded by capitalist-entrepreneurs. In other words, it is production that feeds consumption not vice-versa.

Second, if the prices of the factors of production of a good are based upon the valuations of consumers this does not explain the individual pricing of the factors. If, for example, a consumer will buy a loaf of bread for £1.00, why does the flour that went into it cost, say, 40p, the labour 50p and the hire of the oven to bake it 10p? Why doesn’t flour cost 50p, labour 30p and the oven 20p? Or any other possible combination of prices? One possible answer to this problem is that each factor earns its marginal revenue product – that is, the portion of the value of the increased product that it is attributable to an incremental increase of that particular factor. So for example, if I have a patch of land and a given number of seeds and apply increasing units of fertiliser then each additional unit of fertiliser will be priced according to the additional revenue earned by the additional physical product that results. The problem with this view is that it ignores the fact that no additional product is the result of a single factor alone and that the value of the additional product need not be imputed solely to the additional fertiliser. What if, for example, the purchase price of the land and the seeds already accounted for the fact that additional fertiliser could be applied to it to produce a larger physical product? Moreover, even if, say, the land and seeds were purchased at a price that reflected the fact that only a limited quantity of fertiliser was available and thus only a reduced physical product could be yielded from them, any unexpected increase in the available quantity of fertiliser and thus increased physical product and increased revenue would also cause an increase in the capitalised value of the land and the price of seeds. In other words, there is no reason to assume that the marginal revenue product should be imputed to only a single factor. We are therefore no closer to solving our problem – what is it that causes the particular array of prices between the factors? As we shall see, each factor does, in fact, earn its marginal revenue product, but not in a partial equilibrium where we examine only a particular end or use for a factor. Rather we have to consider the entire assortment of uses to which a good can be directed.

A further problem with the basic “Austrian” approach is revealed when we consider large consumer goods such as cars and computers. It is patently obvious that the value of a car is zero unless it has a steering wheel. Indeed, the demand for steering wheels is likely to be extremely inelastic, stretching all the way up to the height of the value of the entire car. However, in reality, the full value of the car does not result in the imputation of that full value to the steering wheel but rather to all of the other factors as well. Similarly, a computer is useless without the monitor; a television without a plug; glasses without lenses. In fact, it is clear that the utility of thousands of goods is dependent upon the unity of all of their individual components and if any one of them is missing the utility of a particular good drops to zero. Yet in many cases we never have to pay more than a few pounds for the “essential ingredient” to be produced.

How then do we arrive at the prices of all of the individual factors? The answer to this question lies in a deeper understanding of the law of marginal utility. As we know, this law states that the value of a unit of a good is equal to the value attached to the least valuable use to which that unit can be directed. So if, for example, I have five bottles of water, I might use the first for my most important end which is drinking, the second for the next most important end which is washing, the third for cleaning laundry, the fourth for watering plants, and the fifth to make into ice cubes. As each bottle is interchangeable, if one bottle was to be lost it would be the least valuable use – making ice cubes – that would be foregone. Thus, the value of any one unit will equate to the value of the least valuable end of making ice cubes, in spite of the fact that some of those units will be directed to ends with far greater value.

What we can see, however, is that if the value of any one unit of a good equates to the value of the least valuable use to which that unit can be directed then this value must also be imputed to the factors of production. If a portion of those factors was to be lost, the resulting reduced supply of goods would result in the loss of the least valuable ends. Thus, each unit of the factors of production that created the five bottles of water must themselves be valued at the lowest valuable use of a good that those factors will produce.

However, this law will also apply when the factors of production are not specific and can be used to produce any range of goods that satisfy a number of different ends. Let’s say, for example, that a given quantity of factors of production can be used to produce the following consumer goods in descending order of value:

  1. A bottle of water;
  2. A loaf of bread;
  3. A bar of soap;
  4. A pair of socks;
  5. A box of tissues.

If the same factors of production can be used to produce my most valuable good, a bottle of water, as my least valuable good, a box of tissues, then it follows that the factors of production will be valued according to the value attached to the box of tissues. The loss of any portion of those factors of production will result in the cessation of the production of tissues while all of my other goods are still produced. Here, then, is the key to understanding the different prices of the factors of production. The value of a factor is based not upon the utility attached to the specific good to which that factor is directed but, rather, upon the least valuable good to which a portion of its supply is directed. Only highly specific factors of production which can be devoted only to a single end will derive their value fully from that specific end.

In real life, of course, it is never the case that whole combinations of factors of production can be exchanged between different ends. Rather factors have to take their place in different combinations of specific and non-specific factors. It is these various arrays that produce, at any one time, the individual prices of the factors of production. Thus the breakdown of prices of factors used to produce a particular good is derived from the lowest valued uses to which portions of the supply of those individual factors are directed.

We are now, therefore, in a position to see what we mean when we say that a factor of production earns its marginal revenue product. If we gain an additional unit of a particular factor, that unit will be directed towards the next most valuable end that is currently unfulfilled in the economy as a whole. All of the most valuable uses for the factor will already be fulfilled. Yet all units of this particular factor will now be priced according to the value of the marginal unit which will be derived from the least valuable end.

However, the pricing of the factors of production according to their marginal uses is not the only effect of the application of the law of marginal utility. It also affects the value of the supra-marginal products whose direct marginal utility is above that of the marginal product. These products too will be priced according to the combination of prices involved in their factors of production as the loss of any given portion of a factor will not result in the loss of this product but in the loss of the marginal product. Thus, the prices of most goods in the economy are priced according to the least valuable goods that are produced out by the marginal units of their shared factors of production. As George Reisman explains:

Allow me to illustrate Böhm-Bawerk’s point here by means of a modification of his famous example of the pioneer farmer with five sacks of grain. As will be recalled, the five sacks serve wants in descending order of importance. One sack is necessary for the farmer to get through the winter without dying of starvation. The second enables him to survive in good health. The third enables him to eat to the point of feeling contented. The fourth enables him to make a supply of brandy. The fifth enables him to feed pet parrots.

[…]

Now let us slightly modify the example. Let us imagine that the first sack of grain has been used to make a supply of flour, which in turn has been used to make a supply of biscuits, and that it is this resulting supply of biscuits by means of which the first sack of grain performs its service of preserving the farmer’s life […] We can imagine a little tag attached, this time saying, “Biscuits Required for Survival.” As before, our farmer still has four remaining sacks of grain, any of which can be used to make a fresh supply of flour and then a fresh supply of biscuits. And now, just as before, we may imagine rats or other vermin destroying the supply of biscuits. Will the answer to the question concerning the magnitude of the farmer’s loss be materially different? Certainly, his life does not depend on the supply of biscuits any more than it did on the sack of grain. For he can replace that supply of biscuits at the expense of the marginal employment of the remaining sacks of grain, which, of course, is the feeding of the pet parrots. To be sure, additional labor will have to be applied as well, but the magnitude of value lost here is that of the marginal product of that labor, which might be  something such as the construction of a sun shade or an additional sun shade or even the feeding of the parrots. The point is that the value of the biscuits will not be determined by the importance of the wants directly served by the biscuits but by the importance of the marginal wants served by the means of production used to produce biscuits and from which a replacement supply of biscuits can be produced at will.1

Thus, we can conclude, that for the majority of products that are available for sale today, their selling prices are based not upon their direct marginal utilities but, rather, upon their costs of production which is derived from the marginal utilities of the least valuable products to which factors of production are directed. There are several noteworthy effects of this analysis.

The first is that this does not nullify the operation of supply and demand in determining the price of any supra-marginal good. Rather, it results in a shifting of the supply curve to the right so that it intersects the demand curve at a level where price equals the cost of production, plus the going rate of profit. Changes in the availability of the factors of production which either increase or decrease their marginal utility will cause similar shifts of the supply curve to the left or right which will have the corresponding effect of raising or lowering the price of the specific consumer good. This is possible without any change in the quantity that is bought and sold if, for example, the shift of the supply curve takes place on a highly inelastic stretch of the demand curve. The same quantity will be bought and sold simply at a higher or lower price.

The second observation, derived from the first, is that this obliterates the standard economic analysis behind monopoly pricing. The basis of this analysis is that suppliers can exploit inelastic demand curves to reduce supply, raise their prices and thus rein in an artificially expanded profit at the expense of the consumer. However, our theory here reveals that the opportunities for doing this are minimal. For the raising of prices and consequent swollen profit margins will cause competitors to shift factors of production away from the production of marginal goods towards an increase in production of the goods whose prices have been raised, thus restoring an increase in supply and the reduction of prices back to near their costs of production. Thus, for any businessman, the primary tool for estimating his selling price is not elasticity of demand of the particular good that he is selling; rather, it is the cost of production of any potential competitor. It is for this reason why very basic goods such as bread, milk, eggs, salt etc. which have an inelastic demand curve are priced very low; and it is for this reason why sole suppliers in particular industries will earn only the going rate of profit; any attempt to raise prices will simply attract competition.

The third important observation is the impact of this analysis on wages. For labour too is, of course, a factor of production and thus will only draw income in line with the marginal use to which it can be devoted. What results, therefore, is that labour is paid a rate of wages that is far below the direct marginal utilities of the goods that the very vast majority of labourers will be producing. Yet it is also clear that, because the value of marginal products is imputed, via their factors of production, to the supra-marginal products, it is clear that the resulting lower prices means that labour can buy all of this produce. Thus increases in the supply of labour, resulting in the direction of the latter to further marginal uses and thus a lowering of the nominal wage rate, will have no bearing upon the ability of labourers, in their capacity as consumers, to buy its produce and, indeed, will serve to increase the real wage rate. Thus the argument that increases in the supply of labour through, say, immigration are largely unfounded.

What we can see therefore is that the “Austrian” understanding of the prices of goods and their costs of production, although complex, provides a strong bulwark against false theories in many important areas such as stimulus spending, wages, and competition law. Every individual who wishes to offer powerful affronts to the falsehoods that abound in these areas should study it avidly.

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1George Reisman, Eugen von Böhm-Bawerk’s “Value, Cost and Marginal Utility”: Notes on the Translation, QJAE, Vol. 5, No.3: 25-35.

Economic Myths #15 – Unemployment

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One of the key indicators of the economic “performance” of any given country is its rate of unemployment. Low rates of unemployment are understood as a sign of prosperity while high rates are taken as a sign of recession and stagnation. Indeed, during the Great Depression, unemployment reached as high as 25% in the United States. Politicians are particularly keen to monitor the rate of unemployment as low unemployment lends credence to the economic policies of those in power while high unemployment stocks the arsenal of those in the opposition. Given also that entire economic dogmas such as the so-called trade-off between full employment and inflation, not to mention the generation-long post-war Keynesian consensus are, at least, part rooted in the concept of unemployment, one would expect unemployment to be a unique and important category in economic theory.

This short essay will not explore in detail the government induced causes or aggravations of unemployment such as the minimum wage and excessive regulations heaped upon the shoulders of employers. Such topics have been examined countless times over by many economists, “Austrian” or otherwise. Rather, what we wish to concentrate on here is the validity of the very term “unemployment” itself and to determine whether it is really a useful concept in shaping so-called “economic policy” or whether it is really redundant and meaningless.

In the first place, as “Austrians” we must be highly suspicious of any concept that is an aggregation and is not explicitly linked to any notion of individual human action. All voluntary actions are, as we know, the result of the best choice of ends available with scarce means. A man who has several million pounds stashed in his bank account may be content to spend all of his time in leisure and would be “unemployed”. Yet aside from any moral wrangling over the worth of such a lifestyle we would hardly view this as a problem. But what about those lesser privileged folk – the ones who are not working but nevertheless have the outward appearance of needing an income from some kind of employment? Shouldn’t we classify these people as “unemployed” and doesn’t this state of unemployment indicate an egregious case of market failure?

The question turns on whether employment at the terms of the available opportunities is worthwhile for the individual person. If there are jobs available yet he refuses to accept them then it indicates that he is not satisfied with the terms of those opportunities. Perhaps it is the wrong industry, it is in wrong the place, or – most likely – the wage offered isn’t high enough for him. He therefore chooses to abstain and holds out for a better opportunity to appear in the future. From the point of view of individual satisfaction with the scarce means available, the outcome of seeming “unemployment” is therefore optimal. Indeed, labour, like anything else, is a resource that is available for an individual to use. Not all resources are deployed 100% of the time as it would be wasteful to do so. Everyone, for example, owns possessions that are not being used at the current moment – food in the fridge, clothes in the wardrobe, books and DVDs on the shelf, etc. Clearly it would be wasteful – nay, ridiculous – to try and use all of these “unemployed” resources at once. They are more valuable being kept in abeyance ready for utilisation when an opportune moment appears, i.e. when the person believes that use of them would yield more benefit than leaving them idle. More widely, there are always buildings to let, oil in the ground, trees that are left standing, water in lakes and reservoirs, and so on. All of these resources remain idle because an opportunity valuable enough for deploying them has not yet arisen. Indeed, consistent requirement for all resources to be utilised would mean that shops should be empty of all goods as they have already been purchased and consumed, and ultimately everything in the world should be consumed right now. To put it at its most basic, a person actively searching for the right job is not, in his mind, unemployed in the sense of carrying out a wasteful activity.

The inability to see labour as a resource that is deployed at the choosing of the individual labourer leads to many related fallacies and reveals the dangers of looking only at surface phenomena and appearance. An individual does not view employment as an end itself – work for work’s sake. Rather, all employment is action aimed at diverting scarce means available to their most highly valued ends. Employment per se is not a goal or achievement. No one would dig a hole in the ground and fill it up again unless the act of doing so led to a valuable end. Governments and people succumb to the illusion of economic activity brought about by “employment” and the apparent lack of it by “unemployment”, with any focus on providing “full employment” never stopping to ask whether the activity in which employment will be created is worthwhile or is wasteful. The most grievous example of this this is, of course, the forced lowering of interest rates to provoke an artificial investment boom. There will be lots of employment, everyone will be engaged in lots of activity and wages will be rising rapidly. But it is clear that everyone’s endeavours are ultimately wasteful and lie on a doomed path. So-called full employment policies are therefore nothing more than a surface coating to prevent social unrest, to make people feel as though they are doing something worthwhile and to put money into their hands that they can spend. To the extent that these actions create no new wealth, however, they should properly be regarded as welfare and not as employment. The wheels may be turning but the carriage goes nowhere and it is simply expending fuel on motionless activity. Far more difficult would be for governments to concentrate on policies that promote full production instead of full employment as this would, of course, require a dramatic reduction in the size and scope of government power and interference.

We submit, therefore, that unemployment is a meaningless concept at least when applied to the unfettered free market. It may have some relevance in economies where governments impede the ability of the supply of labour to meet demand through minimum wages and the like. Apart from shutting out a good number of low-productive persons from the labour market entirely, such interferences ultimately distort people’s views as to which terms of employment are achievable – they hold out for high wages because there is the illusion that that is what their labour is worth. They do not realise, however, that supply is unwilling to meet demand at that inflated level and hence their search for employment is in vain. All of this, however, is simply a particular application of price theory. If the price of any good is fixed too high it will remain unemployed. There is, therefore, no special concept of unemployment applying only to labour that attracts a different body of theory. Furthermore, the whole question of “nominal rigidity” or so-called “sticky wages” is beside the point when it comes to economic theory. If the demand for a particular good – in this case, labour – should drop it is entirely open for the particular labourers to express incredulity at this fact and to stubbornly hold out for wages that will never meet a willing demand. This is not, however, evidence of the market’s “failure to clear”. It is simply that the supply curve remains stuck to the left. There is an misconception that the market is “efficient” because it “values” everything correctly – a doctrine that underpins so-called “efficient market hypothesis”. But the “efficiency” of the market – the  nexus of voluntary exchanges between individual people – comes from its superior ability to channel goods to where they are most highly valued; it has nothing to do with whether a good should be valued or whether any particular valuation is correct. A good could be utterly useless but if a significant enough people chase a small supply it will command a relatively high price. The market will place this ware in the hands of those who value it the most, but the source of that value is the human mind and this valuation can be and often is erroneous. If people remain unemployed, holding out for unrealistically high wages, the fault lies in their incorrect assessment of the value of their labour, not in any market’s failure. Needless to say, however, the causes of these erroneous valuations are government interferences. It is because government creates such macroeconomic calamity that price bubbles and collapses occur and so-called “sticky prices” are a phenomenon associated with post-boom deflations. Having become accustomed to high wages, it is natural for workers to become frustrated and resistant when supply for these wages suddenly dries up and they not only have to face the prospect of lower wages but also a mass shift out of the capital goods industries – where they may have developed significant, specialist skills in the meantime – to consumer goods industries. In a genuine free market it is highly unlikely that workers would be faced with these problems. However, none of this really has much to do with economic theory, the purpose of which is to expound the formal characteristics of human action rather than the substance of those actions. Rather, sticky wages is more a topic for psychology, the field of human action that studies why people make the valuations that they do.

We conclude, therefore, by emphasising that there is no special category of “unemployment” as it applies solely to labour. Any “unemployment” of labour is explained either as the willing choice of the individual worker to withhold his labour from the market (and thus, to him, the best possible outcome), or as the result of government price fixing which is merely a particular instance of the economic effects of that wider category of interference.

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Executive Pay

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Within the firing line of public vitriol, particularly since the 2008 financial crisis, is the issue of executive remuneration, the rewards and incentives paid to executives and directors of large corporations in return for their productivity. Specifically, of course, we mean remuneration that is deemed to be excessively high in relation to the resulting output that these rewarded executives create. Needless to say the level of remuneration in the financial services sector – the proximate cause of the seemingly endless depression we are enduring currently – has been singled out for its apparent injustice. Why should executives, motivated by their greed and lust for riches, get to walk off with pots of gold when they are responsible for so much entrepreneurial failure while the rest of us are left to suffer job losses, redundancies and unemployment? Indeed there is even the accusation that executive remuneration is the primary cause of the financial crisis, fuelling the fire of so-called “irrational exuberance”.

There are many typical free-market responses to this sort of criticism – that high levels of remuneration are simply a function of supply and demand; that talented bosses would just go elsewhere if a firm did not offer competitive remuneration, and so on. Indeed, many of the same responses are made to criticisms of egregiously low pay in developing countries and the call is always to leave things alone and let “the market” determine the figures. While this is all true, it is only so in a genuine free market and not in the heavily managed and distorted economy with which we are cursed today. It is only by analysing and understanding the influences on wage rates in the economy as it actually exists that we can propose any solution, should one be needed. To simply dismiss the problem leaves it vulnerable to alternative (and false) explanations that lead to the danger of equally false solutions. Indeed, one of these current incorrect analyses is that there is a natural (rather than a deliberately engineered) tendency for the rich to get richer while the poor get poorer, with all economic development fundamentally being a struggle of rich against poor. As libertarians and “Austrian” economists we must examine the root causes of social phenomena and not assume that everything is alright simply because the proximate social relations appear to be voluntary. Let us, therefore, proceed with this task.

Theoretically, executive remuneration is no different from the remuneration of every other type of employee – all workers, from bosses to bin men, earn their marginal revenue product. Bonus payments, an aspect of executive remuneration that seems to particularly grate in the public mind, can even save a firm money in a given year. A firm might agree to pay an executive a £1m bonus if and only if he achieves £1m or more worth of productivity; if he delivers £0-£999K worth then he gets nothing; if he delivers £2m worth then the firm is paying only £1m for double that amount in net income. In both cases the firm receives a level of productivity without having to make a corresponding pay out. However, this idyllic description is not the situation in the economy where the government distorts price signals, causing the delivery of false income during the boom years only to have it all come crashing down at the bust. The basic problem with executive pay lies in understanding the influence of government credit expansion on the economy, and particularly on the financial services sector.

The starting point of the business cycle, as understood by “Austrians”, is the expansion of credit and the lowering of the rate of interest. Not only does this falsely incentivise all firms to enter longer term investment projects but, crucially, this new money enters through the financial system. It is, therefore, the firms most closely connected to the source of new money – large banking and investment operations – that will experience the largest distortionary gains first. Hence, remuneration in these firms will rise fastest and strongest, in line with the false profits made from all of the doomed loans and investments that they happily make in blissful ignorance. Everything at this point looks fine, executive remuneration for apparently successful operations going without mainstream criticism. Yet, once the taps are turned off and the flow of new money dries up, the bust sets in and it is exactly those same firms that benefitted the most in the boom – those closest to the source of new money and ploughed it into unsustainable assets – that have the most to lose. Indeed it is no exaggeration to say that the entire financial system would have collapsed in 2008 had central banks not intervened to prop up asset prices and hence keep financial firms nominally solvent. Executive pay, therefore, is not a cause but merely a symptom of a deeper, underlying problem that is caused by governments and central banks. Anticipation of higher profits does not appear because executives are paid more; rather, it is the false anticipation of future profits caused by the distortions of credit expansion that leads to rising executive pay.

This is not the end of the matter however. For the very same problem – credit expansion – produces an endemic and seemingly endless price inflation, price inflation we are told is the natural consequence of growing economies. Indeed central banks even maintain price inflation targets (the Bank of England’s being 2%) as a result of the false (or perhaps dishonest) impression that price inflation is required for economic growth. The result of this is that anyone who holds cash for an extended period of time can watch the real value of their wealth diminish. This has several important impacts upon the financial services sector. First, companies opt to switch from equity financing to debt financing as it is cheaper, in real terms, to fuel growth through servicing a loan rather than from revenue reserves. Secondly, the need to hold appreciating assets rather than depreciating cash has meant that the average saver – i.e. someone who wishes to put money away for retirement – now has to invest in stocks or bonds rather than simply save cash. Indeed it was once possible to fund one’s retirement simply by hoarding gold coins, the coins appreciating in real value through a gradual price deflation caused by increased productivity. Now, however, everyone has to entrust their hard earned savings to money managers and speculators who, having taken a fat percentage cut, will probably be barely able to keep up with price inflation anyway. Both of these aspects cause a vast swelling of the demand for financial services and, consequently, an increase in executive pay in that sector.

The latter aspect, however – that of investing in order to fund one’s retirement – also has another important consequence. Executives serve their shareholders and are employed to meet the needs of those shareholders by “executing” the purpose for which the shareholders formed the enterprise. They are the delegates, the servants of the shareholders and their scope of activity and their remuneration for the same is bound by that which the shareholders desire. Taking a part ownership of an enterprise as a shareholder, therefore, is an important and active responsibility, one that requires the focus of one’s attention and is not a mere hobby or pastime. It was once the case that most companies and corporations were privately owned by a handful of active investors rather than publically traded on stock exchanges like they are today. Yet, because of the necessity to invest one’s money to keep a pace with inflation, we are now in the position where the majority of beneficial owners of businesses are passive investors, merely entrusting their money to a fund manager who will spread it across a vast array of businesses – probably following an index of shares such as the Dow or S&P 500. The result of this is that there is no one keeping an active eye on executives, or at the very least the capacity for doing so is greatly diminshed. Indeed, the most popular base index for tracker funds in the UK – the FTSE All-Share Index – is comprised of around one thousandcompanies. No single beneficial owner of the companies in that fund can hope to maintain a keen interest in even a significant minority of those organisations. With executives left alone to run the shop entirely, their ends begin to take precedence over the ends of shareholders. The primary preoccupation of the latter is to grow, sustainably, the capital value of the business, investing assets in productive services that meet the needs of consumers. Executives, however, are mere “caretakers” of those assets who can derive a gain from the enterprise only so long as they are in charge. Not only, therefore, will they have the incentive to increase present income as fast as possible at the expense of long term capital growth, but they will attempt to milk the business as much as possible for all they can get during their tenure – the primary method of doing this being through their remuneration packages. This incentive is always present in any business of course, but the lack of shareholder oversight presents an enhanced opportunity for it to be fulfilled. Indeed, most boards – who, nominally regulate the activities of the executive on behalf of the shareholders – are usually made up of other executives in the same or related industries and will, therefore, largely defer to and be empathetic towards the management rather than the shareholders. This is not to imply that executives are only looting businesses for all they can get. There are, of course, many brilliant and competent managers who richly deserve their rewards for growing, sustainably, complex and important operations that serve the needs of consumers. However where all other outcomes are equal and it comes to a basic choice between maximising long term growth on the one hand and increasing present income on the other we can see quite clearly that executives will plump for the latter. Some attempt has been made to rectify the situation by paying bonuses in shares or options and creating longer-term incentive plans – in other words, turning bosses into part-owners – but it does not remove the fundamental problem which is the lack of keen oversight from the beneficial owners.

What we have learned therefore is that excessive executive remuneration, especially in the swollen financial services sector, is not a cause of financial collapse but merely another unhappy consequence of underlying problems – that of government and central bank interference in the economy through meddling with the rate of interest and expanding the volume of credit. If we want to return to executive pay that accurately reflects the creation of long term growth in sustainable businesses then we need to do away entirely with government interference and establish a genuine free market economy.

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Labourers, Capitalists and Entrepreneurs

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Libertarians are well aware of the Marxist myth that labourers or employees are “exploited” by the capitalists, the entrepreneurs, the employers and the bosses, the former producing all of the valuable output in society and only permitted to consume enough to keep them at bare subsistence while the latter cream off the fat and live a life of carefree opulence.

The details of the economic fallacies of this position we will not explore here. Rather, the issue we wish to concentrate on is the common misperception that is “easy” to be a capitalist-entrepreneur (whom, hereafter, we will refer to as a “businessman”) and back-breakingly “difficult” to be a labourer. Such an impression is hard to dispel when, after all, the majority of the population are labourers, only a slim minority are businessmen and the relationship between the two is nearly always at arm’s length. Don’t the businessmen have the luxury of dictating to us the terms of our employment, our wages, what time we have to be there in the morning, what time we can leave, when we can have lunch, how often we can go to the toilet? And don’t they then decide when they’ll let us in to the shops to buy the stuff we need, setting the prices we must pay to ensure themselves enough profit, and us having to choose from whatever they have decided we can buy? Aren’t we just lucky to have whatever scraps that they throw down to us from their table? Although there will always be a natural antagonism between boss and employee the latter should think twice before becoming too envious of those who offer him work by failing to realise the pitfalls of becoming a businessman and ignoring the advantages of remaining as a labourer. Let us explore some of these in detail.

First of all, as a labourer you have the advantage of receiving your income first and incurring your costs later. The businessman pays you immediately once your work is complete and then you have a definite amount of money in your hand right now that you know you can spend on whatever you like. Furthermore, you do not have to wait until the product that you are working on for the businessman is completed before receiving this income, which might be weeks, months or even years before it reaches the hands of the consumer. No, you get your money now, cash in hand, with no waiting. And once you go to the shops you know the prices that you will pay so you can estimate easily how much you can spend and how much you can save in order live sustainably. In short, living as a labourer has a high degree of certainty. Labourers do, of course, partly share in entrepreneurial burdens. Not only do they have to know which skills are the best to offer prospective employers but they also bear the risk of redundancy in the event that the employer is forced to cease trading, or if the entire industry in which they work should become obsolete. But his entrepreneurial risk is greatly diminished compared to that of the businessman. Moreover, as a labourer, there is normally a strict starting point to your day and a strict ending point. Yes, you have to turn up and work for those eight or so hours in the day between those times but the time outside of that is yours and work, except for the very highest salaried employees, does not have to interfere with your leisure time.

Let us contrast this with the position of the businessman. He does not have the benefit of receiving his income first and incurring his costs later. Rather, he must first of all save and then burden himself with costs (including your wages) on an operation without knowing precisely how much this operation will yield in income. Indeed, the whole operation might bring him a net loss. He doesn’t know precisely what the outcome will be and he is, indeed, taking an enormous risk by entering this venture. It is simply anticipation on his part. Yet you, even if you participate in his operation, have been insulated from this by being paid up front. The businessman doesn’t come back to you after the end of a loss-making year and demand some of your wages back. You get to keep everything whereas he may lose a significant portion of his wealth. Equally and oppositely, therefore nor should he be expected to give you some of his surplus at the end of a profitable year. Furthermore, while businessmen as a whole “set prices”, any one of them does not do so as he pleases. Rather, he has to compete with what other businessmen are willing to pay for their inputs on the one hand and sell their outputs for on the other. The prices he pays for goods, raw materials and your wages to produce the goods he will sell are set not by him but by the bids of all the other businessmen who wish to uses these resources in their competing operations. Our businessman must be prepared to pay at least as much as they are if he is to secure the inputs necessary to run his business. Indeed one of the great Marxist myths – that the capitalists drive down wages to the lowest possible – is made plainly untrue by this fact. It is the competition between businessmen that drives up the wages of labour as it increases the demand for it. What is likely to reduce wages, on the other hand, is the existence of other workers as each new labourer adds an additional supply of labour, especially in particular industries where certain skills are necessary for which there is a finite demand. Indeed one of the reasons why unionised labour has always supported the minimum wage is to make the lowest skilled workers unemployable and reduce the competition for their more highly skilled members, thus raising the wages of the latter at the expense of the former. So much, one might say, for the collective interests of each class. When it comes to the prices of the product to be sold, the businessman must similarly compete with all of the products offered by his competitors for the contents of the consumers’ wallets and purses. His prices will therefore be determined by all of the other asking prices of his competitors and he must be prepared to offer a low enough price to draw consumers away from these other businesses1. Once a product is produced it is normally in a businessman’s best interests to sell it as quickly as possible. He does not have the luxury of “un-producing” it, winding back the clock and choosing to do something else. Rather, he is stuck with it and the longer he holds onto it the more likely it is that perishable items will simply be wasted and more durable items will incur further costs of storage. The only option, barring the possibility of personal use (which is obviously impossible for any large scale business) will be to sell it. Very often, therefore, the supply curve for a businessman will be vertical, meaning that he is prepared to take whatever the consumers will pay for his wares. If this is not enough to cover his costs then he will go out of business. He only earns a profit if the consumers are prepared to pay more than the product cost to produce. Occasionally a business may hold onto goods in the anticipation that their prices will rise at a later date, but this is normally the function of speculators in commodities and raw materials which have a diverse range of potential uses and not the function of manufacturers and vendors of highly specific, consumer goods. While businesses as a whole set prices, therefore, any one business is highly restricted in the prices it pays for its inputs and the prices it receives for its outputs and it takes tremendous skill and foresight to ensure that the latter is higher than the former.

Furthermore, the profits that a businessman will earn if he is successful in this regard are in no way “deductions” from wages. Rather, properly considered, wages are deductions from profits. When an businessman brings his produced product to market on a certain day, it will sell for whatever people are prepared to pay for it that day and the businessman will consequently earn certain revenue. If, for the sake of argument, he had been able to bring that product to market without incurring a single cost then his profit would be his entire revenue. In the real world, however, he must incur costs and every single cost, including wages, that has brought him to the position of being able to sell that product is a deduction from that revenue and only the remainder is the resulting profit. If the deductions are too high then he makes a loss. Indeed, this is precisely how a company’s income statement is laid out – revenue at the top followed by costs deducted leading to the final figure which is the profit; hence the expression “the bottom line”. If another businessman brought the same type and quantity of products to market on the same day he would earn exactly the same revenue as our first businessman, but if this second businessman had done so while incurring fewer costs then his deductions would be lower and his profit would be higher. Every time a businessman considers hiring one more employee he has to estimate whether the additional revenue gained from doing so will be higher than the deduction from that revenue he must pay out in wages. In short, your help in his enterprise allows you to pinch from his pie upfront, and only at the very end, after you have vanished, does he know how big the pie is. If he is unsuccessful you, the labourer, might well have left nothing for him.

Another myth we need to tackle is that capitalist-entrepreneurs automatically become rich. For every successful entrepreneur there are a dozen or more failures because the ability to judge, in advance, which products and services consumers will want to and how much they are willing to pay is a rare skill; hence it is very highly rewarded when it is successful. In a genuine free market there would never be a “class” of capitalists or of entrepreneurs. Rather, everyone would be free to risk his money in a new business if he believed that he had identified a marketable good or service. What gives us the illusion of a capitalist class today is the government protection accorded to large, established businesses and their owners and managers. Indeed the cash-bloated financial sector has only swollen to its titanic size because of the largess that government lavishes on this industry, whereas in a genuine free market financial services would earn the ordinary rate of profit. Furthermore, government makes it extremely difficult to start a new business, crushing it with the cost of crippling regulatory requirements before the budding entrepreneurs can give thought to more relevant things such as their product, their customers and their genuine costs. All this serves to make the businessmen an impenetrable caste of permanent membership, hence increasing the resentment of their position. Furthermore, it is possible to mistake the volume of money sloshing around in a business for the wealth that business possesses. It might be awe-inspiring to see a company’s bank statement raking in millions of pounds a month whereas you, as a little labourer, might only earn a thousand pounds in the same period. But deep pockets are usually raided by fatter hands; just as the income is much greater than yours, so too are the outgoings. It matters not a whit if a company is seeing income of £1 million per month. What matters is the differential between the revenue and the costs. If, in order to earn £1 million pounds the business had to pay out £1.1 million pounds then it would be left with a net loss of £100K. Just because lots of money is coming in to the bank does not mean that a company has endless amounts of cash to play around with and this is compounded by the fact we mentioned earlier of businesses having to incur their costs before their revenue is received. At least as a labourer if you decide to spend a bit more on some luxury in a certain month you still have the ability to calculate precisely what you will have at the end of that month. Businesses do not have this ability and particularly where profit margins are slim only a very slight tipping of the balance into the red can cause money to evaporate very rapidly.

Related to this aspect of the volume of cash in a business is the so-called “inequality of bargaining power” – that businesses, being so big and wealthy are more “powerful” than the tiny labourer who has to come, cup in hand, for whatever he can get. There is, however, no such thing as “bargaining power”. Each party enters a contractual agreement because they each desire something that the other possesses. The value of one party gaining what is yours is in his mind and is not inherent in you. If you are able to negotiate terms that are very favourable to you it simply means that he values what you have more than you value what he has. You have no control over this aspect and all it would take is for someone else to come along and offer something that is better than what you have. Secondly, and, ironically, it is not the growing and profitable businesses – the ones who have “bargaining power” – that tend to be restrictive on how much they are willing to pay in costs. The enthusiasm of a new entrepreneurial venture coupled with the either the anticipation or the reality of large profits results in a lower degree of scrupulousness in controlling costs and the very opposite of a Scrooge-like approach to hiring workers. Indeed it has been estimated that entrepreneurs as a whole pay too much in advances for their inputs and make an overall loss, with even the big winners failing to cancel out the losses of the big winners2. The point at which businesses become tight-fisted is when there is strong competition in a saturated market, driving down profit margins resulting in the need to cut costs in order to stay ahead. In other words it is when profits are low – i.e. when a business’s bargaining power is restricted – that causes a business to demand less favourable terms for its employees. There is also the alternative possibility that a business can grow so large that it soaks up the entire supply of an input and hence is said to be insulated from competitive pressure in setting the prices it pays. This is the frequent allegation that is made against large supermarket chains such as Tesco in their dealings with small suppliers. Of this we can say three things. First, in a genuinely free market, if a business has grown that large then it has done so because it has met the needs of consumers better than anyone else. Secondly, such a behemoth contains the seeds of its own destruction as size and domination leads to complacency and stifling innovation, giving opportunity for more nimble and enthusiastic start-ups to enter the fray and draw away suppliers with more favourable terms. Indeed the evolution of the technology sector may, perhaps, illustrate this. Microsoft dominated the PC age; Google the internet age; and Facebook the social networking era. No one firm was able to retain its dominating influence as consumer focus shifted from one thing to the next. Indeed already we are perhaps seeing a waning of social networking with Facebook’s acquisition of WhatsApp specifically for the purpose of attracting a younger audience for whom instant communication through smartphone technology has proven to be more important than creating a profile on a website. Who will dominate this latter era, if it proves to be one, remains to be seen. Thirdly the large corporate monopoly as we have come to know it is most often sustained by government and not by its consumers. Regulatory privilege, artificial barriers of entry and direct government contracts insulate these firms from actual and potential competition, meaning that their “bargaining power” is bestowed by nothing more than government force and fiat. Clearly this would not be the case in a genuinely free market.

What we have seen therefore is that being a businessman is far from easy. Yes there may be the reward of large profits but the path to success, in a free market at least, is fraught with uncertainty and difficulty. Life as a labourer may be relatively low paid, dull, repetitive but at least it is relatively secure and certain. We should end by reinforcing the fact that throughout this essay we have been talking about businessmen who earn their profits through serving the needs of consumers – those who have successfully determined the needs of their customers and directed the scarce resources available accordingly. We have not been referring to the government-protected or what we might call the “political” entrepreneur who has won his riches through lobbying and government protection. These latter creatures should be reviled for what they are and by pressing ahead for the establishment of a genuine free market we can enjoy watching their ill-gotten fortunes evaporate into the hands of those businessmen who truly know how to serve our needs.

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1Contrary to another popular myth competition is not restricted to particular industries. If you are sell apples then it is in your interests to draw people away from spending their money on, say, cinema trips just as it is on other apple vendors. All businesses are competing for the finite contents of consumers’ bank balances.

2Virginia Postrel, Economic Scene; a Vital Economy is one that Suffers Lucky Fools Gladly, New York Times, September 6th 2001: “If the few big wins cancel out the many losses, starting a business would be a risky, but rational, bet — the sort of investment a “cautious businessman” might make. But Professor [John V C] Nye [economic historian] argued that the wins and the losses probably don’t cancel out. Even the biggest winners don’t make enough money personally to cover the losses of all the individuals who went into businesses that failed. The big winners are usually people who, based on rational calculations, shouldn’t have bet their time, money and ideas. They overestimated their chances of striking it rich. But they were lucky and beat the odds. Even more important, the lucky fools create huge spillover benefits for society: new sources of wealth, new jobs, new industries offering less-risky opportunities, new technologies that improve life. Entrepreneurship does generate net gains, but most of those gains don’t go to the risk-takers. The gains are spread out to the rest of us. Capitalism, in this view, works by exploiting the capitalists themselves.”