CHAPTER 8 Modern Mengerian Capital Theory Introduction

Our considerations in Part II suggest the following conclusions from which we shall proceed in this part.

1. Capital theory historically involved misleading physical analogies. Examples are:

(a) Biological analogies: reproductive processes in which “growth” occurs automatically (the Crusonia plant, the woodlot); incubation periods, where capital processes are likened to physical ones that depend primarily on the passage of time (although implicitly it is what happens in time that matters) like aging wine.

(b) Notions of interest that are linked with physical or biological accretion: the idea that interest is that implicit increase in value that occurs continuously and inexorably over the production period.

An approach to capital theory disconnected from its unhelpful historical baggage must realize that the production process is a process of value enhancement over (in) time. It may involve physical processes (transformations) but its essential characteristic and driving force is the creation of value, the regrouping of physical resources into more valuable combinations as a result of deliberate production decisions (not to imply that all or even most of these decisions are “successful”). We shall be concerned to discover how production decisions are made. We realize also that interest is a phenomenon that is crucially distinct from productivity (although we need not deny that the rate of interest may be influenced by productivity, often in non-obvious ways).

2. We can dispense with “time period of production” approaches to capital. While we cannot but note and emphasize the importance of the connection between time and production, and the intuitive validity of the idea that in order to reap the fruits of more productive specializations we have to adopt production methods that are more “roundabout” (more complex, more indirect), nevertheless we cannot capture this idea in the form of any simple notion of “period of production.” Nor need we do so.

In this regard we shall find a number of modern theorists leading the way. The Austrian tradition emanating from Menger in the work of Mises, Rothbard, Hayek, Kirzner, and Lachmann has provided important insights. We shall focus here primarily on the work of Lachmann but we must take note briefly of the important work of Hayek on capital theory, if only for the subsequent work which it inspired. We will then turn to a discussion from another tradition, that emanating from Alfred Marshall. A group of theorists who have been referred to as “post-Marshallian” (Foss 1994, 1995, 1996a,b) has done considerable work on the economics of the firm which bears a clear connection to considerations of capital structure. One of the contributions of this part will be to illustrate the connections between these two literature strands and how one can inform the other.

Hayek and the Fundamental Questions of Capital Theory

In his work on capital Hayek stands, in a sense, between the Böhm-Bawerkian-Ricardian approach and the Mengerian and post-Marshallian approach. His work on capital theory dating from the early 1930s and culminating in the publication of The Pure Theory of Capital (1941), was prompted by a concern with the business cycle. In Monetary Theory and the Trade Cycle (1933) and Prices and Production (1935b) he developed what came to be known as the Austrian (Mises-Hayek) theory of the business cycle. This is essentially a monetary theory of fluctuations, but one that emphasizes a (monetarily induced) “distortion” of the capital stock. Hayek thus naturally drew from the work of Böhm-Bawerk and the relation between the capital stock and time. In so doing he simplified and glossed over many of the subtleties and complications relating to capital aggregation. In his subsequent work, in the environment of the gathering momentum of the Keynesian revolution, he sought to clarify and develop the capital theoretic underpinnings to this work, which he saw as the viable alternative to the flawed and superficial Keynesian approach (see the collection of articles in Profits, Interest and Investment (1939)). Finally, his writing of the Pure Theoryreflects his initial determination to lay out fully the fundamentals of capital theory and to make plain why he maintained that an understanding of capital was vital to a valid approach to (macro)economic policy.¹ In the actual implementation of the project he became aware of the enormity of the task he had set himself, and the finished product, though intricate and involved (by far his most difficult work in economics), was seen by him as an unfinished compromise (as is very clear from his remarks on pages vii–ix of the preface). (Hayek had planned a second volume that would have applied the Pure Theory analysis to trade cycles.)

The basic approach of the book is an equilibrium approach along the lines of (the “Ricardian”) Böhm-Bawerk, Wicksell, and Jevons (all of whom he credits as having anticipated in all essential ways what he has to say). But, in his voluminous side comments and general discussions, he makes it very clear that he understands the limitations of this (equilibrium) approach, and points the way to a more “dynamic” disequilibrium treatment. Thus this work contains not only a fairly early working out of what was later to become a research area of neoclassical economics under the rubric of intertemporal equilibrium theory, but also a wealth of important observations on the meaning of capital maintenance in a dynamic, changing world and other important insights that served as raw material for Lachmann’s later work on capital theory. It is the latter contributions in which we will be interested.

Whereas the classical (Ricardian) theory of capital (as we saw in Part II) had become concerned with explaining the determination of the rate of profit earned on an abstract category of resources (or a fund) known as capital, the Mengerian approach suggested paying attention to the structure of capital. Hayek’s sympathies lie clearly with the latter.

Our main concern will be to discuss in general terms what type of equipment it will be most profitable to create under various conditions, and how the equipment existing at any moment will be used, rather than explain the factors which determined the value of a given stock of production equipment and the income that will be derived from it.

(Hayek 1941:3)²

Hayek’s compositive sympathies are clearly stated:

The problems that are raised by any attempt to analyze the dynamics of production are mainly problems connected with the interrelationships between the different parts of the elaborate structure of productive equipment which man has built to serve his needs. But all the essential differences between these parts were obscured by the general endeavor to subsume them under one comprehensive definition of the stock of capital. The fact that this stock of capital is not an amorphous mass³ but possesses a definite structure, that it is organized in a definite way, and that its composition of essentially different items is much more important than its aggregate “quantity,” was systematically disregarded.

(ibid.:6, italics added)

Hayek explains the problems associated with any attempt to aggregate the capital stock in value terms or in terms of units of labor or time and intends to work systematically towards a theory in which this is not necessary. He begins, however, with a discussion of how an economy directed by a central dictator might make decisions regarding the formation and use of capital goods in an economy devoid of change. This, of course, abstracts from any issues related to the relative evaluation of consumption goods, since the only valuations that matter are the dictator’s. Thus the solution is essentially the same as the classical one. There is, by assumption, no disequilibrium problem; heterogeneity is seen not to matter. Of course, Hayek does this as a foil, a relief against which to illuminate the real-world problems of heterogeneity and change. His method is first to get the abstract problem right. Unfortunately, but understandably, much of the literature that refers to this work concentrates on these equilibrium exercises, rather than on the original focus that Hayek sought to maintain, that is, of inquiring into the decisions governing the use of the various capital resources at our disposal.⁴

The Problem of Imputation

Essentially Hayek was concerned with the question: how are resources made and used? Or, more accurately, how are these decisions made? That is, we seek to understand the decision-making process which leads to the adoption of certain types of capital equipment in combination with others. Obviously, decision-makers have to form a judgment as to the worth of any capital combination and its various components; they have to impute a value to the capital goods they have or are considering acquiring or producing. This is clear from Menger’s notion (developed further by Wieser, who seems to have invented the term “imputation”)⁵ that the value of any resource is derived from the value of the final output for which it is responsible. But, as we have noted in previous chapters, the question remains as to how we are to decide which unit of output is attributable to which unit of input. In the neoclassical literature this problem is solved by assuming that production methods can be varied continuously in such a way that the marginal contributions (products) of each unit of input can be easily discovered. This is also Hayek’s assumption in his discussion of a centrally directed economy. This way of dealing with the problem abstracts from the most interesting questions in capital theory, questions that turn out to be relevant to considerations of economic organization.

It would seem, however, that there is a necessity to invoke some notion of marginal (value) product. The producer must have in mind some opportunity cost when assigning a resource in one particular way rather than another and thus must also have in mind the supposed contribution that its (marginal) assignment makes. As we shall make clear, however, in a world of uncertainty and change, there is an inescapable element of judgment and speculation involved in this. Different decision-makers will see things differently and will (implicitly) impute different values to the capital resources at their disposal from what others would. These differences produce the capital valuation process that is part of the market process and which renders economic calculation possible.

The economist’s description of the imputation process, where the decision-maker has recourse to the value marginal product schedule, is an idealized construct. The process of actual decision-making must mirror in an implicit way this idealization. But it does so by using certain simplifying conventions (for example, based on accounting practices) that form part of an institutional structure rendering the decision manageable (tractable). And in so far as these conventions reflect a widespread sharing of forms of appraisal, they supply the decision-maker with knowledge (type 2) of “how to do it” (as distinct from what to decide—type 3). We shall return to this.

Lachmann’s Conceptual Framework

The Structure of Capital

Perhaps the most important development of Hayek’s original project is to be found in Lachmann’s capital theory. In 1956, Lachmann, who had been a student and colleague of Hayek’s at the London School of Economics, published Capital and its Structure (Lachmann 1978).⁶ This work was really the culmination of his earlier work on capital, the most complete of which was his 1947 article (see Lachmann 1938,1939, 1941, 1944, 1947, 1948; see also Lewin 1997a).

According to Lachmann:

The generic concept of capital without which economists cannot do their work has no measurable counterpart among material objects; it reflects the entrepreneurial appraisal of such objects. Beer barrels and blast furnaces, harbor installations and hotel room furniture are capital not by virtue of their physical properties but by virtue of their economic functions. Something is capital because the market, the consensus of entrepreneurial minds, regards it as capable of yielding an income. . . . [But] the stock of capital used by society does not present a picture of chaos. Its arrangement is not arbitrary. There is some order to it.

(Lachmann 1978:xv)

The value of the capital stock, being dependent on individual expectations and evaluations (time preferences included), is not an objectively observable phenomenon or necessarily even a meaningful concept. Only in equilibrium, where all individuals’ expectations were consistent one with the other, would such a value have any meaning. Lachmann chooses to develop his analysis in a disequilibrium framework. In other words, Lachmann considered the notion of a capital stock (which made sense in an equilibrium context) to be untenable and unhelpful in a disequilibrium world. He thus offers a theory of the capital structure rather than the capital stock.

Lachmann thus emphasizes the heterogeneity of the capital stock. The fact that capital goods are physically very dissimilar is significant precisely because of the existence of disequilibrium. Physical heterogeneity could be reduced to value homogeneity if the values of the various capital goods could be simply added together. Where disequilibrium means that individuals have different and frequently inconsistent expectations, one cannot simply add together individual valuations. The physical heterogeneity is not the essence of the matter. Different physical goods that perform the same economic function could be counted as the same good. It is the difference in economic function that matters. For the most part different capital goods look different because they are designed to perform different functions. But the same capital good could perform different functions under different circumstances. Heterogeneity in use is the key.

Although the capital stock is heterogeneous, it is not an amorphous heap. The various components of the capital stock stand in sensible relationship to one another because they perform specific functions together. That is to say, they are used in various capital combinations. If we understand the logic of capital combinations, we give meaning to the capital stock and, in this way, we are able to design appropriate economic policies or, even more importantly, avoid inappropriate ones (for example Lachmann 1978:123).

Complementarity and Substitutability

Understanding capital combinations entails an understanding of the concepts of complementarity and substitutability. In neoclassical microeconomics, these concepts are developed within a market equilibrium production function framework. Production goods are substitutes or complements for one another to the degree to which, and in the manner in which, their marginal products are related. The marginal products of complements are positively related while those of substitutes are negatively related. What is envisaged is a situation in which production goods are combined in a technological relationship of known and well-understood inputs and outputs. The values of all possible outputs are known with certainty (or with probabilistic certainty), and from this it is possible to calculate the values of the marginal products under all conceivable circumstances. Hence, we have the picture of a given budget line (or hyperplane), formable out of the given equilibrium prices of the production goods and the quantities used, confronting a given isoquant. Substitution is then simply a matter of moving around the isoquant in two-dimensional or multidimensional space. Substitution occurs because of a change in the price of a production good. There is no analysis of any events that occur in disequilibrium, i.e., of events that occur between the time that a price change occurs, is perceived, is acted upon, and results in the establishment of a new equilibrium. The same sort of analysis is applied to changes in technology, which are analyzed as changes in the positions or shapes of the isoquants.

As a mental picture of a single production plan at a point of time, the isoquant diagrams (or algebras) may be enlightening. They summarize a certain “logic of choice.” But they have little to do with Lachmann’s conception of what substitution and technical progress mean in reality. His concepts pertain to a world in which perceived prices are actual (disequilibrium) prices, in the sense that they reflect inconsistent expectations and in which changes that occur cause protracted visible adjustments. Capital goods are complements if they contribute together to a given production plan. A production plan is defined by the pursuit of a given set of ends to which the production goods are the means. As long as the plan is being successfully fulfilled, all of the production goods stand in complementary relationship to one another. They are part of the same plan. (It is not inconsistent to say that their perceived marginal products are positively related, in the sense that their joint outputs depend on each others’ performance. An increased availability—reduction in price—of any one input raises the potential outputs of the plan attributable jointly to all of the inputs and may increase the (joint) demand for all of them.) The complementarity relationships within the plan may be quite intricate and may involve different stages of production and distribution. Substitution occurs when a production plan fails (in whole or in part). When some element of the plan fails, a contingency adjustment must be sought.⁷ Thus some resources must be substituted for others. This is the role, for example, of spare parts or excess inventory. Thus, complementarity and substitutability are properties of different states of the world. The same good can be a complement in one situation and a substitute in another.

Lachmann uses the example of a delivery company (Lachmann 1947:199; and Lachmann 1978:56). The company possesses a number of delivery vans. Each one is a complement to the others in that they cooperate to fulfill an overall production plan. That plan encompasses the routine completion of a number of different delivery routes. As long as the plan is being fulfilled, this relationship prevails, but if one of the vans should break down, one or more of the others may be diverted in order to compensate for the unexpected loss of the use of one of the productive resources. To that extent and in that situation they are substitutes. Substitutability can only be gauged to the extent that a certain set of contingency events can be visualized. There may be some events, such as those caused by significant technological changes, that, not having been predictable, render some production plans valueless. The resources associated with them will have to be incorporated into some other production plan or else scrapped—they will have been rendered unemployable. This is a natural result of economic progress which is driven primarily by the trial-and-error discovery of new and superior outputs and techniques of production.

What determines the fate of any capital good in the face of change is the extent to which it can be fitted into any other capital combination without loss in value. Capital goods are regrouped. Those that lose their value completely are scrapped. That is, capital goods, though heterogeneous and diverse, are often capable of performing a number of different economic functions. Lachmann calls this property multiple specificity.

The Capital Structure is Composed of Complementary Heterogeneous Items

Lachmann’s world is consciously similar to Schumpeter’s world (Schumpeter 1961) of “creative destruction,” except that for Lachmann the innovating entrepreneur is not disrupting some preexisting general equilibrium. His world is one in which a continuous evolutionary process of changing patterns of capital complementarity is occurring. At any point in time, different entrepreneurs will have different and frequently incompatible production plans. Over time the market process will validate some and invalidate others. Lachmann sees the market process as tending to integrate the capital structure, in other words, rendering plans more consistent, although he is careful to add (as we saw in Chapter 2) that the forces of equilibrium may be overwhelmed by the forces of change.

The concept of the capital structure (to be explained further below) is built out of the notion of capital complementarity. A production plan is a construction of the human mind. As such it exhibits a necessary internal consistency. From the point of view of the individual planner, it might be said that the plan is always in equilibrium. The plan is always in equilibrium in the sense that every planner, being rational, may always be counted on to do the best that he can, given all the relevant constraints, where such constraints include the time available to adjust to any unexpected changes. That is to say, at any given point of time any individual planner is in equilibrium with respect to the world as he sees it at that point of time. All productive resources employed in that plan stand in complementary relationships to one another. Between any two points of time, during which unexpected changes will necessarily have occurred, resource substitutions will have been made in an attempt to adjust to the changes. Complementarity is a condition of plan equilibrium (stability); substitutability is a condition of plan disequilibrium (change).

The notion of the capital structure does encompass a sort of economy-wide equilibrium as an ideal type. At the individual level, disparate elements of the production plan are brought into consistency by the planner. These elements are all present in a single human mind. There is no such mechanism guaranteeing consistency between different production plans. The market process does, however, tend to eliminate inconsistencies between plans in so far as not all of them can succeed. In this way plans that are consistent with (complementary to) one another tend to prevail over those that are not.⁸ So whereas the individual planner ensures the complementarity of all of the resources within a production plan, the market process tends towards a situation of overall plan complementarity. This is what constitutes the capital structure. The heterogeneous assortment of capital goods stands at any time in a kind of ordered structure defined by their functions and by the relationships that the various plans have to one another. The latter is a result not of any supra-plan, but of the market process. A capital structure in which this tendency were complete, in which every capital good and every production plan were complementary to every other, would be a completely integrated capital structure. In summary:

In a homogeneous aggregate each unit is a perfect substitute for every other unit, as drops of water are in a lake. Once we abandon the notion of capital as homogeneous, we should therefore be prepared to find less substitutability and more complementarity. There now emerges at the opposite pole, a conception of capital as a structure, in which each capital good has a definite function and in which all such goods are complements. It goes without saying that these two concepts of capital, one as a homogeneous fund, each unit being a perfect substitute for every other unit, the other as a complex structure, in which each unit is a complement to every other unit, are to be regarded as ideal types, pure equilibrium concepts neither of which can be found in actual experience.

(Lachmann 1947:199)

Lachmann chose to describe the world in terms of a capital structure rather than a capital stock. This choice reflects a judgment that to obscure capital complementarity through aggregation would result in an inaccurate and misleading picture of the role of capital in the economy. This can be seen in his account of how the market process works.

The Market Process and the Production Process

At any moment in time individual planners hold inconsistent expectations. This means that the passage of time must disappoint some of them. Some production plans must fail (in part or in whole) while others, of course, may succeed beyond their expectations. This is reflected, according to Lachmann, in two crucial ways—in capital re-evaluations (capital gains and losses) and in changes in cash balances. Whereas the “wealth effects” of neoclassical economics are usually assumed to be small enough to be neglected, the capital gains and losses of Lachmann’s world are the most important forces driving changes in the capital structure. These market evaluations of the prospects of success or failure of the firm and its capital combination are reflected in the financial assets associated with the firm. The financial assets (for example, debt and equity) form a superstructure over the capital assets of the company and constitute its asset structure. They are claims to the physical assets of the company and as such reflect their value (or others’ opinions of their value). Thus, there is an economy-wide financial structure (composed of the individual asset structures) that is related to and reflects the capital structure of the economy. The capital structure and the capital combinations of which it is composed are in turn related to the plan structure. At each of these levels—plans, physical assets, and financial assets—various institutions exist that help define the various structures. A vitally important institution in the financial structure is the stock market. On the stock market assets are valued and revalued every day in accordance with companies’ performances. The stock market reflects a daily balance of expectations concerning the earning prospects of companies. It is probably fair to say that Lachmann considered the stock market to be the most important institution of the market economy (he did not share Keynes’s view that it was basically random in nature (Lachmann 1978:68–71)) and the one, more than any other, that differentiated it from socialized economies—the institution that, together with others in a private financial capital market, was responsible for facilitating the adoption of those capital combinations that contribute to economic progress (Lachmann 1992).

Capital gains and losses provide entrepreneurs with feedback from the market. Ventures that continue to sustain capital losses will eventually have to regroup or stop operating. In this way the financial structure and the capital structure interact to produce a continuing reshaping of the latter.

(Lachmann 1978:94)

Cash Balances as Excess Capacity and Constraint

A more immediate form of feedback comes in the form of changes in the cash balances of the company. The company holds cash as a form of “excess capacity” in order to preserve flexibility. In a sense, cash is the most substitutable of the company’s capital assets. Thus changes in cash balances, like changes in inventory, provide an important indicator of the results of the operation over a period of time. A persistent negative cash flow is the ultimate long-term discipline and often also the first indicator of a problem.⁹ Lachmann sees the traditional neoclassical portfolio approach to cash balance and financial asset holding as misleading. While it is true that production plans must include decisions about financial asset mix (the optimum manner of financing), to assume that observed cash and asset portfolios reflect optimal choices is to lose sight of the feedback process discussed above. That is to say, empirically observed changes in cash holdings and asset values reflect not only intended outcomes but they also reflect results that are unintended (mistakes or surprises—good and bad). In the portfolio equilibrium view, the portfolio reflects the results of portfolio selection based on underlying preferences and shared knowledge. In Lachmann’s (disequilibrium) market process view, the portfolio value reflects portfolio results which are often different from what was intended and cannot be assumed to reflect accurately the preferences and intentions of the planners. Rather it is a barometer of the viability of the overall plan.

Capital gains and losses. . . . [Essentially. . . reflect in one sphere events, or the expectation of events, the occurrence of which in another sphere is indicated, and knowledge of which is transmitted, by changes in money flows.

(Lachmann 1978:95)

Capital Accumulation Ordinarily Involves a Changing Capital Structure

Perhaps the most important general implication of a disequilibrium approach to capital is the proposition that all capital accumulation entails a changing capital structure. This follows from the observation that most technical change is embodied in new (improved) capital goods and/or involves the production of new consumption goods. Capital accumulation that accompanies economic growth as we know it is not simply the addition of the same kinds of capital goods doing the same things. Lachmann’s view of capital accumulation and economic progress is in many ways very prophetic of the revolutionary kind of economic change that has characterized the twentieth century, including the last quarter of the century. It is, in this view, impossible to separate the phenomena of technical progress and capital accumulation; capital accumulation always proceeds hand in hand with technical change. By the same token, failed production plans imply “holes” in the capital structure that signal investment opportunities for others. An approach to economic growth that visualizes capital as a homogeneous aggregate to which investment expenditure adds in an indiscriminate way, so that a government policy adding directly to investment expenditure is, in essence, no different from an increase in private entrepreneurial investment expenditure, is not only untenable but also has far-reaching consequences. The capital structure will be irreversibly different in these two cases. It is very likely that government expenditure “crowds out” not only private sector expenditure but also private-sector-induced technical progress. The shape of the capital structure will be different and, because capital assets are heterogeneous, specific, and durable, will remain different from what it would otherwise have been. It takes a lot of faith in the abilities and objectives of the government agents involved to imagine that no sacrifice in entrepreneurial discovery is involved.¹⁰

The Disequilibrium Method is Particularly Applicable in a World of Rapid Changes

The world around us abounds with problems to which a structural theory of capital of the type outlined in this book is germane. It is hoped that a number of them will attract the attention of economists.

(Lachmann 1978:xi)

The choice of how to characterize capital is dependent on the kind of world in which one lives. In a world in which unexpected changes occur relatively rarely and in which methods of production, distribution, and interaction are very stable (Adam Smith’s corn economy), it might make sense to characterize capital as an equilibrium stock, a fund of more or less agreed-upon value. But in a world in which change is rapid and unpredictable, Lachmann’s characterization of capital as a structure of heterogeneous items becomes even more appropriate. In particular, with regard to the effect of change on incomes, employment, and lifestyles, Lachmann’s changing capital structure gives insights that are not available from an equilibrium approach.

It is generally agreed that we are living in an age of profound changes. It is not the fact of changes in technology that is revolutionary, it is the speed with which it is occurring that is new. The pace of change is not only quicker, it is accelerating. At the same time, however, our ability to absorb and adjust to change has increased many-fold.

Underlying virtually all of the major developments of this century is the revolutionary change in the way in which we generate and use information—hence the phrase “information age.” In some respects this is only the latest in a line of similar revolutions like the original emergence of language and the development of writing, accounting, and printing. The latest, and to date most profound, development in this line of developments is electronic communication, of which the telephone, the computer, and the video and audio recorder are all part. Electronic communication in all of these aspects is responsible for the developments of global markets, of desktop publishing, of fuel injectors for automobiles, of computer aided design of everything from microchips to airplanes, and so on.

To understand the phenomenon of accelerating change occurring together with our enhanced abilities to adapt to change we must realize that the scope and pace of technological change itself is governed by our ability to generate and process relevant information. This means that the current pace of technical change is dependent on past technical advances, particularly the ability to generate and process information. If technological change is seen as the result of many trial-and-error selections (of production processes, of product types, of modes of distribution, etc.) then the ability to generate and perceive more possibilities will result in a greater number of successes. It will, of course, also result in a greater number of failures. Lachmann’s proposition that capital accumulation, proceeding as it does hand in hand with technological change, necessarily brings with it capital regrouping as a result of failed production plans, appears in this perspective to be particularly pertinent. “[E]conomic progress . . . is a process which involves trial and error. In its course new knowledge is acquired gradually, often painfully, and always at some cost to somebody” (Lachmann 1978:18). Today new knowledge acquisition is not so gradual.

The Market Process has Discernible Phases: Imitation and Innovation

The market process is one of continual flux. The shaping and reshaping of the capital structure is driven by the changing shape of the mix of consumer products. This perspective led Lachmann to a characterization of market activities in terms of two distinct phases. “A competitive process taking place within the market for a good consists typically of two phases, and in it the factors of innovation and imitation may be isolated as iterative elements” (Lachmann 1986:15). The successful introducer of a new product or new brand of product gains temporary monopoly power. The spreading knowledge of this success attracts imitators. The learning curve for the latter is shorter. Prices tend to fall as margins are competed away. This brings further pressure for product differentiation and capital reshuffling (reorganization). The process is inseparable from technological change. Market share and firm size at any point of time thus have very little to do with monopoly power. They are both transitory states of a continuing innovation–imitation cycle. This view finds close application in the electronics industry and the development of personal computers, fax machines, copy machines, cameras, cellular phones, and so on. Notably the innovation–imitation cycle is shortening. This is another aspect of the rapidity and acceleration of change. From this perspective the classical doctrine of capital flows establishing a uniform rate of profit is found seriously wanting.

From Böhm-Bawerk to Lachmann and Back: The Division of Labor and the Division of Capital

An important aspect of the information revolution is that it allows for the formation and management of ever more complex capital structures. In his work on capital Lachmann proposed a reinterpretation of a controversial aspect of Böhm-Bawerk’s theory, his famous proposition concerning the superior productivity of roundabout production (i.e., of production processes that are more indirect, that take more “production time”) (Lachmann 1978: eh. V). Lachmann regarded Böhm-Bawerk’s use of time as a unit of measurement for the capital stock as untenable and seriously misleading. He felt strongly, however, that Böhm-Bawerk’s intuition about the sources of economic progress was correct. “[T]he intuitive genius of Böhm-Bawerk gave an answer [that], to be sure we cannot fully accept and which, moreover, is marred by an excessive degree of simplification, yet an answer we cannot afford to disregard” (Lachmann 1978:73). Therefore he suggests dispensing with the notion “period of production” and replacing it with the notion “degree of complexity.” Whereas Böhm-Bawerk argued that the period of production increased with capital accumulation, Lachmann argues that capital accumulation results in the increasing complexity of the production process. In this way he hoped to have given a new and more appropriate meaning to the notion of increased roundaboutness. Lachmann argued that Böhm-Bawerk’s ideas were closely related to those of Adam Smith (Lachmann 1978:79). Both were concerned about the sources of economic progress. Both lived in a world that was “neither a stationary nor a fully dynamic world” (1978:79). Our world is, however, a dynamic world, one in which technical progress is an outstanding feature. For Böhm-Bawerk, roundaboutness was not a form of technical progress. “Technical progress requires new forms of knowledge spreading through the economic system while Böhm-Bawerk assumes as given knowledge equally shared by all” (1978:79).

For Adam Smith the division of labor was the most important source of progress. The same principle can be applied to capital. As capital accumulates there takes place a “division of capital,” a specialization of individual capital items, which enables us to resist the law of diminishing returns. As capital becomes more plentiful its accumulation does not take the form of multiplication of existing items, but that of a change in the composition of capital combinations. Some items will not be increased at all while entirely new ones will appear on the stage. . . . The capital structure will thus change since the capital coefficients change, almost certainly towards a higher degree of complexity i.e. more capital items will now be included in the combinations. The new items, which either did not exist or were not used before, will mostly be of an indivisible character. Complementarity plus indivisibility are the essence of the matter. It will not pay to install an indivisible good unless there are enough complementary capital goods to justify it. Until the quantity of goods in transit has reached a certain size it does not pay to build a railway. A poor society therefore often uses costlier (at the margin) means of transport than a wealthier one. The accumulation of capital does not merely provide us with the means to build power stations, it also provides us with the means to build factories to make them pay and enough coal to make them work. Economic progress requires a continuously changing composition of social capital. The new indivisibilities account for the increasing returns.

(Lachmann 1978:79–80, italics in original)¹¹

Böhm-Bawerk’s thesis about the higher productivity of roundabout production is an empirical generalization. It can be applied, reinterpreted, to our own world. We have achieved, and will continue to achieve, greater productivity, that is, the production of more and better consumption goods and services, by the continuing introduction of new indivisible production goods (which embody new production techniques). This can be cast in terms of Böhm-Bawerk’s idea of “stages of maturity.” Böhm-Bawerk argued that capital accumulation will take the form of an increase in the number of stages of production. “The richer a society the smaller will be the proportion of capital resources used in the later stages of production, the stages nearest to the consumption end, and vice versa” (Lachmann 1978:82). (We leave aside the question of identifying a “stage of production” concentrating on the intuitive meaning of Lachmann’s point.) The increased number of stages is indicative of increased complexity, which, in turn, is indicative of increased productivity. Increased complexity implies “an ever more complex pattern of capital complementarity” (ibid.:85).

We conclude that the accumulation of capital renders possible a higher degree of the division of capital; that capital specialization as a rule takes the form of an increasing number of processing stages and a change in the composition of the raw material flow as well as of the capital combinations at each stage; that the changing pattern of this composition permits the use of new indivisible resources; that these indivisibilities account for increasing returns to capital; and that these increasing returns to the use of capital are, in essence, the “higher productivity of roundabout methods of production.”

(Lachmann 1978:84–85, italics in original)¹²

Finally, Lachmann contends that the increased complexity of the capital structure also implies an increased vulnerability.

A household with six servants each of whom is a specialist and none of whom can be substituted for another, is more exposed to individual whims and the vagaries of sickness than one that depends on two or more “general maids.” Thus an “expanding economy” is likely to encounter problems of increasing complexity . . . [among which are] disproportionalities and the resulting maladjustment of the capital structure [which] may give rise to serious problems in economic progress.

(Lachmann 1978:85)

Concluding Summary

Lachmann’s capital theory seems to have been ahead of its time. It was mostly ignored. Yet, when considered in the light of recent developments in the theory of organizational structure, one finds a striking number of commonalities (without any reference to Lachmann, however).¹³ Lachmann’s capital theory can be seen as a kind of unintended prelude to some of this work. In addition, these commonalities reflect back on Lachmann’s work in giving a new, and arguably more complete, view of capital and its structure.

Lachmann establishes that the competitive process and capital accumulation are inextricably linked. Furthermore, capital accumulation (the progressive creation of capital value over time) necessarily implies an evolving capital structure, that is, a capital structure that is becoming more “complex.” The degree of specialization and interdependence grows. He captures this interdependence by the notion of complementarity. Resources that depend on each other in joint production are complementary. In the face of unexpected changes such “joint ventures” (capital combinations) often have to be regrouped. Much depends, therefore, on the degree to which existing resources can be adapted to originally unintended uses, a property that Lachmann calls multiple specificity. The variations in the degree of specificity are reflected in the capital gains and losses experienced as a result of the changes that occur and are the crucial driving force of the market process.

Lachmann’s theory is thus a theory of progress in which such progress is reflected in and achieved by a continuing specialization of economic activities, a growing division of capital to supplement (and complement) Adam Smith’s division of labor; we have, in general, an increasing division of function. What is noticeably absent from the theory is an explanation, apart from a kind of “black box” reference to the market, of how this is accomplished. That is to say, we are not told how this progressing complexity is managed.¹⁴ How, to use Hayek’s famous phrase, is the necessary “division of knowledge” implied by the increasing division of function to be organized? Lachmann’s theory subsumes, and does not explain, an organizing function, which he delegates to the entrepreneur. Lachmann would surely agree, however, that the evolving capital structure is necessarily part of an evolving organizational structure.

Since all production in the modern world is joint production involving capital combinations (that is, combinations of resources in general, including capital), production necessarily involves organizing or coordinating the various activities of the resources involved. How is this done? Who owns the resources and why? More specifically, relating to the imputation problem anticipated above, there is always a problem of how to share the fruits of any joint venture. All production activities are joint (cooperative) ventures, directly or indirectly, between individuals (workers, capital owners, entrepreneurs). So the question of organizational structure arises logically out of Lachmann’s world-view.

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¹This interpretation of Hayek’s work on capital theory is my own.

²It is a problem for the reader that, having stated this general objective, Hayek then turns to a protracted examination of capital under equilibrium conditions reminiscent of the classical approach, and never really fulfills his originally stated objective. It has been suggested (by Hayek, among others) that Lachmann did just that (see Lewin 1997a).

³In this approach it is clear that both Lachmann and Hayek benefit from Schumpeter’s pronouncements. In his lectures on capital theory Lachmann states:

Schumpeter has a succinct statement of the compositive school approach. Whenever we are talking about a given situation—meaning given tastes, resources and technology—resources must exist in a certain stock of inherited goods, i.e., goods provided in the past. They are simply there, like land. These resources are limited in the way that they can be used. The stock of existing goods constitutes a constraint on human action going forward. The stock of capital is neither homogeneous, nor is it an amorphous heap. Its components complement one another. Some goods must be available for the operation of others. The nature of the composition of the stock is vital—it constitutes a given “structure.”

(Lachmann 1996:126-127, see also 144)

This is an allusion to the words of Schumpeter. In a section entitled “The Structure of Physical Capital,” Schumpeter seems to anticipate much that is relevant to Lachmann’s (and Hayek’s) viewpoint.

The initial stock of goods is neither homogeneous nor an amorphous heap. Its various parts complement each other in a way that we readily understand as soon as we hear of buildings, equipment, raw materials, and consumers’ goods. Some of these parts must be available before we can operate others; and various sequences or lags between economic actions impose themselves and further restrict our choices; and they do this in ways that differ greatly according to the composition of the stock we have to work with. We express this by saying that the stock of goods existing at any instant of time is a structured quantity or a quantity that displays structural relations within itself, that shape, in part, the subsequent course of the economic process.

(Schumpeter 1954:631–632, italics in original)

⁴In the final section of the book (pt IV) Hayek turns to some dynamic considerations. While this section is very useful, particularly in its treatment of fundamental issues concerning saving and investment, it does not really deal with capital and could be seen perhaps as an extended and effective (but largely ignored) reply to Keynes.

⁵The imputation question was an important issue for the “second” generation of Austrian economists (the interwar period) and may have been responsible for a less than accurate understanding of Mises’ contribution to the socialist calculation debate on the part of some Austrian economists. See Kirzner (1994b:vol. II: 20; also chs 15 and 19 thereof).

[This section uses material from Lewin (1997a).]

⁶As mentioned above, there is some evidence to suggest that both Hayek and Lachmann saw Lachmann’s work as a continuation of Hayek’s project. When asked about the Pure Theory Hayek once remarked, “I think the most useful conclusions drawn from what I did are really in Lachmann’s book on capital” (Kresge and Wenar 1994:142). Also, it is clear that Lachmann’s inspiration was Hayek’s work on capital (of which The Pure Theory was the culmination). In his 1948 article he refers to Hayek (1937a) and says, “The ideas set forth by Professor Hayek have been the main inspiration of this paper” (Lachmann 1948).

⁷It is easy to see how his approach relates to the analysis of the individual planning process suggested in Chapter 2, that is, that plans depend on different kinds of knowledge, and are multilayered and necessarily vague.

⁸This would seem to imply that the production plans of individual firms are identical with the plans of one or other individual in that firm. This is not necessarily the case, however. Firms must find a way to harmonize the different visions of its various planners. Presumably the larger the firm, the more difficult this is. But those firms that do so more successfully and adopt successful supra-plans will tend to survive. The market process works its way into the firm in this way. In this way Lachmann’s work on capital is relevant for and related to the post-Marshallian theories of the firm that we shall examine below.

⁹Of course, negative cash flows occur routinely and are planned for in start-up businesses, some of whom go on to become corporate giants. It seems as though a distinction between planned and unplanned might be useful here.

¹⁰Lachmann’s capital theory framework blends nicely with Kirzner’s views on entrepreneurship and Hayek’s views on information to yield some very specific insights on “investment policy.”

¹¹In an important sense durability is an aspect of indivisibility. “While it might be technically possible, the cost of producing a one-blow hammer would be certain to exceed the value of this task” (Steele 1996:144). The profitability of producing a hammer thus depends on there being sufficient demand for its multiple uses.

¹²The reference here to increasing returns is especially noteworthy in light of the current rediscovery of the phenomenon in the context of a variety of new initiatives in economics. These include the new focus on nonlinear economics (Day and Chen 1992), the economics of “lock in” (Arthur 1989, 1994), institutions and economics, and evolution and economics (Hodgson 1988, 1993). Economists are now beginning to place greater emphasis on the importance of particular historical events in explaining the emergence of technologies in a manner that Lachmann clearly foreshadowed in his capital theory. On the topic of increasing returns see Buchanan and Yoon (1994).

¹³At the time of this second edition, this has changed dramatically. The management and organizational literature is now replete with references to Hayek, Kirzner and, most recently, Lachmann, most prominently in the growing area of entrepreneurial studies. See for example Chiles, Bluedorn, and Gupta (2007) for an appreciation of Lachmann’s work. See also Chiles, Tuggle, McMullen, Bierman, and Greening (2010).

¹⁴He seems to imply that a progressive vertical disintegration takes place, thus suggesting an immanent theory of the size of the firm. In this way his theory is related to the literature on the dynamics of the firm to be discussed below.