Production: Particular Factor Prices and Productive Incomes

0:00Okay, well, we're back to production economics and this is the last chapter in the section on production theory that we started yesterday. I like this chapter very much. It contains some of my favorite sections of the entire book, but that's just because of my own idiosyncratic preferences and research interests and so on. I don't want to say hodgepodge is not the right word, but there's a set of related sort of applied topics that are covered, right? We've already discussed the general principles of factor pricing. We've talked about the role of discounting, the place of the entrepreneur and so on. Now Rothbard delves into more detail on certain aspects of the labor market, certain aspects of the market for land and the services of land, certain aspects of the market for capital goods, the cost of the firm, some organizational and managerial issues associated with the firm and so on.

0:59Some of the highlights of the chapter include his extension and development of the theory of rent that we began discussing yesterday. And again, the key pioneer in this area, as Rothbard explains, is the early 20th century American economist Frank Fetter, who Joe mentioned in one of his, in his opening lecture, as being a very important figure in the causal realist or Mengerian tradition in economics, which was thriving in parts of Britain and in the United States before World War I. And it's something that we often forget because we associate the Austrian school with the University of Vienna, with Menger and his followers. And then we think of the modern, the 20th century important Austrians such as Mises, Hayek, the early Lachmann and so on.

1:51And then we have the modern Austrians associated with the Austrian revival, Rothbard of course, and then the post-74 Austrians. We tend to forget that, to a large extent, the Mangerian causal realist tradition was becoming widely incorporated into various parts of what we then would call mainstream Anglo-American economics. Wickstede in the UK and people like Frank Fetter, Herbert Davenport, Frank Taussig, John Bates Clark and others in the US who were major, very important figures in the profession. I'm not sure about Fetter, but his contemporaries in this area were these causal realist guys who were president of the American Economic Association and so on.

2:37I don't know if Fetter was. Davenport was in one year. Fetter was as well. So these were very prominent mainstream American economists, Fetter at Princeton, Davenport at Chicago and at Cornell and so on, Tausig at Harvard. So these were not sort of backwater fringe guys. These were the mainstream guys. and they were doing applications and extensions of the Mengerian causal realist tradition. However, their work became overshadowed and was largely forgotten by the 1920s and 1930s in the Anglo-American world. Anyway, the point is Rothbard takes and rehabilitates Federer's approach to rent, which we talked about yesterday, and incorporates it into a more general theory of factor pricing.

3:24That's one of the important parts of the chapter. The section on cost extends and elaborates on some issues that came up yesterday about differences between Rothbard's approach and the standard cost curve approach, mostly Marshallian, the approach that you get in standard textbook micro theory, Rothbard's treatment of vertical integration and the limits to the size of the firm What does he bring into the discussion of the limits to the firm? That's a very important topic in Austrian economics, but one that hadn't previously been incorporated into this particular application.

4:13Yeah, socialist calculation debate. That's right. And we'll get to that a little bit later. There's some very important lessons in this chapter for our understanding of the socialist calculation debate even though this is not explicitly a chapter on socialism. Those are some of my favorites. I mean, as you think back over the chapter and maybe look at your notes, if you took notes on your reading or as you're looking through the study guide, Did anything else stand out in your mind as being particularly interesting or controversial or difficult about this particular chapter? Any ideas that come to mind? Turn-ons, turn-offs? Nothing specific? Yes?

5:06Sorry, no such thing as involuntary... Unemployment.

5:47And this is a claim that is by no means generally accepted among economists, even among some Austrian economists. There was a certain incident, I don't want to go into the gory details, especially since we're on tape, but a fellow traveler and critic of the Austrian School, So, particularly if some Austrians who are near and dear to our hearts in this own room claimed that this statement is ridiculous, is preposterous, that it doesn't take Dick into account uncertainty in the market process, and blah, blah, blah, it's sort of too equilibrium bound, anyone who believes this must be completely nuts, to which one of our friends responded, well, this is exactly what Mises believed. Mises makes this argument explicitly in Human Action, about all unemployment being voluntary, In an appropriate sense, we understand what's meant by this, to which the critic responded, well, you guys are all cultists because you just bow down to Ludwig, you know, which of course had nothing to do with the point that was under consideration,

6:47namely that it isn't true that no serious economist could believe this, because Mises believed it and he was a serious economist, which doesn't mean that you're using Mises to prove that the statement is true, only to demonstrate that some serious economist thought it was true. and Rothbard has a good explanation of why it is in fact true. I mean do you want to, I mean I think it's right to point out it sounds kind of harsh in one sense. I mean in a sort of a common sense knee-jerk fashion we say well you know I I work in a factory and the factory closed and I lost my job. I didn't choose that. It's not what I wanted. How can you say that I am voluntarily choosing to be unemployed? What does Rothbard mean in context When he says there's no such thing as involuntary unemployment on the free market.

7:34You want me to? Yeah, or anybody. David, do you want to? I was just going to say he means that there's no... If you lose your job because the plant closes, it's not involuntary, but it's... Not voluntary, but he's talking more about actual unemployment. It can't be stopped from... No, it would be unemployed if somebody stops you from being employed. Somebody forces you to work. Okay. Excuse me. No, that's right. That's one way to put it. You could also add that the concept of unemployment, of course, only makes sense relative to a particular wage payment, a wage rate. When we talk about a piece of land being unused, well, it's unused given the market price of land.

8:26Right, given this land is not currently being used because the value that the entrepreneur would realize from using this land is less than what the entrepreneur would have to pay to get it, it's, you know, sub-marginal land. You say the same thing about capital goods, they're not currently being used because their DMVP is less than their, is less than the rental price that's currently being charged. Okay, so unemployment only makes sense relative to a wage rate, right? So, I mean, at some price, all of us would be unemployed, okay? So if I go to Lew Rockwell and I say, well, I'd be glad to give some lectures at Rothbard Graduate Seminar, you know, my price is $50,000 a day.

9:15It's not likely that I would get the job. I mean, very few of us, and that's what David Gordon gets, but the rest of us don't get anything close to that. You know, would you say that, well, Rockwell is being unfair somehow? You know, I'm being coerced into idleness this week because Rothbard won't pay me my 50 large. Rockwell won't pay me my 50 large. I mean, obviously we'd say, well, if I really want to do this thing, I can lower my bid just a little bit. I'll go to it for 40, you know, or whatever. Yeah? I have to comment, one will be that, according to this idea, we have also to say probably that labor is not a specific factor of production, isn't it?

10:04Because yesterday you were opening this possibility that labor could be a specific factor. Yes, now that's right, now he's talking about labor that is at least partly non-specific, that can be allocated to multiple production processes, Production Processes, which is true to all of us, it's true to some extent of all kinds of labor, but you're right, some labor is relatively more specific to particular production processes. But none of them is specific. Yeah, but the one is even in that case, right, even if I can do nothing other than lecture at Rothbard Graduate Seminar. This will be the second comment. This is based on the definition of voluntary as liberty, isn't it, as two kinds of way to say what's free.

10:52Sure. That's right. He is not making some sort of ontological claim about the nature of liberty or what... He's using voluntary and involuntary in a particular praxeological sense, right? meaning that it isn't the case that someone who is willing on the free market if someone who is willing to offer his labor services at a rate below that which the buyer of labor services is willing to pay then there's an opportunity for that for those labor services to be hired there's not there's not a deeper philosophical meaning to voluntary and involuntary in this sense David do you want to comment on that

12:05I mean, what he has in mind here is, you know, catallactic unemployment, right? So there are other senses in which we could use that term unemployment and give it a different sort of metaphysical context, and that isn't what he means here. The defenders, the other people that are speaking about the involuntary unemployment, they confuse two ways of saying involuntary as being impede by someone else, which is the proper way to say it, because it's the only way that allows you to make a distinction between two categories of action, and the physical impossibility to find a job, and this definition is not workable, because it means nothing. I am not free neither to fly, I am not free to...

12:59That's exactly right. The claim is not that there are no constraints imposed on job seekers, right? Right, but rather that the source of persistent unemployment is wage rates that are for whatever reason fixed above their, you know, their equilibrium, their plain state of rest equilibrium values is the point. There's some other interesting things about wages. Rothbard talks about what he calls overt versus total wages or wage rates. Anybody remember what that refers to? Can you see this? Markers not very good. Chad, I want this pen removed.

13:47Does anybody remember what he means by this? Actually, his discussion of wages is pretty sophisticated. He brings a lot of issues in modern labor personnel economics that were not at all in the mainstream of the profession at this time. Here he's talking about the distinction between the actual dollar wage rate, what he calls the overt wage rate, and the total compensation package, which could include other forms of compensation, benefits, non-monetary compensation, the quality of the work environment and so on. He also uses the term psychic income. Did I spell psychic correctly?

14:37Yeah, how'd you know that, you must be psyched. Right, referring to non-pecuniary benefits from employment. Right, I mean, most of the professors in the room... What's he doing? Oh, okay, thank you. Right, most of the professors in the room believe that that they could make a much higher salary if they weren't professors, but instead, you know, were CEOs or worked on Wall Street or whatever. We all believe that we have sacrificed lots of income. That may not be true, but that's what we believe anyway. We choose to go into teaching, into the education field because we enjoy it, right?

15:26For the love of the game, we want to make the world better. We want to educate the next generation and so on. We put up with these paltry, you know, salaries as a form of sort of voluntary self-sacrifice. But it doesn't mean that we're underpaid, right? Because in that sense our compensation, appropriately defined, includes not only cash, but also the satisfaction and enjoyment of being around wonderful people like you. Minus having to be around some of the other... So, I mean, again, that's something that really wasn't in the typical textbook around this time, in the early 1960s. It's a pretty advanced discussion for its time. Why don't we talk about a few of these issues in a little bit more detail, and then we'll kind of see where you guys want to go.

16:17I want to talk a little bit about this Rothbard's analysis of costs. Right, the standard Marshallian analysis differs from Rothbard's analysis in certain critical ways. Right, one is, the standard analysis describes sort of two planning horizons, the so-called short run and the long run. What's meant by the short run, and somebody mentioned this yesterday, I think it was Joe, what's meant by the short run in the standard analysis, it's not quite, It's something between Rothbard's plain state of rest or Mises's plain state of rest and the final state of rest. It means more than simply the period at the conclusion of every voluntary transaction.

17:05It's an equilibrium concept that's kind of a hybrid of the PSR and the FSR. And you know, there's the standard definition that there's at least one factor of production that cannot, the use of which cannot be varied for that planning period. Okay, and then the long run period in which all factors of production are varied, are variable. Rothbard doesn't like the fixed cost, variable cost distinction. And he actually, there's some very important literature that's referred to in a footnote. I didn't write down the page. There's a long footnote where he refers to a work that was done by some English economists. There's a volume edited by Buchanan and Thirlby called LSE Essays on Cost, which they may have the footnote in front of them.

17:53Yeah, here it's this one, on page 592. Yeah, so the footnote at the bottom of page 592 refers to the very important literature from which he derives a lot of his critique of sort of modern cost curve analysis, and that's definitely worth looking at. One critical point that we referred to yesterday is this assumption, the role that the assumption of perfect competition plays in the standard analysis, and the fact that the standard analysis is not causal, right, but relies on the principle of mutual determination or simultaneous determination. Right, that it begins with the assumption that firms are price takers in factor markets, that the markets for factors of production are perfectly competitive.

18:38So any given entrepreneur, any given firm simply looks at the price of capital and the price of labor, takes those prices as given, decides how much capital to use, how much labor to use, and so on. Right? And of course, the market for the product produced by the entrepreneur is also assumed, those prices are also in the standard model, a competitive model, exogenous and fixed. Right? So all the entrepreneur does really is solve a math problem. Right? There's no appraisement, there's no forecasting, there's no entrepreneurship in the sense that we described it yesterday. You have given input prices, given output prices, a production function with different characteristics. You just have to maximize profits, you know, using calculus. That's pretty much all there is to it.

19:25I said, you know, you get something like this, that here's a production process with two inputs. I think it's an example I used in class. I think it was aluminum and steel, A and S. And you have these green lines corresponding to different levels of output that particular combinations of aluminum and steel can produce, right? So you can, so there's some, there's some partial substitutability among the inputs here, okay? So we don't have the, we don't have fixed proportions, we have variable proportions. So you can use all the different combinations of A and S that lie along that first green line, give you a hundred units of output, Q, okay, and all the combinations of aluminum and steel on this second green line give you 200 units of steel, right, so that's all given to the entrepreneur, these green lines are given by the technology of production, by the characteristics of the production process, which of course is also assumed to be exogenously given, it sort of drops down from heaven, here's your production technology, and so there are, you know, there's a price of aluminum and there's a price of steel that's given exogenously in the market,

20:35gives you these purple lines, right, the ratio of relative prices between aluminum and steel. And so if I want to produce a hundred widgets, I want to produce a hundred automobiles, whatever, a hundred units of output, the least costly way to do that is by using this many units of aluminum and this many units of steel, okay. If I want to produce two hundred units of output, the least costly way to do it, given these prices, is point B, to use this many units of aluminum and this many units of steel, Right, and so, the manager, the plant manager, the decision maker, sort of computes, well, for every possible Q, what's the least costly way to produce that much Q, and how much does that cost? Well, then I plot that on a curve with costs on the vertical axis and output on the horizontal axis.

21:25I do that for every possible Q and I get some kind of a total cost curve, right, that might have that kind of curvature or might not, depending on the production function. Okay, so I get my total cost curve by calculating the least costly way to produce any given level of output, given factor prices. Okay, and we say, oh, well, what happens if prices change, you know, if one of the inputs becomes more expensive, again, for reasons that are not explained. There's some exogenous change, in this case, in the aluminum market. Okay, so the price of aluminum goes up, it was P.A., now it's P.A. prime, that's a higher price. Okay, so now if you want to produce a hundred units of steel, a hundred units of output, a hundred automobiles or whatever, the least costly way to do it is not point A anymore, now it's point C, right, because you can produce, you can use less, you can spend less on A and S

22:23if you use the combination represented by point C rather than the old one at point A. okay so a couple things have happened number one the entrepreneurs costs have gone up total costs have increased and number two the proportions of aluminum and steel that are cost minimizing have changed right so you're from a substitute using more steel and less aluminum than it was before but also its total cost of producing a hundred units and every level of output has gone up so the total cost per ships ships up okay what does Rothbard say about this well First of all, he says, you know, these, the Marshalian short run is not interesting. Okay, it's not the relevant, that's not a relevant planning period for the entrepreneur.

23:12A couple of reasons, right? Well, the entrepreneur, the prices that the entrepreneur cares about, and Joe made this point in one of his talks yesterday, I think, or the day before, is the prices the entrepreneurs care about are the prices they actually pay for things. Right? When I go out into the aluminum market and the steel market, what do I actually pay? And what do I think I can actually sell my automobiles for? The actual real prices that are paid in everyday markets. They're not equilibrium prices in the Marshallian sense. They're simply real everyday market clearing prices or plain state of rest PSR prices. Okay? So that's what the entrepreneur looks at. And the economist in trying to either to calculate, you know, to reason through Tracing through, what would be the long-term effects of an increase in the amount of aluminum that is discovered that's available, an increase in stocks of steel, what impact would that have on the production process and on prices if we hold everything else constant, right?

24:15That's a mental exercise, so I think if we trace this process through in analytical time, on the vertical axis of Joe's diagram, what effect would that have on prices and allocation of resources and so on? That doesn't happen in the real world, but it's useful to the economist in thinking these things through, right? And then there's these ERE prices, which again is a mental construct that's used by the economist to try to understand what's, to try to distinguish between interest and profit, for example, as we discussed yesterday. I think to keep in mind is that costs in Rothbardian Analysis, like costs are simply factor prices, or if we mean costs as total dollar amounts, right, the price of a factor times the number of units of the factor that I use, right, so the determinant cost is not sort of exogenously given in some kind of perfectly competitive input market, but rather I as an entrepreneur, I participate in the determination of my costs, right, in my decisions to go out and purchase or to abstain from

25:17from Purchasing Factors of Production. Factor prices are set in factor markets through a rivalrous process of competitive bidding among potential factor users and factor owners. There's no role for so-called perfect competition in Rothbard's analysis. We'll see when we look at shapes of cost curves, we'll look at the concept of average cost, how that comes into the picture. So he concludes that the sort of standard cost curve analysis, you know, at best it doesn't do any harm, okay? It's just a different way of looking at the same phenomena that can be described perhaps more precisely using verbal, primarily verbal reasoning. But at worst it leads to all kinds of misconceptions.

26:04It underlies the whole model of perfect competition, leads us into other kinds of error. You know, there is some, there's some technical matter in this chapter, you know, about returns to scale, divisible versus indivisible factor. Some of my, how shall I put this delicately, some of my more philosophically inclined friends, their eyes glaze over at a lot of the parts of this chapter. Returns to Scale and, you know, increasing average costs and the, you know, get me epistemology or methodology or radical libertarian political economy or whatever. Okay, there is some of that in here, but there's a lot of this kind of stuff too. But just, if you're in that category, suck it up.

26:52He does talk a little bit about, you know, kind of the technical or technological aspects of production. Ways in which factors of production, if they have different characteristics, can be combined. Walter, you all right there? Yeah, there's no water in here. I thought you were getting ready to come up to the board and correct me on something. He points out that, for example, if all factors of production are perfectly divisible, then you have constant returns to scale. The beginning of business is kind of a logical derivation, right? That if particular means can be combined to achieve one particular end, then twice as many of the same means can produce twice as many of the same ends.

27:42You can simply reproduce, here's one process, we just set up another process right next to it. There should be no difference in terms of the productivity of those two processes, But that's only the case if both the factors that you use and the product that's being produced are perfectly divisible into infinitesimally small units. When you have indivisibilities either of factors and or of the output, then you don't necessarily get constant returns to scale. Right? Other things can happen depending on the circumstances. He has an interesting discussion of the refrigerators. So, you know, make a note by that.

28:29Go back and look at that example, if you don't remember it. He says, you know, for example, that you're, you know, it takes a certain amount of capital and labor, let's say, a certain combination of factors to produce one refrigerator. Well, if you add just a little bit more of each factor of production, you get, you know, 1.2 refrigerators, but nobody wants to buy 0.2 of a refrigerator, okay? So as you, you know, when you start out producing refrigerators, right, you're spending money on factors, but you don't have any output that you can sell until you get a refrigerator, right? Right, so your average cost, your per unit cost as you begin to use factors before you get to a full refrigerator is going up.

29:19Okay, because you're having, you know, you're increasing your use of factors, you're spending more money on factors. You're using more factors but you're not getting any more saleable output. Right, until you hit that first refrigerator and now I have something I can sell so my average cost goes down. And then I start working on the second refrigerator and my average cost rises until I get the second refrigerator made and so on. So you have this kind of bumpy, discontinuous sort of average cost curve. Again, talking only here about quantities of factors used, we'll get in just a second to the prices that you pay for those factors. It says, well, suppose that not only the output but the factors of production themselves are indivisible, right?

30:04Right, so I can hire, you know, one hour of Walter Block's time, but let's say I can't hire a minute of his, I can't rent him for a minute, for whatever reason. He's unwilling to supply his services for less than a full hour, okay? Or I can rent the services of an automobile for a certain period of time, but not for less than that, whatever, right? Well, then the shape of the cost curve depends, it depends on how those indivisible factors are utilized, okay? So, you know, the point is, if I only want Walter Block for a minute, but I'm stuck with him for an hour, right, then for 59 minutes his services are underutilized, okay? I only need him for one, I want him to make one little point and then sit down and not say anything else, okay?

30:49But I can't do that. So the point is, if I have to pay him for a whole hour, then for 59 minutes his services are being wasted. He's sitting here but not being used. So he's underutilized, hypothetically, for that 59 minutes, okay? So, you know, as I'm able to use more and more of his services, okay, as these physical, as indivisible factors become less underutilized, then I get increasing returns to scale, okay, meaning more output per unit of input, okay? And likewise, as he becomes more overutilized, I get decreasing returns to scale. You know, the net effect cannot be determined ex ante, praxeologically.

31:35Right, it depends on the particular characteristics of these resources. It depends on how Walter is being combined with the other factors, and how useful he is during these periods when he's remaining idle and so on. Did you ever hand up? I guess, only a technical and small remark on the average cost per unit, that it should be infinite until we are first in it. Yeah, sure, okay. Yeah, that's right. If you're producing zero and you're hiring, if I'm hiring no factors at all, then it should be zero, okay? If I have to hire, right, at the first moment when I hire him, if my output is zero, then I, right, then I can't really have a, As I say, it's undefined, right? Cost per unit is undefined at zero.

32:23You're right. Really, all I'm trying to illustrate is the bumpiness and gappiness, not the origin of the curve. Don't say that again. You're right, but don't say that. But see, there's something else going on too here. It's not only that the quantities of factors increase as I expand output, but Rothbard is quite explicit about this. We're not in the world of perfect competition. Okay, so as one particular entrepreneur expands output, he must bid factors of production away from other entrepreneurs who are also seeking them. Okay, so we're in a world of scarce factors of production, they're economic goods. Okay, so factor prices begin to rise as firms expand output, they try to bid factors of production away from other users.

33:08Right, so in addition to these physical aspects of production, And we also have to take into account that factor prices will be rising, okay? So this, you know, I've got my sort of bumpy curve, if you forget about the origin for a minute, my bumpy curve, you know, it doesn't have, it's sort of detrended, right? But if we add the increase in factor prices, we want it bumpy and upward sloping, okay? Because not only do we have this indivisibility issue going on, but also factor prices are going up. And he says, if you combine the technological features with the factor pricing features, we could say that average cost tends to rise as firms expand output due to the increase in factor prices.

34:01But this may be offset from the gains from more efficient utilization of fixed factors of production. Okay, so as I expand my output of lectures, I have to pay more to bid away the water and the electricity and the books and the other factors of production that I need, which makes my average cost rise. On the other hand, I may be able to make more efficient use of Walter Block, which pulls my average cost back down. You know, exactly how these things balance out, again, cannot be determined ex ante, but depends on the particulars of this process. Oh, he also makes this point about, well, sorry, along the same lines, you know, what, so the bottom line, what's the optimal scale of production, or if there's not something, this is something that the entrepreneur is trying to figure out, right, so the entrepreneur tries different combinations of inputs and different output levels and, you know, experiments and realizes profits and losses and makes adjustments and so on. So this is a real, the idea is that these

35:05Decisions about how to use factors are made, you know, in real time by real flesh and blood entrepreneurs as they experiment with different combinations of inputs and outputs, okay? It's not merely a blackboard exercise. Okay, one other thing I want to talk about, just before we sort of open it up a little bit more widely because I think it's extremely important. It's one of my favorite sections of the book is this part on business income, okay? and it gets into a little bit of accounting and management and I do most of my own research in sort of business administration. So this is actually quite a lot of insight and novelty in this section, in particular the treatment of vertical integration and firm size is innovative and I think even today has not really been incorporated into not only the mainstream but even into some Austrian analyses of questions of the firm.

36:04Okay, remember that we talked yesterday about these ERE returns in the evenly rotating economy to different factors of production, right? And we said that in the ERE there's no profit and loss because there's no uncertainty about the future, right? So all factor prices are bid up to equal their DMRPs or DMVPs, so there's nothing left over for the entrepreneur, there's no residual for the entrepreneur. So in the ERE, land and labor earn rents, they get a per unit price for the use of their services.

36:51Again, remember, this is the Rothbard-Feder kind of rent, just the payment per unit of time. It's not the Ricardian or Marshallian or the rent-seeking notion of rent that Walter mentioned yesterday. It's not something bad. It's not a monopoly gain. It's not something over and above, sort of the factor of payment. It simply is the factor of payment. So factors of production, land and labor get paid rents. Capital does not get a rent. Capital goods don't earn a rent, remember, because the value of the capital goods is imputed back to the original factors, the land and labor that were used to produce those capital goods. So capital gains are an interest. What about, you know, what about business owners? What about capitalist entrepreneurs? Well, they earn dollar amounts of income, but these dollar amounts can be decomposed into different elements.

37:44Now remember that outside of the ERE, entrepreneurs earn entrepreneurial profit and loss. So if the real prices, the PSR prices of the factors of production are less than the discounted value of the output when it's sold, that remainder, that residual is money in the entrepreneur's pocket. That's Mises' definition of entrepreneurial profit. If the entrepreneur ends up paying more for the factors of production than the prices that are realized for the output in the future, taking discounting into account, the entrepreneur suffered a loss, an entrepreneurial loss. So outside the ERE, entrepreneurs get profits and losses. What do business owners get in the ERE? Well, it kind of depends how they're used.

38:34Right and Rothbard points out that there are two sources of income for the business owner, even in the ERE, independent of profit and loss, even if there are no profits and losses. Well, one is if the business owner is actually employed in the business, sort of running things on a day-to-day basis, think of an owner-operated mom-and-pop store. Well, part of the compensation going to the owner is what we might call an implicit wage, right? So think of it in an opportunity cost sense, that I need someone to manage the firm and if I manage it myself, then the money I save from not having to hire somebody else to manage it, right, that's money in my pocket.

39:21So the money I would have paid to somebody else but paid to myself, that's like a wage. So that's a rent in the federal sense. So the entrepreneur, the business owner who runs the firm is getting paid, at least implicitly, I'm paying myself some rent for being the manager. Rothbard also has the, he introduces this sort of interesting concept of, you know, ownership and he says the owner does exercise a kind of a function that's different from simply and really providing labor services. That's also what he calls the ownership function or the decision-making function. We'll talk about that a little bit later, but there's this idea that by virtue of owning assets, alienable assets, there's a certain kind of decision authority that is tied up with ownership and can't be delegated to hired hands.

40:16And exercising that decision authority, providing that decision authority is like providing a service and it earns some rent as well. It earns an implicit rent or an implicit wage payment as well. That turns out to be important when we get to this issue about vertical integration. Rothbard also points out just almost sort of in passing a point that I think is vastly underappreciated in the literature that the standard Marshallian intermediate micro cost curve analysis leaves out a lot of the really important issues in governance and management and entrepreneurship because it's told strictly from the perspective of the manager, of the plant manager, not from the perspective of the entrepreneur or the business owner.

41:09And again, think of your intermediate micro-theory course, your advanced micro-theory course, where the professor gives you a problem to solve and says, okay, here are the cost curves, here's the demand curve, find the profit-maximizing level of output. Okay, well, MR equals MC, or I take derivatives or I do something and I solve it. What real-world problem is that equivalent to? Well, you know, it's like a movie. You wake up one morning and there you are, the manager of the local Wal-Mart down there in Opelika. And, you know, the Wal-Mart's just there. The store is there, the customers are there, all the products are on the shelves. All you've got to figure out is how much stuff to sell, or maybe if you have downward sloping demand curve, what sticker prices to put on the things, so marginal revenue equals marginal cost.

42:03You know, how did the store get there? How did the merchandise get on the shelves? How did this operation even come to be in existence in the first place? That's totally outside the scope of the problem, right? So the problem that you solve in so-called profit maximization, you know, the theory of the firm in standard micro-text, is really just a managerial problem of equating marginal revenue and marginal cost. It doesn't have anything to do with the decision about Establishing the enterprise and the important decision of how much capital to invest in this particular line of business, right? The investment decision is completely exogenous from the point of view of the plant manager.

42:48You know, Mises has the famous line in Human Action where he's talking about he's responding to the market socialist response. He's giving a rejoinder to the market socialist response to Mises' original critique, right, where he said socialism cannot lead to an efficient allocation of resources because there are no factor prices, there's no way to rationally calculate profits and losses to allocate resources efficiently and so on. The market socialist said, oh, well, you know, the government can own all the factories and we put a manager in charge of each factory and we tell that manager to equate marginal revenue and marginal cost, you know, choose output so MR is equal to MC.

43:35Isn't that exactly what managers of firms in capitalism do? What difference does it make that the government owns things? Right, and Mises, you know, great response is to point out that that's not the real problem, okay? The genius of capitalism is not that it allows managers to, you know, Maximize Profits by setting it MR equals MC, right? What capitalism does is allocate resources to different activities in the economy. How much capital should be allocated to each plant? How much capital should be allocated to each branch of industry and so on? These are problems that market socialism doesn't address at all, okay? And Mises has this line about playing market, right?

44:21You can have socialist managers and give them a little socialist factory to run and let them pretend it's like a game, let them play market. So you can simulate that, but under socialism, even under market socialism, you don't have entrepreneurs who are playing speculation and investment. That is impossible when the means of production are owned by the state or owned in common. And this is a reference here that, right, that the real, the critical problem is not this sort of managerial problem, but the entrepreneurial problem, the investor's problem, okay?

45:00I don't, I guess the reason this point about implicit incomes is so important is because, right, He points out that for the entrepreneur to calculate the profitability of a venture, he needs to have cardinal numbers, he needs to have costs and receipts expressed in monetary units because otherwise you have heterogeneous capital goods and heterogeneous outputs and you need some way to aggregate them and you do that by putting everything in money in monetary terms. So, the entrepreneur needs to have some understanding of the opportunity costs of the factors that he employs, right? So, you know, for example, if the entrepreneur has a certain amount of capital invested in some line of production that's earning, you know, a 3% return on investment, whereas there are other investment opportunities in the market, you know, I could take that money out and invest it in the stock market, or I could put it in a bank vault and earn a 5% return, but I'm not going to be very satisfied with the 3% return on the investment I get from producing automobiles or widgets or whatever.

46:09Okay, so the entrepreneur needs to take these implicit costs, opportunity costs into account, right? So he needs to know how much interest am I forgoing on my invested capital? If I own land, right, how much could I rent this land? What can I get for renting this land out of the market? And the fact that I'm using the land myself, right, I'm forgoing that implicit rent. And the same thing with my own labor, right, I need to have a sense of what I could earn on the market to know what's my opportunity cost of running the business myself. Rothbard's point is, you need external markets for these factors to be able to calculate their implicit values, to be able to compute these implicit incomes.

46:58So there has to be a market for my capital, an alternative investment vehicle. There needs to be a market for land and a market for my labor services to be able to put a number to what my labor is really worth. Okay, if you don't have those market, if there are no markets for those factors, I don't have a very clean way of computing my implicit wage. To use your labor specificity example, right? If I run my own, you know, business giving economics lectures, but no one else would hire me to do anything, even to be a ditch digger, right? Then it's very hard for me to come up with a number for my opportunity wage. I mean, I make an educated guess. I make something up. But my decisions made on the basis of those educated guesses will be less accurate, right?

47:49Less informative, less correct than decisions I make if I actually have a market wage that I can use as a benchmark. So you need external markets. That's where Rothbard gets his vertical integration story, his vertical integration argument. He says that, well, you know, he's trying to address the problem that was an issue commonly raised at the time. Well, what if firms either just sort of start to grow internally or they merge, a bunch of firms get together and merge into one, into bigger firms, you get bigger and bigger firms until the whole world is just run by one huge corporation. Like, you get these science fiction movies, you know, dystopian movies where, you know, the corporation runs the whole world, Google, let's call it, okay.

48:41I used to say Microsoft when I gave this lecture before, but they're an old hat, obviously. So, Rothbard says, is this something that we should worry about? And then he tries to establish here, and then also, this is in the monopoly chapter, right? The fact that on the free market there could never emerge one huge firm that controls everything, right, or all the corporations couldn't get together and form one big cartel that controls everything. Why? Well, he points out that as firms expand, right, there are some costs of expansion that have to do with indivisibilities in this decision-making factor. The decision-making factor cannot be applied over an infinite range of activities.

49:27There's finite capabilities to the human mind. So some limits begin to creep in at that point. But there's sort of an ultimate limit to firm size, and it has to do with this need for external market prices. So he describes a vertically integrated production process in which the firm sells intermediate products to itself. He says, well, if the firm becomes so large that there are no external markets for these intermediate products, then the firm doesn't have any way of computing what's the appropriate transfer price or accounting charge to use when Division A sells to Division B. So the entrepreneur can't keep accurate records of the profitability of the individual units of the Vertically Integrated Production Process.

50:18This leads to inefficient production. He uses this concept of calculational chaos. I think it's a great metaphor. As external markets disappear, meaning the firm becomes so large, Google gets so large that it employs all the computer programmers in the world, and it owns all the computer hardware in the world, and so on. As external markets begin to disappear, disappear, islands of non-calculable chaos swell to the proportions of masses and continents. As the area of incalculability increases, the degrees of irrationality, misallocation, loss, impoverishment, etc. become greater. So the firm can never become so large that it is the exclusive buyer and seller of particular intermediate products because it has no way to calculate whether its activities are generating Profits are generating losses and it will suffer in market competition against its smaller, more nimble and more efficient competitors who don't face this problem.

51:27This relates to this question if you look at the historical record of socialism, right? Many critics of the Austrians, critics of Mises will say, look, Mises writes this article in 1920 and says socialist economic, rational economic planning under socialism is impossible. He doesn't just say hard, difficult, it can't be done. Okay, well, the Soviet Union didn't turn out so well. But, you know, it didn't disappear immediately. I mean, from 1920 to, you know, 1991, sorry, 1917, 1921, that's not bad. It wasn't prosperous, but it kind of eeked out a living for quite a few decades. Doesn't that prove that Mises was wrong?

52:13That socialism is possible, maybe it's just not as good as capitalism, but it certainly is possible. One thing to keep in mind is that, and this is the point that Rothbard makes, that ironically, the fact that they were never successful in achieving their goal of total worldwide socialism made it feasible for existing socialist economies to survive as long as they did. Why? Because, you know, the Soviet Union, you know, the practical question, the Soviet central planner, you know, has to build a railroad from point A to point B. You know, what material should he use to build the railroad tracks? And the structural engineers come back and say, well, here's a list of metals that would work.

53:00work, steel, iron, aluminum, titanium, platinum, gold, all of these would work to build railroad ties. But we didn't see them build railroad ties out of gold. Mises' argument says, well, if there are no factor markets, there's no market for steel, there's no market for platinum, there's no market for gold, the planner has no way of knowing, which is the least costly way to build railroad tracks. Why not use gold? Well, I mean, what did the Soviet central planners actually do? Yeah, they didn't have markets for steel. They didn't have markets for gold inside the Soviet Union. Okay, but, I mean, for one thing, they did have knowledge of historical market prices.

53:46They knew that before the abolishment of factor markets, factor prices had been this or that. Now, as you go forward in time, those historical memories become less and less relevant. But the other thing they could do is pick up a copy of the Wall Street Journal and look at what was the world market price of steel, what was the world market price of platinum or gold or whatever. In other words, there were factor markets, there were market prices, they were just external to the Soviet Union. So the existing socialist economies were, and if you want to include Cuba, North Korea, and whatever today are, like islands of socialism surrounded by the sea of an external market. So they're like the position of a large firm in a sense that has become so large that a lot of relevant internal markets have disappeared, but not all of them.

54:37So they could only survive because there was a capitalist world outside them. You know, if total world socialism had been achieved in 1917 or 1920 or 1925, then it would have, you know, probably collapsed in six months, okay? Not decades later, okay? Somebody asked a question in the questions that you guys submitted before about Ronald Coase and the transaction cost approach to the firm. I don't remember who that was. I like to talk about Ronald Coase because it makes Walter's blood boil. The hair on the back of his neck stands up on end. I'm not talking about Coase's theory of property rights, his 1960 article that Walter will probably attack later, but his 1937 paper on the nature of the firm.

55:27And someone asked about transaction cost theory and then the so-called new institutional economics that explains characteristics of the firm in a sort of Coase's framework, right, that the reason we do things in firms is because there are costs of transacting in the market, search costs, and costs of writing contracts, and negotiating with trading partners and so on, and by internalizing some of those functions, then the entrepreneur's fiat substitutes for the market transaction, and that can lead to cost savings, right? So if the external transaction costs are high, it may be more efficient for the entrepreneur to internalize particular functions. So is that compatible with the Austrian approach?

56:14I think it is, although there's some disagreement within the Austrian School on this point. In my mind, what Coase is offering is not really a theory, it's more kind of a heuristic device, I guess, that the fact that entrepreneurs do internalize certain functions and that they use what Rothbard calls the decision-making factor, rather than simply delegating all decisions to external parties indicates that they have some comparative advantage in doing so. That they have some ability to make decisions. And if you want to interpret that as a transaction cost saving, then I think that's fine. And, you know, again, not to engage in too much of appeal to authority, but, you know, very eminent contemporary Austrian economists such as Kirzner and Rothbard are both pretty sympathetic to the Kosian Framework.

57:10Kirzner has a statement in his 92 book where he states the Kosian framework in kind of Hayekian knowledge terms. He says, in a free market, any advantages that may be derived from quote-unquote central planning, by which he means from establishing firms. So Kos even used this language in his 37 piece that the firm is like a little island of socialism, an island of command and control role in this vast sea of the external market, although that's not strictly speaking true, but Kirzner says, any advantages that may be derived from internalizing activities in a firm are purchased at the price of an enhanced knowledge problem. In other words, this sort of Hayekian knowledge problem becomes more important as the firm becomes larger and so and so on.

58:02So we may expect firms to spontaneously expand to the point where the additional advantages of central planning, i.e. internalizing activities, are just offset by the incremental knowledge difficulties that stem from dispersed information. So it's a Hayekian spin on Coase's theory of the firm. In a very interesting article that doesn't get read as much as it should on social, I I think in my mind it's the clearest statement of Rothbard's understanding of the socialist calculation debate. This is a 1976 article. I don't know if we have it online on Mises.org, but we should. In here he refers to Coase explicitly. He says, Coase pointed out that there are diminishing benefits and increasing costs to each of these two alternatives, in other words market and firm, resulting, as he put it, in an optimum amount of planning in the free market system.

58:54Our thesis, his own thesis, adds that the cost of internal corporate planning become prohibitive as soon as markets for capital goods begin to disappear. So that the free market optimum will always stop well short not only of one big firm throughout the world economy, but also of any disappearance of specific markets, and hence of economic calculation in that product or resource. I actually have written an article that was in the Review of Austrian Economics in 1996 that reviews and sort of elaborates on Rothbard's treatment of the limits to the size of the firm and sort of talks about how that compares to some contemporary approaches in organization theory and strategic management for dealing with issues of firm size. That's one of my favorite parts of the chapter.