Production: The Structure

0:00I consider this one of the most inventive chapters in Man Economy and State, because not only does Rothbard use Mises' concept of the evenly rotating economy to deduce theorems about production, but he also invents a concept of a world of specific factors, and that's unrealistic, as we'll see. But it allows Rothbard to elucidate the precise nature of costs in production. So what we're going to do is go through those two concepts and then show how they're useful in economic theorizing. In fact, these mental constructs are really the essence of economics, praxeological economics.

0:52Mises in fact says that the method of mental constructs is a specific method of praxeology. That's a direct quote from Human Action. So Rothbard begins with Mises' evenly rotating economy. And here there's a little bit of ambiguity, maybe even confusion. There's really two different concepts of equilibrium in Mises, of unachievable equilibrium. One is known as the evenly rotating economy of the ERE. That deals with constancy. That deals with a world of absolutely no change. That deals with a world of robotical reaction rather than human reaction. That is applicable, as we'll see later on, to distinguishing between interest and profit.

1:38There's a complex of returns, of income returns to the firm, and they must be isolated and analyzed. It also sheds light on the nature of entrepreneurship. But there's also something that Mises calls the final state of rest or FSR, which is a concept of slow change. That is, changes are assumed to take place one at a time. One change will fully work itself out before another change intervenes. The reason why we need this construct is to be able to isolate and examine the nature of market adjustment processes.

2:24As we'll see, if there's an increase in the price of oil, we'll see a plain state of rest immediately. Demand goes up. I'm sorry, the demand for demand goes up. Price goes up. Entrepreneurs start to make plans for the future. But that's at that precise moment. If nothing else were to change, then there would be a series of adjustments of the entire economy that may take many years or even decades to that change in the price of oil. So what the final state of rest does is to assume that no other change intervenes until the entire production structure, the entire capital structure, the entire pattern of allocation of resources is readjusted to that change in demand. So in this chapter, Rothbard is actually talking about the final state of rest.

3:13or actually using it. Now, the final state of rest is a situation in which when the economy is again finally adjusted, we know it, or we know conceptually that will be finally adjusted when there are no more profits or losses. If no other change intervenes, if no other change, exogenous change is introduced, no other change in tastes, technology, available resources, skills of the population, weather patterns, everything is frozen, Then the economy will fall into an evenly rotating state, or rather an evenly rotating situation in which it repeats itself, day after day or season after season, okay? That then is another construct. So when Rothbard says it's the ever-shifting goal of human action, what he means is that eventually if there's one change and there's a full adjustment to that change and no other change occurs, Then you'll have the evenly rotating economy.

4:10So there is a connection between the final state of rest and the evenly rotating economy. So we want to, we live in a real world of a continual change in data. When I use the term economic data, I'm going to refer to value scales, or what neoclassically economists call tastes and preferences. Available resources. I'm going to include in available resources, not just natural resources, but also labor skills, labor aptitudes, desirability that people have for different types of labor, as well as features of our world that may not even really be good in any sense, like weather patterns, okay? Anything that can affect production is going to be frozen, right?

4:56Also, there are no depletable natural resources in the evenly rotating economy, okay? Or if there are, then as one source of, let's say, oil or a mineral is completely depleted, a new source is just found serendipitously at the time that the other source is completely depleted. We can assume, we don't have to assume that people are immortal, but we do assume that as one person leaves the labor force, someone with the exact same skills replaces him, enters the labor force. So all these things are frozen. What's important is not the actual way that we frame this unrealizable construct, but it's an instrument.

5:45And the instrument is one that will allow us to shed light on change by freezing change in a logical way, by exhausting any possible avenue by which there can be a change in the data. Okay, so now what about the final state of rest? The final state of rest is a situation in which the economy has come to rest, okay, in the sense that all adjustments have been made, there are no profits and losses, there are no entrepreneurial profits and losses, capitalists do earn an interest return, an equal interest return, let's say everyone earns 10% on all the investments in the economy, So, we would say that the economy is producing those goods, which satisfy the most urgent wants of the consumers in the most economical way.

6:36Okay, using the best available technology or the most economical of the available technologies. Suddenly something happens in that situation. Let's say there's an increase in demand for oil, big increase in demand for oil. Okay, so Rockwell points out that there's really two phases in this analysis. He calls it evenly rotating economy analysis, but it's really the final state of rest analysis. One period is a transition to the final state of rest. The other is the new final state of rest itself, which emerges. When that final state of rest emerges, and I'll give you a sort of a visual of this, what happens is that the pattern of prices is such that if no other changes are introduced into the economy, that pattern of price will repeat itself every day.

7:25It's not to say there's no, as Jeff, Dr. Herbert reported out, that there's no change or there's no reappearance of people's value scales every day or every week or whatever it is. People going to market, new stocks coming into the market, okay, all of that goes on, okay. The exchange doesn't halt, it just goes on in the same way as the day before and the day before that and so on. So let's, let me just give you a graph that represents one use of this final state of rest analysis. It's up here. Okay.

8:10We're currently at point, at this point right here. Let's assume that's the intersection of the demand and supply for oil. The relevant curves are the vertical S1, that's the stock of oil at that moment in time, and the instantaneous demand curve D1, there's a certain price and a certain quantity, determined by the intersection. Suddenly there's an increase in the demand for oil globally on the part of China and India and so on. Immediately there's an increase in demand, or in price rather. There's a new plain state of rest, so that price is now much higher than it was before, it jumps from P1 to P2, okay?

8:56That, we actually observe that in the real world, okay? That's the exchange equilibrium that we've been talking about. That's a change in value scales that drives the price up, that price emerges in the real world, people economize on their use of oil, okay? People who have not had that change in value because they have to cut back. Others who experience the change in value scales are the ones that bid up the price of oil, those people in firms and so on in India and China. But what happens? Suddenly now there's these huge profits, far above all profits of other firms in the economy. Now, if at that moment we freeze the economic data, we don't allow any changes in value scales, technology and so on, What's going to happen over time, and it's going to take time, that's the key to this analysis, is that entrepreneurs that are already in the industry will begin to make plans to expand their oil.

9:54Okay, refineries will put on second and third shifts, will begin to get an increase in supply. So the instantaneous supply curve will shift down from S1 to S2, driving the price down somewhat. There'll be a series of these changes that will occur one after the other. As more time elapses, entrepreneurs will begin to add to their plant, to bring into production old equipment, so refineries will expand. The same time, firms that provide oil drilling equipment will begin to gear up and produce more. You'll have Wildcat speculators who, I don't know if the word speculators, but those people that look for new oil explorers, They'll begin to gear up and begin to explore for more oil.

10:43And over time, the supply of oil will increase. It will continue to increase until we reach some final state of rest. That is, there'll be a new price, it'll be higher than the old price. It will be P, F for final state of rest, prime. At that point, as the supply is increased, all profits in the oil industry will be wiped out. More resources will have been allocated from the rest of the economy to producing oil, okay?

11:17There'll be a lot of other changes that have occurred in the economy, which I'll get to in a moment. But the other thing that will happen is that resources that specifically produce oil or more or less specific to the oil producing industry will now have a higher price, okay? They'll be bid up in price. So therefore, the so-called cost of production will be higher. The price will fall no lower than this P.F. crime, okay? What we call the marginal revenue products of all factors will be the same in the oil industry as they are elsewhere. So wages will be the same again. Initially, wages will be bid up, okay, as entrepreneurs begin to react to these profits by hiring more workers and also by renting more equipment and demand and purchasing more equipment, okay?

12:08So we have traced out the full adjustment. Now, this can take not just years, but it could take decades. So it doesn't happen right away. And in fact, at the next moment, in the real world, after the price of oil shoots up, there are other changes. At the same time, there's a complex of changes going on that have nothing to do with the oil industry, other exogenous changes at that moment. Why is this useful? It allows us to know what direction any particular change is pushing the economy in. As applied economists, we then have to, with this analysis, you know, given this analysis, okay, that we've absorbed, we have to then use our insight and our historical insight and try to then see what's going to be the ultimate outcome of all these changes.

13:00There might be increases in commodities at the same time as the increase in the price of copper, for example, the same time as there is an increase in the price of oil. Well, copper may be used in oil equipment and that could slow down the adjustment or could counteract the adjustment, could drive costs up before and erode profits in the oil industry. We have to know this analysis in order to be able to make an educated prediction of what Hayek would call pattern prediction of the outcome of all the relevant processes occurring at any given moment in time. Okay, so we're not saying that economics uses this mental construct because things do happen one time, or one step at a time, or one change at a time. We're not saying that, okay? We're saying that in order to grasp the full tissue of adjustment processes, which are all interrelated and interlinked at any given time, you have to be able to know how each change will drive the economy.

13:58So in other words, in this example, I point out that in this particular change will be an increase of demand for oil, push up the price, profits represented by pie will increase, and then the various instantaneous supplies will increase over time. But also, the price of oil is the cost of production in plastic. So there'll be a fall in the supply of plastic, an increase in the price of plastic. Kids next Christmas will get fewer skateboards, because the price of plastic or plastic is an input into skateboards. Of course, the production of skateboards will go up, there will be fewer skateboards. That will increase the demand for a substitute for Christmas. Let's say video games, the demand for video games will go up. There will be an increase in demand for work in the video game industry.

14:44All of these things are endogenous changes that result from a change in the price of oil. So even if you assume one change, there's still very complex changes that are going on throughout the economy that is being analyzed in this state of rest. So the entire economy is revolutionized by that one change. So that the new final state of rest is one that doesn't look any... It's not just that there's a different price of oil, there's more oil being produced. Doesn't look anything like the prior state of rest. That is the way the economy looked at P1, okay, where we were assuming that there was a final state of rest which we call, that that price was a final state of rest price equal to P.F. That is, at that point, whatever other changes had occurred, stopped.

15:31So this analysis is bounded on both sides by this fully adjusted economy. So this shows us also the function of profits and losses in moving resources around the economy. Let me use you as guinea pigs and put up a little graph to sort of show this, this analysis, sort of something new that came up with, I have it here. Yeah. Peter Klein and I are writing a book on the fundamentals of economic analysis and I was coming up with a graph to try to explain or visual to try to explain the relation of the final state of rest, the plane state of rest in the economy.

16:28If you look at the horizontal axis, that's historical time, and let's say it's in market days. The PSRs are the prices we see when we look out these windows. They're the actual prices that are being paid at the gas stations along College Avenue. The actual price being paid at the Peter Pitt pit and Cheeseburger Downtown. Actual price is being paid at Super Walmart, okay, right now. There is a structure of prices in the economy that are emerging from people's value scales and the stocks available. And that's what happens in the real world. We move through historical time from one state of rest to the next. The changes that occur today, today being the today's plain state of rest, set up processes that begin to work themselves out, are buffeted and changed and moved around by other changes tomorrow and the day after.

17:26So every day there's a new plain state of arrest emerging. Actually every moment I use market day as a sort of representative of that. However, if we were to right now freeze all changes, we were to freeze technology and so on and value scales, and Value Scales, then we would stop moving along historical time and move along a notional analytical time. We would move up this line, okay, towards this goal, what Rothbard calls the goal of human action. That is this revolution in the economy that will occur and it will eventually... Now here we're freezing all the data, okay, and there's many, many changes. It's going to take decades for all of these changes that have just occurred and that have occurred in the past and have not been fully worked out to work themselves out into a new final state of rest.

18:18I've drawn the lines deliberately of different lengths, the vertical lines, to show that sometimes we're closer, sometimes we're further away from this final state of rest, depending on entrepreneurs anticipating what's going on, depending on whether processes reinforce one another or counteract one another. It doesn't matter. We never reach the red points, which represent final states of rest in the economy, okay? So Rothbard says that, so when other changes occur, we're now at PSR2, if things were to be frozen tomorrow, we would move up towards FSR2. Every plain state of rest has a final state of rest to which it is tending, okay? And to which profits and losses will push it, and at which point profits and losses, When the final state, when the economic adjustment processes culminate in the final state of rest, those profits and losses will become nil.

19:14Now, if nothing happens, if we reach this point, there are no more changes, then the evenly rotating economy will come into being. So that's the relationship between the two. It's a little bit more explicit in Mises than it is in Rothbard. Rothbard will take the shortcut and says, well, it's a tentative, evenly rotating economy. Well, that's not quite true, okay, because the evenly rotating economy is such that people don't even have expectations of future. With the final state of rest analysis, people tend, expectations can change. In fact, that's one of the changes that we analyze from day to day, okay? What will happen to the economy if nothing else changes, but expectations about some source of supply, about some demand in the future, okay?

20:06So I hope you like my sort of innovative diagram. Actually, I had come up with this a while, I give this at the Austrian Colloquium at NYU and in relation to another paper that I was giving. And the response was, everyone looked at Israel Kirzner and said, well, didn't you draw something like that in the 60s or something like that? So he says, yeah, I did. Oh, well, that's good, you know? So it was good because it was sort of, Israel had drawn it once before. He said, not exactly. He said, Professor Salerno, this is an innovation. And he says, I had something like that. He's always very kind and very generous in that respect. Okay. All right. Now let me say some words about the evenly rotating economy.

20:53The only way to rotate the economy is important not for grasping adjustment processes but for grasping the distinction between profit and loss and also a distinction between profit and interest and also grasping the function of the entrepreneur. Rothbard has many good things to say about the ERE. First of all, let me give you an idea of the ERE. If you're in the ERE and nothing is changing, that is implications for the production process, the production structure. What we assume in the ERE is this, that the prices of goods, now or in the future, are known to people as openly and as clearly as you can see this $20 bill.

21:44We know exactly what the price of, let's say, a VCR is now, or an LCD television is right now, okay, now and in the future, and it's unchanging. Every day, people's values, people come into the markets with their value skills, which have not changed, stocks are produced, which do not change. So there are plain states of rest, but they're exactly like every other plain state of rest. So the economy moves, but it evenly rotates. So, if in fact, everyone knows the price of all goods, as you know the price of this $20 bill or as you see this $20 bill, and let's assume you trust me completely, implicitly trust me, and I tell you that in one year's time, I will hand this $20 bill to you, how much will I be bid for this?

22:35Let's say you're all entrepreneurs, because entrepreneurs are the ones who are bidding, okay? Actually, again, that's an inconsistency in the ERE. There are no entrepreneurs, but there are sort of these people that are producers that bring the factors together. But in any case, the price would be very close to $20. And assuming that people have time preference and they still do in the ERE, the price might be $19.50, depending on what the social rate of time preference is. So all prices would be exactly the same. All prices would be, rather all prices would never change over time. All prices of goods would be equal to their so-called cost of production. We'll talk about that. It's actually the prices determining the cost, as we'll see. There'd be no room for profit or loss.

23:21There would be really no room for the entrepreneur. The factors of production really couldn't come together spontaneously. There would be no room for money, as we'll see. So let me talk about what Rothbard sees as characteristics of this ERE. The ERE in the language of neoclassical economics is the long-run equilibrium, which departures from, according to neoclassical economics, are monopolistic. So if there are profits in the real world, if there's advertising in the real world, well, there has to be something suspect about that. There has to be something inefficient about that, because everybody knows everything in the ERE. Why do we need advertising, except to manipulate consumers?

24:07Why are there profits, except if there's a restriction of supply somehow, or market barriers to entry? So Rothbard points out the following. He says, first of all, that the ERE is an ethically neutral tool. It's not an optimum position. Why would we think that, you know, people robotically going through the same sort of motions every day and actions and so on, why would we think that that's sort of ethically superior to spontaneous indeterminate human action? Okay, it's certainly not. It's a useful analytical tool. It's not only unrealistic, but it's also unrealizable. We can... action means change. If we believe that tomorrow will be like today and next year like this year, we would never act.

24:58Okay, so there's not real action in the ERE. There's nothing ethically better about the ERE or the final state of rest as it implies really a cessation of all one satisfaction. There's zero props and losses, as I said, and that's why should that be legitimate? Why should we say that an unrealizable goal sets the standard for economic efficiency? It certainly does not. It also can be described because it is static in a system of equations. And these equations suppress the causal element in human action.

25:44The fact that human action causes change, causes adjustments to anticipated changes. and so on. It uses functions, we know that our functional relationships among variables rest on the notion of determination, whereas again human reason and will and action are all indeterminate. Also this mathematical analysis, which you can conduct of the ERE, which you don't need to conduct, violates Occam's razor, multiplies entities unnecessarily. We can We can describe the ERE in words, as I've done, and we can describe it precisely and exactly, and adequately for our purposes. We don't need math to do it. And I'll follow those all with a number of other criticisms.

26:32Okay, I don't want to spend too much time on this. One last thing I want to do say about this is that there is no monetary demand in the evenly rotating economy, Because everyone knows exactly what their expenditures and incomes will be on every single day, okay? So if you're going to need money, a certain sum of money, tomorrow at a certain time, there will arise various investments that will allow you, that will mature at that period of time, will allow you to earn an interest rate. There will be no demand for money. If there were really no demand for money, then if the demand for money fell to zero, Let's say as you're approaching the the ERE or the FSR, as people became more and more certain of what was going to be the future, prices would explode upward as everyone would try to get rid of their cash balances, okay?

27:22That's why real money is not used in the classical economics, but a numeraire is used, okay? That's why it sort of degenerates into border, okay? Okay, let me very quickly talk about Rothbard's invention, okay, and that is the world of specific factors. What he assumes in this construct is that every human being, every piece of land on the earth can be used in one and only one process of production. A diamond miner can do nothing else except be a diamond miner. He's incapable of any sort of work, other work. An economist can only give economics lectures and maybe, you know, do research, but nothing else, and so on.

28:14So everyone can only be employed in a valuable way in one process of production. And again, every piece of land has its own use. Now, in the real world, factors are, most factors are relatively non-specific. No factor is purely nonspecific, meaning that it can have equal efficiency in all different processes of production, okay? If that were the case, if all factors were purely not, you can't think that through, if all factors were purely nonspecific, there would only really be one factor. If they had all equal capability in all processes of production, and you can't really have one factor.

29:02You have to have more than one factor in order to have production. In other words, it has to be a combination of things so they can be transformed into something else. So in the real world, we have some specific factors like a diamond mine. That's specific to the production of diamonds. But most land is relatively nonspecific. It might be better for best for producing corn, but it can also produce soybeans and other sorts of crops. Same thing with human beings. They might be best at one thing, but if the man conditions change, then they can go into other things. Their marginal product will change, their marginal revenue product will change, they may have lower wages, but again, labor is the most nonspecific, by the way, of all the factors, okay?

29:50No labor is completely specific. So, Rothbard then shows what production would look like here.

30:01And basically, let me get a tight shot of that.

30:14These are two different production processes, A and B. Beginning at the third stage, two stages removed from the consumer, you would have the three factors producing, those three dots there, Producing one capital good, three factors in another production process produce another capital good and so on. So you have four capital goods in the second stage, again they'd have to be combined with specific labor, these specific capital goods and then they would be combined and they would produce the two capital goods that you see emerging in stage one, that's the stage in which consumers goods are produced. Those two specific capital goods would be combined with labor and then the final consumer good would emerge, okay?

31:00Every process would be like that, that process. So what Rothbard does then is to assume, analyze this under a world of what we might call joint ownership of the factors of production, okay? In the case of joint ownership, all the specific factors in a particular production process receive the income. So let's say there's one production process in which two types of labor, two types of land and three types of capital goods are combined. And what if the capital that they produce is purchased for 80 ounces of gold, he uses gold in his example.

31:48Is there any way of determining how much each factor gets? No, it's a lump sum payment. There's no way of determining their relative contributions in value terms to the output of that product. And therefore, there has to be a system of bargaining. The key thing in this world has to do with costs. Now, what are the costs involved in production in a world of specific factors? This is where the mental construct shows its usefulness. Okay, first of all, the costs are subjective, cannot be determined by outside observers.

32:35Let's get to land and capital. Land and capital, to say specific, have absolutely no cost. Okay, there's no cost of using land and capital. They can be used in that particular process and nowhere else. So there's no opportunity cost. But also, there's no cost, sort of disutility cost, as we'll see if there is a labor, okay? The final product, once it has been produced, has no cost. There's a decision to sell the final product, has no cost. We're assuming that there's no use value for the final product, it's only an exchange value. There is a cost to labor, okay, that's the only cost in this world. We call it the cost of this world, and that cost is the utility of leisure foregone.

33:26We call it the disutility of labor. How then is the price of the product that emerges determined? Well, it's determined not by the costs. The costs determine the extent that they affect labor. If people have greater leisure preferences, what we're going to find is in this specific world, So, you're going to have fewer goods forthcoming, fewer consumer goods. If people's leisure preferences fall relative to earning an income, earning a money income, then it's going to be more produced. So, the cost is only going to affect the supply. And that was Jevin's point many years ago in 1871 when he wrote his theory of political economy.

34:11That costs only have any influence on price through supply. So you're going to have a supply merge, you're going to have people's value scales, there are still consumers in this world obviously, the people that earn income, these various joint factor owners, they'll then determine the prices, okay? The prices then are what is received in income by the joint owners of the factors of production. So that the costs are then determined by the prices, okay? You can see that very starkly in a world where there are no nonspecific factors, that the costs are imputed back from the prices onto the factors. Because what are costs? They're nothing but the sum that must be paid to produce a particular good.

34:59So in the first stage, the owners, the joint owners of the consumer good, If you could get a certain amount of gold, they then take some for themselves in their labor capacities, and then they must also spend some on capital goods. There's one other cost in this world, and that is the fact that laborers do have an opportunity cost besides leisure, and that is producing in shorter or longer processes of production. In other words, they can produce more goods for a higher income if they produce in a longer process of production, or they could produce a smaller quantity of goods, which will earn them a lower income if they all agree to engage in a shorter process of production, if they all go fishing with fishing poles rather than first producing a net and then fishing.

35:58So there is a time, time preference is a cost also in this world. So, time preference is part of this world. Okay, then Rockwell, and I'm just going to sum that up, basically analyzes the same world now with people who hire the factors of production, hire all the factors, they're called the capitalists, and then receive the income and pay the workers from that income. The final section I want to quickly go through in about two or three minutes. That's the section that deals with money, cost, prices, and Alfred Marshall. As Rothbard points out, the payments to the factors, okay, it's so starkly clear here in this chapter, are the money costs.

36:43So the costs themselves do not determine prices. Everything runs up from the consumer goods, up through the various factors. And it is true, in the evenly rotating economy, he brings this in, in this world, The total money spent on any particular good would be equal to the total money cost of that good. So the Marshallian economists, who claim that costs have an independent influence on supply, claim that it's really the money costs that determine the prices, or have an equal influence as the blades of a scissor in supply and demand in determining the prices, okay?

37:35So, Rothbard points out that the confusion stems from this. When you reason in the ERE and you don't realize it's only a mental construct, the equality between money costs, the average cost or the per unit cost and the price of the good or alternatively, the total revenue earned and the total cost, that equality makes it easy to confuse the causal relationships. That is, it may appear as if the cost is determining the price, what in fact it's not. So, the combination of the ERE and the world of joint factors makes it completely clear that prices, which are determined by consumer valuations in conjunction with existing stocks are what determines the costs.

38:30The costs are nothing but payments to the factors of production. One last point I wanted to make was that Marshall thought that the Austrians were right in the immediate run or the short run, that utility sort of dominated, but that in the long run, which he saw as the difference between the waves in the ocean, the waves in the ocean being the changes in prices going on from day to day, and the level of the ocean being the long run level of the final price, okay? Marshall claimed that the final price was the real price in some sense, the underlying price, the price to which everything returned, okay? and that therefore, that price, since it was equal to cost, was a determining factor.

39:20Whereas the Austrians see that that price is nothing but a fictional endpoint that can never be reached, because of changes intervening every day. Well, to put this up, it's a state of affairs that is at best decades away, if it ever even really can be reached, okay, from the, let me just get a wide shot on this, okay. That's up here. These are the real prices. These are the actual prices. These are what determine economic activity. These are what entrepreneurs use for calculation. These prices are what drive their actions, both existing and expected prices.

40:10The prices that emerge up here have nothing to do with the entrepreneurs. They don't care about them. They don't think about them. The economist, they're a figment of the economist's imagination, which is a useful figment. I'll stop there and take questions. And actually, there were some good questions that came in, too, on this chapter, which I hope I have addressed, especially the usefulness of fictions, even fictions that are logically contradictory and can't exist like the ERE.