Production & the Market Process

Robert P. MurphyMises AcademyAugust 6, 2011

Lecture 4: Chapter 7 of Man, Economy, and State

Guest Lecture by Peter G. Klein

Production: General Pricing of the Factors (ch. 7)● Role of production theory in MES

○ Structure (ch. 5)○ Interest (ch. 6)○ Factor pricing (general) (ch. 7)○ Entrepreneurship (ch. 8)○ Factor prices and incomes (ch. 9)

● Importance○ Step-by-step development of production

theory: a Rothbardian innovation■ Menger: general principles■ Böhm-Bawerk, many insights, but not systematic■ Only tangentially addressed by Mises

○ Small role in alternative, currently fashionable Austrian approaches

Background: Austrian theory of imputation

● Definition● Characteristics● Comparison to other approaches● Significance

General principles of pricing for higher-order goods

If, as the result of a change in tastes, the need for tobacco should disappear completely, the first consequence would be that all stocks of finished tobacco products on hand would be deprived of their goods-character. A further consequence would be that the raw tobacco leaves, the machines, tools, and implements applicable exclusively to the processing of tobacco, the specialized labor services employed in the production of tobacco products, the available stocks of tobacco seeds, etc., would lose their goods-character. The services, presently so well paid, of the agents who have so much skill in the grading and merchandising of tobaccos in such places as Cuba, Manila, Puerto Rico, and Havana, as well as the specialized labor services of the many people, both in Europe and in those distant countries, who are employed in the manufacture of cigars, would cease to be goods. Even tobacco boxes, humidors, all kinds of tobacco pipes, pipe stems, etc., would lose their goods-character. This apparently very complex phenomenon is explained by the fact that all the goods enumerated above derive their goods-character from their causal connection with the satisfaction of the human need for tobacco. With the disappearance of this need, one of the foundations underlying their goods-character is destroyed. [Menger, Principles, p. 65]

General principles of pricing for higher-order goods (cont.)

[This is the] general law of the determination of the value of a concrete quantity of a good of higher order. Assuming in each instance that all available goods of higher order are employed in the most economic fashion, the value of a concrete quantity of a good of higher order is equal to the difference in importance between the satisfactions that can be attained when we have command of the given quantity of the good of higher order whose value we wish to determine and the satisfactions that would be attained if we did not have this quantity at our command. This law corresponds exactly to the general law of value determination. [Menger, Principles, pp. 164-65]

Background: Austrian theory of imputation

● Definition● Characteristics

○ What is being priced: unit factor services○ Assignment of a good to an “order” is subjective (e.g., bread)

● Comparison to other approaches○ Classical economists, Marx○ Neoclassical economics: assumptions of variable

proportions, profit maximization, and perfect competition● Significance

○ Central to Misesian critique of socialism Schumpeter (1942): feasibility of economic calculation under socialism follows “from the elementary proposition that consumers in evaluating (‘demanding’) consumers’ good ipso facto also evaluate the means of production which enter in the production of those goods.”

Rothbard’s approach to imputation

● Like neoclassical model: inputs (land, labor, capital), outputs, profits, and losses

● Some unique aspects○ No cost curves○ Economic (causal-realist), not technological, explanation: emphasis

on means and ends (implies time and uncertainty)○ No assumptions about perfect competition in factor markets○ Emphasis on factor specificity, not merely variability, for marginal

productivity theory○ Explains prices of real-world, discrete factors (units of labor, capital

goods, etc.), not generic aggregate categories of “capital,” “labor,” etc.

○ Entrepreneur is present!

Rothbard’s approach to imputation (cont.)● Discounted marginal value product (DMVP = DMRP)

○ Drop assumption of purely specific factors and consider substitution across lines of production

○ Money revenue attributed (“imputed”) to one service unit of a factor, discounted by social rate of time preference (i.e., pure rate of interest)

○ Establishes entrepreneur’s maximum willingness to pay for one service unit of a factor.

○ Given competitive bidding by entrepreneurs, ERE factor prices (rents) will equal the factor’s DMVP – as long as the factor is isolable.

■ Variable proportions■ Nonspecific factors

Examples �

Calculating DMRP and ERE price

● Nonspecific factors 4A + 10B + 2C → $100used in variable proportions: 3A + 10B + 2C → $80MRP(A) = $20P(A) = $20

Calculating DMRP and ERE price

● Nonspecific factors 4A + 10B + 2C → $100used in variable proportions: 3A + 10B + 2C → $80MRP(A) = $20P(A) = $20

● Nonspecific factors 4A + 10B + 2C → $100used in fixed proportions: 3A + 7.5B + 1.5C → $75MRP(A) = $25P(A) = no more than $25

Calculating DMRP and ERE price

● Nonspecific factors 4A + 10B + 2C → $100used in variable proportions: 3A + 10B + 2C → $80MRP(A) = $20P(A) = $20

● Nonspecific factors 4A + 10B + 2C → $100used in fixed proportions: 3A + 7.5B + 1.5C → $75MRP(A) = $25P(A) = no more than $25

● An indispensable 1A + 2B + 3C → $200(non-isolable) factor: 0A + 2B + 3C → $0MRP(A) = $200P(A) = no more than $200

Calculating DMRP and ERE price

● Nonspecific factors 4A + 10B + 2C → $100used in variable proportions: 3A + 10B + 2C → $80MRP(A) = $20P(A) = $20

● Nonspecific factors 4A + 10B + 2C → $100used in fixed proportions: 3A + 7.5B + 1.5C → $75MRP(A) = $25P(A) = no more than $25

● An indispensable 1A + 2B + 3C → $200(non-isolable) factor: 0A + 2B + 3C → $0MRP(A) = $200P(A) = no more than $200

● The adding-up problem● The $20,000 steering

wheel

Böhm-Bawerk’s “law of costs”

● Classical and Marxian versus Austrianvalue theory● Böhm-Bawerk’s law: prices of reproducible

goods, produced under competitive conditions, tend to equal their money costs of production● But, this doesn’t mean that cost determines

price, because the “costs” are determined by foregone utilities elsewhere in the economy!● Distinction between proximate and ultimate

costs

Neoclassical model of factor pricing

S

Aisocosts: X = pSS + pAAX2/pA

X2/pS

X1/pA

X1/pS

Q100

A

BQ200

Q300

Neoclassical model of factor pricing II

S

A

X2/pA

X2/pS

X1/pA

X1/pS

Q100

A

B

price of aluminum rises from pA to pA’

X1/pA’

X2/pA’

CX3/pA’

(use this to derive factor demand curves which, combined with a supply curve, determines the price of the factor)

Neoclassical model of factor pricing III

S

A

Leontief technology

X2/pA

X2/pS

X1/pA

X1/pS

Q100A

BQ200

Q300

(conclusion: prices are indeterminate)

production function isoquant Isocost

○ Take factor prices as given, let them vary, and trace out factor demand curves.

○ At given prices, find cost-minimizing bundles for each output level, then trace out short-run total cost curve.

utility function indifference curve budget constraint

○ Take goods prices as given, let them vary, and trace out demand curves.

○ At given prices and income (wealth), find the utility-maximizing bundle of goods.

®

Note: close parallel to neoclassical utility theory

Average and marginal physical product

Land, labor, and capital

● Differences○ Land and labor: original or primary factors,

irreproducible○ Capital: reproducible○ Note on “human capital,” “knowledge capital,” “social

capital,” etc.● Rents

○ Marshall-Ricardo○ Fetter

● Rent and capitalization● Gross and net rents● ERE returns to land, labor, and capital

Takeaways

● Important task of price theory: explain factor prices, not just consumer-goods prices

● Role of factor pricing the socialist calculation debate● Austrian challenge to cost-of-production theories● More to come in chapter 9!