Production Theory:

In recent years it has been a mainstay of economics textbooks to emphasize production possibility curves (PP). What stands behind this analysis is the assumption that decisions made about: What to produce? How to produce it? and For whom is it to be produced? is the price system. Acs and Gerlowski (1996. Managerial Economics and Organization) have stated that:

Economists refer to the collection of related markets in a capitalistic economy as the price system. The price system achieves coordination by answering threebasic questions concerning what to produce, how to produce it, and for whom toproduce it. One basic criterion used in determining the adequacy of the price system is whether the allocation of resources obtained by the price system happensefficiently. (88, emphasis in original)

Put very simply, efficiency is the process of getting more for less. … An economyis efficient when it is impossible to get more output from existing resources. Efficiency is what all economic systems strive for whether they are individuals,organizations, or countries. …

The study of the interrelationship of all markets is known as general equilibrium theory. (89, emphasis in original)

The most common reasons for markets not achieving efficient coordination are market power, imperfect information, increasing returns in production, and externalities. When any of these conditions prevail, the market may be inefficient.When people found that markets were inefficient in coordinating economic activities, they often organized firms. Remember the functional component in the definition of firms – they organize economic activity. (89, emphasis added)

Notice the ‘most common reasons for markets not achieving efficient coordination’ –

Market power – results from market structures and pricing decisions – the more participants in a market, the lower the degree of market power exercised by any party (Competition). If there are few sellers and many buyers, the sellers are able to set prices at higher levels than would have been the case if the were many sellers. Similarly, if there is a single buyer of a resource, the buyer is able to dictate a lower price than would have been the case with many buyers bidding for the resources. [Incomplete markets]

Imperfect information – Acs and Gerlowski have observed: “The competitive model assumes that firms and households are well informed. Imagine knowing every good and service sold at every store and the price at which they sold. If information were perfect –complete and accurate – problems of how to allocate resources would be relatively easy to solve. But information is imperfect – less than complete and accurate – and costly to acquire.” (109,

emphasis added) They continue: “Imperfect information can flaw the tendency toward an efficient equilibrium such as predicted in thestandard competitive model.” (109) “Imperfect information regarding prevailing wage rates for labor (or rental rates for capital) can alsocreate problem leading to inefficient production.” (110)

A situation ‘… is often referred to as one with asymmetric information.That is, the seller has more information than the buyer. One of the consequences of asymmetric information is that there may be relatively few buyers and sellers, far fewer than there would be with perfect information. (111)

Increasing returns in production – Alfred Marshall defines ‘increasing returns’

as: “… we say broadly that while the part which nature plays in production shows a tendency to diminishing return, the part which man plays shows a tendency to increasing return. The law of increasing return may be worded thus: -- An increase of labour and capital leads generally to improved organization, which increases the efficiency of the work of labour and capital.” (265)

Marshall further observes: “… the two tendencies towards increasing and diminishing return press constantly against one another. In the production of wheat and wool, for instance, the latter tendency has almost exclusive sway in an old country, which cannot import freely. In turning the wheat into flour, or the wool into blankets, an increase in the aggregate volume of production brings some new, but not many ; for the trades of grinding wheat and making blankets are already on so great a scale [economies of scale] that any new economies that they may attain are more likely to be the result of new inventions than of improved organization. In a country however in which the blanket trade is but slightly developed, these latter may be important ; and then it may happen that an increase in the aggregate production of blankets diminishes the proportionate difficulty of manufacturing by just as much as it increases that of raising the raw material. In that case the actions of the laws of diminishing and of increasing return would just neutralize one another ; and blankets would conform to the law of constant return. But in most of the more delicate branches of manufacturing, where the cost of raw material counts for little, and in most of the modern transport industries the law of increasing return acts almost unopposed. (266)

In a footnote to this last paragraph, Marshall comments, additionally:

In an article on “The Variation of Productive Forces” in the Quarterly Journal of Economics, 1902, Professor Bullock suggests that the term “Economy of Organization” should be substituted for Increasing Return. He shows clearly that the forces which make for Increasing Return are

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not of the same order as those that make for Diminishing Return : and there are undoubtedly cases in which it is better to emphasize this difference by describing causes rather than results, and contrasting Economy of Organization with the Inelasticity of Nature’s response to intensive cultivation. (Emphasis added)

Notice the wording, “… the inelasticity of nature’s responses to intensive cultivation…” This represents a continuation of the mistakes made by the Rev. Thomas Malthus – who permitted population to grow geometrically, and by holding technology constant, results in holding resources to grow at an arithmetic rate – allowing technology to grow at a fixed rate. This is given lie to by analyzing data from USDA’s Agricultural Statistics for both corn and wheat [yield/acre] during the last three-quarters of the Twentieth Century and the opening years of the 21st Century. The dramatic expansion in per-acre-yields through time is attributable to changes in technology, e.g., the development of hybrids custom designed to maximize output based on environmental conditions. Similar results have been accomplished by the International Rice Institute [funded by that dirty capitalist institution – the Rockefeller Foundation] – IR 8 hybrid variety in the Philippines, which more than doubled the per-acre-output over traditional varieties. This is the essence of ‘increased productivity’ – more from the same or less!

As a transition to externalities, it is important to review what Marshall has called the Economies of Production [seeking Cost Minimization] and its correlates:

Many of those economies in the use of specialized skill and machinery which are commonly regarded as within the reach of very large establishments, do not depend on the size of individual factories. Some depend on the aggregate volume of production of the kind in the neighbourhood; while others again, especially those connected with the growth of knowledge and the progress of the arts, depend chiefly on the aggregate volume of production in the whole civilized world. And here we may introduce two technical terms. (220)

We may divide the economies arising from an increase in the scale of production of any kind of goods, into two classes – firstly, those dependent on the general development of industry ; and secondly, those dependent on the resources of the individual houses of business engaged in it, on their organization and the efficiency of their management. We may call the former external economies, and the latter internal economies.

Externalities – Before explaining externalities, it is helpful to remember one of The associated factors of the Law of Scarcity – what Milton Friedman called TANSTAAFL, or ‘There ain’t no such thing as a free lunch.” In addition, it should be noted production economies – the economies that

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arise “… from an increase in the scale of production of any kind of goods, may be divided into two categories: -- “firstly those dependent on the general development of the industry; and, secondly, those dependent on the resources of the individual houses of business engaged in it , on their organization and the efficiency of their management. We may call the former external economies, and the latter internal economies. (Marshall, 221, emphasis in original) It was A.C. Pigou who seized upon the negative externalities in his well known book, The Economics of Welfare (1920) declaring it a ‘market failure’ requiring government intervention to protect the third parties and it was Ronald Coase who pointed out that it was simply a ‘transaction cost’ that, under the correct circumstances, could be eliminated by negotiations. (“The Problem of Social Costs,” Journal of Law and Economics, 1960)

According to Acs and Gerlowski: “Externalities arise when an individual or firm takes an action but does not bear all the costs or receive all the benefits…. Therefore, the market fails to guide their allocation. …This failure is especially likely when there are significant scale economies in some production process, so that it is less expensive to produce many units than to produce few.” (111) These provide the logic for the connection between ‘externalities’ and ‘increasing returns of production’.

The notion of externalities is associated with the recognition that both production (producer) and consumption (consumer) activities may give rise to harmful (negative) or beneficial (positive) effects that are not borne by parties to the activities, but rather are externalized onto others, i.e., third parties. Sometimes these are referred to as ‘spillover’ effects. These ‘third party’ effects may be classified into four categories:

external economies (positive effects) of production;external diseconomies (negative effects) of production;external economies (positive effects) of consumption; andexternal diseconomies (negative effects) of consumption.

External diseconomies of production are uncompensated costs imposed on a third party (non-participant) in the activities of a production unit, e.g., acid rain produced by the burning of sewerage sludge at the Buckman Plant on Tallyrand that damages the pained finish on imported automobiles.

External economies of production are uncompensated benefits that are bestowed upon to some third party as a result of the production activities of a firm, e.g., expansion of output by one firm may require ‘supplier firms’ located in the same area (least cost transportation location, LCTL) to also expand their production to meet demand – Anheiser-Busch plant

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and bottle, can and packaging materials suppliers – creating addition jobs and household incomes for workers in Jacksonville. (Marshall, 279: and Alfred Weber, 1909)

Similar results are associated with expected for consumption activities and their uncompensated costs imposed and unrewarded benefits bestowed on third parties as the result of consumption activities.

When viewed from the perspective of the nature, structure and cost of obtaining information, and their consequences insights are gained regarding the allegations of economic inefficiencies and the presumed need for government intrusion and intervention into free markets. The economic inefficiencies allegedly associated with incomplete markets (the exercise of market power), less than perfect information, increasing returns, and externalities are society operating inside its production possibility frontier. This represents levels of resource use (less than full employment of resources) and production below the economy’s potential. The combined effects of the situation are underproduction (un- or underemployed resources and lower returns to the owners of ‘factors of production’) → increased relative product scarcities (and associated higher prices for underproduced goods) → reduced satisfaction of human needs and wants (lowered levels of ‘social welfare’) → need, according to A.C. Pigou, for government intervention to correct the so-called ‘market failure,’ by stimulating consumer demand and ‘full resource employment,’ especially of labor – however ‘full employment’ is defined.

Consider the diagram below:

Unemployed Resources

Problem: Problem: á la A.C. Pigou á la R.H. Coase &

J.M. Buchanan

‘Market failure’ ‘Government failure’

- “inefficient regulations’; - “riddled with monopoly” - “when a command economy is

subject to arbitrary decrees by inept bureaucrats”

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Remember that Acs and Gerlowski have identified four basic factors responsible for the failure of competitive markets:

- imperfect information

- missing or incomplete markets (exercise of market power)

- existence of externalities

- presence of increasing returns

It is worth mentioning that a fifth factor that that contributes to the failure of both a free market and the failure of government: ‘rent-seeking’ behaviors on the part of members of special interest group in the private sector and government bureaucrats. At this juncture it is appropriate to quote Acs and Gerlowski’s comments of ‘rent-seeking’:

Up to this point we have examined how rents can have a positiveinfluence on organizations. In other words, they can be used to increase efficiency. There is also a negative side to the existence of quasi-rents in organizations. The presence of rents in an organization can create incentives to attempt to reallocate theserents. Quite often these attempts at reallocating rents do not increasetotal value and may decrease it. Economists consider such activitiesas pure costs. Activities that no serve social function other than totransfer rents or quasi-rents have come to be called rent-seeking behaviors and directly unproductive activities (DUP). (234, emphasis in original; emphasis added)

The terms ‘rent’ and ‘quasi-rent’ may not be unfamiliar to many. The concept of ‘economic rent’ goes back to writings of David Ricardo [“Essay on the Influence of a Low Price of Corn on the Profits of Stocks.”] According to Robert Formaini’s analysis of Ricardo [“David Ricardo: Theory of Free International Trade,” Economic Insights, 9 (2); @ www.dallasfed.org/research/ei/ei0402.html.] is revealing. He has noted that the Corn Laws (1815):

… forbade the importation into England of food grown elsewhere andsought to maintain the rising prices for British agricultural productsthat had occurred during the Napoleonic wars, when the French navyhad embargoed British ports. Facing the loss of food imports, Britainhad to use more of its own land to feed its population. This caused crop prices, and hence, land rents to rise at rapid rates during the war period.(emphasis added)

Several things are at work here: First, less fertile land (lower productivity) had to be pressed into agricultural production. The use of less fertile land under cultivation, created a ‘surplus value’ on the more productive land, i.e., ‘economic rent’. Second, owners of the most fertile land have a vested interest in maintaining agricultural commodity prices

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high (self-serving, rent-seeking behavior). Third, provides a template for the same ‘rent-seeking behaviors’ in contemporary American markets – in which ‘special-interest groups’ (sugar cane and tobacco growers, steel and auto producers, textile manufacturers, etc.) seek rents through government intervention in ‘free international markets’ and the erection of trade barriers – tariffs, quotas, voluntary export restraints, and content requirements). Trade restrictions benefit small, well organized and funded, special interests at the expense of the consumer and results from collusion between these special interests and government. Interestingly, Robert J. Carbaugh (International Economics, 3rd Ed,) has concluded:

U.S. protection policy is determined by special interest groups thatrepresent producers. This is because consumers generally are not organized, and their losses due to protectionism are widely dispersed.But the gains from protection are concentrated among well-organizedproducers and labor unions in the affected sectors. Those harmed by a protectionist policy absorb individually a small and difficult

Many people view members of the bureaucracy as ‘self-less public servants.’ Such a view strains credulity, since each and every individual, despite their protestations otherwise, are in fact self-interested, pursuing the gratification of their own wants and needs. Government failure is associated with ‘rent-seeking’ behavior (using the powers of government to obtain that which has been denied to them through free competitive markets) and the existence of inefficient regulations –

Consider the following quotations from Alan Greenspan’s paper: “Antitrust,” given at the Antitrust Seminar of the National Association of Business Economists, Cleveland, September, 1961; published by Nathaniel Branden Institute, New York, 1962. Re-printed in Ayn Rand. 1967, Capitalism: The Unknown Ideal, 63-71.

The world of antitrust is reminiscent of Alice’s Wonderland: everythingseemingly is, yet apparently isn’t, simultaneously. It is a world in which competition is lauded as the basic axiom and guiding principle, yet ‘too much’ competition is condemned as ‘cutthroat.’ It is a world in which actions designed to limit competition are branded as criminal when takenby businessmen, yet praised as ‘enlightened’ when initiated by the government. It is a word in which the law is so vague that businessmenhave no way of knowing whether specific actions will be declared illegaluntil they hear the judge’s verdict – after the fact. (63)

Greenspan then acknowledges that:

Americans have always feared the concentration of arbitrary power in the hands of politicians. Prior to the Civil War, few attributed such power to businessmen. It was recognized that government officials had the legal power to compel obedience by the use of physical force – and that business-men had no such power. A businessman needed customers. He had to appealto their self-interest. (63)

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There are several arresting points in this quotation: first, (i) there was once a ‘fear’ of ‘arbitrary power’ wielded by politicians; second, (ii) the Civil War was a benchmark – ‘few’ attributed the abuse of power to the private sector [remember that Karl Marx released the Communist Manifesto in February 1848, which was followed by the outbreak of revolutions throughout Europe] … now the alleged venality of the capitalist class was uncovered … and spread to the United States (see: www.age-of-the-sage.org/ philosophy/ communist_ manifesto.html); third, it was government workers that wielded the monopoly-legal power to coerce individuals to obey their dictates [remember Lincoln’s actions against judges who insisted on the ‘rule of law’ by placing them under house arrest … see: Thomas J. DiLorenzo. 2006. Lincoln Unmasked: What You’re not Supposed to Know About Dishonest Abe.]; and fourth, as noted by Adam Smith (1776): “… businessmen had no such power…. (they) needed customers …. (have) to appeal to their self-interest.”

Greenspan continues his analysis:

This appraisal of the issue changed rapidly in the immediate aftermath of the Civil War, particularly with the coming of the railroad age. Outwardly, the railroads did not have the backing of legal force. But to the farmers of the West, the railroads seemed to hold the arbitrary power previously ascribed solely to the government. The railroads appeared unhampered by the laws of competition. They seemed able to charge rates calculated to keep the farmers in seed grain – no higher, no lower. The farmers’ protest took the form of the National Grange movement, the organization responsible for the passage of the Interstate Commerce Act of 1887. (63-4, emphasis added) The industrial giants, such as Rockefeller’s Standard Oil Trust, which were rising during this period, were also alleged to be immune from competition,from the law of supply and demand. The public reaction against the trusts culminated in the Sherman Act of 1890. (64, emphasis added)

Notice Greenspan’s words which have been emphasized – seemed, appeared, and alleged – reflects his questioning of intent. He continues:

It was claimed then – as it is still claimed today – that business, if left free,would necessarily develop into an institution vested with arbitrary power. Is this assertion valid? Did the post-Civil War period give birth to a new form of arbitrary power? Or did the government remain the source of suchpower, with business merely providing a new avenue through which it could be exercised? This is the crucial historical question.

The railroads developed in the East prior to the Civil War, in stiff competition with one another as well as with the older forms of transportation – barges, riverboats,, and wagons. By the 1860’s therearose a political clamor demanding that the railroads move west and tie California to the nation: national prestige was held to be at stake. But the traffic volume outside of the populous East was insufficient to draw commercial transportation westward. The potential profit did not warrant the heavy cost of investment in transportation facilities. In the name of

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‘public policy’ it was, therefore, decided to subsidize the railroads in their move to the West. (64, emphasis added)

The contrast between the economic realities in the East and the West that Greenspan has drawn is revealing – in the East there were ‘competitive forces’ that were lacking in the West [‘with one another’ and ‘older forms of transportation’ (barges, riverboats, and wagons’)]. He then describes ‘a political clamor’ – i.e., individuals who would benefit directly from the railroads (ranchers, farmers and land-owners and political wanna’ be’s) – in a disgusting display of ‘rent-seeking’ behaviors – explaining the reasons that these ‘special interest groups’ went to government to obtain the results that they wanted! The market demand for transportation services – ‘traffic volume’ (manifest as ‘potential profit’) in the West was insufficient to attract risk-taking, private sector entrepreneurs to the westward expansion of the transportation system – the railroads. The answer was expansion of government powers! In order to satisfy the ‘needs’ and ‘wants’ of the ‘special interest groups’ in the West, (short-term profits from the ability to tap into the eastern markets for meat and grain) government intervention was necessary – the ‘subsidization of the railroads.’

Between 1863 and 1867, close to one hundred million acres of public lands were granted to the railroads. Since these grants were made to individual roads, no competing railroads could vie for traffic in the same area of the West. Meanwhile, the alternative forms of competition (wagon, riverboats, etc.) could not afford to challenge the railroads in the West. Thus, with the aid of government, a segment of the railroad industry was able to ‘break free’ from the competitive bounds which had prevailed in the East.

As might be expected, the subsidies attracted the kind of promoters whoalways exist on the fringe of the business community and who are constantlyseeking an ‘easy deal.’ Many of the new western railroads were shabbily built: they were not constructed to carry traffic, but to acquire land grants.

(64, emphasis added)

Notice the form of the subsidy – 100 million acres of public lands taken out of the public domain and given to ‘special interests’ … alternating ‘square-mile blocks’ for each linear mile of track laid … including subsurface mineral rights, including oil and natural gas! Additionally, the lack of competition from other roads and other forms of transportation, created what Edward H. Chamberlain referred to as a ‘spatial monopoly’:

Let us apply the reasoning to the second phase of differentiation mentionedabove, – that with respect to the conditions surrounding a product’s sale. An example is the element of location in retail trade. The availability of a commodity at one location rather than at another being of consequence topurchasers, we may regard these goods as differentiated spatially and may apply the term ‘spatial monopoly’ to that control over supply which is a seller’s by virtue of his location. (1933. The Theory of Monopolistic Competition: A Re-orientation of the Theory of Value, 62-3)

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His observations apply not just to retail establishments, but extend to other sectors of the economy, see: Appendix D, “Urban Rent as a Monopoly Income,” 266-69.

Greenspan’s discussion of railroad expansion in the West focuses on the consequences of ‘special interest rent-seeking’ and government intervention into the ‘free-market’:

The western railroads were true monopolies in the textbook sense of the word. They could, and did, behave with an aura of arbitrary power. But that power was not derived from a free market. It stemmed from govern-ment subsidies and government restrictions. (65, emphasis added)

The source of the monopoly-power was NOT the forces of free-markets, but government intervention, which had eliminated competitive interactions and supported the creation of monopoly pricing. Greenspan continues:

When, ultimately, western traffic increased to levels which could support other profit-making transportation carriers, the railroads’ monopolistic power was soon undercut. In spite of their initial privileges, they were unable to withstand the pressure of free competition.

In the meantime, however, an ominous turning point had taken place in our economic history: the Interstate Commerce Act of 1887.

That Act was not necessitated by the ‘evils’ of the free market. Like subsequent legislation controlling business, the Act was an attempt to remedy the economic distortions which prior government interventions had created, but which were blamed on the free market. The Interstate Commerce Act, in turn, produced new distortions in the structure and finances of the railroads. Today, it is proposed that these distortions be corrected by means of further subsidies. The railroads are on the verge of final collapse, yet no one challenges the original misdiagnosis to discover – and correct – the actual cause of theirillness.

To interpret railroad history of the nineteenth century as ‘proof’ of the failure of a free market, is a disastrous error. The same error – which persists to this day – was the nineteenth century’s fear of the ‘trusts.’ (65, emphasis added)

Greenspan then proceeds to analyze the ‘trusts’ and the passage of the Sherman Act (1890), beginning with Standard Oil:

What observes failed to grasp, however, was the fact that the control by Standard Oil, at the turn of the century, of more than eighty percentof the refining capacity made economic sense and accelerated the growth of the American economy.

Such control yielded obvious gains in efficiency, through the integrationof divergent refining, marketing, and pipeline operations; it also madethe raising of capital easier and cheaper. Trusts came into existence

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because they were the most efficient units in those industries which, being relatively new, were too small to support more than one large company.(65-6, emphasis added)

Greenspan’s observations may force us to consider the path of many ‘high technology’ industries today – transistors/semiconductors, software, biotechnology, and information technologies – the so-called ‘new economy’ industries. Here, once again, the ideas of ‘increasing returns’ and ‘technological lock-in,’ expressed by Kaldor, David and Arthur, along with ‘transaction costs’ developed by Coase find application.

More specifically, Greenspan, details the economic development processes of industries:

Historically, the general development of industry has taken the following course: an industry begins with a few small firms; in time, many of them merge; this increases efficiency and augments profits. As the market

expands,new firms enter the field, thus cutting down the share of themarket held by the dominant firm. This has been the pattern in steel, oil, aluminum, containers, and numerous other major industries. (66)

The observable tendency of an industry’s dominant companies eventually tolose part of their share of the market, is not caused by antitrust legislation, but by the fact that it is difficult to prevent new firms from entering the fieldwhen the demand for a certain product increases. Texaco and Gulf, for example, would have grown into large firms even if the original Standard Oil Trust had not been dissolved. Similarly, the United Steel Corporation’sdominance of the steel industry half a century ago would have been erodedwith or without the Sherman Act..

It takes extraordinary skill to hold more than fifty percent of a large industry’s market in a free economy. … The rare company which is able to retain its share of the market year after year and decade after decade does so by means of productive efficiency – and deserves praise, not condemnation.

The Sherman Act may be understandable when viewed as a projection of the nineteenth century’s fear and economic ignorance. But it is utter nonsense inthe context of today’s economic knowledge. … (66)

The error of the nineteenth-century observers was that they restricted a wide abstraction – competition – to a narrow set of particulars, to the ‘passive’competition projected by their own interpretation of classical economics. As a result, they concluded that the alleged ‘failure’ of this fictitious ‘passive competition’ negated the entire theoretical structure of classical economics,including the demonstration of the fact that laissez-faire is the most efficientand productive of all possible systems. …. (67)

Greenspan next contemplates what most people, today mistakenly perceive as MONOPOLY …

A ‘coercive monopoly’ is a business concern that can set its prices andproduction policies independent of the market, with immunity from

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competition, from the law of supply and demand. …

The necessary precondition of a coercive monopoly is closed entry – the barring of all competing producer from a given field. This can be accomp-lished only by an act of government intervention, in the form of special regulations, subsidies, or franchises. …. (68, emphasis added)

The ultimate regulator of competition is a free economy is the capital market. So long as capital is free to flow, it will tend to seek those areas which offer the maximum rate of return. …

… What it [a free capital market] does guarantee is that a monopolist whose high profits are caused by high prices, rather than low costs, willsoon meet competition originated by the capital market. (68, emphasis in the original)

The analysis is then extended to the aluminum industry of the United States – and ‘the history of the Aluminum Company of America’ or ALCOA before the Second World War. In this section, he notes:

In analyzing the competitive processes of a laissez-faire economy, one mustrecognize that capital outlays (investments in new plant and equipment either by existing producers or new entrants) are not determined solely by current profits. An investment is made or not made depending upon the estimated discounted present worth of expected future profits. Consequently, the issueof whether or not a new competitor will enter a hitherto monopolistic industry, is determined by his expected future returns.

The present worth of the discounted expected future profits of a given industry is represented by the market price of the common stock of the companies in that industry. (69, emphasis in the original)

The churning of the nation’s capital, in a fully free economy, would be continuously pushing capital into profitable areas – and this would effectively control the competitive price and production policies of business firms, making a coercive monopoly impossible to maintain. Itis only in a so-called mixed economy that a coercive monopoly canflourish, protected form the discipline of the capital market by

franchises, subsidies and special privileges from governmental regulators. (70, emphasis added)

Perhaps the most damning of Greenspan’s observations and social costs of antitrust policies are saved for last, and includes a silly quote from the former Supreme Court Judge:

To sum up: The entire structure of antitrust statutes in this country is ajumble of economic irrationality and ignorance. It is the product: (a) of a gross misinterpretation of history, and (b) of rather naïve, and certainly unrealistic, economic theories.

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… No one will ever compute the price that all of us have paid for that Act (Sherman) which, by including less effective use of capital, has kept our standard of living lower than would otherwise have been possible. …..

Those who allege that the purpose of the antitrust laws is to protect competition, enterprise, and efficiency need to be reminded of the following quotation from Judge Learned Hand’s indictment of ALCOA’s so-called monopolistic practices. (70)

It was not inevitable that it should always anticipate increases in the demand for ingot and be prepared to supply them. Nothing compelled it to keep doubling and redoubling its capacity beforeothers entered the field. It insists that it never excluded competitors;but we can think of no more effective exclusion than progressivelyto embrace each new opportunity as it opened, and to face every newcomer with new capacity already geared into a great organization, having the advantage of experience, trade connections and the elite of personnel.

ALCOA is being condemned for being too successful, too efficient, and too good a competitor. Whatever damage the antitrust laws have done to our economy, whatever distortions of the structure of the nation’s capital they may have created, these are less disastrous than the fact that the effective purpose, the hidden intent, and the actual practice of the anti-trust laws in the United States have led to the condemnation of the pro-ductive and efficient members of our society because they are productive and efficient. (70-1, emphasis in the original)

So there you have it! Government as the ‘protector’ of the consumer and society from the rapacious business community ultimately makes businesses less efficient by retarding innovation, mal-allocates scarce resources, limits output, and drives prices higher than they would have otherwise have been – absent the Interstate Commerce Act (1887) and the Sherman Act (1890). One can only imagine the costs of other government interventions into the free market on Americans’ standard of living.

Back to Production and Its Implications

Hopefully, the material abstracted from Alan Greenspan’s article, “Antitrust,” will provide insights into the textbook issues championing business innovation (the development of new products, the adoption of more efficient organizational structures, and investment in new processes). It raises concern over the Government’s Sword of Damocles that hangs over the heads of the of the entrepreneur – the risk of being savaged by the very bureaucrats pursuing their own self-interest at the expense of the national welfare that they have been charged to protect – for more on this issue, read: Formaini’s description of James Buchanan’s contributions to ‘public choice’ economics at: www.dallasfed.org/research/ei

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Acs and Gerlowski, then call attention to differences between ‘resource-based’ industry [the old economy or ‘rust-belt industry] and ‘knowledge-based’ segments of the economy [the ‘new’ economy]. Examples of the former include – iron and steel, automobiles, textiles, food processing, while the later includes: semiconductors, software, computers, photo-voltaic, nanotechnologies, biotechnology, robotics. Firms in the former industries tend to be labor and capital intensive and experience diminishing returns, while the latter are characterized by ‘intellectual’ capital [protected by patents, copyrights, trademarks (federal level) and trade secrets (state-level)] created by research and development (R&D) activities – and tend to experience increasing returns. Several scholarly articles may be referred to formulate an understanding of the nature, structure and attributes of the so-called ‘new’ economy:

N. Kaldor. 1972. The Irrelevance of Equilibrium Economics. Economic Journal, 82, 1237-1255.

P.A. David. 1985. Clio and the Economics of QWERTY. American Economic Review: Papers and Proceedings, 75, 2, 332-337.

W.B. Arthur. 1990. Positive Feedbacks in the Economy. Scientific American, 262, 2, 92-99.

W.B. Arthur. 1989. Competing Technologies, Increasing Returns, and Lock-in by Historical Events. Economic Journal, 99, 1, 116-131.

D.E. Booth. 1986. Long Waves and Uneven Regional Growth. Southern Economic Journal, 53, 2, 448-460.

As noted previously, the following articles are significant in the interpretation of the ‘knowledge-based’ economy:

The role of private property and property rights:T.L. Anderson and P.J. Hill. 1983. Privatizing the Commons: an Improvement?

Southern Economic Journal, 50, 2, 438-450.

The possible organizational/management structures:R.H. Coase. 1937. The Nature of the Firm. Economica, 4, 386-405.

Problems of the Pigovian approach and an alternative:R.H. Coase. 1960. The Problem of Social Cost. Journal of Law and

Economics, 3, 1-44.

More on the nature, structure and benefits of private property rights:H. Demsetz. 1967. Toward a Theory of Property Rights. American

Economic Review, 57, 2, 347-359.

The special case of ‘intellectual property rights’:Thomas A. Stewart. 1994. “Your Company’s Most Valuable Asset: Intellectual

Capital,” Fortune, __________. 1997. “Why Dumb Things Happen to Smart Companies.” Fortune,

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June 23, 159-60.

Additionally, several books are also helpful:

A.P. Carnavale. 1991. America and the New Economy. San Francisco: Jossey Bass.

Thomas A. Stewart. 1997. Intellectual Capital: The New Wealth of Organization. New York: Doubleday/Carraway Books.

It’s important to note that Alfred Marshall, devoted extensive material devoted to the issue of ‘increasing returns’

Technological Change: Shift from Muscle- to Brain-Power

In the research and development-intensive, knowledge-based industries large investments of capital and brain-power (advanced degrees in the ‘hard’ sciences) are required. In such industries, as production expands, unit costs continue to fall, while profits increase. This shift is best seen in the concept of Schumpeter’s ‘perennial gale of creative destruction’ resulting in the (Nikolai) Kondratiev or 55-year business cycle. Additionally, as Acs and Gerlowski have noted:

… experience gained with one product or technology can make it easierto make new products incorporating similar or related goods. In these cases, the competitive market fails. (111)

It ‘fails’ in the Pigovian (A.C. Pigou. 1920. The Economics of Welfare) sense of the term. Robert L. Formaini and Thomas F. Siems [“Ronald Coase – The Nature of Firms and Their Costs,” Economic Insights, (Dallas Federal Reserve), 8 (3)] have reported what Pigou had concluded, that:

… government regulations enhance efficiency by correcting for claimedimperfections, which Pigou called market failure.

Acs and Gerlowski has stated:

Market failure is defined as a malfunction in the market mechanism that results in a misallocation or an unproductive use of resources. (111-2, emphasis in original)

Once it is explicitly acknowledged that all resources are scarce, any misallocation via ‘a malfunction of the market mechanism’ reduces the total level of social welfare … less is produced, prices are higher and consumers deprived of potential satisfaction of needs and wants. Acs and Gerlowski, then point out:

One approach is to try to reproduce the conditions of the competitive model in the economy. Therefore, you break up large firms – AT & T,

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IBM, GM – to create ones with less market power. Most traditional textbooks [and University professors] take this approach. This book takes a different tact. Since we are unlikely to replicate the competitivemodel, we should concentrate on how to deal with [alleged] market failure. For example, the information problem is at the heart of under-standing how organizations function. (112, emphasis added)

One of the chief reasons for the need for organizational coordination, a la Coase’s “The Nature of the Firm,” finds its roots in the division of labor (specialization of task), which simultaneously, reduce production costs and increasing transaction costs! Clearly, the attainment of efficient outcomes must involve tradeoffs.

Buchanan – A Defense of Property Rights

An interesting take on this may be found in James M. Buchanan’s short, but penetrating book: Property as a Guarantor of Liberty (1993). Buchanan provides an alternative defense for the existence of private property – it is not simply justifiable on the basis of economic efficiency (minimization of negative externalities), but the defense of private property rights adds both to productivity improvements, but, perhaps more importantly, also supports individual freedom (or liberty). He begins his argument with an analysis of the Hobbesian jungle – where there is no separation of that which is ‘thine’ and what is ‘mine’. In such a state, the

…life of any person is described to be ‘poore, solitary, nasty, brutish, and short.’ (4)

Under such conditions, individuals would value security (of person and property) sufficiently to voluntarily surrender:

… authority to an emergent sovereign who promises subsequentprotection.

Such trade-offs would not be made, if the individual expected to be worse off than before the relinquishment of authority to the sovereign.

Quite often the starting point for an analysis of social relations is the so-called ‘tragic commons’ (See: Garrett Hardin. 1968. “The Tragedy of the Commons,” Science, 162, 1243-8 – a very disturbing article justifying government fertility control, even by draconian means), where land (or other value-generating resource) is held and used in common is ultimately degraded as each individual seeks to use the land first and most intensively (the maximization of individual self-interest, at the expense of the greater whole or society). Each individual is governed by self-interest (the desire to maximize that individual’s returns from his/her actions) and the quest to ‘capture’ as much value for him/her own advantage as possible. This is as Adam Smith had described things in his famous The Wealth of Nations (1776) ……………………….

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The result of this unfettered competition for the use of the scarce resource (land) is ‘over-use’ of the land … declining fertility, de-forestation, over-fishing or soil erosion. The message is that ‘private choice is combined with common access,’ results in over exploitation, e.g.:

… each participant’s behavior, at the relevant margin of use, imposesexternal diseconomies on the well-being of others in the sharing group(5)

or society. Under such conditions:

… all participants can be made better off, as signaled by their own agreement under some collectively chosen constraints on private choice. (5)

This solution is beset by two problems – (i) minority views; and, (ii) the need for enforcement of the collective will … there is always the temptation for the majority to force its will on others and, ultimately, their willingness to employ coercion employing some collective mechanism of enforcement. Yet, there is a simpler solution, one that does not involve government – the establishment of well-defined private property rights that are easily enforced and transferable.

Buchanan has noted that:

… one implied means of internalization of the relevant externalities isthe partitioning of the shared resource among the separate users, the replacement of common usage by private and separated property in specifically assigned parcels. (6)

This represents, “… a movement toward independent and private usage” of resources. The tension that exists between privatization and the implied social contract is described by Buchanan:

The privatization of the commons [i.e., the creation of private propertyrights] suggests that productive reform lies in the direction of increasingindividual independence (reducing interdependence), whereas agreementamong individuals in the contract with the emergent Hobbesian sovereign suggests that productive reform lies in the direction of increasing individual interdependence through membership in the commonly-shared institution of the sovereign [government]. (6, material in brackets added)

In fact, there is no conflict between these approaches, rather a difference in emphasis. The tragic commons focuses on the assignment of separated, ‘specifically assigned parcels’, accompanied by ‘rights of exclusion’ [the ability of the individual owner to gain exclusive rights to the land and appropriate all the rents for his/her own benefit, by excluding others]. This begs the issue of enforcement of private property rights. The defense of private property is based on the efficiency criterion, assuming “that political authority acts benevolently.” (7, emphasis added)

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The Hobbesian jungle places emphasis on the need for enforcement and protection of private property rights [role of the sovereign (or government), enforcement of contracts]. This provides a “theory of legitimacy for a coercive political-legal order,” based on the consent of the participants. This raises a thorny issue for the sovereign (or government): What if the participants withdraw their consent? What happens to the ‘legitimacy for a coercive political-legal order’? Is the sovereign or government, then induced to arbitrarily exercise coercion? If it does, then is the sovereign or government acting illegitimately?

It seems that the socialists (or as Hayek and Mises refer to them – the ‘statists’) have a better intuitive understanding of the nexus between enforceable private property rights and the liberty of the individual property owner. This helps explain their willingness to severely curtail and circumscribe ‘private property rights’, justifying it as being undertaken in the ‘interest of the welfare of the social whole’. Perhaps, a more reasonable, though unstated reason is that when the individual property owners have their rights protected and enjoy liberty and freedom of use, the political class is always in danger of their withdrawal of consent. It is in the interest of the political class to reduce the sanctity of private property rights, limit the freedoms (liberties) that go along with them, and increase individuals’ dependence upon the sovereign or government. Nowhere has this been more clearly seen than in the former

Buchanan emphatically states that the partitioning of the commons involves the establishment of “… well defined limits or boundaries…” by some initial agreement. It is not enough for there to be ‘well-defined’ property rights, those rights must be enforceable and exchangeable, in order for liberty (or freedom) of the individual to be assured! He then goes on:

This initial agreement [contract between the sovereign and the property owners or ‘participants’] establishes the law of property and defines violations of this law to occur when [the limits or] boundaries are crossed.(10)

Much of the legal framework has been codified in ‘common law,’ e.g., the ‘Law of Capture’ applied to fluid resources – water, petroleum, and natural gas.

Buchanan continues by noting that initially, there are no advantages to be derived from ‘specialization of task’ or the ‘division of labor,’ except along age and sex lines—based on the individual and the family-unit, which produces all ‘goods and services’ that are needed by that unit – they are economically ‘self-sufficient’ units (autarchic), operating independently of others. Individual autarchy (economic self-sufficiency) represents maximal independence of the individual or family-unit and maximal efficiency of resource use:

The individual’s well-being, in his or her own reckoning, depends not at all on the behavior of others. (10)

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However, such independence has an obvious opportunity cost, the incremental value of goods and services that could have been produced and would be available for consump-tion through the miracle of division of labor (or specialization of task).

Interindustry Linkages & the Instantaneous Assumption

In the traditional simple circular flow model, the firm is typically represented as a box on the right-hand side of the diagram. Inputs (factors of production, i.e., land, labor, capital and entrepreneurship) flow into the firm from households (resource or factor owners), while a compensatory flow of payments for the use of those resources (rents; salaries, wages and other forms of labor compensations; returns on capital; and profits) flow from the firm to the factor owners or households. The summation of all returns to factor owners represents an ‘income estimation’ of GDP. Simultaneously, within the firm the firm a transformation takes place, wherein the factor inputs are converted into semi-finished or final goods and services. With the successes of firms pursuing ‘outsourcing,’ and increasing adoption of this ‘buy’ model by highly integrated firms, as opposed to ‘in-house’ production components or ‘make’ approach, the number of specialized, sub-contracting firms producing semi-finished components, can be expected to increase. Within limits, this specialization results in increasing returns and economies of production. The sum of all value of all producers of goods and services (as expressed by the prices consumers pay) is the ‘Output’ method of expressing gross domestic product (GDP). This should provide insight into the basic fact that there is an overlap between microeconomics and macroeconomics – they are NOT separate and distinct, but, as Mises and Hayek have noted, that there are ‘real-couplings’ through the existence of the activities of the firm taking place through time – the short- and the long-run.

Perhaps a more innovative, as well as a more revealing approach to the economic issue of production is to be found in what has come to be known as the Hayekian Triangle, named after Frederick Hayek who developed the view in the 1930s. His approach must be contrasted with the Keynesian model with its focus on the ‘short-run’. Hayek’s view considered, what Roger Garrison refers to as, a ‘real coupling’ between the ‘short-run’ and the ‘long-run’. At the heart of the Hayekian view is a ‘capital theory’ –

… the theory of a time-consuming, multi-stage capital structure envisioned by Carl Menger [Principals of Economics, 1871] and developed by Eugen von Böhm-Barwerk [Capital and Interest, 1889]. Decades before macro- economics emerged as a recognized subdiscipline, Böhm-Barwerk had modeled the fundamental Mengerian insight into macroeconomic theory to account for the distribution of income among the factors of production. (2001. Time and Money: The Macroeconomics of Capital Structure, 4, emphasis added)

Garrison continues:

Dating from the late 1920s, Hayek [“Das Intertemporale Gleichgewichtssystem der Preise und die Bewegungen des Geldwertes,” 1928; and Prices and Production, 1935],

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following the lead provided by Ludwig von Mises [The Theory of Money and Credit, 1912], infused the theory with monetaryconsiderations. He showed that credit policy pursued by a central monetary authority can be the source of economy-wide distortions in the intertemporal allocation of resources and hence an important cause of business cycles. (4, emphasis added)

Oh, my! Notice what is being said and the implications …. ‘credit policy’ of the Federal Reserve Bank … can ‘distort’ the inter-period allocation of resources [what von Mises refers to as ‘malinvestment’, not simply ‘misinvestment’] and therefore is ‘an important cause of business cycles.’ Hummm … the Fed is the cause of the very thing that it is supposed to be preventing! This is expressed clearly by Garrison:

Hayek’s focus [1935] on a money-induced artificial boom reflects the fact that, as an institutional matter and as an historical matter, money enters the economy throughcredit markets. Hence, it impinges, in the first instance, on interest rates and affects the intertemporal allocation of resources. (5, emphasis added)

He concludes this section by stating:

There is a real coupling between the short run and the long run …. Identifying the relative-price effects (and the corresponding quantity adjustments) of a monetary disturbance, as compared with tracking the movements in macro-economic aggregates that conceal those relative-price effects, gives us a superior understanding of the nature of a cyclical variation in the economy and points the way to a more thoroughgoing capital-based macroeconomics. (5, emphasis in original)

Before returning to the nature of production and the Hayekian Triangle, several salient realities must be pointed-out. First, the explicit recognition of the significance of ‘time’ [t-n → t0 → tn] and the ‘intertemporal allocation of resources’ in the analysis of economic relationships, i.e., the ‘real’ coupling of short run and long run. This contrasts starkly with Keynes’ driven focus on the short-run (“In the long run we’re all dead.”) and the supposed preoccupation of classical economics with the long run (said to be the result of devotion to Say’s Law – “Supply creates its own demand.”) Garrison argues that:

… Hayek’s writings – and those of modern Austrian macroeconomics – can be comprehended as an effort to reinstate the capital-theory ‘core’ that allows for a ‘real-coupling’ of short-run and long-run aspects of the market process. Hayek was simply observing an important methodological maxim, as later articulated by Mises (1966, 296):

[W]e must guard ourselves against the popular fallacy of the drawing a sharp line between short-run and long-run effects. What happens in the short run is precisely the first stages of a chain of successive transformations which tend to bring about long-run effects.

Additionally, according to Sean Corrigan (2002. “Say’s Law for Our Time,” www.mises.org), Keynes’ model is based on the identity:

Income = Consumption plus Investment, +/- Net Exports and Government

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A careful review of the structure of the data in Table B-1 Gross Domestic Product, 1959-2005; and Table B-2 Real Gross Domestic Product, 1959-2005 available in the Economic Report of the President, confirms this observation:

GDP = PCE + GPDI + NX + GCE & GI

where:

GDP - Gross Domestic Product;PCE - Personal Consumption Expenditures;GPDI - Gross Private Domestic Investment;NX - Net Exports; and GCE&GI - Government Consumption Expenditures &

Government Investment.

Corrigan continues:

… let us assume that what makes us rich is not consumption ….

Clearly, it is production that matters, for this is what ultimately lifts us out ofsavagery. That this should be controversial shows how far we have fallen from the good common sense of our forefathers.

For we can play Oliver Twist all we like, importunately holding up our plates for more, but unless we offer something in return, we are unlikely to be able to rely on our portion being replenished at will.

This simple observation sounds very much like a quote from Adam Smith (1776. An Inquiry into the Nature and Causes of the Wealth of Nations ):

Clearly, production is important (it is the sources of goods and services and of the incomes necessary to attract resources), additionally, production provides the means by which ‘specialization’ can be accomplished – it is the source of the wherewithal of households to purchase product outputs, rather than having to provide them for himself. Adam Smith’s parable of pin-factory helps in understanding the efficiency improvements of ‘division of labor’ and the concomitant decline in costs and product prices. (See: www.divisionoflabour.com/archives/000006.php.)

The Hayekian Triangle lays out the structure of the production processes, explicitly – from ‘early stages’ (extractive and refining processes and manufacturing) through the ‘late stages’ (distributing and retailing). [See below] This diagrammatic

OUTPUT

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OF CONSUMER GOODS

EARLY LATE STAGES STAGES

mining manufacturing retailing refining distributing

STAGES OF PRODUCTION PRODUCTION TIME (t0 → tn)

framework and its labeling accentuate the intertemporal linkages [t-n → t0 → tn] that are assumed away by traditional economic models – both macro – (Keynesian and neo-Keynesian) and micro – (normatively exemplary perfectly competitive) models. Garrison has noted:

Attention to the intertemporal structure of production is unique to Austrian macroeconomics. (45, emphasis added)

Garrison observes:

Capital-based macroeconomics gives play to both the value dimension and the time dimension of the structure of production. The relationship between the final,or consumable, output of the production process and the production time that the sequence of stages entails is represented graphically as the legs of a right triangle. In its strictest interpretation, the structure of production is conceptualized as a continuous-input/point-output process. The horizontal leg of the triangle represents production time. The vertical leg measures the value of the consumable output of the production process. Vertical distances from the time axis to the hypotenuse represent the values of good-in-process. The value of a half-finished good, for instance is systematically discounted relative to the finished good – and for two reasons: (1) further inputs are yet to be added; and (2) the availability of the finished good lies some distance in the future. Alternatively stated, the hypotenuse represents value added (by time and factor input) on a continuous basis. (46)

Keep in mind that Gross Domestic Product (GDP) can be estimated in several ways – the summation of values of all incomes (Households) and the summation of the values of all final outputs or products (Firms). A third way of estimating GDP is the summation of all Values Added, i.e., at each and every stage of production.

Perhaps more importantly, Garrison notes, revealingly:

… the Hayekian triangle has a double interpretation. First, it can depict goods

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in process moving through time from the inception to the completion of the production process. Second, it can represent the separate stages of production, all of which exist in the present, each of which aims at consumption at differentpoints in the future…. The double labeling of the horizontal axis … is intended to indicate the double interpretation: ‘Production Time’ connotes a time-consuming process; ‘Stages of Production’ connotes the configuration of the existing capital structure.

… as long as we think in terms of the employment of means, and the achieve-ment of ends, and the time element that separates the means and the ends, the Hayekian triangle remains applicable.

The continuous-input/point-output process that is depicted by the Hayekian triangle takes time into account but only as it relates to production. (47)

It might be noted that the Hayekian triangle serves as a compliment to Alfred Weber’s theory of location (1909. Location of Industries) – wherein mining activities and production of the of final product are separated by geographic space, this separation can be overcome, but only at a cost (transportation costs), as well as, time (t0 → tn). The output from mines must be processed then this product must be moved to new locations for further processing and, ultimately fabricated into final products that must be distributed to final consumers (or final demand). All of these activities cannot be accomplished ‘instantaneously,’ both processing and transporting are time-intensive.

Garrison provides a straight-forward explanation of Hayek’s triangle:

… the vertical and horizontal dimensions of the triangle are intended to represent value and time separately, the relevant time dimension measuresthe extent to which variable resources are tied up over time. Production time itself, then, has both a value dimension and a time dimension.

… it is intended to indicate the general pattern of the allocation of resources over time and the general nature of changes in the intertemporal pattern. (49)

This explicit recognition of the importance of time permitted the Austrian School to interpret:

…the rate of interest to reflect a systematic discounting of future values –whether or not capital was involved in creating them or money was involved in creating them or money was involved in facilitating their exchange…capital or, more pointedly, the intertemporal structure of capital – is the primary focus.The centrality of the interest rate derives from its role in allocating resources – and sometimes in misallocating them – within the economy’s capital structure. (Garrison, 6)

If further pushing toward a fuller macroeconomic understanding is to pay, it may well involve paying attention to the economy’s intertemporal capital structure. (6)

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Clearly, adjustments in the economy are NEVER instantaneous, nor are they perfect.

Second, notice the FULL title of John Maynard Keynes’ well-known book: The General Theory of Employment, Interest and Money – in it there is no mention of capital, but, as put by Garrison, “… its shadow, interest, does.” Garrison notes that:

Classical economists saw the rate of interest, also known as the rate of profit, as the price of capital. Keynes, who clearly rejected this view, was involved in creating them or money was involved in facilitating their exchange. (6, emphasis added)

But, perhaps more importantly, Keynes’ model is a “demand-dominated model,” one has to ask: “What is the role of supply or production and its need for investment?” Garrison’s full comments on Keynes and the so-called ‘general theory’ are:

Keynes (1936: 378), whose demand-dominated theory offered us nothing in the way of a ‘real coupling,’ simply refocused the profession’s attention on the short- run movements in macroeconomic magnitudes while paying lip service to the fundamental truths of classical economics: “ if our central controls succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again from this point onward.” This comes immediately after his claim that the “tacit assumptions {of the classical theory} are seldom or never satisfied.” (4)

It’s necessary to go back to basics – the factors of production are: land, labor, capital and entrepreneurship … Notice how Alfred Marshall [Principles of Economics, 8th Ed., 1920] has put it:

The agents of production are commonly classed as Land, Labour, and Capital. By Land is meant the material and the forces which Nature gives freely for man’s aid, in land and water, in air and light and heat. By Labour is meant the economic work of man, whether with the hand or the head. By Capital is meant all stored-up provision for the production of material goods, and for the attainment of those benefits which are commonly reckoned as part of income. It is the main stock of wealth regarded as an agent of production rather than as a direct source of gratification.

Capital consists in great part of knowledge and organization : and of this some part is private property and other part is not. Knowledge is our most powerful engine of production; it enables us to subdue Nature and force her to satisfy our wants. Organization aids knowledge; it has many forms, e.g. that of a single business, that of various businesses in the same trade, that of various tradesrelatively to one another, and that of the State providing security for all and help for the many. (115)

Later in the book, in Book V, “General Relations of Demand, Supply and Value;” Chapter III, ‘Equilibrium of Normal Demand and Supply,’ Marshall observes:

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… It is for instance often sufficient to take the supply price of the different kinds of raw materials used in any manufacture as ultimate facts, without analyzing these supply prices into the several elements of which they are composed; otherwise indeed the analysis would never end. We may then arrange the things that are required for making a commodity into whatever groups are convenient, and call them its factors of production. Its expenses of production when any given amount of it is produced are thus the supply prices of the corresponding quantities of its factors of production. And the sum of these is the supply price of that amount of commodity. (283)

Mises (1998) calls attention to the obvious, but all too often ignored production relationships whenever there are MORE than, a single activity taking place:

Other things being equal, the more the production of a certain article increases,the more factors of production must be withdrawn from other employments in which they would have been used for the production of other articles …. (340)

He then emphasizes the forward looking perspective of the ‘entrepreneur’:

The planning entrepreneur is always faced with the question: To what extent will the anticipated prices of the product exceed the anticipated costs? If the entrepreneur is still free with regard to the project in question, because he has not yet made any inconvertible investmentsfor its realization, it is average costs that count for him. But if he hasalready a vested interest in the line of business concerned, he seesthings from the angle of additional costs to be expected.. (340)

Information

Perfect Information – the perfectly competitive market is the ‘gold-standard’ of market structures. In their ‘Glossary,’ Acs and Gerlowski have defined Perfect Information in the following manner:

Every participant (and potential participant) in a market becomes aware of every price, product specification, and buyer and seller location at no cost. (446)

The atomistic participants have access to perfect information, thereby abolishing uncertainty and risk. The term ‘market structure’ is employed to describe the whole environment (physical, economic, social, and political), within which households and businesses conduct their myriad transactions. James V. Koch (1976. Microeconomic Theory and Applications. Boston: Little, Brown and

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Company) has suggested that perfect competition may be interpreted as a parable [a short fictitious story that illustrates a moral attitude or religious principle], since the conditions assumed for its fulfillment have never existed. Economists then argue that it functions as a norm or yardstick by which markets are to be evaluated. Hummm …. Frank Knight, while noting that virtually every business is a partial monopoly, expressed amazement that: “… the theoretical treatment of economics has related so exclusively to complete monopoly and perfect competition.” (1921 Risk, Uncertainty and Profit, 193). Again, Acs and Gerlowski, in their ‘Glossary,’ have defined Perfect Competition, as:

An arrangement of buyers and sellers in which there is perfectinformation, a homogeneous product, similar firms, and free entryand exit. (446)

What then are these assumptions which have never existed? The key assumption upon which perfectly competitive markets are based is that all parties to transactions or exchanges have access to perfect information. Additionally:

- a large number of both buyers and sellers;- no market participant (buyer or seller) has the ability to

influence the market price;- each firm’s product is homogeneous and indistinguishable,

i.e., there are no means of product (or service differentiation)in the market … labels, packaging or trademarks;

- there are no barriers to either entry to or exit from the market in the long run, e.g., licenses or zoning regulations designed to keepnew firms out and preserve the monopoly power of existing firmsand ‘sold to the public’ as a means to protect health and safety;

- all factors of production are perfectly mobile; there are no impediments to resources moving to uses in activities and localswith highest returns (and away from lower rates of returns),in summary, all activities take place at a single point in space;

- adjustments are instantaneous; and- firms seek to maximize profits (the spread between total revenue (TR)

and total cost (TC).

The implications of perfect information and perfect competition are that there are some mystical forces that impel markets toward an efficient equilibrium.

Imperfect Information – introduces the notion that it is impossible for market partici- pants to have access to flawless information. It is not possible to foretell the future or to fully anticipate the actions or re-actions of other market players. Imperfect information involves several factors – information will always be incomplete and less than totally accurate. Additionally, and perhaps even ore importantly from an economic perspective, information is not costless to acquire. Acs and Gerlowski have reported:

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The firm may not know exactly what the marginal products of its inputs are. Further, attempts at estimating them may be flawed for a number of reasons.

Imperfect information regarding wage rates for labor (or rental rates for capital) can also create problems leading to inefficiencies in production. (110)

When one market participant has more and/or better information than other participants, such ‘informational asymmetries,’ create the potential for opportunism. According to Acs and Gerlowski:

The policy of taking advantage of an informational asymmetry in yourbehavior; is a central assumption of transaction cost economics. (446)

Less than perfect information enables one or the other participant to a market transaction to engage in ‘opportunistic behavior’. Once again, Acs and Gerlowski have defined the concept:

Action taken when one party to an agreement acts in his or her ownselfish interests, even at the expense of other parties involved in the agreement. (446)

It is well to remember the definition of a firm: “A bundle of contracts …” or agreements’, that ‘sticky stuff’ that tends to bind disparate interests together to accomplish efficient production, distribution and consumption based on mutual advantage.

There are a number of manifestations of ‘informational asymmetries’ in markets:

Moral Hazard – “An ex post contracting situation and source of transaction costs that occurs when one party’s actions are imperfectly observable and when the incentives of the parties may be less than perfectly aligned.” (Acs and Gerlowski, 446)

Incomplete Contracts – “Agreements that fail to fully specify actions under every conceivable course of events.” (Acs and Gerlowski, 444)

Ex ante Opportunism – “Prior to signing the contract, the parties involved (at a minimum) must reach a consensus as to what contingencies the agreement governs. There are said to be information asymmetries when the amount and quality of information held by each party differs or is believed to differ.” (Acs and Gerlowski, 171)

Incomplete

Private Information – Information asymmetries are associated with the existence

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of ‘private information’. Information is never costless, it must be acquired research, investigation (collection of ‘raw data’), processing(organization and interpretation), and communication. Each of theseactivities involve costs or the expenditure of scarce resources. Such information is private when it is acquired by participants in the private sector (members of businesses and households). These data are protected by:

CopyrightsPatentsTrade Secrets

Copyrights and patents (private ownership rights) are protected by theFederal Government, as mandated by the U.S. Constitution; Trade Secrets are protected under state legislation.

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