Menger’s Principles of Economics: The Value of Capital
Continuing the theme of causal realism and economics as a process which always occurs through history, Menger explains the purpose of capital.
Once again, Menger brings us back to what I, at least, take to be the overall most important element of his approach to economics: causal realism. We took some space earlier to discuss the essential historicity of Menger’s Principles, and perhaps now the point will become more clear. Menger, Walras, and Jevons all helped revolutionize economics by overturning classical value theory, but it should be emphasized that it was Menger’s strict causal realism that moved him in that direction in the first place. He does not deal in grand abstract, idealized scenarios (built specifically to allow the easy explication of theory). Rather, he approaches every economic question by building the more complex upon the irreducible. From the bedrock laws of cause and effect and a commitment to treat the perceived, physical world as real, Menger steadily constructs his theories. The theories are sound to the extent that they reflect the real actions of real economizers and the conditions to which they are subject. Out of this, he has given us the general theory of the good, the subjective theory of value, and marginal utility, but from there we must understand more complex, further looking, and risky economic behavior. We have seen the basis for microeconomic interactions, but how then can we use these insights to develop a theory of capital?
Well, with a bit of causal realism, of course. Right away in our current selection, Menger brings history to bear on economics: “The transformation of goods of higher order into goods of lower order takes place, as does every other process of change, in time.” As he explains that capital formation is a function of saving, and saving is the decision to forgo consumption in the present to enjoy greater consumption in the future, Menger indicates the essential role of the entrepreneur. The owners of capital (usually) must forgo consumption in order to accumulate capital, and they are only remunerated upon successfully generating greater productivity from their investments than the amount of savings initially invested. And because human beings are always captive to their imperfect knowledge, their subjective experience, and the constant flow of time, no one can be quite sure that their decisions to save or invest will actually produce greater satisfaction in the end. Menger is careful to note, though, that the value of capital is not always determined by the capitalist’s “abstinence,” or choice to defer consumption. Rather, we can accumulate capital value in any number of ways, including simply by expanding our demands or outright forceful seizure. Seen in this light, of course, imperialism can easily become a foray in capital accumulation and exploitation. Menger is not commenting on the propriety of particular instances of capital’s growth, concentration, or products. Rather, we get a realistic portrait of how capital goods attain value and what role they actually play in either causing human flourishing or squandering wealth.
Principles of Economics
By Carl Menger
Trans. James Dingwall and Bert F. Hoselitz. Institute for Humane Studies. 1976. Originally Published: 1871.
Chapter III. The Theory of Value
3. The Laws Governing the Value of Goods of Higher Order
B. The productivity of capital.
The transformation of goods of higher order into goods of lower order takes place, as does every other process of change, in time. The times at which men will obtain command of goods of first order from the goods of higher order in their present possession will be more distant the higher the order of these goods. While it is true, as we saw earlier, that the more extensive employment of goods of higher order for the satisfaction of human needs brings about a continuous expansion in the quantities of available consumption goods, this extension is only possible if the provident activities of men are extended to ever more distant time periods. A primitive Indian is occupied incessantly with the task of meeting his requirements for a few days at a time. A nomad who does not consume the domestic animals at his command but decides to breed them for their young is already producing goods that will become available to him only after a few months. But among civilized peoples, a considerable proportion of goods that will contribute only after years, and often only after decades, to the direct satisfaction of human needs.
Thus by relinquishing their collecting economy, and by making progress in the employment of goods of higher orders for the satisfaction of their needs, economizing men can most assuredly increase the consumption goods available to them accordingly—but only on condition that they lengthen the periods of time over which their provident activity is to extend in the same degree that they progress to goods of higher order.
There is, in this circumstance, an important restraint upon economic progress. The most anxious care of men is always directed to assuring themselves the consumption goods necessary for the maintenance of their lives and well-being in the present or in the immediate future, but their anxiety diminishes as the time period over which it is extended becomes longer. This phenomenon is not accidental but deeply imbedded in human nature. To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period. Command of the means for the maintenance of our well-being at some distant time avails us little if poverty and distress have already undermined our health or stunted our development in an earlier period. Similar considerations are involved even with satisfactions having merely the importance of enjoyments. All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future.
Human life is a process in which the course of future development is always influenced by previous development. It is a process that cannot be continued once it has been interrupted, and that cannot be completely rehabilitated once it has become seriously disordered. A necessary prerequisite of our provision for the maintenance of our lives and for our development in future periods is a concern for the preceding periods of our lives. Setting aside the irregularities of economic activity, we can conclude that economizing men generally endeavor to ensure the satisfaction of needs of the immediate future first, and that only after this has been done, do they attempt to ensure the satisfaction of needs of more distant periods, in accordance with their remoteness in time.
The circumstance that places a restraint upon the efforts of economizing men to progress in the employment of goods of higher orders is thus the necessity of first making provision, with the goods at present available to them, for the satisfaction of their needs in the immediate future; for only when this has been done can they make provision for more distant time periods. In other words, the economic gain men can obtain from more extensive employment of goods of higher orders for the satisfaction of their needs is dependent on the condition that they still have further quantities of goods available for more distant time periods after they have met their requirements for the immediate future.
In the early stages and at the beginning of every new phase of cultural development, when a few individuals (the first discoverers, inventors, and enterprisers) are first making the transition to the use of goods of the next higher order, the portion of these goods that had existed previously but which until then had had no application of any sort in human economy, and for which there were therefore no requirements, naturally have non-economic character. When a hunting people is passing over to sedentary agriculture, land and materials that were not previously used and are now employed for the first time for the satisfaction of human needs (lime, sand, timber, and stones for building, for example) usually maintain their non-economic character for some time after the transition has begun. It is therefore not the limited quantities of these goods that prevents economizing men in the first stages of civilization from making progress in the employment of goods of higher orders for the satisfaction of their needs.
But there is, as a rule, another portion of the complementary goods of higher order, which has already been serving for the satisfaction of human needs in some branch or other of production before the transition to the employment of a new order of goods, and which therefore previously exhibited economic character. The seed grain and labor services needed by an individual passing from the stage of collecting economy to agriculture are examples of this kind.
These goods, which the individual making the transition previously used as goods of lower order, and which he might continue to use as goods of lower order, must now be employed as goods of higher order if he wishes to take advantage of the economic gain mentioned earlier. In other words, he can procure this gain only by employing goods, which are available to him, if he so chooses, for the present or for the near future, for the satisfaction of the needs of a more distant time period.
Meanwhile, with the continuous development of civilization and with progress in the employment of further quantities of goods of higher order by economizing men, a large part of the other, previously non-economic, goods of higher order (land, limestone, sand, timber, etc., for example) attains economic character. When this occurs, each individual can participate in the economic gains connected with employment of goods of higher order in contrast to purely collecting activity (and, at higher levels of civilization, with the employment of goods of higher order in contrast to the limitations of means of production of lower order) only if he already has command of quantities of economic goods of higher order (or quantities of economic goods of any kind, when a brisk commerce has already developed and goods of all kinds may be exchanged for one another) in the present for future periods of time—in other words, only if he possesses capital.
With this proposition, however, we have reached one of the most important truths of our science, the “productivity of capital.” The proposition must not be understood to mean that command of quantities of economic goods in an earlier period for a later time can contribute anything by itself during this period to the increase of the consumption goods available to men. It merely means that command of quantities of economic goods for a certain period of time is for economizing individuals a means to the better and more complete satisfaction of their needs, and therefore a good—or rather, an economic good, whenever the available quantities of capital services are smaller than the requirements for them.
The more or less complete satisfaction of our needs is therefore no less dependent on command of quantities of economic goods for certain periods of time (on capital services) than it is on command of other economic goods. For this reason, capital services are objects to which men attribute value, and as we shall see later, they are also objects of commerce.
Some economists represent the payment of interest as a reimbursement for the abstinence of the owner of capital. Against this doctrine, I must point out that the abstinence of a person cannot, by itself, attain goods-character and thus value. Moreover, capital by no means always originates from abstinence, but in many cases as a result of mere seizure (whenever formerly non-economic goods of higher order attain economic character because of society’s increasing requirements, for example). Thus the payment of interest must not be regarded as a compensation of the owner of capital for his abstinence, but as the exchange of one economic good (the use of capital) for another (money, for instance). [Henry C.] Carey falls into the opposite error, however, when he assigns to parsimony a tendency directly inimical to the creation of capital.
C. The value of complementary quantities of goods of higher order.
In order to transform goods of higher order into goods of lower order, the passage of a certain period of time is necessary. Hence, whenever economic goods are to be produced, command of the services of capital is necessary for a certain period of time. The length of this period varies according to the nature of the production process. In any given branch of production, it is longer the higher the order of the goods to be directed to the satisfaction of human needs. But some passage of time is inseparable from any process of production.
During these time periods, the quantity of economic goods of which I am speaking (capital) is fixed, and not available for other productive purposes. In order to have a good or a quantity of goods of lower order at our command at a future time, it is not sufficient to have fleeting possession of the corresponding goods of higher order at some single pint in time, but instead necessary that we retain command of these goods of higher order for a period of time that varies in length according to the nature of the particular process of production, and that we fix them in this production process for the duration of that period.
In the preceding section, we saw that command of quantities of economic goods for given periods of time has value to economizing men, just as other economic goods have value to them. From this it follows that the aggregate present value of all the goods of higher order necessary for the production of a good of lower order can be set equal to the prospective value of the product to economizing men only fi the value of the services of capital during the production period is included.
Suppose, for example, we wish to determine the value of the goods of higher order that assure us command of a given quantity of grain a year hence. The value of the seed grain, the services of land, the specialized agricultural labor services, and all the other goods of higher order necessary for the production of the given quantity of grain will indeed be equal to the prospective value of the grain at the end of the year, but only on condition that the value of a year’s command of these economic goods to the economizing individuals concerned is included in the sum. The present value of a year’s command of these economic goods to the economizing individuals concerned is included in the sum. The present value of these goods of higher order by themselves is therefore equal to the value of the prospective product minus the value of the services of the capital employed.
To express what has been said numerically, suppose that the prospective value of the product that will be available at the end of the year is 100, and that the value of a year’s command of the necessary quantities of economic goods of higher order (the value of the services of capital) is 10. It is clear that the aggregate value of all the complementary goods of higher order required for the production of the product, excluding the services of capital, is equal not to 100, but only to 90. If the value of the services of capital were 15, the present value of the other goods of higher order would be only 85.
The value of goods to the economizing individuals concerned is, as I have already state several times, the most important foundation of price formation. Now if, in ordinary life, we see that buyers of goods of higher order never pay the full prospective price of a good of lower order for the complementary means of production technically necessary for its production, that they are always only in a position to grant, and actually do grant, prices for them that are somewhat lower than the price of the product, and that the sale of goods of higher order thus has a certain similarity to discounting, the prospective price of the product forming the basis of the computation, these facts are explained by the preceding argument.
A person who has at his disposal the goods of higher order required for the production of goods of lower order does not, by virtue of this fact, have command of the goods of lower order immediately and directly, but only after the passage of a period of time that is longer or shorter according to the nature of the production process. If he wishes to exchange his goods of higher order immediately for the corresponding goods of lower order, or for what is the same thing under developed trade relations, a corresponding sum of money, he is evidently in a position similar to that of a person who is to receive a certain sum of money at a future point in time (after 6 months, for example) but who wants to obtain command of it immediately. If the owner of goods of higher order intends to transfer them to a third person and is willing to receive payment only after the end of the production process, naturally no “discounting” takes place. In fact, we can observe the prices of goods that are sold on credit rising higher (apart from the risk premium) the further the agreed-upon date of payment lies in the future. All this, however, explains at the same time why the productive activity of a people is greatly promoted by credit. In by far the greater number of cases, credit transactions consist in handing goods of higher order over to persons who transform them into corresponding goods of lower order. Production, or more extensive fabrication at least, is very often only possible through credit; hence the pernicious stoppage and curtailment of the productive activity of a people when credit suddenly ceases to flow.
The process of transforming goods of higher order into goods of lower or first order, provided it is economic in other respects, must also always be planned and conducted, with some economic purpose in view, by an economizing individual. This individual must carry through the economic computations of which I have just been speaking, and he must actually bring the goods of higher order, including technical labor services, together (or cause them to be brought together) for the purpose of production. The question as to which functions are included in this so-called entrepreneurial activity has already been posed several times. Above all we must bear in mind that an entrepreneur’s own technical labor services are often among the goods of higher order that he has at his command for purposes of production. When this is the case, he assigns them, just like the services of other persons, their roles in the production process. The owner of a magazine is often a contributor to his own magazine. The industrial entrepreneur often works in his own factory. Each of them is an entrepreneur, however, not because of his technical participation in the production process, but because he makes not only the underlying economic calculations but also the actual decisions to assign goods of higher order to particular productive purposes. Entrepreneurial activity includes: (a) obtaining information about the economic situation; (b) economic calculation—all the various computations that must be made if a production process is to be efficient (provided that it is economic in other respects); (c) the act of will by which goods of higher order (or goods in general—under conditions of developed commerce, where any economic good can be exchanged for any other) are assigned to a particular production process; and finally (d) supervision of the execution of the production plan so that it may be carried through as economically as possible. In small firms, these entrepreneurial activities usually occupy but an inconsiderable part of the time of the entrepreneur. In large firms, however, not only the entrepreneur himself, but often several helpers, are fully occupied with these activities. But however extensive the activities of these helpers may be, the four functions listed above can always be observed in the actions of the entrepreneur, even if they are ultimately confined (as in corporations) to determining the allocation of portions of wealth to particular productive purposes only by general categories, and to the selection and control of persons. After what has been said, it will be evident that I cannot agree with [Hans Karl Emil von] Mangoldt, who designates “risk bearing” as the essential function of entrepreneurship in a production process, since this “risk” is only incidental and the chance of loss is counterbalanced by the chance of profit.
In the early stages of civilization and even later in the case of small manufactures, entrepreneurial activity is usually performed by the same economizing individual whose technical labor services also constitute one of the factors in the production process. With progressive division of labor and an increase in the size of enterprises, entrepreneurial activity often occupies his full time. For this reason, entrepreneurial activity is just as necessary a factor in the production of goods as technical labor services. It therefore has the character of a good of higher order, and value too, since like other goods of higher order it is also generally an economic good. Hence whenever we wish to determine the present value of complementary quantities of goods of higher order, the prospective value of the product determines the total value of all of them together only if the value of entrepreneurial activity is included in the total.
Let me summarize the results of this section. The aggregate present value of all the complementary quantities of goods of higher order (that is, all the raw materials, labor services, services of land, machines, tools, etc.) necessary for the production of a good of lower or first order is equal to the prospective value of the product. But it is necessary to include in the sum not only the goods of higher order technically required for its production but also the services of capital and the activity of the entrepreneur. For these are as unavoidably necessary in every economic production of goods as the technical requisites already mentioned. Hence the present value of the technical factors of production by themselves is not equal to the full prospective value of the product, but always behaves in such a way that a margin for the value of the services of capital and entrepreneurial activity remains.