 Our next lecture will be given by Dr. Peter Klein and his lectures on production and the firm. Peter? Thank you. I understand that Professor Salerno referred to me in his introduction, and I certainly want to return the favor and say what an honor it is to follow him and to be on the same program with someone so distinguished and someone of such advanced age. I think it's really cool that a lot of you guys have copies of various institute books and are getting autographs from the different speakers. You know, I wish I had thought of that when I was a student. I was attended Mises University many times when Murray Rothbard was one of the speakers, and I owned, I suppose I had most of his books that were in print at that time, but I never had the courage to ask him to sign any of them. I guess I thought I was too cool for that somehow, and I didn't want to act like, you know, it was a big deal, but of course, you know, then he passed away in 1995 without me ever getting him to autograph a book, and that's one of my great regrets that I never did that. So of course I have the books by Salerno and Block and De Lorenzo, and I'm definitely getting their autograph this week, because you don't know how much longer those guys are going to be around. But anyway, let's continue our discussion of economic theory today by discussing production and the firm. We've already talked about Austrian method and fundamental categories of action, value and exchange, capital and interest, entrepreneurship, economic calculation, and so on. I want to add another foundational topic to the mix here, namely to talk about production and the firm. Now, what do I mean by a firm? I mean, what is a firm? What does the word firm mean? Well, if you ask a layperson, if you ask the man or woman on the street, you know, could you draw me a picture of a firm? You know, they might draw something like this, a factory, and there might be smoke coming out of the smokestacks and little workers going in or out, but of course, if you're an economics major, you know that a firm doesn't look like that at all. A firm looks like this. Or if you've been to graduate school, like this. The point here is that the concepts of the firm you get in sort of mainstream economic theory don't correspond well at all to our common sense notion of what we mean by a business firm. Now, one of the confusions in the literature is that the term theory of the firm, as it's used in the mainstream textbooks, sort of confuses two separate issues. One issue is, sorry, I thought I was missing a slide, one issue is the theory of production, and the other issue is the theory of the firm per se. Now, what are some Austrian building blocks for thinking about the theory of production and the theory of the firm? Well, we already have the basic elements of such a theory from our previous discussions this week, right? We have the notions of inputs and outputs. We have land, labor, and capital as inputs into production, and we have output, consumer goods, as the end result of those production processes. We have Manger's notion of higher order goods, factors of production, versus lower order goods with goods that we consume being at the bottom of Manger's scale. We have the idea of prices, right? That in an economy in which resources are privately owned, they can be exchanged in markets and they will generate market prices. That's information, as we discussed yesterday, that entrepreneurs use in using their judgment, applying their understanding to try to estimate the costs and benefits, and the net benefits of particular courses of action. We discussed that yesterday, and Professor Salerno discussed it a little bit today as well. If the money receipts from production exceed the outlays for the factors, taking into account appropriate discounting for time preference, then the business vendor has generated a money profit. Otherwise, it has generated a money loss. And as we discussed yesterday, the notion of production in the real world, in real time, implies the passage of time and the bearing of uncertainty. So the receipts are only realized in the future after production takes place, and they cannot be known with certainty when decisions about production are made. The agent who is driving this process, the economic actor who is purchasing factors of production, assembling them into different combinations, deploying them in an attempt to earn the largest possible money profit, and to avoid money loss is the entrepreneur. And the entrepreneur's primary decision-making tool, as was discussed in the previous lecture, is economic calculation, comparing benefits and costs in a common unit, in a monetary unit. Now note that an Austrian approach to production in the firm has a particular flavor or has particular characteristics. Namely, we want a causal, realist approach to production, not the kind of production theory that one gets in the mainstream textbooks, which almost seems as if it's written by engineers. It emphasizes the physical technology of production rather than the economic valuation aspects, the notion of action, of means and ends, and so on. Austrian economic theory, beginning with Manger, is a theory of causal relations. Manger begins his famous treatise by stating that the most fundamental economic principle is that of cause and effect. So we want a theory of production that is both causal and realist, that emphasizes real production processes, real prices, not hypothetical, perfectly competitive general equilibrium prices, that is couched in terms of real factors of production, real resources, real production methods, and so on. So we often use the term causal, realist to describe Misesian economic theory, Austrian economic theory, and we certainly want a causal, realist theory of production in the firm. We want to explain prices, quantities, characteristics of real goods and services exchanged in real markets, not hypothetical goods and services in hypothetical markets. So, as I mentioned before, the term theory of the firm, as it's used in the textbooks, often confuses two separate issues. What we might call the theory of production, what can we say about ways in which factors can be combined to producing consumer goods? What are the attributes of factors? What can we say about factor combinations, the characteristics of different combinations, and so on? Now that includes elements such as the economy's structure of production, the relationships and interrelationships between higher order and lower order goods, how factors of production are priced, as we've already discussed yesterday and today. Resources are exchanged in markets. Entrepreneurs buy and sell factors. They're in factor markets where factor prices are determined. What can we say about those prices? How are they formed and so on? And that helps us to understand the notion of cost from the perspective of the entrepreneur. Now, these are extremely important issues, but they're not, they're distinct from what we might call the theory of the firm per se. What is a firm? How large will the firm be? What is the nature of the firm? How are firms organized? So by the theory of the firm, we have in mind something like the legal or common sense notion of an organization. Can we explain Microsoft? What activities will be conducted by Microsoft? What activities will be conducted by other firms? What's done inside the firm? What's done between firms? So these are sort of the classic questions in the theory of the firm include why do entrepreneurs establish firms in the first place, as opposed to doing everything as a sort of diffused, loosely structured network of independent contractors? What determines the size and scope of the business firm? How should firms be organized and managed? Again, the firm in this narrower sense refers to legal boundaries, who owns, which entrepreneurs will own which resources, and how will those entrepreneurs combine these resources in productive ways? The theory of production asks what inputs, how are particular inputs used to produce particular outputs? Unfortunately, the term theory of the firm until pretty recently was used by mainstream economists to describe both of these areas. And of course, most of the attention, 90% of the attention was on the first set of questions with very little attention until the last 20 years or so being devoted to the latter set. We'll talk about both of those today. Now those of you who have taken a course in intermediate micro-theory in a mainstream economics department have probably seen plenty of pictures like this. So the neoclassical approach to production usually proceeds along something like the following lines. Imagine a production process. I copied and pasted this from some textbook that I had. I think it's producing automobiles or something like that. And there are two inputs, aluminum and steel. The factor prices, the prices of aluminum and steel are given exogenously in some hypothetical factor market. And these pink lines on the left-hand side represent different combinations of input A and input B that all have the same cost, so-called ISO cost lines. The black curvy line is what they call an ISO quant showing you how different combinations of input A and input B can be used to produce a certain quantity of output. How many of you have seen these kind of pictures before? You can do all the usual fun stuff. You can change input prices and shift curves around and say what's the least costly way to produce one unit of output, two units of output, ten units of output, or whatever. You notice it looks a lot like an indifference curve diagram. You've seen those before. So there's a nice kind of formal symmetry between neoclassical production theory and neoclassical consumption theory that people like if they value mathematical tractability above other things. The way these diagrams are used is, okay, figure out what's the least costly way to produce certain quantities of output, and then we plot those when we get something like the middle diagram, which is a total cost curve. So we put on the horizontal axis the quantity of automobiles, whatever it is. So if I want to produce one automobile, what's the cheapest way to do it? How much does it cost? I want to produce 10 automobiles. What's the cheapest way to do it? How much does that cost? And so on, you get this nice total cost curve from which one can derive all of the other cost curves that mainstream textbooks like to diagram and fiddle around with and so on. Got a marginal cost curve, an average cost curve, average total cost, average variable cost, average fixed cost. You can sort of do these out the wazoo, as they say. And then there's all sorts of things you can do to play with these curves. One of the things that's interesting, if you look at human action and man-economy and state, both of them devote considerable attention to production theory. Man-economy and state in particular devotes about five chapters, five very lengthy chapters to the theory of production. And there are even some diagrams, some charts, some equations. But one thing that's completely absent from human action and man-economy and state is any cost curves. There's no cost curve diagrams like these whatsoever. And that would strike you as odd because those are the kinds of pictures that dominate the conventional microeconomics textbooks on the theory of production. How does the firm maximize profits given these cost curves and some revenue curves? The curves have different shapes depending on the circumstances and that's basically what production theory is all about, is manipulating cost and revenue curves. But there are no cost curves in the Austrian treatments of production. Why is that? Well, there are a number of problems with this kind of approach to production. For example, the notion that factor and output prices are taken as given, but then used ultimately to explain factor and output prices. What I mean is in this sort of standard approach, we take all of the prices, the decision makers assume to be a price taker from which these curves and so on can be derived, but then the curves are used to explain the price in the market and the prices of aluminum and steel or whatever. So there's a sort of circular reasoning in taking factor prices and output prices as given, using them to derive sort of an analytical apparatus that is then supposed to explain factor prices and output prices. You know, you can make these things fancy. You can have a demand curve that's downward sloping instead of horizontal. You can derive factor demand curves and you can have all kinds of strategic interaction among the decision makers and so on. However, in all of these cases, some things are absent. There is no time or uncertainty in this approach to production. There's no time whatsoever because production and consumption are simultaneous. There are no stages of production that take place that are arranged in real time. The decision to purchase a certain quantity of inputs and produce a certain amount of output, set of simultaneous decisions. There is no causal explanation for factor prices. As I've mentioned before, factor prices are assumed to be given and then the model is used to derive a set of factor prices. There's a sense in which this kind of approach, if you want to use this language, emphasizes kind of a set of equilibrium conditions. If the curves look like this and the input prices have these values and the output prices have these values and there are these many firms with these characteristics, then the market is in equilibrium. So it's kind of a general equilibrium in a sense, or a mechanistic simultaneous determination kind of approach to production. It's very different from Manger's notion of a causal realist explanation. Another way we could characterize the problem, as Murray Rothbard did, is that this approach to the firm emphasizes the wrong problems. It emphasizes the wrong problems. What I mean is that important issues of production here are portrayed as if they're shown from the perspective of the plant manager. Imagine there's a factory producing whatever automobiles and there's inputs, aluminum and steel and the decision that the decision maker is faced with is what quantity of output to produce and what quantities of inputs to purchase. If you have the equations, you can solve it and find out the optimal profit maximizing quantity. I remember when I studied this stuff in school, in graduate school, my friends and I used to joke about hiring ourselves out to major manufacturing firms as consultants and we would go into Toyota or something and say, okay, look, the problem is you guys want to maximize profits. If you just show me your cost curves, I can find the tangency point for you or if I'm fancy, I can take the first derivative and set it equal to zero and I'll tell you the profit maximizing quantity and you'll pay me a million bucks or whatever. That's not really the interesting problem that Toyota faces. If there is a plant in a particular spot, those of you who came in from Atlanta by car, most of you, you remember passing that huge Kia plant that's in West Georgia, it's an enormous factory. Assume that that Kia plant is already set up and everything's already in place, the inputs are readily available, the outputs are already ready, all you have to do is figure out what's Q star and press a button and optimal quantity. Okay, once you get to that point, it's pretty easy. The hard questions are things like, why is there a Kia plant there in the first place? Why does Kia motors exist? Why did the top level decision makers decide to put a factory there in West Georgia and not someplace else? Why is it of a certain size? Why does the plant manager, the one who's making this decision or should we produce one more car today or one fewer car today, how did that manager come to be there? Who gave the decision making authority to that particular manager? The whole idea of taking costs and revenue curves and finding the place where MR is equal to MC, that's almost a trivial problem compared to the real problem of how do you produce cars and where do you set up the production processes and how much capital do you give to each plant and so on. Solving for MR equals MC is, I mean anybody can do that and a freshman economics major can do that. That's the wrong problem. There's a very interesting discussion in Mises' human action on socialism and the socialist calculation debate where he, Professor Salerno outlined Mises' argument, Mises' famous argument about the impossibility of economic calculation under socialism. Now, after Mises presented his argument, there were a number of responses and critiques by pro-socialist economists and some of them in the 1930s and 1940s said, well, okay, Mises is right that you couldn't have a sort of complete top-down centrally-planned system, but why couldn't you set up a socialist economy in which you have factories, production plants, just like in a capitalist economy, and you have managers who decide how much to produce and instead of them being employees of a capitalist firm, we'll just make them all civil servants. The government will own all the factories and will hire plant managers who will work for the government and we'll put them in these factories and we'll say, hey, do the same thing that you would do if this were capitalism. In other words, take the cost curves and solve for everything and find the quantity where MR is equal to MC. Won't it be just like capitalism? How will it be any different? And, you know, Mises' characteristically insightful reply is that these market socialist proponents completely misconceive what capitalism is all about. The central problem of resource allocation under capitalism is not what quantity, you know, maximizes profit given all the characteristics of the firm. The real problems are how does an economy allocate factors to production to different activities? How much capital should the auto industry have compared to some other industry? How much capital should Kia have compared to some other automobile manufacturer? How much capital should be invested in this factory that's here rather than somewhere else as opposed to other Kia plants and factories? How do you decide who will be the plant manager and, you know, who will perform other tasks? Those are the really critical problems solved in a private property regime that no socialist system can possibly address. If the resources, if factors of production are owned by the state and individuals involved in these decisions are employees of the state, then there's no way to answer those questions of what should be done and how it should be done. So you see that implicitly what Mises is doing is criticizing the neoclassical theory of production and saying all of this intellectual energy is wasted on answering a second-order trivial question. What's the profit-maximizing quantity given this, this, this, this, this, this? What's really important is those givens. Where did they come from? What determines them and so on? So what does an alternative account of production look like? Well, we want to build on Austrian constructs. We start with Mengehr and Baumbavark and Mises and Hayek and so on. As I mentioned before, there's this middle section of man-economy and state, chapters 5 through 9, which provides one of the most detailed and certainly the most systematic exposition of Austrian production theory. Also, Ludwig Lachman's 1952 book, Capital and its Structure, which as of late has been somewhat neglected within the Austrian tradition, is a valuable contribution to this literature as well. Israel Kursner's essay on capital should be mentioned in this context also. The key issues that we want to address are what determines the prices of factors of production and how factors of production will be used. We want to try to understand and explain the economy's structure of production. And we want to incorporate the notions of entrepreneurial profit and loss. So let's start with some considerations about factor pricing. So we have factors of production, land, labor and capital. And notice, by the way, labor, of course, doesn't just mean physical labor, manual labor. So-called white-collar jobs, management jobs, are part of the labor force as well. What can we say about land, labor and capital? How they're priced? How they're priced on a rental basis? How they're priced on a purchase basis and so on? Well, one of the fundamental concepts here is the notion developed by Austrian economists in the 19th and early 20th centuries, which has come to be known as the theory of imputation. The theory of imputation. And this is the idea that the prices of factors of production, as determined in factor markets, where entrepreneurs are bidding against each other for the services of factors, depend on, in simple terms, the value of marginal units of factors to the entrepreneur. The prices of factors are determined by the value of those factors to the entrepreneur. Technical terminology, that factors that you rent, like labor, right? So you rent the labor services of an individual and you pay him or her so many dollars per hour or dollars per week or whatever. How much is an entrepreneur willing to pay for somebody's labor? Well, they want to calculate how much more output do I get by employing that additional labor and how much do I think I can sell that output for on the market? Like the Derek Jeter example that Professor Herbner used yesterday. And Rothbard calls this the discounted marginal value product, you might say in modern terminology, discounted marginal revenue product, right? So the marginal revenue product is the addition to anticipated total revenues from employing one more unit of the input or factor. And of course the entrepreneur has to discount this by the rate of interest because the payments from selling the output are received in the future, whereas the outlay for the wage paid to the factor is paid earlier in time. So in the sort of equilibrium state, the prices of these rental factors would be equal to their discounted marginal revenue product. Now there are some important sort of conditions. Factors must be non-specific for this condition to hold. In other words, if a factor is purely specific to one production process or purely specific to one entrepreneur, then you don't have the condition of multiple entrepreneurs bidding against each other for the services of that factor. And if the factor owner has a very strong bargaining position, is very skilled at bargaining, the factor owner may be able to command a higher price than the discounted marginal revenue product. The factor must also be what Rothbard calls isolable, meaning that you can isolate the contribution of that factor from the contribution of the other complementary factors that are used in production. So if you have a factor that can only be used in a fixed proportion with other factors, so the steering wheel on an automobile, you can't add a second steering wheel and sell the car for a little bit more and add a third steering wheel and sell the car for a little bit more. So you don't generate more revenues by adding more steering wheels because you need one steering wheel and four tires and one speedometer and so on that have to be used in particular proportions to produce an automobile. So just having one more steering wheel doesn't generate more revenue unless you also have four more tires and one more speedometer and so on and so forth. Of course, that doesn't apply to all inputs into car production. You know, a little bit more steel, you can make a little bit bigger car and maybe sell it for more. But there may be some factors whose contribution to production cannot be isolated from the contribution of other factors because the whole bundle is... you can value the whole bundle of factors but not the individual factors. These are qualifications, right? In those cases, in these sort of strange cases, you have bargaining between entrepreneurs and factor owners. But given that the factor is non-specific, at least partially, and isolable, at least partially, then its price on the factor market will tend to be determined by its discounted marginal revenue product. We're just restating in different words what Professor Herbner was saying yesterday about Derek Jeter, right? So the reason why professional athletes get paid a lot and economics professors get paid very little is because the market value of their output is, strangely, a much higher than the market value of ours. Factors of production that can be bought and sold in their entirety, the purchase prices are determined by sort of capitalizing the future stream of rental prices as in a machine. You can rent a machine and you'll pay the discounted marginal revenue product of the services of that machine. If you can buy the machine outright, that price will tend to be set by sort of the present value of this future stream of rental prices that would accrue to renting the factor. Okay. This is pretty straightforward stuff. I mean, there's nothing fancy going on here. This was a major innovation in economic theory because for a long time economists had believed that the causal relationship between the values of factors and the values of outputs ran the other way. Right? The classical view, for example, was that the costs of production are what determine the prices of the output. What determines how much a smartphone will sell for in the market? Well, it depends on the cost of producing that phone. If these costs are very high, the entrepreneur will have to add a markup and therefore will have to charge a very high price in the market. What the Austrian showed is that the causation is the other way around. Not from the costs of the factors to the price of the product, but rather from the price of the product to the cost of the factors. In other words, remember, according to Manger, value is subjective. Consumers have subjective valuations for the goods and services they consume. Those values are reflected in the purchase prices of consumer goods. And those prices are, in a sense, imputed backward, imputed up the production chain, up the supply chain to the inputs that are used to produce those outputs. Mises use the example of land prices. This is a picture of a vineyard in the Champagne region of France. If you go down to the grocery store, the liquor store, whatever, and buy a bottle of Champagne here in Auburn, maybe to celebrate the end of Mises' U, if it's good Champagne, you might pay 100 bucks for the bottle, if it's high-end Champagne. Why is Champagne so expensive? Well, the classical explanation, a large degree adopted by Marx as well, is that, well, the reason a bottle of Champagne costs so much is because the land that is used to produce the grapes that make Champagne is really expensive land. And it's true, if you try to buy up this farmland in this region of France, I mean, the land prices are sky-high. So it takes a lot of money to produce Champagne because you've got to buy this expensive land. Therefore, you charge a high price for the bottle. And, of course, a few moments' reflection make us realize that that can't be the explanation. What if consumers decide they don't like Champagne anymore? People's preferences taste change or other alternative beverages come onto the market and consumers decide they'd rather drink a red bull than a bottle of Champagne or whatever it is. And the demand for drinking Champagne falls. What's going to happen to the market price of these bottles of Champagne on the grocery shelves? Those prices are going to fall. Sellers will try to unload their inventories. They'll discount the price of Champagne and eventually the market price of Champagne drinks is going to go down. What's going to happen to the price of the land that is used to grow the grapes to make Champagne? Well, I mean, if this land is, you know, if the highest valued use of this land is to produce something that nobody wants to buy then who wants to own this land? There's no value in owning the land. So it is the value that consumers place on the drink Champagne that determines the prices of the land that is used to grow the grapes that are used to make the Champagne. Okay, so prices determine costs on the other way around. All costs are ultimately opportunity costs. All costs are ultimately opportunity costs. That's what we as Austrians mean by cost. I mentioned yesterday the cost to you of sitting here in this lecture listening to this lecture is the value of the other things that you're not doing because you're here instead of doing those other things. That's the cost to you, the value for gone. But it's the same thing in the production process. The cost of using this land to produce grapes to make into Champagne is the value of the consumer goods and services that we don't have because this land wasn't used to make them instead. So costs are not, in a sense exogenous to the market valuation process. Costs are the result of consumer valuations. There's always consumer valuations that determine business behavior not the other way around. And this is why we have confidence in stating that in a market economy in which goods in which factors of production can be bought and sold in markets they will tend to be allocated to their highest valued use. In other words, resources will tend to flow towards those entrepreneurs and those production processes in which they are used to make the goods and services that consumers desire the most relative to other goods and services that could be produced with those same inputs and by those same entrepreneurs. It needs a whole notion of consumer sovereignty that the consumer is the captain of the ship, not the factory owner, not the industrialist, not the manager. It derives precisely from this mutation. Now, consider in more detail the role of the entrepreneur in making all this happen. Remember, we're not assuming that champagne comes into existence on its own. The consumer sort of push a button and instantly champagne comes into existence. No, there are thinking, choosing, acting human beings involved in every step of the process. There are consumers who conceive of the drink in ways it might be produced and use economic calculation to determine what's the least costly way to produce this product and hope that consumers will desire it and so on. In what Mises and Rothbard call the evenly rotating economy, kind of an equilibrium, kind of a long run equilibrium state, factors of production will tend to earn their new products. Labor will be paid what it's worth on the margin. Land will be paid what it's worth on the margin, meaning it's value to consumers. The value of the goods and services it produces, value to consumers of what it produces discounted for the rate of interest. Capitalists will earn interest payments as compensation for forgoing current consumption and making their capital resources available to be used in production. But there won't be any profits and losses. Why? Well, because if I'm an entrepreneur producing champagne and I earn a certain amount of revenues from the production of that champagne, well all of these revenues are paid out to the inputs that are used in the production process. By the marginal productivity theory of valuation and distribution. In other words, there's nothing left over after all the factors of production have been paid. Why? Well, because if I could produce champagne that's worth a bottle of champagne and sell it for 100 bucks and I can buy land and labor and so on to produce that bottle of champagne for only 80 bucks having something left over, well that provides an incentive for other entrepreneurs to outbid me for those factors of production. Another entrepreneur says well you know I'll pay 81 for that factor bundle and somebody else says I'll pay 82. Right? And the factors of production would be bid up to the discounted value of that $100 worth of output. There wouldn't be anything left over for the entrepreneur. In the real world of course the values of factors of production, these discounted marginal revenue products are not known with certainty. Right? They're not given by textbook authors. Rather they have to be anticipated. They have to be guessed or forecast by entrepreneurs using understanding, using judgment and some entrepreneurs will be better at this than others. Right? Some entrepreneurs will make mistakes they'll say hey I can buy these factors for 80 bucks and combine them into a bottle that I can sell for 100 and they go and spend the 80 bucks and they build their thing and their bottle and they put it on the shelf you know six months later and nobody wants it. People are willing to pay 70 for it. Okay? And leaving discounting aside this entrepreneur's lost 10 bucks and maybe 10 bucks per bottle and it's a big operation it's a big deal and he's out of business. Okay? Another entrepreneur was more accurate in his or her forecasts of what consumers would be willing to pay and is able to purchase factors of production for less than their eventual discounted marginal revenue product thus having something left over. The point is that profit and loss are exclusively the result of uncertainty. Building on the discussion we had yesterday about uncertainty in entrepreneurship in a world without uncertainty where output prices are known in advance and discounted marginal revenue products can be known in advance there's nothing left over for the entrepreneur either positive or negative. It's only in a world of uncertainty where discounted marginal revenue products must be estimated, anticipated by entrepreneurs that we have profits and losses. Okay so again we're not talking about probabilistic risk here that can be estimated you know approximated with a probability distribution function and so on but rather true uncertainty what night called uncertainty rather than risk. Let's spend a few minutes now talking about the theory of the firm per se how do we get from these notions of the production process how production takes place how factors are priced what determines cost and so on to saying something about the firm as sort of a formal entity the firm as a legal entity what and why as I mentioned before in the mainstream micro theory textbooks you get very little about this issue at all. What they mean by a firm is typically a production process, a production function y is equal to f of x1 x2 x3 and so on so the theory of the firm in micro textbooks is the theory of a productive process and as I've suggested in the last few minutes it's not a very good theory of a production process now there has been some there have been many important theoretical developments in the last two or three decades trying to flesh out this notion of the firm as a legal entity what's sometimes called transaction cost theory or the transaction cost approach associated with people like Oliver Williamson one of the Nobel laureates from the year before this last year there's also what's become known as the property rights approach to the firm associated with people like Oliver Hart at Harvard, defining the firm not as a production function but in terms of ownership of resources and I think this is essentially the right way to define a firm that really what we're interested in is who owns what assets and why right so in this way of thinking about the firm the definition of a firm is an entrepreneur a capitalist entrepreneur plus the assets the alienable assets meaning assets that can be bought and sold that the entrepreneur owns could be a single capitalist entrepreneur it could be a team of capitalist entrepreneurs who jointly own factors of production such as partnership or a set of shareholders in a corporation ownership of factors of production in this conception conveys a kind of authority kind of decision making authority about how factors of production will be used what do I mean well in a world of if there's no uncertainty if there's merely probabilistic risk or even no risk at all then people can write contracts with each other that stipulate exactly who gets to do what under particular circumstances right so I hire Mark Thornton as my employee to run my Kia plant and I can write a contract that says exactly what he has to do under particular circumstances how fast he should run the machines how many cars he should ship out and so on under different conditions that we specify however in the real world of uncertainty there will always arise situations that we didn't previously agree upon so there's some condition in the market something that affects supply technological innovation perhaps change in market conditions that wasn't previously covered in my agreement with Mark who has the ultimate decision who has the final say on how the assets that are owned by Kia will be used well the definition of ownership in this context is the right to make decisions about the use of resources in circumstances that weren't previously agreed upon ok so the whole idea of me being the owner and Mark being my employee my hired manager is that if something comes up that we didn't previously agree upon the person who gets to make the final call is me because I own the factory he doesn't he's just my employee he's a contract worker he agreed to do certain things in exchange for a certain payment but when conditions arise that were not specified in our agreement he has no authority ownership conveys the right to make decisions about how factors will be used in conditions not previously specified by contract that's what ownership is in this context so notice some of you may have heard maybe familiar with the terminology used by Hayek Hayek wrote a famous article called Taxis and Cosmos talking about two different forms of social organization right a taxes is what Hayek described as sort of a designed order something that's designed from the top down like central planning for example whereas a cosmos is sort of spontaneous order or something that emerges from the bottom up an emergent order to use popular term that you hear sometimes today in this context the firm is not a cosmos but rather a taxes there's the firm is designed by its owners right the owner or owners get together and make conscious decisions about what to produce and how to produce it and what resources to acquire and what assets to divest and so on now of course that doesn't mean that every single detail of the firm's operations are planned from the top down that would be impossible in any kind of large complex organization and all but the simplest organizations it simply means that the owners always by the virtue of their ownership have a kind of residual controlling authority so even if I delegate a lot of day-to-day responsibility to Mark and then go off to my yacht in the Caribbean or whatever the fact that I chose to hire Mark that I can fire him if I want that I chose to delegate certain authority to him and that I can take that authority back if I desire means that I'm the ultimate decision maker the owner is the ultimate decision maker in this sense now you notice that there isn't a one-to-one relationship between the firm as ownership of assets and the production process or the production function in modern jargon right one firm can own multiple production processes you know multi-divisional multi-plant multi-product firm that produces different outputs and has many different plants and so on some firms don't own any production processes whatsoever I was talking to a guy at the conference yesterday who has sort of a virtual business he sits in the front of a computer screen and he sells things to consumers on his website he doesn't own any manufacturing or distribution he outsources all the production to somebody in China maybe and he uses UPS or FedEx to do his distribution and delivery PayPal to do the payment processing and so on that's still a firm because this individual owns his own labor he owns his computer he owns the facility that he uses and so on the production process he contracts that out firms can jointly operate production processes through a joint venture for example so the theory of production is not the same thing as the theory of the firm these two theories address different questions you know what does Austrian economics say about these classic questions in the theory of the firm why do firms exist what determines how big they are their boundaries what determines how they are organized in my own work on these questions I've built extensively on the insights of Ronald Kos Chicago economist, idiosyncratic economist who wrote a famous paper published in the 1930s called The Nature of the Firm which has really become the basis of almost all of the modern research on firms as organizations Kos's emphasis was on what he called transaction costs the costs of transacting in the market the argument offered by Kos is that there are some advantages to authority or hierarchy in the sense that I've described it the authority or hierarchy that comes along with ownership in principle Mark and I could be independent contractors I own some stuff he owns some stuff and we get together to work out some arrangement by which we produce cars but that may not be an efficient way to organize automobile production every time new circumstances arise we have to renegotiate our contract every time I want to do something I have to deal with Mark or find somebody else to deal with I have to negotiate with input providers I have to negotiate with marketing firms and so on to sell my stuff maybe I don't want to do that I don't want to have to renegotiate with these different trading partners every time a decision needs to be made I prefer to own all of the resources that are needed for doing this activity and have people like Mark and the other actors involved as my hired employees with authority over them a purely voluntary set of market transactions which if I can offer Mark a high enough wage can really be my employee subject to my authority rather than be a free agent an independent contractor if in fact it is more efficient to reduce these costs of negotiating and exchanging information and so on then I can afford to pay him more than he would earn as his own man so Coase emphasized that firms exist to economize on these transaction costs of negotiations to exchange among different owners of factors if we add to this the nightian notion of entrepreneurial judgment we realize that look there's certain things that you can exchange in markets certain things that you can buy and sell or write a contract over but the exercise of judgment the exercise of ultimate authority over the use of productive factors is not something that itself can be contracted for in other words you don't buy and sell judgment in the market you buy and sell assets so if I own the Kia plant I have ultimate responsibility over how that Kia plant how the building and machines will be used under conditions of uncertainty I delegate some authority to mark but I cannot delegate to mark ultimate authority for how these resources will be used unless I sell him the factory and make him the owner because that's the definition of ownership the one who holds these ultimate decision rights so if I wish to exercise judgment what night calls judgment in production the only way I can do that is to buy some assets is to own some productive resources is to be a capitalist entrepreneur so I may have great ideas about producing cars I may have this great vision I may imagine an opportunity to make money producing cars but I do not become an entrepreneur until I actually purchase factors of production combine them in particular ways and deploy them to produce stuff so I have to invest resources to exercise the entrepreneurial function in other words that's why entrepreneurs start firms because the entrepreneur must own some assets to exercise entrepreneurial judgment and once you have an entrepreneur plus some assets you have a firm what determines the boundaries of the firm how big should Kia be how many plants should Kia own how many different cars should Kia make should Kia be vertically integrated in other words manufacture building wheels in its own engines put together its own chassis and so on should it contract a lot of that out should it be more like Toyota uses what they call lean production system with few inventories and a lot of outsourcing of production to partners these are questions that economic theory can't answer for a specific case that is itself a matter of entrepreneurial judgment what we can say these boundary decisions will be influenced by what costs called transaction costs if it is very costly to outsource my components because it takes a lot of negotiation and renegotiation with a company that builds the engines it will be more cost effective for me to build the engines myself if it is costly to use an independent marketing firm I will tend to do my own marketing at the same time the cost of managing in house production and in house marketing must be taken into consideration as well if it is very difficult to motivate employees to monitor employees and so on well then I may find that it is more cost effective to outsource so the decision to in source or outsource is affected by what the entrepreneur expects the cost of external versus internal production to be of course there is a market for entrepreneurial talent and there are limits to entrepreneurial judgment a skilled entrepreneur cannot oversee an infinite amount of productive activity there are some limits to how many products how many plants how many assets the entrepreneur can own and control in a way that is consistent with satisfying consumer wants and the market will tend to penalize entrepreneurs who grow too fast who acquire too many assets and are not able to deploy them in ways that satisfy consumers because other entrepreneurs will enter and compete against those incumbents Rothbard has a very interesting discussion in man economy and state which I elaborated on in a 1996 article on how the socialist calculation problem the need to be able to calculate profits and losses in terms of money prices limits the size of the firm because as the firm grows larger external markets for its inputs and its out and intermediate products and so on begin to disappear as they are internalized and the entrepreneur loses valuable information that is embodied in those market prices so this places a limit on how efficient a large firm can be and therefore how large a firm can become on the free market again you can read about this in Rothbard and in my 1996 article so what do we get out of all of this Mark's giving me the evil eye so I'll tell you what we get but my claim is that Austrian economics offers a unique account of the production process it's not just a verbal rendition of neoclassical micro and that's what you sometimes hear critics say well you know Austrians talk about inputs and outputs and production and marginal revenue products and so on same thing as Neoclassical it's just the Austrians don't use math I'm trying to the argument I'm offering is that that isn't the case whatsoever so what I'm doing is a causal realistic analysis of factor pricing and factor use it's grounded in subjectivism and marginal utility theory it's built on the fundamentals of human action and not a mechanistic deterministic sort of physics based approach engineering based approach to production it emphasizes the economic not the technological direction of production of course there's a lot more that needs to be done in this area the theory of rent is somewhat underdeveloped in the Austrian tradition the theory of factor rents I've done some research on the internal organization of the firm from an Austrian perspective but I think there's room to do a lot more work in this area relating the microeconomic microeconomics of production to the macroeconomic aspects of the business cycle is something that is extremely important as you've already learned and will be learning more this week the Austrian business cycle theory is not just a theory of entrepreneurial error but it's a theory of the misallocation of productive resources a structure of production that is distorted or is not organized in a way that's consistent with the pattern of final goods and services desired by consumers what causes economic disruptions is that we cannot instantly and costlessly readjust the structure of production when interest rates change when changes in consumer preferences are revealed and so on because factors of production are at least partially specific to particular activities to particular lines of business that's the whole idea Austrian business cycle theory you have a half finished building and then interest rates rise and real estate market crashes you can't instantly convert those bricks into something else you've got a half finished house and it takes a while to convert those resources the relatively specific resources capital in particular to alternative uses it's not that bricks don't have uses don't have value used elsewhere it's that it takes a while to convert them well this gets at the notions of factor specificity the isolability of different factors the degrees to which factors can be used in multiple production processes this is sort of a lynchpin of the Austrian theory of the business cycle but the more explicit connections to the micro aspects micro economic aspects of production have not in my view really been brought out in the Austrian literature this would be a good research project for a young Austrian scholar there's more that can be done as well in critiquing the cost curve analysis I hinted at some of the reasons why Austrians don't use cost curves because cost curves take costs take factor prices as given and go on to do other things whereas Austrians seek to explain factor prices but there's clearly much more research that can be done in doing this kind of critique as well so I guess it's lunchtime and I better stop