 Our next lecture is Dr. Peter Klein who's a professor at the University of Missouri. Peter is one of those faculty members who originally attended Mises University and he was a Mises Fellow. He's also the director of the McQuinn Center for Entrepreneurial Leadership and Dr. Klein will be speaking to us today on production in the firm. Thank you Mark and thanks all of you for being here. I believe Mark mentioned in his introduction on Sunday night that this is the 27th year that we've held the Mises University and I attended my first Mises University in 1988 and I haven't missed one since and I think I'm starting to get it now. Each year I understand a little bit more but I hope that you will get as much out of this week as I got out of my first Mises University and have gotten out of so many Mises universities since and certainly hope that we'll see you again many times here at the Institute for this event and other events. This morning I want to talk to you about Austrian production theory. We've learned a little bit about production already from for example Professor Holzmann's lecture on the Division of Labor, Professor Garrison's remarks on capital, even some of what we heard just in the previous lecture by Joe Salerno on calculation and the role of the entrepreneur. These are all elements of or building blocks towards an Austrian robust Austrian approach to production theory and the role of the firm, right? So we're going to talk about producing things, building things, the actions of purposeful individuals in building things. I won't have anything to say about the role of the president in building things. You can you can discuss that on your own. So what is production, right? Nice definition from man economy and state by Rothbard. The use by man Rothbard's writing in the 60s so you'll forgive the politically incorrect English. The use by man of available elements of his environment as indirect means as cooperating factors to arrive eventually at a consumer's good that he can use directly to arrive at his end. So those of you who have read man economy and state may recall this passage in the context of Rothbard's famous ham sandwich discussion. So he begins the book with a nice homie example of consumption good and important good that's desired by consumer ham sandwich. He talks about the production process for ham sandwiches and so forth, right? So the idea is the consumer wishes to satisfy a particular want or need satisfying his hunger in this particular case, right? Now if there are ham sandwiches just sitting around, right? If there are as many ham sandwiches as the consumer could possibly eat available to just grab, well then he eats them and we can talk about how he might rank different quantities of ham ham sandwiches. We have a preference ranking over the ham sandwiches and so forth, but we don't have to worry about how the ham sandwiches got there. As far as the actor is concerned, you know, you wake up and your home is filled with ham sandwiches. It sounds like a dream, you know, a wonderful dream that that I had the other day, but what if the ham sandwiches aren't already there and have to be produced using the materials that are available for the actor to use, right? So production is about transformation, right? Transformation of nature-given or God-given materials into goods that eventually we can consume, not that we consume directly, but that we use, that we combine, we bundle, we transform in particular ways to make them into goods and services that we can consume, right? So man is using these indirect means, factors of production, resources, right, to produce the ham sandwich or whatever the consumer good is that he or she ultimately wishes to consume. So notice that, you know, this is not a sort of creation ex nihilo, right, but rather making something out of nothing, but rather a process of transforming factors, resources that are available into new combinations. Notice the focus on purposeful human action, right? So ham sandwiches don't just come into existence on their own. I'm sorry, Mr. President, we don't all make a ham sandwich. Somebody has to make it, right? There has to be some purpose, some active will that brings together the bread and the ham and the mustard or whatever. Now even in this very simple formulation, right, the use of these indirect means to satisfy an end, we have important implications such as the passage of time, okay? The transformation of bread and ham and mustard and so forth into a consumable ham sandwich is not instantaneous. And if you remember just picking up on a point, you know, towards the end of the previous lecture, right, if we're talking about production using, you know, intensively using capital goods, factories, machines, industrial resources, it takes a lot of time, right, not only to get consumable goods and services through these production processes, these lengthy production processes, but also to alter the nature of the production process itself, right, to rearrange resources by reconfiguring the factory or shutting down the factory, dismantling the factory and recreating it or a different factory somewhere else. That doesn't happen instantaneously, right, but even with a ham sandwich there's a passage of time. There's also an important distinction here among different categories of productive factors, resources that can be used as indirect means, right, economists typically distinguish between what we might call original or originary and secondary factors of production. So some productive resources are given to us by nature like our labor, right, and certain kinds of, you know, things that occur in the natural environment, apples that you can pick from a tree and so forth, right, if instead of ham sandwiches we're eating apples and all you need to do is apply your labor to pulling an apple off of the apple tree and there you have an apple ready for consumption, right, but in most production processes in an advanced economy the resources, the factors that we're using are not simply labor and nature-given raw materials, but also machines and industrial inputs and so forth. In other words, resources that are themselves the product of some previous production process, right, and of course this is obviously if you just think about producing any, you know, good or service in a modern industrial economy, even if we're really talking about apples, right, that come from a large commercial orchard with machines, right, there are machines that are used to process the apples, to pick the apples, there are tools, and then there are the machines that were used to make those tools and those machines and the machines and labor of course that were used to make those machines and so on and so forth, okay, so we not only use these original factors, we also use produced factors or secondary factors of production. Production theory is extremely important. Now sometimes I say this just to you as friends and the several million people listening on the web, sometimes Austrians tend to give production theory a little bit of short shrift. Why? Because it's not sexy, okay. A lot of people find talk of factories and, you know, marginal products and resource combination industrial production to be a little bit dull and pedantic. I personally find it fascinating and I'm sure that you do too, but if you look back at, you know, recent Austrian literature over the last three, four decades, production theory seems to get relatively less emphasis than business cycle theory, than methodology, than comparative economic systems and other topics that might seem a little bit more exciting. However, if you look for example at Rothbard's man economy and state, you find that the topic that gets the most sustained systematic treatment is production theory. So five entire chapters of this large book are devoted exclusively to the fairly mundane details of production and I think they're handled very well in man economy and state and that's one of the great contributions of Rothbard's treatise. So we certainly want to not assume or take for granted that well, production, everybody understands how that works. There aren't many novel insights to be generated. Let's just go on and think about more controversial or exciting stuff. Now in fact, it turns out there are a lot of aspects of production theory that need further development even within the Austrian school and those of you who are looking for topics for further study, you're interested in writing papers or doing research in the Austrian tradition, I would urge you to look very seriously at issues related to production, the theory of the firm, the theory of the entrepreneur and the role of the entrepreneur in production and I think you'll find a lot of opportunities to generate new knowledge. What do we mean by the firm? I'll have more to say about how we can define and think about firms in just a moment but loosely speaking, the firm is simply the locus of productive activity. So the firm is where these production processes that we're describing take place, right? So a firm includes factors of production, resources that are used and combined into consumer goods but also what you might think of as a coordinating agent, namely an entrepreneur. So entrepreneurs are in charge of production, entrepreneurs direct production, entrepreneurs manifest their activity through firms, firms are guided, directed, controlled by entrepreneurs and so you see production theory, the theory of the firm and the theory of the entrepreneur are all very closely intertwined, right? And have to be treated together in a systematic integrated approach to understanding a market economy and I'll try to sketch some of that out for you today. So what are some basic elements to an Austrian approach to production theory? Well we've already talked about inputs, right? Land and labor, the originary factors of production, land here referring not just to physical land but to apples that come from trees and minerals and so forth and then capital goods, the produced factors of production. So those are inputs and consumer goods of course are outputs. So we're interested in how inputs are transformed, combined, massaged, manipulated into the production of outputs. Prices of course are an important element of production theory as well. Not only prices for consumer goods, so there's a market for ham sandwiches with prices and quantities, right? But there are also markets for the bread that's used to make ham sandwiches and ham and there's a labor market for ham sandwich workers and so on. So we're very interested in markets and prices not just for consumer goods but for producer goods as well. When entrepreneurs combine resources into the production of consumer goods, right? If they're doing this on a commercial basis, right? So assume you're not making a ham sandwich at home to eat but you're a professional ham sandwich manufacturer, I don't know, your subway or something, right? Or Arby's. You're interested in producing these consumer goods not to eat them yourself, although maybe during the break you get to eat them. But you're interested in producing them so you can sell them to other people who will give you money for them, right? One of the ways or the way in which we judge the success of this productive operation on the part of the ham sandwich entrepreneur is in terms of the entrepreneur's ability to earn profit and avoid loss, okay? So the entrepreneur, the ham sandwich entrepreneur hopes to get as much revenue as possible from selling ham sandwiches at the least possible cost of procuring the inputs, right? So profits are revenues minus costs. Entrepreneurs want to acquire profits and avoid losses. And as we'll see, profit and loss plays a vital role in the overall social allocation of productive resources among entrepreneurs. Talk about that in just a moment. I've already mentioned time, right? These are what I have in green are elements of production that are more unique to the Austrian tradition as opposed to mainstream economics, right? The role of time we already discussed but critically important too is the role of uncertainty, right? Even in the case of the guy making the ham sandwich at home, right? There's a possibility that it might not be good, right? Maybe you don't like it after you've made it and eaten it. Maybe you run out of mustard or something before it's finished and it's a disaster or you drop it. Or some of you might remember the famous scene from one of my favorite movies, Spinal Tap, where the bologna doesn't fit on the, there's round bologna or round ham and square bread and it's just a complete disaster, I think is the word that Nigel uses. So you might be unsuccessful. Of course the commercial ham sandwich entrepreneur well knows that the revenues, the anticipated revenues, the hoped for revenues from selling the ham sandwiches may not end up covering the cost of producing them and that entrepreneur may earn a loss. So at the moment that the actor begins the process of acquiring the resources and combining them, whether the end result will be successful, whether the consumer good will satisfy the consumers need, whether it will generate enough income to cover expenditures for the entrepreneur, these things are not known. So production inherently implies uncertainty. There's uncertainty about the degree to which the produced, the end of production will satisfy the goal that that production was aimed at. The agent coordinating the production process and the commercial context is the entrepreneur and the entrepreneur employs the technique that Professor Celerno described in great detail in the previous lecture, economic calculation. So it's only in a monetary economy with profits and losses measured in money that production with a large number of heterogeneous factors and so on is possible. So efficient production, a wise use of resources to produce consumer goods, except in the simplest cases of Robinson Crusoe and his island, is only feasible in an economy with money and money prices such that the entrepreneur can calculate as Professor Celerno described in the last lecture. The general approach that we take, excuse me, the general approach that we take in Austrian production theory and something that distinguishes this approach quite sharply from the production theory in neoclassical economics is its causal realist character. And I'm using the term causal realist here in Karl Manger sense of looking at economic processes in terms of cause and effect. Manger was of course steeped in Aristotelian philosophy and contrasted his own approach to that of his contemporaries Valraz and Jevons who had a much more mechanistic approach to production and exchange. So it's causal, it begins with the concept of means and it means and ends and it's realist or realistic in the sense that the goal is to explain real world economic phenomenon. We want to explain prices, quantities, characteristics of real goods and services produced in exchange in real markets, not hypothetical goods produced in imaginary markets. So you will not hear any reference, for example, in my discussion to perfect competition. We're not interested in what firms would behave if there were an infinite number of them in a setting of perfect and complete information, infinitesimally small firms, perfectly divisible outputs and so forth. So those of you who have studied competition theory from the neoclassical perspective understand that production theory in that context is about building deliberately false hypotheticals. Here's a kind of a market that could never really exist in reality, could not exist in reality, what would its properties be and let's work out all the mathematics of how to describe this process. Causal realist economics is not interested in that. Causal realist economics is interested in explaining real goods and services produced in real markets by real people, okay? I'm sorry, in the interest of time I have some remarks on some critique of neoclassical theory but I meant to, I intended to skip it. I meant to take out the slide, sorry. So let's, a primer on some of the key concepts from production theory. I'm drawing on Manger, Bombavirk, Mises and Hayek, as well as in particular the chapters I mentioned in Rothbard's man economy and state. Also a somewhat neglected book on Austrian production theory, it's very important for Austrian production theory is Ludwig Lachman's book from 1952, Capital and its Structure. The key issues that we're interested in are ideas about the structure of production, which were already discussed by Professor Garrison and others, right? This notion of higher order and lower order goods as the taxonomy was developed by Manger, the notion of the describing the production process as a triangle, right? The famous Hayekian triangle that you see illustrated on the Mises University t-shirt. Does anybody have the t-shirt on right now? That's a key element of this approach to production. We'll talk a little bit about that. Talk a little bit about the pricing of factors, right? What determines the price of ham, the price of bread, the price of ham sandwich, worker labor and so forth. Use that to understand how costs are seen from the point of view of the entrepreneur and then how the entrepreneur uses this information in pursuit of profit and avoidance and in the attempt to avoid loss, okay? So let's talk a little bit about pricing of factors, right? First of all, remember what we mean by factors here is land and labor and of course labor includes not just manual labor, blue collar labor, but you know, management is a kind of labor as well, right? And of course capital goods produced means of production. One of the great Austrian contributions to production theory is the so-called theory of imputation. Imputation theory deals with the manner in which consumer valuations for lower order goods, in other words the things that we consume directly, are imputed through the production process through entrepreneurial behavior back up to the higher order goods that are used to produce them, okay? Specifically, let me go over some of this technical jargon and then illustrate a little bit with an example. The prices of factors that are rented in factor markets, okay? Why do I say rented? Well again, think about hiring labor, right? From the point of view of an entrepreneur, the entrepreneur does not buy a worker, right? You don't buy the worker, rather what you do is you rent the labor services of the worker. I will pay you so many dollars per hour or per day or per week in exchange for you providing these services, right? Just like you can rent a car, you can rent an apartment, you can rent industrial machines and so forth. Now, for some factors of production like machines and buildings, you can not only rent them from an owner, you can actually buy them outright. Of course, you can't do that with labor in a free society, right? What determines the prices that will be paid for the rental use of factors of production? What determines wages, right? What determines the rental price on a machine? What determines the rent for the land on which a factory sits? The Austrians pointed out that these rental prices will tend to equal what Rothbard calls their discounted marginal revenue products. They're discounted marginal revenue products. What's a marginal revenue product? Well, the marginal revenue product of a resource, a factor of an input, is given by taking the amount of output that that factor can produce in a given amount of time and multiplying that by the price at which that output is sold, okay? So the marginal revenue product of a unit of labor to produce ham sandwiches, right? If one hour's worth of labor can produce, you know, 10 ham sandwiches and then each of those ham sandwiches sells for a dollar each, right? Then the amount of revenue generated from one hour's worth of that labor is difficult math, $10, right? So who says Austrians aren't good at math, right? If the worker were to become more productive, right, and this worker can now produce 20 ham sandwiches in one hour, then the marginal revenue product of that labor would be now higher, now it would be $20, right? Or if the worker is just as productive as before, but the price of ham sandwiches were to rise. Suppose that consumers increase their demands for ham sandwiches and the price rises from $1 to $1.50, right? Then that same worker who produces 10 ham sandwiches per hour, that labor is now worth not $10, right, but $15. The amount of ham sandwiches produced times the price at which the ham sandwiches can be sold. That's the marginal revenue product of a unit of an input. The amount of additional revenue generated by combining that input with the other inputs that are used to produce this particular output, okay? Now, since production takes place through time and we've already learned about the role of time preference and discounting, right, if the entrepreneur has to pay the labor in advance and only gets the receipts from the sale of the output in the future, right, then the amount that's paid to the factor will be discounted according to time preference, according to the interest rate, okay? In the case of the ham sandwich, the discount might be relatively unimportant if the ham sandwich is produced right on the spot and sold right then, okay? But if I'm purchasing materials to build automobiles, I have to hire labor, I have to rent factors and so forth now to sell automobiles that will only be ready for sale in six months, then the amount that I pay for my factors will be discounted a noticeable amount, right, over the price relative to the price of the automobiles once they're produced. A lot of production processes, of course, are very lengthy. I've been reading some, there's a fascinating book that I've recently blogged about on, I'm very interested in the movie industry, so the economics of cinema, the production of cinema and other kinds of creative art, but cinema in particular. There's a great book about Terry Gilliam's movie, Brazil. Most of you have probably seen Brazil, of course, young Austrians have probably seen all the great dystopian movies and read all the books, but Brazil, of course, is one of the classics, but there's a huge battle between the director, Terry Gilliam, and the studio over the final edit and the production of the movie and sort of dragged on and on. I mean, to make a major film, of course, it takes two, three, it can easily take even four years from, you know, kind of signing the initial contracts, making the advance payments to the director and starting to hire the technical crew and the actors. By the time you can sell even one movie ticket, right, for a blockbuster, it's definitely two years, three years in the future. So discounting plays a very important role when there's a substantial amount of time involved in production. There are some exceptions to the principle that rental prices are equal to discounted marginal revenue products in peculiar cases. Some factors, you know, only have any value when they're combined with one other particular factor in some idiosyncratic combinations, in which case the rental prices have more to do with bargaining between the factor owner and the factor user than the precise discounted marginal revenue product. We can talk about those things in the Q&A if you want. Now, for factors that you can buy outright, like a machine or a piece of land, the purchase price, right, will be simply equal to the discounted value of the expected future stream of rental prices. Okay, so if you have land and I rent the land for you at, you know, paying $100 a week, you might be willing to sell me that piece of land for the present discounted value of a stream of $100 a week for, you know, what we project to be the expected life of that useful asset. And like I said, of course, you can't do that with labor. Why is this important? Well, when the Austrian approach, Austrian theory of imputation was sort of outlined, an overview was given by Manger in his principles, but not developed in great detail until the second and third generation of Austrian economists. But this was actually quite a, quite a radical way of understanding the relationships between costs and prices, right? So prices, prices of, here we mean the prices of consumer goods, what consumers are willing to pay and what prices for, what the prices for ham sandwiches or for movie tickets and so forth. And the costs, costs are the prices paid by entrepreneurs for the inputs into production. And, you know, the classical view that came out of the British, the view that came out of the British classical tradition from Smith and Ricardo and Mill and so forth was this idea that prices are determined by costs. In other words, the reason a ham sandwich costs $259 at Subway, right, is because Subway takes the cost of the labor and the ham and the bread and the condiments and the electricity and the utilities and so forth adds a markup, 5%, 10%, and then passes that onto the consumer, right? So the prices that people pay in markets for consumer goods is their production cost plus some little extra so the producer can have something to put in his pocket. The Austrians pointed out, through their imputation theory, that that way of thinking about pricing has the causation exactly reversed, that the causation goes the other way around. In other words, the only reason that a ham sandwich worker has any value whatsoever is because people like to eat ham sandwiches, okay? So the prices that consumers are willing to pay for goods and services is then imputed backwards to give value to the units of labor and capital and raw materials and so forth that are used to produce them, right? So to understand this first, think about what we mean by cost, right? What is the cost of using a resource? What's the cost of using labor to produce ham sandwiches, right? Well, in a subjectivist sense, right, the cost of using that labor to produce ham sandwiches is the value of the other goods and services we could have had if that labor had been used to produce them instead. Okay? So think about it this way, if you have a worker who's so specialized that all he can do is make ham sandwiches and he can't do anything else. So what are we giving up by employing him to produce ham sandwiches as opposed to letting him engage in his next most valuable activity? Nothing or very little, okay? The cost of using that resource is not that high. We don't have to give up very much to get more ham sandwiches if we're using that kind of labor. If, on the other hand, we're using labor, you know, it would be a good example, you know, if we have a brain surgeon making ham sandwiches, you know, maybe he's really good at slicing the meat with his little scalpel and do little patterns and stuff. I mean, yeah, of course, you might get really delicious ham sandwiches, okay? But that's not a very efficient use of a surgeon's labor because he could be much more effectively, he could produce much more valuable goods and services in surgery, right? This is the whole notion of division of labor and comparative advantage that you learned about yesterday from Guido Hulsman, right? So first, remember that the right way to think about cost is opportunity cost, not dollar expenditure, okay? Second, as we have just described, right? Factor prices tend to equal their discounted marginal revenue products when people are free to negotiate and bargain and exchange in factor markets, what's sometimes called the marginal productivity theory of distribution. And factors tend to be allocated to their highest valued uses in production. Why? Because entrepreneurs will bid against each other for the use of factor services. And how much the entrepreneur is willing to pay for a unit of a factor depends on what? How much revenue the entrepreneur thinks that factor can generate, right? My willingness to pay for the ham sandwich worker depends on how many ham sandwiches I think he can produce and how much I think I can sell, at what price I think I can sell the ham sandwiches. You know, Mises used the example of wine to illustrate this point, right? So if anybody recognizes this photograph, Hulsman's not here, he already bragged about his wine knowledge yesterday. This is a photograph of the Champagne or Champagne region of France, right? Where some of the most expensive, these are the grapes that go into super expensive bottles of Champagne, you know, $100 bottles of Champagne, $200 bottles of Champagne, right? Now, if you want to go buy some of this land to be a farmer or you want to rent, you know, a chateau for the weekend, you know, that's where we'll go for the staff retreat at the end of the conference to discuss how things went. It costs a lot, right? It's really expensive to get land in this part of France, right? So the classical approach would say, ah, why does it cost $200 a bottle? Why does it cost $200 for a bottle of fine Champagne? It's because this land is so expensive. You have to pay a lot to be able to get the grapes that you can use to make that particular drink. Mises points out, no, the causation is the other way around, right? The reason this land is so expensive, the reason this land is so valuable is because people are willing to pay a really high price for that top end Champagne. And so producers, entrepreneurs know that they anticipate they can get a substantial amount of revenue from producing the stuff, from producing goods and services that you produce with these inputs. So they bid against each other actively for the use of this land, for the services of the machines and the labor and so forth that are used to produce that high end Champagne. So the price of the land gets bid up because the price of the drink is very high, right? And it's of course easy to see this if people around the world all of a sudden became teetotalers, if everyone swore off alcohol for some reason and no one, for personal reasons or religious reasons or whatever, if the whole world stopped drinking wine, what's going to happen to the value of this land? Right? I mean it's because land prices will collapse in Champagne. This land won't be worth anything or it won't be worth any more than generic land that you can use for cows or whatever, okay? So expensive, costly resources are costly because they are useful to produce valuable things. It's not that things are valuable because they are used, because they are produced with costly inputs, okay? Now let's talk a little bit more explicitly about the entrepreneur and the role of profit and loss. So, you know, Mises has this concept, a sort of a long run equilibrium concept that he calls the evenly rotating economy or ERE for short. And you know, the ERE is what Mises calls an imaginary construct, meaning it's not a description of a realizable state of affairs, but a useful reasoning tool, a state of affairs we can imagine and use to try to understand the relationships among certain kinds of factors and actions and so on, right? So imagine that the economy is in this kind of long run equilibrium state. All of the factors of production, including management of course, will earn rents determined by their discounted marginal revenue products, right? Champagne land will generate high rental prices and subway workers will get paid wages according to their sandwich making ability and the value of the sandwiches to consumers and so on. Now capitalists, those actors who specialize in advancing funds for use in the present in exchange for the return of those funds in the future, they will earn a reward as well. They'll earn an interest return, right? And you can think of interest in this sense as kind of a reward for foregoing consumption. So I'm willing to lend $100 to Mark Thornton today in anticipation that he will pay me back $110 next year. Actually that would be really high interest right now, thanks to Ben Bernanke, you know $100 and a fourth of a penny or whatever a year from now. But if everything is adjusted, right? If all markets have, if all factor markets have been adjusted such that the rental prices of factors are exactly equal to their discounted marginal revenue products, right, then there's nothing left over, right? So if I'm an entrepreneur who's producing sandwiches or whatever, the amount I have to pay for the inputs is just equal to the returns I get from selling the output. Right now I get a wage for myself, I get a salary for myself as the as the manager of the restaurant, but including my labor as one of the inputs. Once I've paid for all of my inputs, I don't have anything left over, right? So there's no profit, there's no money profit or money loss. You know, I said earlier in the lecture that neoclassical economists talk about these, you know, kind of fantasy situations, why am I doing it now? Right? Simply because this allows us to see, well, what is it that generates profit and loss? Right? Why do we have profits and losses in the real economy? Because the real economy is not like the ERE, right? In the evenly rotating economy, everybody can anticipate the future perfectly. Entrepreneurs know exactly what consumers, how much they'll be willing to pay, what the money supply is going to be, macroeconomic conditions, whatever, right? Entrepreneurs can perfectly anticipate their future revenues and so they know exactly what to pay for factors of production discounted as appropriate, right? Of course, in the real world, you don't know exactly how much you can get for selling your stuff in the future. You don't really even know if the ham sandwich is going to taste right or not. Okay? So outside of this imaginary construct of the evenly rotating economy, entrepreneurs earn either profits or losses based on their ability to anticipate the future prices of the goods and services that they're producing. Okay? So entrepreneurs who are pretty good at anticipating how much consumers will be willing to pay for ham sandwiches, for bottles of expensive wine, for movie tickets, and so on, right? They will be able to acquire factors of production, they'll be able to bid factors of production away from other entrepreneurs whose ability to anticipate the future is not as good. Why? Because if I'm generally pretty bad at anticipating what future consumer goods prices will be, then I'll end up overpaying for at least some of my factors. I'll pay more for them now than what their discounted marginal revenue product will eventually be revealed to be and I'll lose money, right? And if I consistently lose money, I'll run out of capital and I can't get a loan and eventually I'll stop being a business person. I won't be an entrepreneur anymore and I'll do something else. Entrepreneurs who are pretty good over time at making these anticipations of the future, right, will tend to be successful, they'll earn profits, they'll be able to acquire more capital at the expense of less successful entrepreneurs. So there's a process through time, a sort of selection process by which productive resources are kind of channeled or directed towards those entrepreneurs who systematically do a better job at dealing with uncertainty. Now, Mises and Rothbard did not use the specific terminology of the famous American economist Frank Knight, but I think they easily could have. Knight is, although not an Austrian and in many ways a critic of the Austrians on some subjects, Knight introduced a very useful distinction between what's called risk and uncertainty. We'll be talking a little bit more about this in a lecture later in the week, right, but think of Knightian uncertainty as, you know, a situation where we don't know what's going to happen in the future and we don't have sort of an actuarial table or a mathematical model, a predictive model that can tell us, you know, on average exactly what is going to happen, right? So we're not talking about gambling with dice or roulette where, yeah, I don't know what number is going to come up, but I know there are 32 numbers and, you know, the probability of any one number coming up is 1 over 32. We don't mean a situation like that. We mean a situation that's much more complex than that and cannot be reduced to, you know, to some sort of probability calculation. Knight used the term judgment to describe these entrepreneurial anticipations of the future under genuine uncertainty and actually Mises uses the term judgment as well, though he doesn't refer to Knight specifically. Mises says, he says, I'm paraphrasing, he says the entrepreneur does not, the entrepreneur sees what other people see, but the entrepreneur judges the future differently. The entrepreneur has a particular anticipation of the future that cannot be modeled in a way that any other person would come to exactly the same realization if provided with the same information, right? The entrepreneur exercises a unique faculty of judgment, and that is the source of profit and loss. To make a long story short, without uncertainty, no profit and loss, okay? Now, what about the firm? What about the business firm specifically? You know, if you took a, if you've taken courses in production theory or what is sometimes called the theory of the firm in a kind of, you know, mainstream neoclassical economics course, you might have found it pretty disappointing, because what's often called the theory of the firm in a neoclassical economics course is just a mathematical description of production, right? So a function that characterizes the relationships between inputs and outputs, you know, y is output and y is equal to 3x1 plus 2x2 squared plus the square root of x3, right? So if you add that much of each of the x's, you get that much of the y, and that's supposed to tell you all you need to know about production, you can generate different cost curves and so on from doing that. I think that's a very peculiar way to think about firms, and it's been criticized on a number of different grounds, right? For example, that it doesn't, you know, put it this way, at best, that kind of approach is sort of, you know, a description of a production process, but it doesn't tell you anything about how that production process is organized, governed, managed, and most importantly, owned, right? So when we talk about firms in an Austrian sense, we're referring to the ownership of productive capital resources, right? Who owns the assets and the labor for that matter that are used in combination? Who has the ultimate responsibility for deciding how productive resources will be combined and recombined, right? For which consumer goods will particular resources be dedicated, and in what quantities, in what proportions, how will adjustments be made, right? Will a set of productive assets be assembled here or over here? Will they be combined in this way or that way? Those are decisions to be made by human actors, right? That's a, that's a part of the purposeful human action aspect of production. The entrepreneur who owns resources, what in my 2010 book I call the capitalist entrepreneur, is this agent who's making these decisions, right? So the firm in this context is an entrepreneur, a capitalist entrepreneur, a resource-owning entrepreneur, plus the assets that the entrepreneur owns, okay? And of course, the entrepreneur could be a team, it could be a group, a partnership, a corporation, right? It could be a set of capitalist entrepreneurs pooling resources and deciding collectively how they want their resources to be used, right? This is what we mean by a firm. So when we say that General Motors is a firm or Microsoft is a firm or whatever is a firm, we're referring to the key decision makers, those who possess ultimate responsibility over the use of the productive resources and those productive resources over which these agents have authority, okay? And I use the word authority very carefully and deliberately. The idea is that ownership of a productive resource conveys some decision rights over how that resource will be used, right? So there is, in a sense, hierarchy within a firm, okay? And notice, this is even in a purely free market context, right? I mean a voluntary hierarchy, right, by which a resource owner and say a provider of labor services who does not own resources get together and agree, contract, strike a deal, okay? I will hire you to work on my machine under these conditions and I'll pay you this much. And you agree to take some direction for me over how this machine will be used in particular circumstances, right? Notice that providing direction is absolutely necessary under conditions of uncertainty. If there's no uncertainty, we could just say, well, you will do exactly these things and I'll pay you this much. And you can decide right now if you agree to that or you can walk away. But if there's uncertainty, then we cannot specify every task in detail that the provider of labor services will be required to perform to be combined with this capital asset because circumstances may arise that we didn't anticipate, right? Well, what if something happens that we didn't previously agree upon in the contract, now who gets to decide how the machine will be used? Well, that's the definition of ownership, right? The resource owner is the one who gets to decide how the resource will be used in circumstances that were not previously specified in some kind of explicit agreement, okay? And going back to the concept of the production process or the production function, notice that there's no one-to-one relationship between a firm in this ownership sense and a production process or a production function, meaning that a single firm can own multiple production processes, you know, Apple Computer, there's a production process for making iPhones and for making iPods and iPads, there's a production process for producing the iTunes, you know, services as a store, there's a production process for making Apple software and so on. And, you know, and Apple's really even not that diversified a company. You know, imagine if Apple started making automobiles or Apple started making airplanes or something, you know, that'd be a fairly independent production process governed by the same key decision makers that are governing Apple's other processes. And, of course, the same thing about the other end of the spectrum too, you can have a very small firm that doesn't even own an entire production process on its own. But, you know, jointly works with other firms to produce things in tandem, right? I'll provide these inputs, you provide those inputs, we'll write a contract that governs our interaction and we'll team up. A joint venture, for example, or a coalition or a diffused network, like if you want to think of Wikipedia as a firm, okay, you can imagine that lots of individual writers and authors and editors and so forth are pooling their services to produce the output of Wikipedia. There's no one firm that controls that process. In other words, there's not much of a relationship between the production function and the firm in terms of ownership of assets, while in a typical intermediate-level microeconomics text in the neoclassical tradition, the firm is simply that production function and nothing else, okay? So, what are some important questions we can ask about firms in this ownership sense? I mean, there's a famous article by Ronald Kos, published in 1937, called The Nature of the Firm, you know, sort of is posed a set of questions that most subsequent theories of the firm have tried to grapple with, namely, why do we have firms at all? Why do firms exist? What determines the boundaries of the firm and how are firms organized internally? So, this existence question refers to, you know, the whole idea of a, you know, hierarchically organized firm with ownership of productive resources, because you can imagine a world in which we don't have any firms whatsoever, but every single human agent, everyone who participates in the division of labor, is kind of an independent contractor. Everybody owns their own tools, their own machines, their own capital goods, and we get together either in an ad hoc manner or maybe governed by some kind of a long-term contract, and we produce things as networks of independent contractors without any central coordinating agent. I mean, why don't we do it that way? Why do we have bosses and workers? Why do we have capitalist entrepreneurs who own substantial amounts of productive resources and direct others in the use of those resources? I mean, Kos's answer was phrased in terms of transaction costs, and I won't say much more about Kos, especially if I say anything favorable because that will give Walter Block a heart attack. But the answer given by Frank Knight, I think, is more consistent with the Austrian Rothbardian view that I'm expounding. Right, Knight's idea was in terms of ultimate responsibility. The terminology Knight used, he said, entrepreneurial judgment is non-contractable. In other words, judgment meaning this ultimate responsibility for how resources will be used in situations that we didn't perfectly anticipate, is inextricably linked with ownership. If you own a resource, then by definition, you have the rights to determine how that resource will be used in situations that are not covered by some kind of prior agreement. And you cannot sell your ultimate responsibility to somebody else. If you own the resource, then as part of ownership, you possess that ultimate responsibility. The only way to get rid of your ultimate responsibility is to do what? To sell the asset. You can't own the asset, but let somebody else have ultimate responsibility over the asset. Then you don't own it anymore. So in other words, if an entrepreneur wishes to exercise what Knight and Mies is called judgment, right? If an entrepreneur wishes to exercise ultimate responsibility over the use of productive resources in an attempt to earn money profit and avoid money loss, the only way the entrepreneur can do this is by acquiring assets. In other words, by becoming a firm, by starting a firm. So firms exist because of uncertainty and the need to exercise ultimate responsibility over resources. What determines the firm's boundary? In other words, how many productive activities will be inside versus outside the firm? How large will the firm be? How diversified will the firm be? How many assets will it own? How many workers will it employ and so forth? And again, Koss's answer is in terms of transaction costs. Rothbard has a very important addition to this argument that I've summarized in my 1996 article in the review of Austrian economics on the need for economic calculation. In other words, to the extent that a firm becomes so large, that it becomes the sole user of particular intermediate products, such that the external market for that intermediate product goes away, then the firm suffers from Mies' calculation problem. Right? Remember the way Salerno described it in the previous lecture. Calculation is a problem of one-wheel acting. You need multiple wheels participating in the division of labor. If one firm is the sole owner of and the sole user of a particular intermediate product, then it can no longer use the information that's embodied in market prices to make decisions about the use of that productive resource. And the firm suffers from what Rothbard called Calculational Chaos. So Mies' calculation problem helps to place an upper bound on the size of the firm. And this points out, by the way, that Mies' calculation, Mies' account of calculation is not exclusively about socialism. Right? I mean that's the context in which the argument has most often been deployed, but it's a much more general argument about the need to have market prices for factors of production. And it affects not only the socialist planner, but could potentially affect a very large cartel of private firms or a single firm that became so large that external markets for some of its inputs began to disappear. And I've done some work. In fact, if you care to spend, I think, 20 bucks on my newest book, which you can find in the bookstore, co-authored by Nikolai Foss called Organizing Economic Judgment. You can see it downstairs. It's red. It's very pretty. I'll be happy to sign it for you. We discuss issues of sort internally organizing firms in terms of the costs and benefits of delegating authority from the capitalist entrepreneur to subordinates. I have a little slide on Rothbard, but I'll let you read about it in the article, in the 1996 article. Now, I just should point out, as an aside, that the view of the firm that I have been describing for you in the last several minutes is not the only approach to the firm that one finds in the Austrian literature. And it's worth taking just a moment or two to explain the differences between what I'm describing and what you find in some other Austrian texts. There's some approaches to the firm that focus not on the Misesi and calculation problem, but more on Hayek's knowledge problem, so-called problem of dispersed tacit knowledge. The idea that, well, successful firms are those that are able to exploit diffused dispersed tacit knowledge among their employees more effectively than other firms. And if you're familiar with Hayek's writings on tacit knowledge, you know, Hayek's main recommendation, of course, is decentralization, delegation, that's Hayek's justification for the market system, is that it allows individuals to make decisions based on their own dispersed, their own tacit knowledge, tacit knowledge that only they possess that the central planner does not possess. And so an implication of that for the firm is that, you know, firms should be as decentralized as possible, right, that hierarchies are sort of per se inefficient, and firms should be to use sort of trendy modern management jargon, should be flatter, you should flatten the hierarchy, flatten the corporate hierarchy, empower the workers to make more decisions using their own knowledge, and so forth. The whole theory of so-called market-based management is sort of an application of the sort of Hayekian paradigm to thinking about the organization. And I think there's, I mean, it's certainly true that there is tacit knowledge dispersed in organizations, there's no doubt about it. And by delegating authority to subordinates under some circumstances, that may be an effective way of making use of tacit knowledge, but by no means is that a general argument for delegation and decentralization, right? I mean, why? Because there is value to central coordination in a private free market context, in a context of private ownership of resources. There are many reasons why it may be, it makes a lot of sense, to concentrate at least some authority in the hands of central decision makers, right? So remember, that's what asset ownership is. Owners have decision rights that non-owners do not possess, which implies some limits to the delegation of authority. And there's sometimes where, you know, the charismatic boss may actually do some good, okay? There may be situations where decisions have to be made quickly and the decision maker possesses a certain kind of information that is critical for decision making that other agents don't possess. There are problems of, you know, monitoring and governing employees who have a lot of discretion over how they use their day, what they do, what they do during the day, how they use their time and so on. So those may be good reasons to limit delegation. In fact, I mean, both Kursner and Rothbard seem very comfortable with what's typically called the sort of Kosian notion of the firm as a hierarchy, right? That the firm is a planned order and not a spontaneous order, although there may be elements of spontaneity within the firm, right? Kursner, he's implicitly referring to Kos's 1937 article when he writes as follows, in a free market, any advantages that may be derived from quote unquote central planning, meaning internal coordination within a firm, are purchased at the price of an enhanced knowledge problem. So here Kursner is trying to recast Ronald Kos's transaction cost argument for the firm in terms of sort of Hayeky and Tesset knowledge. Kursner says we may expect firms to spontaneously expand to the point where additional advantages of central planning so-called are just offset by the incremental knowledge difficulties that stem from dispersed information. Or in Murray Rothbard's terminology, right? Kos pointed out that there are diminishing benefits and increasing costs to each of these two alternatives, organizing through the market, organizing within the firm, resulting, as he put it, in an optimum amount of planning in a free market system. Our thesis, meaning Rothbard's own contribution to this debate, adds that the costs of internal corporate planning become prohibitive as soon as markets for capital goods begin to disappear, so that the free market optimum will always stop well short, not only of one big firm throughout the world market, but also of any disappearance of specific markets and hence of economic calculation in that product or resource. So here's a Misesian interpretation of Kos's argument for authority. Okay, so Mark is giving me the evil eye. I'll skip some of my critique of Roderick Long so he and I can hash it out later and just leave you with a reminder that the Austrian tradition does offer a unique theory of production. It's not just a verbal restatement of neoclassical production theory. It's different from neoclassical production theory in important ways, causal, realistic, grounded in marginal utility theory, emphasis on economic rather than technical or technological aspects of production, and it gives the central role to the decision-making, coordinating entrepreneur. But of course there's much more research that remains to be done in this area, and so as I said at the beginning, there's really a fertile ground for young scholars such as yourselves to make real important contributions to the Austrian school. I think we should stop now and have lunch.