Capital in Disequilibrium

Capital in Disequilibrium
The Role of Capital in a Changing World
Second Edition
Pr1rv LrviN
Ludwig
von Mie
Intitute
A U B U R N , A L A B A M A
Copyiight zu11 by the Ludwig von Mises lnstitute
Published undei the Cieative Commons Auiibution License !.u.
http://creativecommons.org/licenses/by/3.0/
Ludwig von Mises lnstitute
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Contents
Acknowledgments . . . . . . . . . . . . . . . . . . vii
Pieface to the Second Edition . . . . . . . . . . . . . . xi
1. lntioduction and Outline. . . . . . . . . . . . . . 1
Part I. Baground: Equilibrium and Change
z. What Does Equilibiium Mean` A Discussion in the Context of
Modein Austiian ldeas . . . . . . . . . . . . . . 1
!. Equilibiium and Expectations Re-Examined A Dieient
Peispective . . . . . . . . . . . . . . . . . . !1
Part II. Capital, Interest, and Prots
.. Capital in Histoiical Peispective . . . . . . . . . . . 1
. Modein Capital Teoiy . . . . . . . . . . . . . . v
e. Te Hicksian Maiiiage of Capital and Time . . . . . . . v!
. Te Natuie of lnteiest and Piots . . . . . . . . . . . 1uv
Part III. Capital in a Dynamic World
c. Modein Mengeiian Capital Teoiy . . . . . . . . . . 1z
v. Capital and Business Oiganizations . . . . . . . . . . 1.
1u. Oiganizations, Money, and Calculation . . . . . . . . . 1
11. Human Capital . . . . . . . . . . . . . . . . . 1v!
1z. Human Capital, the Natuie of Knowledge, and the Value of
Knowledge . . . . . . . . . . . . . . . . . . zz
Conclusion . . . . . . . . . . . . . . . . . . . . z!
Bibliogiaphy . . . . . . . . . . . . . . . . . . . . z.!
lndex . . . . . . . . . . . . . . . . . . . . . . zv
v
Acknowledgments
l owe a laige intellectual debt to two iemaikable and veiy dieient
teacheis.
Te spaik of inteiest, of which this book is the culmination, was
ignited when, as an undeigiaduate (in 1vec), l took a couise in capital
theoiy fiom my teachei Ludwig Lachmann, at the Univeisity of the
Witwateisiand in Johannesbuig, South Afiica. Lachmanns ideas have
inuenced the wiiting of almost eveiy page of this woik. liom him
l leained at a young and impiessionable age to think ciitically about
the implications of time foi human action. liom him l inheiited an
enduiing fascination with the questions posed by capital theoiy, a fas-
cination enhanced by the veiy complexity of the subject. l suspect that
it would not have tioubled him in the least that his student piesumed
to diei fiom him in some ways and to extend his appioach into novel
aieas, on the contiaiy, l imagine he would have been quite pleased. ln
paiticulai, Lachmanns inuence as an economist was limited by the
absence of conciete oi piactical implications of his woik. Yet, as l have
tiied to show, his geneial insights have specic applications in the
aieas of the theoiy of the im, in human capital, and many othei aieas.
Piofessoi Lachmann, in addition to pioviding a ciucial component
of my education, helped me in othei ways at the beginning of my
piofessional caieei. He was always consideiate and iespectful of his
students and his memoiy inspiies and sustains me.
l am indebted in a less peisonal, but neveitheless impoitant, way
to Gaiy Beckei. Piofessoi Beckei was my PhD thesis commiuee chaii-
man and my teachei foi a numbei of giaduate couises. Te oppoitu-
nity to study with him was of inestimable value to me in my tiaining
as an economist and, moie paiticulaily, in gaining an appieciation of
the impoitance of human capital (and ielated subject aieas, like the
economics of the family). His inuence will be paiticulaily appaient
in the chapteis that deal with human capital.
vii
viii CAPlTAL lN DlSEQUlLlBRlUM
Tis woik, then, has been in the pipeline foi many yeais, dui-
ing which time l have beneted fiom talking to many individuals. l
cannot hope to iecall them all, at least not without engaging in an
inappiopiiate exeicise of intellectual autobiogiaphy. Howevei, they
include Kail Miueimaiei, Landis Gabel, Sam Weston, Bob loimaini,
Rogei Gaiiison, Richaid Ebeling, Don Lavoie, and Kaien Vaughn. l
have beneted fiom comments on piesentations at the Colloquium on
Austiian economics at New Yoik Univeisity, most notably fiom com-
ments by Maiio Rizzo, lsiael Kiiznei, Petei Boeuke, Joe Saleino, Bill
Butos, Rogei Koppl, David Haipei, Don Boudieaux, liedeiic Sautet,
and Sanfoid lkeda. l also beneted fiom comments ieceived at pie-
sentations at the Southein Economic Association and the Histoiy of
Economics Association meetings. Laiiy White piovided veiy useful
comments.
l am veiy giateful to Steven Hoiwitz who iead the entiie manu-
sciipt of an eaily veision and piovided numeious stylistic and substan-
tive coiiections.
Tis book would not have been wiiuen without the eoits and
encouiagement of Maiio Rizzo. lt was he who ist suggested it and
piovided impoitant diiectional indicatois. ln addition, his woik in
Austiian economics has been an impoitant souice of inspiiation foi
me and has helped me to gain gieatei insight into and appieciation of
many of the themes that appeai in the pages that follow.
ln the yeais since the ist edition of this book l have beneted fiom
too many individuals to name. My coauthoi Howaid Baetjei cannot go
unmentioned howevei. His woik on capital and knowledge is ciucial
to my cuiient undeistanding of the subject. loi editoiial assistance at
the Mises lnstitute l thank Jeiey Tuckei and Paul loley.
l need haidly add that none of the individuals mentioned above is
to be implicated in any of the eiiois that may be found in this woik,
especially wheie they aie the iesult of my stubboin iefusal to follow
theii advice.
ln addition to colleagues and teacheis, l have been foitunate to
have had the suppoit of fiiends and family, without which l could not
have found the time and iesolve to complete this woik. My paients,
Meile and Heiman Lewin, have been a constant souice of suppoit and
have stood by me in my obstinate deteimination to follow the calling
ACKNOWLEDGMENTS ix
of academe. To my fathei-in-lawlelix Shapiio, also my constant fiiend
and admiiei, l owe moie than l can say. And nally and mostly, my
family, my childien Dan, Andy, Shiialee and Gabbi, each in theii own
way has helped me in this stiange pioject (as they must see it), and
my wife Beveiley, my paitnei in life, who has stiuggled valiantly to
identify with hei husbands deteimination to complete this weiid time-
and eneigy-consuming pioject.
Pieface to the Second Edition
lt has been twelve yeais since the oiiginal publication of this book
in 1vvv. Much has happened in the inteivening yeais to aect its
ielevance.
ln the woild of economic policy, the ielevance of (Austiian type)
capital theoiy has incieased diamatically. Te appeal of what Ludwig
Lachmann iefeiied to as neoclassical foimalism has not diminished.
Policy-makeis, following the counsel of theii economic advisois, who
aie iuled by a belief in the signicance of economic aggiegates, have
peisistently ignoied, indeed piecipitated, capital stiuctuie distoitions,
the iesults of which have been two majoi domestic economic ciises
(the dot-com bust and the housing-bubble meltdown), a global ciedit
ciisis, a chionic scal decit and an exploding debt buiden that thieat-
ens to destioy the veiy fabiic of the economys value-cieating poten-
tial. Tis book is designed foi those who wish to undeistand, in a
thoiough and fundamental way, the natuie and signicance of capital.
What makes an economy capitalist` Howdoes value get cieated ovei
time` lf we get this wiong we may end up paying a high piice indeed.
Te eiioneous ideas upon which disastious economic policy has
been based have come down fiom the intellectual foiebeais of the
cuiient geneiation of economic advisois. A full appieciation of this
entails undeistanding the natuie of baules fought long ago ovei the
natuie and signicance of capital and capital theoiy. Accoidingly, the
focus of this book on this paiticulai aspect of the histoiy of economic
thought iemains veiy ielevant.
ln the woild of economic theoiy, though the majoiity of the eco-
nomics piofession iemains oblivious of, and contemptuous of, any-
thing outside of its naiiow quantitative oiientation, and, indeed, has
become even moie nely specialized and technically esoteiic, so that
its membeis know moie and moie about less and less ovei time, on the
giowing fiinges of the piofession a numbei of heteiodox appioaches
xi
xii CAPlTAL lN DlSEQUlLlBRlUM
have piospeied and aie giowing. One of these heteiodox appioaches
is that of Austiian economics, which has continued to gain adheients,
including fiom young, eneigetic giaduates who aie beginning to make
theii maiks. l hope that the ie-publication of this book in a moie
accessible foim will seive to encouiage this development and piovide
a im foundation foi the diveise applications of capital theoiy that aie
now becoming evident.
One aiea in which such applications have been giowing apace is
that of management and business studies, paiticulaily in the aieas
of stiategic-management, oiganization studies and entiepieneuiship.
Te Austiian ideas most ielevant to this line of ieseaich concein the na-
tuie of iesouices and how they can be oiganized in pioductive combi-
nations to pioduce value. Te capital-natuie of pioductive iesouices
has pointed in the diiection of the Austiians. Tough long inteiested
in Schumpetei, scholais in this aiea have iecently enthusiastically em-
biaced the ideas of Hayek, Kiiznei, and, most iecently, Lachmann. ln
paiticulai, undeistanding iesouices as capital has led to an appiecia-
tion of the impoitance of time and knowledge in pioductive piocesses,
and of social institutionsconnected themes examined below, espe-
cially in Chaptei v. Tis liteiatuie stieam has giown iapidly since
1vvv. An indication of some of this woik and its connection to the
woik below can be found in Lewin and Baetjei (zu11).
Tis book is about capital in a disequilibiium woild, a dynamic
woild. ln the yeais since its ist publication the woild in which we live
has become even moie dynamic. Te pace of change has acceleiated.
Te digital-age woiks its magic eveiy day in the foim of new piod-
ucts, new oiganizations, new pioduction techniques, new modes of
communication, and who knows what else. Tis incieased dynamism
has enhanced the ielevance of the capital-based fiamewoik developed
in this book. One shoitcoming that is glaiingly obvious to me now
in ietiospect is the insucient auention paid to an undeistanding
of capital as a foim of embodied knowledge, as ist developed by
Howaid Baetjei, to whose woik l enthusiastically iefei the inteiested
ieadei (Baetjei 1vvc, zuuu, Lewin and Baetjei zu11).
l have made veiy few changes to the oiiginal text. l have added
some iefeiences to woik published since the ist edition, l have added
some explanatoiy footnotes and deleted some otheis (deemed obsolete
PRElACE TO THE SECOND EDlTlON xiii
oi unnecessaiy) and l have taken the oppoitunity to make a few stylis-
tic impiovements. One majoi advantage of the new edition is that the
footnotes aie now found below the text iathei than at the back of the
book.
Petei Lewin,
Dallas, June zu11
CHAPTER 1
lntioduction and Outline
Case Study
Tis book is the iesult of a capital pioject, a pioduction plan. Moie
accuiately it is the nal pioduct of a seiies of ielated inteitempoial
plans, and is the inteimediate pioduct of some highei level plans. Tis
stiuctuie of plans encompasses both my own paiticulai plans and the
plans of otheis, like the publishei and the editois. As l wiite this, it
is still too eaily to say whethei the pioject is to be judged a success,
by me oi the othei planneis. But, whatevei the nal judgment, the
planning piocess is illustiative of the ingiedients of capital planning
in geneial.
l am wiiting this intioduction having alieady completed (at least a
ist diaf ol) the iest of the book, save foi the conclusion. Tis means
that you, the ieadei, aie going to iead the intioduction and the iest
of the book to which it iefeis in ieveise oidei fiom the way in which
they weie wiiuen. Te ieason foi this is obvious. l could not have
wiiuen the intioduction ist, oi at least not most of it with all the
details and the outline to follow, because l did not know what l was
going to wiite in the book. To be suie, l did have a geneial idea of
the chaptei layout and the points that l wanted to establish in each
chaptei, but l was unable to imagine in any kind of detail the woids
and sentences that would eventually ll the pages. Tis is in pait
due to the fact that the wiiting was a kind of leaining expeiience, a
kind of spontaneous unfolding of ideas that depend sequentially on
one anothei, a kind of leaining by doing. And in pait this was also
because of the occuiience of events that could not be anticipated in
any detail. l shall aigue that all planning is like this to some degiee.
Because of the way that we expeiience time, plans aie necessaiily
1
z CAPlTAL lN DlSEQUlLlBRlUM
incompletely specied. (We may say that planning foi pioduction is
an emeigent piocess.)
Neveitheless, my inability to completely visualize the unfolding
of my pioduction plan, which depended in pait on the fulllment of
the plans of otheis, and inuenced the plans of still otheis, will not,
in itself, pievent its fulllment. lt is not necessaiy that eveiy aspect
of the plan tuin out as expected, especially as theie aie many aspects
that could not be expected. But some things must tuin out as expected.
Among these aie the ciucial actions of mine and otheis which confoim
to ceitain pieconceived oi tacitly held notions of how people do and
will behave in ceitain types of ciicumstances. Tis plan, like any othei
that is to have a chance of success, pioceeded within an institutional
fiamewoik of shaied ways of doing things.
Tis book, the pioduct of a capital pioject, is the iesult of team
pioduction. l did the wiiting, my editoi did the guiding and the nudg-
ing, and the publishei did a numbei of things including oveiseeing
the whole pioject, pioviding the necessaiy nancial capital and equip-
ment and the suppoit sta. Tis team tianscends the boundaiies of
the im. ln a sense theie aie a numbei of ims involved, myself,
the editoi, the publishei, the publisheis supplieis and customeis, and
so on. We aie all pait of a giand matiix of oiganizations, some of
whose employees aie pait of the team. So the book is in ieality
a team pioduct. Each membeis contiibution helped to facilitate its
pioduction. Te value of the nal pioduct is thus causally auiibutable
to these eoits and, theiefoie, the value of these joint eoits can be
imputed fiom a knowledge of the value of the pioduct.
Team pioduction has to be cooidinated, and in oidei to facilitate
this cooidination eciently it may be aigued that the membeis of the
team should ieceive the full value of theii maiginal contiibution to the
pioduct. Tis tuins out to be quite pioblematic, especially when the
extent oi the value of the contiibution of any team membei is wholly
oi paitially indeteiminate (dicult oi impossible to measuie). But, as
a piactical mauei, the existence of ceitain types of oiganizations and
institutionslike a im that specializes in publishing, and a maiket
economy, wheie contiacts and piomises aie made and honoied and aie
expected to be honoied, and in which money is used and undeistood,
lNTRODUCTlON AND OUTLlNE !
so that decision-makeis can auiibute a value to the eoits of the team
membeis even though theie may be a laige element of indeteiminacy
suiiounding each ones contiibutionhelps to facilitate the necessaiy
cooidination.
So capitalistic pioduction is about moie than the existence of capi-
tal goods. lt involves in addition the social and institutional fiamewoik
that l have mentioned and the human capital of the individual team
membeis.
Tese aie also indispensable paits of the capital stiuctuie, and thus
of the value of any pioject. lt is tiue, foi example, that my piioi
conscious investments in human capital (geneially in leaining to iead
and wiite and moie specically in the studying of economics) helped
to equip me foi the task of wiiting this book. Knowledge capital is a
ciucial pait of capital in geneial. (loi a discussion of the ielationship
between knowledge and capital see Lewin and Baetjei zu11.)
ln this case study l anticipate some of the themes that l shall
examine in this book
Te complexity of plans and the inevitable existence of disequi-
libiium does not imply the failuie of all plans, oi of all aspects
of plans. Pioduction occuis in a changing woild, but this can
only happen if some aspects of that woild aie ielatively stable
and oideied.
Capital is moie than an aiiay of capital equipment and involves
an undeistanding of how value gets cieated by a combination
of human and physical iesouices ovei time in an oiganizational
stiuctuie that facilitates that cieation.
Oiganizational foim, ioutines, habits, iules, noims, and moies
aie thus pait of the social capital of any society. And the knowl-
edge of its membeis is pait of its human capital. And both aie
pait of its capital stiuctuie.
Any social policy that involves iegulating oi substituting foi
these laigely spontaneous value-cieating stiuctuies should, at the
veiy least, be awaie of the complexity of this all-encompassing
capital stiuctuie.
Some moie detail is piovided in the iest of this chaptei.
. CAPlTAL lN DlSEQUlLlBRlUM
A Disequilibrium Approa to Capital
Most students of economics encountei the theoiy of capital as pait of
a theoiy of nance and/oi pioject evaluation. When consideiing the
question of how to measuie (known oi estimated) values that occui
at dieient points in time, they get intioduced to the aiithmetic of
piesent values. And while the notion of piesent value can be elabo-
iated and dissected in many subtle ways, its basics deiive fiom some
veiy stiaightfoiwaid, intuitive ideas. lt is suipiising, then, to nd
that capital theoiy is iegaided as a paiticulaily esoteiic and laigely
iiielevant pait of economics.
Obviously, although piesent-value aiithmetic is an impoitant pait
of an undeistanding of capital, it is only a pait of that undeistanding.
lt is the othei paits that have been iegaided as obscuie and iiielevant.
Although capital theoiy may be dicult, it is haid to see that it could
justiably be judged as iiielevant. Afei all, the maiket economies
of the woild aie ofen iefeiied to as capitalist economies. Suiely a
good undeistanding of the meaning and signicance of the capital in
capitalist is of some impoitance, foi histoiy and foi policy. lf capital
is that phenomenon that makes maiket economies dieient, ought we
not to accoid it a piominent place in the education of an economist`
As will become cleai fiom the discussion below (Chaptei .), much
of the ieluctance of economists to deal with the theoiy of capital is
a iesult of the histoiical context in which it was developed. Te his-
toiy of thought in capital theoiy contains volumes of discussion on
intiicate technical and sometimes philosophical issues that modein
economists have come to think they can do quite well without. Tis
impiession was stiongly ieinfoiced by the Keynesian ievolution and
Keyness summaiy dismissal of capital theoiy as iiielevant. Even with
the emeigence of a moie ciitical appioach to Keynesian macioeco-
nomics, this habit of ignoiing the deepei issues that a consideiation of
the natuie of capital invites was not bioken. Capital theoiy is widely
(if tacitly) iegaided as a topic in the histoiy of economic thought.
Tis book is an auempt to ieawaken to some extent an inteiest
in the kind of issues that emeiged in the histoiical capital theoiy
discussions. While it cannot be denied that much of those discus-
sions meandeied into aieas of dubious ielevance to the functioning
lNTRODUCTlON AND OUTLlNE
of modein capitalist economies, it also iemains tiue that many of the
issues emeiged and continue to emeige fiomany caieful consideiation
of the natuie and signicance of capital. A good undeistanding of
these issues would hopefully enhance oui ability to talk intelligently
about oui economies and to make wise policy.
Te histoiy of capital theoiy contains ielevant lessons and l ex-
amine this histoiy in an auempt to undeistand it and to fiee capital
theoiy fiom it, in the sense that its signicance will be seen to extend
fai beyond the conceins to be found in those histoiical discussions.
Tose conceins, it seems to me, aie laigely the iesult of a paiticulai
appioach to capital theoiy, a paiticulai mindset, which we may call
an equilibiium appioach. Dating at least fiom Ricaido, economists
have become accustomed to thinking about economic concepts in the
context of a woild in which individual plans laigely dovetailed. Tis
enabled themto build giand systems in which economic aggiegates, in-
cluding capital (the value of capital foi the economy as a whole), made
peifect sense. Even with the advent of the maiginalist ievolution, and
the ielated discoveiy of subjective utility, the assumption of equilib-
iium enabled the constiuction of logically consistent and contextually
meaningful aggiegates like national income, wealth and capital.
Te debates in capital theoiy thus took it foi gianted that it was iel-
evant to discuss such things as the coiiect way to measuie the capital
stock theoietically. So while some (like Bhm-Baweik) tiied to aigue
foi a simple logical foimula involving pioduction time (although, as we
shall see, this was only a small pait of his theoiy), otheis (like Claik and
Knight) tiied to nesse oi banish the pioblem (of how capital should
be valued) by assuming that the maiket takes caie of it, by assuiing
that the multitude of heteiogeneous capital items in existence aie all
somehow consistently and spontaneously integiated into the laige,
peimanent oiganic netwoik of pioduction which had no beginning
oi end. Tese lauei theoiists thus wondeied about the meaning and
ielevance of pioduction time and quite piedictably the discussion
piogiessed into the iealm of metaphysics.
ln a woild in which individual plans may embody dispaiate views
of that woild, which the unfolding of time would put to the test, as
is the case in the ieal woild, the value of capital has no objective
meaning. Yet capital evaluation is peifoimed all the time and is a
e CAPlTAL lN DlSEQUlLlBRlUM
ciucial and indispensable pait of the maiket piocess. One might do
well, theiefoie, to abandon any seaich foi the appiopiiate method to
measuie economic aggiegates like the capital stock and focus instead
on undeistanding how the piocess of capital valuation actually func-
tions as pait of the maiket piocess as a whole. Tis is the appioach
taken in this book.
Capital as Value
Physical analogies featuied heavily in the capital theoiy debates. Tis
piobably ieects not only the diculty of the subject in which analo-
gies based on familiai physical piocesses helped to simplify, but also
the natuial tendency to think about pioduction as a physical piocess.
Pioduction, afei all, (ofen) involves the physical tiansfoimation of
mauei fiom one foim into a moie useful one. And since these physical
piocesses weie seen to be involved, it was but a small step to seeing
themas the essence of the piocess. Yet, l shall aigue, these engineeiing
aspects of pioduction aie among the least impoitant foi an undeistand-
ing of the social signicance of capital. Pioduction technologies exist
within a social fiamewoik. lt is the value that is placed on these tech-
nologies, undei dieient ciicumstances, that needs to be explained.
lndeed, the evaluation of technologies is also a laige pait of the stoiy
of theii discoveiy and adoption.
We see capital as an aspect of wealth, the iesult of the cieation of
value. Value is cieated in the context of tiade (except in the unlikely in-
stance of completely autaikic pioduction, tiading with natuie). And
tiade occuis in an institutional context. lnstead of focusing on the
meaning and measuiement of capital as an aggiegate categoiy, we
shall focus on the individual capital evaluation decision. liom the
peispective of the individual, capital value is the peiceived value of
a paiticulai pioduction plan oi set of plans. We examine theiefoie
the logic of this individual evaluation, wheie we nd the aiithmetic
of piesent value to be indispensable, and we examine the institutional
context in which these evaluations, and the decisions to which they
lead, occui.
Out of these individual decisions emeige the iesults of the maiket
piocess. And these iesults aie most ofen at some vaiiance with the
lNTRODUCTlON AND OUTLlNE
imagined and expected iesults of the planneis whose combined and
inteiacting actions gave iise to them. Tese planneis thus expeiience
capital gains and losses, that is, ievisions to the capital evaluations
embodied in oiiginal plans. Tese capital gains and losses aie a ciucial
pait of the maiket piocess. Tey aie indispensable guides to ongoing
decision-making in a changing woild. lt is thus staitling to iecall
that capital gains and losses weie taken out of capital theoiy in the
tiaditional appioaches to capital. Tis is ielated to the banishment of
piot in the same context. lt is a context of the banishment of change.
Te absence of change means no moie (and no less) than the coinciding
of the expected with the actual, and this must mean that eveiyone
plans on the basis of accuiate and consistent expectations. So if we aie
to undeistand why piots aie eained, we must undeistand why people
make capital gainswhy some people aie able to evaluate combina-
tions of pioductive iesouicescapital combinationsmoie accuiately
than otheis, accoiding to theii judgment of the maiket. Tat is, we
must iecognize the existence and impoitance of dierent individual
evaluations, even of the same things. Capitalist economies aie chang-
ing economies. How do they cope with change`
Outline
Te main body of this book is divided into thiee paits. Pait l, consisting
of two chapteis, examines the concept of equilibiium and its ielation-
ship to change. Chaptei z investigates the concept of equilibiiumin the
context of the enduiing debate in modein Austiian economics about
the piesence oi absence of equilibiating tendencies. Tis exeicise in
the histoiy of thought has ielevance beyond Austiian ciicles, how-
evei, as the issues involved aie intiinsic to the subject. loi example,
it is at the heait of much of the debate in macioeconomics between
the English Keynesians (see, foi example, Kaldoi 1vceu.) and the
Ameiican neoclassicals. What is at stake aie the implications of the
fact that dieient individuals have dieient and ofen inconsistent
expectations. ls theie a tendency foi these expectations to become
moie consistent ovei time as a iesult of the maiket piocess` lf yes,
what does this mean` lf no, does this mauei` How do individuals
make decisions on the basis of inconsistent plans` Te inescapable and
c CAPlTAL lN DlSEQUlLlBRlUM
tioubling loose ends of mainstieameconomics aie nicely biought out
in this debate, paiticulaily in the insightful analysis of lsiael Kiiznei.
lf we want to assume that maikets aie eithei in, oi aie in the piocess
of appioaching, equilibiium, ought we not to be able to explain how
they get into equilibiium oi aie able to appioach it`
ln Chaptei ! l suggest that it is the adoption of an insuciently
examined concept of equilibiium that is behind the appaient impasse
that this and ielated debates have ieached. Specically, if equilibiium
is dened, along with Hayek, as a situation in which individual plans
aie mutually consistent (and iealistic), then a closei examination of
the way in which individuals plan will ieveal that economies aie at
any time both in and out of equilibiium and aie tending towaid and
away fiom equilibiium at the same time. Tis paiadoxical conclusion
is the iesult of a semantical sleight of hand. Te Hayekian denition of
equilibiium does not examine the limits and dimensions of the individ-
ual plans that featuie in it. Once we iealize that individual plans aie,
of necessity, based on dieient types of knowledge, aie incomplete in
ciucial iespects, and aie multidimensional in natuie, we iealize that
some aspects oi plans aie, and must be, highly, oi even completely,
consistent, while, at the same time, othei aspects of plans aie (and
must be, if we aie to have the kind of change necessaiy foi dynamic
maiket piocesses) inconsistent. And we shall see that equilibiium in
ielation to some aspects, oi levels, of plans is a necessaiy condition foi
the toleiation of disequilibiium in otheis, the levels at which innova-
tion occuis. Te insights deiived in this chaptei piovide a necessaiy
geneial backdiop foi the consideiation of capital evaluation and the
decisions to which they give iise in a changing economy, which occupy
the iest of the book.
Pait ll, Chapteis . thiough , consists of investigations into the
natuie of capital and the ielated concepts of inteiest and piots. Tese
concepts cannot be adequately consideied apait fiom theii develop-
ment in the histoiy of economic thought. Chaptei . is an impiession-
istic histoiical outline of the development of the concept of capital. lt
is suggestive iathei than accuiate oi complete. l examine the model
oeied by Adam Smith in the Wealth of Nations as a piototype coin
economy, an agiaiian economy devoid of disiuptive innovation in
pioductive methods. ln this coin economy, capital is a homogeneous
lNTRODUCTlON AND OUTLlNE v
ciiculating fund. (Adam Smiths contiibutions to the notion of the
division of laboi will occupy us latei in a dieient context.) When we
move fiom Smiths woild to the woild of Ricaidos Principles we nd
that things aie not so simple. Ricaido stiove valiantly to apply Smiths
insights and method to a woild in which much of the pioductive equip-
ment was in the foim of heteiogeneous machineiy. He salvaged
homogeneity by banishing consideiations of change, by focusing on
the conditions of the long-iun stationaiy state. Tose who followed
Ricaido thus came to see this long-iun equilibiium not only as the
condition towaid which the economy was always moving, but also as
a soit of essential ieality that chaiacteiized the maiket system below
the suiface ieality of which oui senses may at any time be awaie.
ln this sense, all modein-day theoiists who woik in teims of sta-
tionaiy oi steady-state economics aie Ricaidians. Teii appioach is
to be contiasted with that of Cail Mengei who, while also following
Adam Smith in some iespects, oeied a dieient vision of the econ-
omy and of the piocess of pioduction. loi Mengei pioduction was
chaiacteiized by a time stiuctuie of pioduction that was the iesult
of individual inteitempoial planning. Teie is no suggestion that the
economy is in a stationaiy-state equilibiium.
Tese two appioaches exist in uneasy combination in the woik of
peihaps the most famous capital theoiist in economics, Eugen von Bhm-
Baweik. Tough a disciple of Mengeis, Bhm-Baweiks woik has
been adopted by neoclassicals, neo-Ricaidians, and Austiians alike as
embodying theii paiticulai appioaches. We thus examine how it is
that these appaiently conicting visions could coexist in the woik of
the same theoiist. liom Bhm-Baweiks woik we will leain a gieat
deal about the ways in which time is seen to be involved in the piocess
of pioduction. ln paiticulai, his asseition that the essence of capitalist
pioduction is the adoption of incieasingly ioundabout methods will
be seen to be of enduiing ielevance.
One way of ieading Bhm-Baweik can be seen to be consistent
with the modein pioduction function appioach to capital. Tis is ex-
amined in Chaptei . Te pioduction function stoiy iests on some pai-
ticulai assumptions pioduction is an unvaiying input-output scheme
in which both inputs and outputs aie unambiguous aggiegate values.
Te logic of the pioduction function appioach is infoimative and yields
1u CAPlTAL lN DlSEQUlLlBRlUM
some impoitant insights into the meaning of constant ietuins to scale,
diminishing ietuins, and technological change. lt has also iecently fo-
cused auention on the impoitant phenomenon of endogenous change.
But these insights come only by stiaining to the limit the bounds
within which the pioduction function makes any sense.
Te debate between the Cambiidges in the 1vus, 1veus, and 1vus
featuied the English neo-Ricaidians against the Ameiican neoclassi-
cals. Taking the pioduction function appioach to be denitive of pio-
duction economics, the neo-Ricaidians ielentlessly picked at its logical
limits in an eoit to disciedit it and seem to have been laigely success-
ful in this. But what they gained in logical consistency, they aiguably
lost in ielevance. Both the Cambiidges implicitly assumed a Ricaidian
equilibiium woild in which the iate of piot was unifoimly equal
to the iate of inteiest. liom the peispective of a technologically dy-
namic maiket economy, both appioaches would appeai to be laigely
iiielevant.
John Hicks was a penetiating thinkei, an economist who helped
to guide his colleagues thiough the dicult issues of the day. He did
consideiable woik on the theoiy of capital ovei his long and pioductive
caieei and, although his woik as a whole dees easy categoiization,
he had an abiding sympathy foi the Austiian appioach, as exemplied
paiticulaily by Cail Mengei. ln Chaptei e l examine his last full length
woik on capital theoiy (Hicks 1v!b), which he called a neo-Austiian
appioach. ln it we shall nd a convenient expiession of the type of
evaluation aiithmetic facilitated by a money-using maiket economy.
Although we cannot follow Hicks into his woild of social accounting,
we shall nd much that is useful in his insights.
ln the development of capital theoiy vaiious appioaches to the
chaiacteiization of piots and inteiest have emeiged. ln Chaptei
l biiey ieview this and give piominence to one paiticulai appioach,
the puie time piefeience theoiy (PTPT) of inteiest. Te most notable
aspect of this view is the caieful sepaiation of the concepts of piot
and inteiest. Te foimei is seen to be the iesult of changes in the value
of capital combinations in a woild of change and unceitainty, while
the lauei is an expiession of time piefeience. While time piefeience
is indeed (and contiaiy to some appioaches) to be seen as an expies-
sion of individuals feelings of unceitainty, it is to be veiy caiefully
lNTRODUCTlON AND OUTLlNE 11
distinguished fiom the concept of piot. Although they may be dif-
cult to disentangle in piactice, piot, ient, and inteiest aie sepaiate
and distinct concepts.
ln Pait lll, Chapteis c thiough 1z, l tuin to an examination of capi-
tal in a dynamic woild. ln Chaptei c we look at a Mengeiian appioach
to capital theoiy. We take Hayek to be the modein pioneei, in his
wiitings in the 1v!us culminating in his Pure eory of Capital (1v.1).
Te Pure eory in itself is not a woik about capital in a changing woild
but it points in that diiection. ln paiticulai, in his extended analysis
of the so-called pioblem of imputation, Hayek iaises questions of
ielevance to such a changing woild. Ludwig Lachmanns woik on
capital theoiy may be seen as picking up Hayeks cue. Lachmann
consciously adopts a disequilibiium fiamewoik to ie-examine what
he takes to be the valid insights of Bhm-Baweik. He ends up with
a fascinating synthesis of Adam Smith and Bhm-Baweik, one that
sees in the giowing complexity of modein pioductive stiuctuies a iep-
iesentation of Bhm-Baweiks incieasingly ioundabout methods of
pioduction and Adam Smiths division of laboi.
As mentioned above, capital evaluation decisions occui within an
institutional-oiganizational fiamewoik. ln Chaptei v l exploie the link
between capital stiuctuies (naiiowly undeistood) and oiganizational
stiuctuies. Te oiiginal pioneeiing woik of G. B. Richaidson and Edith
Peniose is seen to have much in common with Lachmanns Mengeiian
appioach, and fiom this a link is foiged to some latei woik in the
aieas of pioduction and oiganizations. ln Chaptei 1u this is seen to
be ielevant to the woik of Mises and otheis on the question of capital
calculation in maiket economies.
ln Chaptei 11 l tuin to an examination of human capital. Te
human capital ievolution in economic theoiy sometimes seems to
have had moie of an impact in adjacent elds like sociology and an-
thiopology than in economics itself. lt is tiue that the concept of
human capital has now peimeated the mainstieam in many aieas, foi
example in giowth theoiy, in the theoiy of the im, and, of couise,
in laboi economics. lts application to a consideiation of the dynamics
of maiket economies has, howevei, been suipiisingly limited. ln this
chaptei l auempt to diawout some implications along these lines while
summaiizing some of the keynotes of the liteiatuie, deiiving piimaiily
1z CAPlTAL lN DlSEQUlLlBRlUM
fiom the woik of Gaiy Beckei, T. W. Schultz, and Jacob Mincei. ln
Chaptei 1z l confiont some subtle issues aiising out of the special
natuie of knowledge as a phenomenon that would seem to be ielevant
to human capital as a pioduct. ln obseiving that knowledge is at once
fallible, unfathomable, and tacit, we aie diawn full ciicle back to a
discussion of equilibiium in a changing woild.
Te book closes with a concluding chaptei that summaiizes the
woik and exploies some implications foi economic policy.
PART l
BACKGROUND
EQUlLlBRlUM AND CHANGE
Tis ist pait of this woik consists of two chapteis (z and !).
1
ln
Chaptei z l summaiize biiey some issues connected with the mean-
ing and existence of equilibiium. Tis contioveisial aiea has been
made dicult by the fact that the teim equilibiium is ofen used in
an inconsistent mannei, eithei by a single theoiist in dieient places
and times oi as between dieient theoiists. So l tiy ist to claiify
what is meant (oi what should be meant) by equilibiium. l adopt
the Hayekian denitionthe mutual consistency of individual plans.
liom this point of view l examine a cuiient debate, one that is specic
to modein Austiian (maiket piocess) economics, but is ielevant to and,
in many ways, ieective of, economics in geneial. Tis is the debate
about the piesence oi absence (and, indeed, meaning) of equilibiating
tendencies in the economy. Te chief (fiiendly) piotagonists in this
discussion aie Ludwig Lachmann and lsiael Kiiznei. Te legacy of
this debate is still with us.
ln Chaptei ! l tuin to the question of what ieally is at stake heie.
l oei a dieient peispective, a dieient appioach to the question of
equilibiium. lf we say that the economy is always in disequilibiium,
because plans must be inconsistent to some degiee, then aie we not
undeimining oui ability to do economics, to undeistand human action
in the economy` Oi is action possible and undeistandable in disequi-
libiium` l shall contend that if we wish to adopt Hayeks appioach to
equilibiium, we must mean that we can act in a woild wheie the plans
that motivate and dene those actions aie not mutually compatible.
Tis is haidly contioveisial. Afei all, the maiket piocess featuies
1
A shoitei veision of some of the mateiial in this pait appeais in Lewin (1vvc).
1!
1. CAPlTAL lN DlSEQUlLlBRlUM
iivalious actions, that is, actions that aie pait of mutually inconsistent
plans. Successful plans tend to displace unsuccessful ones. But can
we theiefoie say that, oveiall, plans tend to become moie consistent
so that theie is a tendency towaid equilibiium` ls this impoitant`
l shall answei both in the negative. luitheimoie, l shall maintain
that capital accumulation and economic piogiess depend in a ciucial
way on the absence of equilibiium and in no way on oui ability to
discein equilibiium tendencies. Moie specically, l shall aigue that
the Hayekian denition iequiies too much. Plans aie complex, mul-
tilayeied constiucts. Oveiall plan consistency is, theiefoie, eithei
impossible oi hopelessly impiecise. l shall aigue that at some levels
plans aie and must be highly compatible, while at othei levels (as pait
of the maiket piocess, foi example) they aie and, if we aie to have
economic piogiess, they must be, incompatible.
Te issues discussed in this pait and the iesolutions oeied piovide
an impoitant backdiop foi the consideiation of capital in a dynamic
woild.
CHAPTER z
What Does Equilibiium Mean`
A Discussion in the Context of
Modein Austiian ldeas
Equilibrium Examined and Dened
A teim which has so many meanings that we nevei know what
its useis aie talking about should be eithei diopped fiom the vo-
cabulaiy of the scholai oi puiied of confusing connotations.
(Machlup 1vc.!)
Te continuing use of the woid equilibiium by dieient people to
mean dieient things justies yet anothei biief examination. No pie-
tense, howevei, is made at completeness.
l can think of at least seven dieient appioaches to equilibiium.
Tese aie not mutually exclusive and aie, indeed, ielated in impoitant
ways
1. equilibiium as a balance of foices
z. equilibiium as a state of iest (a stationaiy state)
!. equilibiium as a state of unifoim movement (a steady stateof
which z is a special case)
.. equilibiium as a constiained maximum
. equilibiium as an optimum
e. equilibiium as iational action
. equilibiium as a situation of consistent plans.
ln each case at least two dimensions can be identied. Equilibiium can
ielate to the entiie economy (geneial equilibiium) oi to a subset of the
economy (paitial equilibiium) oi to the individual. Equilibiium can be
consideied foi a single all-encompassing peiiod (static equilibiium), oi
1
1e CAPlTAL lN DlSEQUlLlBRlUM
foi a succession of self-contained peiiods (tempoiaiy equilibiium) oi
foi a succession of ielated sub-peiiods (inteitempoial equilibiium).
Examining this fuithei, we note that equilibiium as a balance of
foices (as the woid implies)
1
in some sense is at the base of all othei
equilibiium concepts. And if change (and its absence) is dened
appiopiiately, denitions 1 and z aie seen to be equivalent. So, foi
example, the tiaditional supply and demand equilibiium is a balance of
foices that acts to keep piices stable (at iest). ln the case of the piice
of an asset, we may say that if the piice is stable, the bulls balance the
beais.
z
ln the case of a peiishable good, those foices (whatevei they
aie technology, piice expectations, etc.) which tend to inuence the
amounts oeied foi sale and puichase at vaiious piices in a way that
tends to push the piice up aie balanced by those that tend to push it
down. Tis is one way to think of stable piices. lf neithei supply noi
demand change, piice (once in equilibiium) will not change. lt is also
an optimum (denition ) of soits in the well-undeistood sense that,
given the fundamental conditions of supply and demand, buyeis and
selleis aie doing the best they can. liom anothei peispective, it is a
1
lnteiestingly e New Shorter Oxford English Dictionary oeis a numbei of de-
nitions
1. A well balanced state of mind oi feeling. . . . z. A condition of balance
between opposing physical foices. . . . !. Astate in which the inuences
oi piocesses to which a thing is subject cancel one anothei and pioduce
no oveiall change oi vaiiation. . . . Econ. A situation in which supply
and demand aie matched and piices stable.
Although z and ! aie piobably the most intuitive colloquially, 1 comes closest to oui
usage, as we shall see.
z
[Te maiket] cannot make bulls and beais change theii expectations
but it neveitheless can cooidinate these. To cooidinate bullish and
beaiish expectations is, . . . the economic function of the Stock Ex-
change and of asset maikets in geneial. Tis is achieved because in
such maikets the piice will move until the whole maiket is divided
into equal halves of bulls and beais. ln this way diveigent expecta-
tions aie cast into a coheient pauein and a measuie of cooidination
is accomplished . . . asset maikets aie inheiently iestless, and equilib-
iium piices established in them ieect nothing but the daily balance of
expectations. (Lachmann 1vebz!z!c, italics added)
Cleaily Lachmann is heie using the teim cooidination in a iathei limited sense and
in no way to suggest a iendeiing of expectations compatible.
WHAT DOES EQUlLlBRlUM MEAN` 1
constiained maximum (denition .) in that buyeis and selleis maximize
the peiceived oppoitunities to buy and sell, and theieby achieve a max-
imum of satisfaction as deteimined by theii piefeiences in ielation to
the (peiceived) oppoitunities. lt may not be an optimum, howevei, if
theie aie oppoitunities of which the economic agents aie unawaie (see
Kiiznei 1vvu), oi if theii actions aect oppoitunities in othei maikets
adveisely. Also, it is possible to see how momentaiy equilibiium can be
geneialized to a situation of unifoimchange (denition !) foi example,
wheie demand and supply inciease piopoitionately.
So while, in an appiopiiate sense, equilibiium as a balance of foices
is also a state of iest (oi a situation of unifoimchange) and a constiained
maximum, it may not be an optimum. Also, in each case it is possible to
conceive of situations that aie not in equilibiium. Some theoiists have
found it helpful, howevei, to dene the constiaints so bioadly as to con-
ceive of individuals as being always in equilibiium (see Shmanske 1vv.).
So, again using the example of simple supply and demand, a situation of
non-piice iationing, not allowing the piice to iise and cleai the maiket,
can be seen as an equilibiium situation if we include in all individual de-
cisions the costs imposed by iationinglike waiting in line. lndeed, us-
ing this appioach, one may piedict that the lines at the checkout countei
of a supeimaiket would tend to an equilibiium size that equalizes wait-
ing time. Tus the supply cuive becomes veitical at the xed piice below
the maiket-cleaiing piice. ln eect, the money piice has been ieduced,
but the ieal piice (including waiting cost) has gone up because of a shif
in the supply cuive to the lef (fiom an upwaid slope to a veitical one).
So demand always equals supply if we aie caieful to include all ielevant
factois.
!
While it is cleai that this appioach may piove enlightening
in some cases, when extended to the level of all agents foi the entiie
economy it can involve distuibing and paiadoxical implications. Tus,
consideiing all possible costs and benets, the woild is at all times in
a Paieto optimal equilibiium, a Panglosian best of all possible woilds
given the ielevant constiaints. Tings aie what they aie because we un-
deistand how individuals had to act the way they acted in oidei to max-
!
Beckei (and otheis using the Chicago appioach) have used this type of ieasoning
to explain iegulation-busting behavioi (biibes, black maikets, etc.) wheie individuals
aie seen as weighing all of the costs and benets involved in violating iegulations, etc.
(Beckei 1v11ue.)
1c CAPlTAL lN DlSEQUlLlBRlUM
imize, given the constiaints that existed and weie peiceived by them
(again see Shmanske 1vv. foi a complete discussion). Tis appioach
uses equilibiium to chaiacteiize iational action (denition e) wheie ia-
tional is undeistood to iefei to the system as a whole and not just to
individuals. loi noimative (policy) puiposes this is obviously not veiy
helpful. Te policy-makei is, afei all, subject to the same, univeisally
peiceived, constiaints. We shall see that the diculty aiises because of
the lack of a distinction between individual and system equilibiium.
ln a lectuie deliveied in 1v!e, Hayek dened equilibiium as a situa-
tion in which the dieient plans which the individuals composing [a
society] have made foi action in time aie mutually compatible (Hayek
1v!b.1). Tis is my denition . As this is the denition that we
shall adopt in the iest of this woik, it is woith examining in some
detail. An impoitant aspect is the move away fiomthe puiely physical
dimensions of equilibiium as a state of iest oi balance of foices, to one
imly based in the human mind. Equilibiium is heie conceived as
a situation in which individual knowledge and expectations, and the
actions based on these, aie compatible with the data, wheie the data
foi one individual include the actions of othei individuals. Sciatching
the suiface of any of the denitions oeied above indeed ieveals that it
is impossible to think of equilibiium in economics without biinging in
the peiceptions of individuals. Afei all, we aie dealing with human ac-
tions and these aie deteimined by the peiceptions of the actois. So, in
the case of the supply and demand of a single well-dened maiket, foi
example, the piice will not be obseived to change when all individuals
aie fullling theii mutually ielated plans to buy and sell, and wheie
such plans aie not fullled we may expect these plans to be ievised.
.
Te volitional, intentional aspect of equilibiiumis likewise obvious
in all of the othei appioaches. Tis is widely iecognized, although in
.
lt is possible to conceive of a situation of statistical equilibiium wheie mutually
oseuing individual eiiois aie such as to leave the piice unchanged. ln such a situa-
tion, although individual plans aie not mutually compatible, we have equilibiium as a
kind of balance of foices. lndividuals aie iight on aveiage. Hayek discusses this case
in passing (Hayek 1v!b.!n.) ln a way this anticipates aspects of the iational expecta-
tions liteiatuie developed since the 1vus. As we shall be conceined with equilibiium
in teims of its implications foi individual peiceptions, we shall not considei this case
in any moie detail. A sucient, though not necessaiy, condition foi piice stability in
the paitial equilibiium static (non-giowth) case, is the compatibility of plans to buy
and sell.
WHAT DOES EQUlLlBRlUM MEAN` 1v
the foimal technical tieatments of modein economics one is ofen apt
to lose sight of it, as foi example in the case of neo-Ricaidian capital
theoiy and geneial equilibiium theoiy. Teie is no doubt, howevei,
that Hayeks insights have been accepted in piinciple and have been
vaiiously endoised by a numbei of eminent neoclassical economists.
loi example
[Equilibiium iefeis to] those states in which the intended ac-
tions of iational economic agents aie mutually consistent and
can, theiefoie, be implemented. (Hahn 1vc...)
[Equilibiium is a] state wheie no economic agents have an in-
centive to change theii behavioi . . . the equality of demand and
supply should not be taken as a denition of equilibiium, but
iathei as a consequence following fiom moie piimitive behav-
ioial postulates. (Stiglitz 1vczc)
Tus we shall say that an equilibiium situation is one in which individ-
ual plans aie fully cooidinated. Each plan can be successfully executed.
Means aie exactly matched to ends.
Implications of Equilibrium
lt will be immediately appaient that equilibiium thus dened is an ex-
tiemely unlikely event. lt is patently uniealistic. One might wondei at
its widespiead acceptance as a standaid of iefeience. Tis iaises the im-
poitant question of the function of equilibiium constiucts in economic
theoiy. Obviously, theoietical constiucts aie, to a gieatei oi lessei
extent, uniealistic. Tey all abstiact fiom ieality in oidei to illuminate
it. loi example, one common use to which equilibiium constiucts
aie put is the tiacing of the (ultimate) consequences of any change
while imagining all othei possible ielevant changes to be absent. ln
this way a geneial idea of cause and eect can be built up by isolat-
ing the eects of dieient causes.

Te ciucial question is what aie

Machlup identies foui basic steps in equilibiium analysis

1. lnitial positioneveiything could go on as it is.
z. A disequilibiating change.
!. Adjusting changes.
.. linal positionnew equilibiium.
Compaiing . with 1 establishes causeeect (see the discussion in Machlup 1vc..).
zu CAPlTAL lN DlSEQUlLlBRlUM
peimissible abstiactions, and what abstiactions iendei a theoietical
constiuct useless` When is the usefulness of the model compiomised
so that its iesults (the causeeect connections that it suggests) aie no
longei ieliable guides to ieality` Tis is an involved question that we
shall not be able to answei heie in any detail. l shall contend, howevei,
and hopefully motivate in the couise of oui discussion, that theoietical
constiucts that abstiact completely fiom the implications foi human
action of the passage of time and its implications foi changes in knowl-
edge aie not likely to be veiy helpful in undeistanding economic pio-
cesses. While it is tiue that equilibiium is in the model and not in the
woild,
e
l want to build a biidge between the model and the woild
and maintain that timeless models cannot do this.

Tis is most cleaily

seen in discussing the stability of equilibiium.
Befoie tuining to this, howevei, we should pause to note some
othei aspects of equilibiium, undeistood as the mutual compatibility of
individual plans, including the ielationship between micio and macio
equilibiium, oi between individual and system equilibiium.
c
Hayek
makes an impoitant distinction between these
l have long felt that the concept of equilibiium itself and the
methods which we employ in puie analysis have a cleai mean-
ing only when conned to the analysis of the action of a single
peison and that we aie ieally passing into a dieient spheie and
silently intioducing a new element of altogethei dieient chai-
actei when we apply it to the explanation of the inteiactions of
a numbei of dieient individuals. (Hayek 1v!b!)
lt is fiom a caieful consideiation of the meaning of individual equilib-
iium that a numbei of implications foi oui undeistanding of system
equilibiiumemeige. liist, Hayek aigues that the tautological pioposi-
tions of puie equilibiium analysis aie not diiectly applicable to the ex-
planation of social ielations. Examining individual equilibiium shows
e
Tis phiase is fiom ODiiscoll and Rizzo (1vvez.). See geneially Machlup (1vc).

See also the discussions in Rizzo (1vvu, 1vvz).

c
l will use this designation to distinguish in geneial a highei level than individual
equilibiium, whethei it be the entiie economic system oi a subsystem of it (foi exam-
ple, an isolated maiket). As will become cleai fiom the text, the ciucial distinction
is between equilibiium as it applies to an individual mind and as it applies to the
inteiaction between two oi moie minds.
WHAT DOES EQUlLlBRlUM MEAN` z1
it to be equivalent to iational action. What is ielevant [howevei] is
not whethei a peison as such is oi is not in equilibiium but which of
his actions stand in equilibiium in so fai as they can be undeistood
as pait of one plan (ibid.!e). Second, the iole of the individuals
knowledge and, theiefoie, the knowledge of all individuals, is of ciucial
impoitance. lt is impoitant to iemembei that the so-called data, fiom
which we set out in this soit of analysis, aie (apait fiom his tastes) all
facts given to the peison in question, the things as they aie known to
(oi believed by) him to exist, aie not, stiictly speaking, objective facts
(ibid.!e). So it is quite conceivable, and likely, that in some iespects
dieient individuals knowledge of the same ciicumstance will be
not only dieient but inconsistent. And some types of knowledge aie
likely to be moie ieliable guides to action than otheis.
Tiid
since equilibiium ielations exist between the successive actions
of a peison only in so fai as they aie pait of the execution of the
same plan, any change in the ielevant knowledge of the peison,
that is, any change which leads him to altei his plan, disiupts
the equilibiium ielations between his actions taken befoie and
those taken afei the change in his knowledge. ln othei woids,
the equilibiium ielationship compiises only his actions duiing
the peiiod in which his anticipations piove coiiect. [And] since
equilibiium is a ielationship between actions, and since the ac-
tions of one peison must necessaiily take place successively in
time, it is obvious that the passage of time is essential to give the
concept of equilibrium any meaning.
(ibid.!e!, italics added)
So equilibiiumis not only a ielationship between individuals at a point
of time, it is necessaiily also a ielationship between actions ovei time.
loi equilibiium to exist duiing a peiiod of time it must exist at eveiy
point of time within that peiiod. lf equilibiiumexists at a point of time,
then individuals plans aie consistent with each othei and with the
technical facts of the woild such that each plan can be successfully im-
plemented. Tis means that in the absence of any change (meaning the
aiiival of new knowledge) equilibiium will exist at every point of time.
Tis denition of equilibiium thus implies inteitempoial equilibiium.
v
v
See also (Hicks 1vez.).
zz CAPlTAL lN DlSEQUlLlBRlUM
A Tendency Towards Equilibrium?
Hayek on Equilibrium Tendencies
ln the histoiy of the development of the equilibiium concept econo-
mists have been conceined with ceitain basic piopeities that equi-
libiia may oi may not exhibit. Te most basic is the question of
existencewhethei oi not an equilibiium can be shown logically to
exist. Accoiding to oui denition this involves showing that a sit-
uation exists (logically) such that all plans can be implemented. ln
the voluminous mathematical liteiatuie on geneial equilibiium such
a pioof was ultimately discoveied, but at the expense of the impo-
sition of a set of heioic iestiictions on knowledge, piefeiences and
technology. lt was also possible to show that undei ceitain even
moie iestiictive conditions such an equilibiium was unique (lngiao
and lsiael 1vvu). lt is cleai, howevei, that the impoitance that these
piopeities assumed is diiectly ielated to the foimal, technical, mecha-
nistic natuie of the conception of equilibiiumthat tended to dominate
this liteiatuie (and still does). loi Hayek, equilibiium was nevei un-
deistood as a state that could evei actually be said to exist, although
its logical existence is cleaily implied. He was moie conceined with
the question of whethei oi not it could be shown oi aigued that
a tendency towaid equilibiium (a gieatei degiee of plan cooidina-
tion) chaiacteiized the actual maiket piocess. Tis is ielated to the
questions of stability and/oi convergence that the mathematical econo-
mists have been unable to answei satisfactoiily.
1u
But foi Hayek
(and those who followed his lead) it was not a theoietical mauei.
As this will be quite impoitant, l will quote at some length fiom
Hayek
We shall not get much fuithei heie unless we ask foi the ieasons
foi oui concein with the admiuedly ctitious state of equilib-
iium. Whatevei may occasionally have been said by oveipuie
economists, theie seems to be no possible doubt that the only
justication foi this is the supposed existence of a tendency
towaid equilibiium. lt is only by this asseition that such a
tendency exists that economics ceases to be an exeicise in puie
logic and becomes an empiiical science. . . .
1u
Once in equilibiium, will the system iemain theie (stability), and staiting fiom
any aibitiaiy point, will it conveige to equilibiium`
WHAT DOES EQUlLlBRlUM MEAN` z!
ln the light of oui analysis of the meaning of a state of
equilibiium it should be easy to say what is the ieal content of
the asseition that a tendency towaid equilibiium exists. lt can
haidly mean anything but that, undei ceitain conditions, the
knowledge and intentions of the dieient membeis of society
aie supposed to come moie and moie into agieement oi, . . . that
the expectations of the people and paiticulaily of the entiepie-
neuis will become moie and moie coiiect. ln this foimthe assei-
tion of the existence of a tendency towaid equilibiiumis cleaily
an empiiical pioposition, that is, an asseition about what hap-
pens in the ieal woild. . . . And it gives oui somewhat abstiact
statement a iathei plausible common-sense meaning. Te only
tiouble is that we aie still pieuy much in the daik about (a) the
conditions undei which this tendency is supposed to exist and
(b) the natuie of the process by which individual knowledge is
changed. (Hayek 1v!b...)
Tis was a pieoccupation of Hayeks thioughout his caieei even as he
moved beyond economics naiiowly undeistood. Whethei oi not he
was able to piovide a satisfactoiy answei to items (a) and (b) in the
quotation above is a mauei of some debate (see, foi example, Rizzo
1vvu, 1vvz, Lewin 1vv.).
Lamann versus Kirzner
Te ievival of the Austiian ieseaich piogiam, in its maiket piocess
vaiiety, since the 1vus, has seen a ietuin to this issue of equilibiating
tendencies in a moie eneigetic fashion. ln paiticulai, it has emeiged
as a dening issue within the Austiian School of economics in a way
that was cleaily foieshadowed duiing some histoiical moments in June
1v. in South Royalton, Veimont, at a confeience maiking the stait of
this ievival (Dolan 1ve). At that confeience two papeis in paiticulai
outlined the two key peispectives that have appeaied to be in conict
evei sinceby Ludwig Lachmann and lsiael Kiiznei (Lachmann 1vea,
Kiiznei 1ve). ln these two papeis (and some otheis by the same
authois in the confeience volume) we nd a cleai, concise aiticulation
of the issues.
11
Both Kiiznei and Lachmann iegaid the maiket as a
11
ln paiticulai, Lachmanns analysis of equilibiium appeais in its most uncompio-
mising veision. lt is piobably fiom heie, moie than fiom any othei time and place,
that Lachmanns ieputation as a iadical subjectivist gained momentumand has since
tended to dominate in evaluations of his woik.
z. CAPlTAL lN DlSEQUlLlBRlUM
piocess in time, out of equilibiium. Both iegaid the question of equi-
libiating tendencies to be pioblematic. But foi Kiiznei the pioblem is
iesolved by the actions of the entiepieneui in noticing disequilibiium
situations and pioting by theii iemoval, thus pioviding a ieason to
believe in, and an explanation of, a tendency in maikets towaids equili-
biium.
Te pioblem is most simply seen once again in the supply and
demand analysis of an isolated maiket. As Kiiznei iemaiks, ofen oui
explanations pioceed no fuithei than an identication of the maiket-
cleaiing piice at the inteisection pointalmost implying that the only
possible piice is the maiket cleaiing piice. Oui common-sense expla-
nations pioceed in teims of familiai Waliasian equilibiating piocesses.
At piices below maiket cleaiing, theie is an excess supply in the aggie-
gate (unsold stocks) and this will tend to foice piices down, while the
opposite is tiue foi a situation of excess demand (unsatised buyeis).
Tus, we explain theie will be a tendency foi piice to giavitate towaid
the equilibiium level. We should note that it is implicitly assumed
that theie is always only one piice in the maiket. One uncomfoit-
able question, then, is whethei we may assume that a single piice
emeiges befoie equilibiium is auained. Suiely a single piice can be
postulated only as a iesult of the piocess of equilibiation itself. Vaii-
ous explanations have been oeied and devices suggested foi dealing
with this pioblem, including Maishallian adjustment piocesses and
peifect competition, none successfully. Te pioblem iemains because
disequilibiium occuis piecisely because maiket paiticipants do not
know what the maiket-cleaiing piice is (Kiiznei 1ve11e11).
Tis appioach can be geneialized to equilibiium in contexts othei
than the isolated maiket. Te pioblem of explaining conveigence to
equilibiium is a pioblem of explaining how individuals out of equilib-
iium obtain the infoimation necessaiy foi them to have knowledge of,
and incentives to make, the appiopiiate adjustments. ln the piocess
of developing the solution Kiiznei ieaims the Hayekian denition
of (dis)equilibiium. Disequilibiium is a situation in which not all
plans can be caiiied out togethei, it ieects mistakes in the piice in-
foimation on which individual plans weie made (ibid.11c). lt is the
Kiizneiian entiepieneui who notices these mistakes and is able to take
advantage of them. Kiizneis well-known, and justly admiied, theoiy
WHAT DOES EQUlLlBRlUM MEAN` z
of entiepieneuiial action in the iemoval of all mannei of piice dis-
ciepancies will not be summaiized heie.
1z
Suce it to say that the
entiepieneui is an all-puipose aibitiageui (my teim) who is aleit to
piot oppoitunities that exist as a iesult of piice dieiences at a point
of time, piice dieiences between two points in time (afei accounting
foi inteiest and holding costs), oi piice and cost dieiences (that is the
piice of a nished pioduct and the cost of all the iesouices, including
inteiest, necessaiy to pioduce it). By exploiting these geneialized piice
disciepancies the entiepieneui tends to iemove them, thus pioviding
the answei to the oiiginal uncomfoitable question. Te tendency to
equilibiium is supplied by entiepieneuiial action. Kiiznei then states
cleaily the issue that we aie investigating
Disequilibiium iepiesents a situation of widespiead maiket
ignoiance. Tis ignoiance is iesponsible foi the emeigence
of piotable oppoitunities. Entiepieneuiial aleitness exploits
these oppoitunities when otheis pass them by. G. L. S. Shackle
and Lachmann emphasized the unpiedictability of human knowl-
edge, and indeed we do not cleaily undeistand how entiepie-
neuis get theii ashes of supeiioi foiesight. We cannot explain
howsome men discovei what is aiound the coinei befoie otheis
do so. . . . As an empiiical mauei, howevei, oppoitunities do
tend to be peiceived and exploited. And it is on this obseived
tendency that oui belief in a deteiminate maiket piocess is
founded. (ibid.1z1)
Lachmann makes it cleai that he does not believe in a deteiminate
maiket piocess. While he is ieadily piepaied to endoise the notion
of individual equilibiium, he has no use foi geneial equilibiium (and,
as is cleai fiom the context, any equilibiium othei than that of the
individual) oi tendencies towaid it. Te notion of geneial equilibiium
is to be abandoned, but that of individual equilibrium is to be ietained
at all costs. lt is simply tantamount to rational action. Without it
we should lose oui sense of diiection (Lachmann 1vea1!1). Te
ieason foi his iejection of maiket equilibiium is his undeistanding
1z
loi a iecent statement see Kiiznei (1vvz). Since the ist edition of this book was
published in 1vvv, Kiiznei has continued to explain and iene his ideas as they have
gained in exposuie and populaiity especially in the eld of management studies. See
Kiiznei (zuuv).
ze CAPlTAL lN DlSEQUlLlBRlUM
of the implications foi action of the passage of time. Once again, as
with Kiiznei, l shall not stop to summaiize in any detail Lachmanns
well-known views in this iegaid. l meiely note some implications. He
consideis it axiomatic that the passage of time cannot occui without
the aiiival of newknowledge. Each moment in time is unique and time
is iiieveisible. As soon as we peimit time to elapse, we must peimit
knowledge to change (ibid.1z1zc, italics iemoved). l have iefeiied
to this as Lachmanns axiom.
1!
Although old knowledge is continually being supeiseded by
new knowledge, though nobody knows which piece will be ob-
solete tomoiiow, men have to act with iegaid to the futuie and
make plans based on expectations. Expeiience teaches us that
in an unceitain woild dieient men hold dieient expectations
about the same futuie event . . . diveigent expectations entail in-
coheient plans . . . what keeps this piocess in continuous motion
is the occuiience of unexpected change as well as the inconsis-
tency of human plans. . . . Aie we entitled, then, to be condent
that the maiket piocess will in the end eliminate incoheience
of plans. . . ` To say that the maiket giadually pioduces a consis-
tency among plans is to say that the diveigence of expectations,
on which the initial incoheience of plans iests, will giadually
be tuined into conveigence. But to ieach this conclusion we
must deny the autonomous chaiactei of expectations. . . . Ex-
pectations aie autonomous. We cannot piedict theii mode of
change as piompted by failuie oi success. (ibid.1zc1zv)
Teie is thus no way to know which of the oppoitunities peiceived
by the Kiizneiian entiepieneuis aie ieal and which aie (peihaps
inconsistent) gments of theii dispaiate expectations. ln this way
Lachmann depaited company fiom Kiiznei and Hayek and was not
piepaied to asseit the existence of any tendency towaid equilibiium.
What emeiges fiom oui ieections is an image of the maiket as a
paiticulai kind of piocess, a continuous piocess without beginning oi
end, piopelled by the inteiaction between the foices of equilibiium
and the foices of change (Lachmann 1vebe1).
1.
1!
Lewin (1vv.z!e). Accoiding to a well-known Austiian axiom, Time cannot
elapse without the state of knowledge changing (Lachmann 1vcev).
1.
loi an in-depth examination of this debate, see Kaien Vaughn (1vvz, 1vv.ch. ).
Te debate continues, though in muted teims since Lachmanns death in 1vvu. Kiiznei
has auempted to iestate and iene his position (1vvz) and Maiio Rizzo has piovided a
WHAT DOES EQUlLlBRlUM MEAN` z
Te issue of conveigence, of a tendency towaid equilibiium,
1
thus
iemains a contentious issue in which a lot is peiceived to be at stake.
liom Lachmanns lead, fuithei investigations of the meaning and im-
plications of Lachmanns axiom have followed, the most elaboiate of
which is the in-depth examination by ODiiscoll and Rizzo (1vve). Te
vaiying ieactions to this book beai testimony to the depth of the iif
within the subjectivist Austiian family. Tis is well captuied in the
two ieviews by Kiiznei (1vv.a) and Lachmann (1vv.).
1e
Although intia-
family disputes aie ofen the most vocifeious, wheie theie is so much
agieement on eveiything else of signicance it is peihaps suipiising.
Yet it appeais to be fundamental.
Hayekian equilibiium is a state of complete cooidination of plans
(and the expectations on which they depend). An equilibiating ten-
dency is thus a tendency of maikets to cooidinate human aaiis. By
denying the existence of equilibiating tendencies, Kiiznei woiiies, one
may be led to deny the plausibility of possible systematic piocesses
of maiket cooidination and in the extieme iendei economic science
non-existent (Kiiznei 1vv.a.u.1). On the othei hand, Lachmann
woiiies that by aiming the existence of peisistent equilibiating ten-
dencies we aie playing iight into the hands of oui opponents who
meiely have to point to obvious instances of malcooidination to win
debating points (Lachmann and White 1vv). luithei, the ioot
of oui diculty lies in this in a maiket . . . all cooidinating activ-
ity must engendei some discooidination of existing ielations (Lach-
mann 1vce11) hence endogenous change. Tose who take Lachmanns
axiom seiiously see no way to avoid the conclusion that change is
endogenous and continuous, thus making any statement about equi-
libiating tendencies inheiently suspect. At the heait of the pioblem
is the autonomy of individual expectations and the choices to which
they lead. Lachmanns axiom follows fiom the inability to deny its im-
plication that individual behavioi cannot be piedicted because futuie
fuithei ciitique (Rizzo 1vve). loi a summaiy of Kiizneis position, see Kiiznei (1vv).
loi a moie iecent summaiy, see Kiiznei (zuuv).
1
See the appendix to this chaptei.
1e
Oiiginally published soon afei ODiiscoll and Rizzo (1vve, ist edition 1vc) in
the Market Process Newsleer. loi iefeiences to some of the contiibutions to this
debate see Boeuke, Piychitko, and Hoiwitz (1vv.).
zc CAPlTAL lN DlSEQUlLlBRlUM
knowledge cannot be piedicted (ODiiscoll and Rizzo 1vve). Expecta-
tions ielating to the choices of othei individuals must be diveise and,
theiefoie, aie bound to be falsied. But if expectations aie bound
to be falsied, implying that piediction is impossible, how do we do
economics` lndeed how do we act at all` ls life possible without
equilibiium`
Appendix: Equilibrium, Time and Expectations
Te pioblemof conveigence to equilibiiumievolves essentially aiound
the piioi pioblem of how economic agents in a disequilibrium situation
acquire information that would motivate them to take actions that would
result in the economy moving toward equilibrium. Tey cannot be pie-
sumed to know what the equilibiium piice is, since this would assume
away the entiie pioblem. Kiizneis answei, as we have seen, is that the
entiepieneui, the impoitant economic agent in this context, acts on
the basis of piice disciepanciesbuying low and selling highthus
moving piices towaid the establishment of one piice. But how do we
know that this will be the equilibiium piice` Te pioblem may be seen
most simply if we once again use the simple supply and demand case
of an isolated maiket.
Te simplest case is the one wheie we assume that the positions
of the supply and demand cuives aie unaected by the actions of
individuals in the maiket. Tat is to say, the eects of tiading at false
piices must be assumed to be negligiblesmall enough to be ignoied.
We thus ignoie any possible income eects that might give iise to
path dependence. We iule out changes in the data as a iesult of the
actions of the maiket paiticipants themselveswe iule out endogenous
change, and we iule out changes that emanate fiom outside of this
maiket, like changes in technologywe iule out exogenous change. ln
this case the equilibiium piice is a xed taiget, an unmoving auiactoi.
Should the maiket aiiive at it, it will stay theie in the absence of any
exogenous change. Te question is if the piice is not at the equilibiium
piice, will it move towaids it`
Tiaditionally, and piedictably, this pioblem has been answeied by
auempting to investigate how individuals might ieact to the infoima-
tion they ieceive in disequilibiium. So foi example, when the piice is
WHAT DOES EQUlLlBRlUM MEAN` zv
above the equilibiium piice, theie will be moie available foi sale than is
demanded. Te existence of excess supply will tend plausibly to suggest
to economic agents (oi an entiepieneui will suggest to them) that they
ieduce the piice that they oei oi ask, and in this way the piice will tend
to fall. But to what level will the piice fall, how do agents foim theii
expectation of what the piice should be` Tese ieaction functions can
be of gieatei oi lessei complexity, and depending on theii piopeities
the pioblem will exhibit a smooth tiansition towaid the equilibiium
piice in each successive peiiod, an oscillating appioach, a peipetual
ciicling aiound it, oi an explosive diveigence away fiom it.
Tis is the familiai coinhog cycle. lt sueis fiom pietending to
know how individuals will ieact in any given disequilibiium situation.
lt is not plausible to suggest that individual ieaction functions that de-
pend on each otheis ieaction to evei incieasing highei levels can be
mathematically modeled in a satisfactoiy way. Howevei, it may be
aigued that anothei ioute is available. Whatevei the piecise way in
which individuals ieact, as long as theie is enough variation in reactions,
and as long as we allow enough time to elapse in the absence of funda-
mental change, we may aigue that as a iesult of sheei tiial and eiioi,
piopelled by vaiying ieactions to disequilibiium piices, the maiket will
eventually, if not soonei then latei, hit on the equilibiium piice. lt is
haid to believe that an unmoving equilibiium piice will not eventually
be discoveied and established. lt is, afei all, a piefeiied piice in the
sense that it iesults in the mutual fulllment of all buy and sell plans
and we ieasonably expect it to emeige out of individual fiee tiades.
Nowof couise the pioblemis that it is not at all plausible to assume
that the supply and demand cuives aie xed foi the duiation. Te
above exeicise may establish a conveigence in piinciple (not a iigoi-
ous pioof, but a suggestive aigument), and this may suggest fuithei
that, as an empiiical mauei, ieactions aie such in the ieal woild that
a tendency towaid the equilibiium piice will pievail even though
it is continually being thwaited by shifs in supply and demand. Te
aigument is that the tendency in the maiket is towaid equilibiium. To
the extent that this is distuibed it is as a iesult of exogenous changes
in supply and demand foices, like a new technology, new pioducts,
etc. Tus, it is the piesence oi absence of endogenous change that has
emeiged as a ciitical issue.
!u CAPlTAL lN DlSEQUlLlBRlUM
Te simple supplydemand case is suggestive in two ways. liist,
wheie the woild is such that the undeilying iealities (in this case the
positions of the supply and demand cuives oi, moie accuiately, the
contingent tiades that they iepiesent) aie constant, it seems natuial to
aigue that conveigence will occui. So even if, foi centuiies, most peo-
ple believe eiioneously that the woild is at, and foi some time theie
is a vaiiation of beliefs, since the woild iemains iound no mauei what
we believe oi howwe act messages fiomoui expeiience will eventually
convince us (all of us) that it is iound. Teie is a notable conveigence
of expectations as a iesult of expeiience. No one now expects to fall
o the edge. Geneially a stable (constant) decision enviionment is
conducive to conveigence, exhibiting the iequiied feedback. Second,
the simple supplydemand case can be geneialized to situations of mul-
tiple maikets as long as we continue to ignoie income oi wealth eects
and iule out exogenous changes. Ten the entiepieneui becomes key.
Piice disciepancies in geogiaphically sepaiated maikets oi foi inputs
veisus outputs will then tend to be eiadicated even as each maiket is
gioping its way to isolated equilibiium. And in this case it is easy to
see how piices aie poweiful tiansmiueis of infoimation. Once again,
the iesult is ideal, depending as it does on the assumption of unvaiying
undeilying iealities and sucient vaiiation in individual ieaction.
CHAPTER !
Equilibiium and Expectations Re-Examined
A Dieient Peispective
[l]iom time to time it is piobably necessaiy to detach oneself
fiom the technicalities of the aigument and to ask quite naively
what it is all about. (Hayek 1v!b.)
Te debate iefeiied to in the pievious chaptei is in many ways ielated
to the geneial pioblem in economics of dealing adequately with the
phenomenon of time. lt seems that eveiy economist of note has, in one
way oi anothei, peiceived some diculty associated with accounting
foi the passage of time while maintaining equilibiiumand has wiestled
with it (Cuiiie and Steedman 1vvu). On the one hand theie is the
undeniable fact of human action in an oideied society. On the othei
hand theie aie the undeniable facts of novelty and disequilibiium and
the inability to foiesee all consequences. All action is futuie oiiented
it iests on connecting piesent causes to futuie eects, which seems to
imply successful piediction. How is one to ieconcile these appaiently
iiieconcilable peispectives`
Describing and Understanding Action
One possible iesolution may lie in ie-examining the concept of expec-
tations and concepts ielated to it. l oei a scheme that will include an
aiticulation of the following concepts events/occurrences, laws of nature,
social laws, acts/actions, plans, knowledge and expectations. We take
note of the passage of time by iecoiding occurrences oi events that we
categoiize accoiding to oui undeistanding of them. Events that occui in
natuie, that do not involve humans, aie undeistood accoiding to what
we think of as the forces (or laws) of nature. Events that occui in soci-
ety, that ielate to humans, aie undeistood accoiding to the intentions
!1
!z CAPlTAL lN DlSEQUlLlBRlUM
and meanings of the individuals involved. At one level it is possible
to desciibe human events as pait of events in natuie, physiologically
foi example. So it is possible to examine human acts in teims of the
biological piocesses, in the biain and in the iest of the body, that biought
them about. But the natuie of the undeistanding we achieve by this is
of the same type as of events in natuie. To acquiie an undeistanding
of events as human or social events iequiies examining (intei)subjective
intentions and meanings.
1
We may say that events in society aie the
iesults of actions. Tey involve human acts.
z
To desciibe an act satis-
factoiily, iecouise must be had to motives, means and outcomeseven
if the lauei aie unintended. Outcomes aie connected to (undeistood
in teims ol) a multitude of actions, ielated and unielated. Tis seems
to me what we mean when we talk about equilibiium in teims of the
consistency, compatibility and cooidination of plans. Plans embody a
numbei of ielated acts. Tey aie ielated by purpose. Tus dieient acts
may be complementary, when they woik towaids the same puipose, oi
competitive, when they woik foi conicting puiposes, oi they may be
unielated.
!
Te notion of plan, so widely used by economists, is in
need of fuithei examination.
1
While dieiing fiom his appioach in some iespects, this echoes Mises insistence
on methodological dualism (see foi example Mises 1vch. 1). Mises appioach to
this can be desciibed as somewhat piagmatic.
What the sciences of human action must ieject is not deteiminism but
the positivistic and panphysicalistic distoition of deteiminism. Tey
stiess the fact that ideas deteimine human action and that at least in the
piesent state of human science it is impossible to ieduce the emeigence
and tiansfoimation of ideas to physical, chemical oi biological factois.
lt is this impossibility that constitutes the autonomy of the sciences of
human action. (ibid.v!)
Te ultimate givens in social science aie the ideas of individuals, including theii judg-
ments of value. Teie is no accounting foi these in teims of moie ultimate (physical)
causes. Saying that judgments of value aie ultimately given facts means that the
human mind is unable to tiace them back to those facts and happenings with which
the natuial sciences deal (ibid.ev).
z
Act noun 1 Athing done, a deed b An opeiation of the mind (e NewShorter
Oxford English Dictionary).
!
Tis chaptei uses mateiial fiom Lewin (1vvc). An anonymous iefeiee has
pointed out that an impoitant distinction must be made between the plans of a given
individual and the plans made by dieient individuals. A question aiises whethei an
EQUlLlBRlUM AND EXPECTATlONS RE-EXAMlNED !!
What Do We Mean by Consistency of Plans?
Teie aie thiee impoitant things to note about plans
1. Plans depend on dierent kinds of knowledge. As alieady indi-
cated, a plan is dened by its puipose oi set of puiposes. lts
foimulation depends on its puipose and on the desiies (pref-
erences) and knowledge of the plannei. Tis knowledge is an
innitely complex phenomenon, and opeiates at many levels, as
we shall latei iemaik in some detail in oui discussion of human
capital. loi the moment we note simply thiee types oi levels
(a) Te individual will have knowledge of those laws of na-
tuie to which we iefeiied eailieiknowledge type 1. Tis
knowledge will have been gained in a vaiiety of ways
accoiding to the individuals peiceptions and expeiience
(and may be to some extent a piioii).
(b) Second, the individual will have knowledge of the social
woild, social lawsknowledge type 2. Tis knowledge
will depend on the existence of, and the individuals peicep-
tion and expeiience of, social institutions. By institutions
we mean heie those typical and stable featuies of the social
woild on which individuals come to iely. So they include
iules of behavioi, standaid categoiies, habits, customs, and
the like. We will discuss this in gieatei detail in a moment.
(c) Tiid, the individual will have knowledge of specic and
unique events that have occuiied (histoiy) and in oidei to
caiiy out the actions constituting the plan, the individual
must foim some mental pictuie of the specic possible con-
sequences of those actions and decide on which aie moie
oi less likely. To be suie, some actions will involve gieatei
and lessei degiees of conscious anticipation, and some may
individual is always awaie of the complementaiy oi contiadictoiy natuie of his oi hei
plans. Does the haiboiing of plans contiadictoiy in theii likely outcomes imply iiia-
tionality oi just ignoiance` Piesumably a iational individual would not knowingly
adopt contiadictoiy plans. loi gioups of individuals, contiadictions aie inevitable in
maiket economies. Tese contiadictions, and also some complementaiities, aie mostly
unknowable to individuals ex ante and aie only ievealed (if at all) ex post with the
unfolding of the maiket piocess.
!. CAPlTAL lN DlSEQUlLlBRlUM
be so habitual as to seem almost ieexive. Neveitheless,
even these implicitly involve imagined consequences, as
would piesumably be biought to the foie upon inteiioga-
tion. We may hesitate to gioup these anticipations oi ex-
pectations in the categoiy of knowledge, but we do so, as a
thiid level of knowledge (knowledge type 3), in the convic-
tion that expectations may be held with gieatei oi lessei
condence. (ln the case of habitual actions iefeiied to just
now, we may imagine the ielevant expectations to be held
so condently as to be indistinguishable fiom(tacit) knowl-
edge as usually undeistood as some soit of absolute con-
dence.) Expectations aie thus heie consideied to be a
special aspect of knowledge. Type 1 and z knowledge is
knowledge of an abstiact kind, knowledge of geneial piin-
ciples (ielated to the natuial woildapples fall fiom tiees
to the giound, exposuie to bacteiia can cause infection,
oi ielated to the social woildpeople stop at ied lights,
dollai notes aie a geneially accepted means of payment),
wheieas knowledge type !histoiical knowledge and ex-
pectations/anticipationsis knowledge of specic unique
events.
.
z. Plans cannot be completely specied, they cannot include a speci-
cation of everything that can happen (imagined or unimagined).
.
Tis discussion is, in many ways, similai to (peihaps the same as) ODiiscoll
and Rizzos distinction between typical and unique elements in any situation and
between pauein and detail piediction (1vveev1). And, once again, theie aie close
similaiities to and dieiences fiom Mises. Mises was conceined with the souices of
knowledge. l am less so. So his distinction is twofold, ist on the basis of whethei oi
not knowledge can be consideied a piioii, and second, whethei oi not it yields ceitain
(unambiguous, eteinal) knowledge. My scheme is elaboiated veiy specically in the
seivice of tiying to desciibe how action is possible in disequilibiium (with iefeience
to a Hayekian equilibiium of consistency of plans). So l distinguish between dieient
types of knowledge, not accoiding to theii souices, but accoiding to theii degiee of
ceititude, and second, accoiding to theii subject mauei (human oi natuial). ln this
lauei iegaid my methodological dualism is not that dieient fiom Mises. So l lump
togethei knowledge that is (oi might be) a piioii with that gained by expeiience, but
distinguish it accoiding to whethei it is about the social oi natuial woild. Mises would
put mathematics in piaxeology togethei with economics, wheieas l put mathematics
in natuial (nonhuman) science.
EQUlLlBRlUM AND EXPECTATlONS RE-EXAMlNED !
Te notion of plan in the liteiatuie is veiy vague. Lindahl (1vzv
and especially 1v!vb)

and Lachmann spent some time talking

about aspects of individual plans. Of these, Lindahls foimu-
lation is the most developed.
e
He distinguishes, foi example,
between thiee types of actions that aect the plans degree of
deniteness (Lindahl 1v!va.) thus conceiving of some exibil-
ity in the execution of the plan. Tis means that even if some
anticipations aie not fullled, if the plan contains sucient ex-
ibility, that is, sucient ioom foi contingencies, it may not be
disappointed and thus need not be ievised oi abandoned. lt
may be accommodated within equilibiium. Likewise Lachmann,
in dieient (but similai) ways, auempted to account foi plans
that contained contingencies.

But neithei of these authois, noi

anyone else to my knowledge, has iemedied the vagueness that
continues to suiiound the concept. Teie is an aspect of paiadox
in this. lt is because theoiists have failed to make cleai that real-
world plans aie necessaiily vague and ofen only dimly peiceived
by the planneis, that the plans in the theoiists discussion have
assumed a specious, but unaiticulated, piecision. Tey have
fosteied the (unconscious) impiession that they aie meant to
depict detailed pioject analysistype meansends schemes, even
though such details aie nevei piovided, even by way of exam-
ple. Te necessaiy vagueness of ieal-woild plans is implied by
the natuie of time and the way in which we expeiience it, in
shoit, by Lachmanns axiom. As futuie knowledge cannot be
gained befoie its time, and as plans must inevitably depend to
some degiee on futuie knowledge, many of the aspects of a plan
must simply be unspecied. We do not plan in teims of micio

See also Cuiiie and Steedman (1vvuchs . and ).

e
lt can haidly be pietended that eveiy individual has a cleai conception of the
economic actions that he is going to peifoim in a futuie peiiod. Neveitheless, in the
gieatei numbei of cases it will ceitainly be found that undeilying such actions theie
aie habits and peisistent tendencies which have a denite and calculable chaiactei
compaiable to . . . explicit plans . . . we may accoidingly without dangei pioceed to
geneialize oui notion of plans, so that they will include such actions. Plans aie thus
the explicit expiession of the economic motive of man, as they become evident in his
economic actions (Lindahl 1v!vbv!).

See Lachmann (1vc., !, 1v1.u) and Lewin (1vv.z.zu).

!e CAPlTAL lN DlSEQUlLlBRlUM
details, but iathei in teims of macio categoiies. We cannot
expeiience futuie events befoie theii time and the expeiience is
nevei an exact coiiespondence of the anticipation, both because
the dieience is a mauei of degiee and because some of the
aspects of the event could not have been imagined.
c
!. Plans aie multilayered, that is to say, an individual at any one
time will have a veiy laige numbei of plans by which he con-
ducts his life. Each will ielate to a dieient puipose and usually
will have veiy dieient fiames of iefeience including a dieient
time fiame. So foi example, l may at a moment of time be acting
within plans to teach my class (as planned) today, nish a ist
diaf of this chaptei this week, fulll the expectations of my chil-
dien to help themwith theii homewoik this entiie yeai and save
enough money to see them thiough college ovei the next ten
yeais. Plans may be nested (within one anothei) oi paiallel. And
while it might be possible ideally to conceive of all of an individu-
als plans as existing within one giant life plan, this, as we shall
see, can haidly advance oui undeistanding. Rathei we should
iealize that although the plans may exist in a stiuctuie of soits,
one being ielated to the othei in teims of puiposes and means,
this ielationship, this stiuctuie, is likely to be only dimly and pai-
tially peiceived and is, moieovei, likely to be evei changing as
individual plans aie adopted, ievised and abandoned. So when
we speak of plan cooidination acioss individuals, and whethei
oi not theie is a necessaiy tendency foi them to become moie
cooidinated, oui disagieement may be ielated to the fact that the
concept of plan cooidination has not been cleaily undeistood. lt
may be that some types of plans do exhibit such a tendency while
otheis do not, and that the functioning of the maiket system
depends ciucially on this dieience. ln paiticulai, it may be, as
c
No mauei how l tiy to imagine in detail what is going to happen to me, still how
inadequate, how abstiact and stilted is the thing l have imagined in compaiison to
what actually happens' . . . loi example, l amto be piesent at a gatheiing, l knowwhat
people l shall nd theie, aiound what table, in what oidei, to discuss what pioblem.
But let them come, be seated and chat as l expected, let them say what l was suie they
would say the whole gives me an impiession at once novel and unique. . . . Gone is
the image l had conceived of it, a meie pie-aiiangeable juxtaposition of things alieady
known' (Beigson 1vev1, quoted in Rizzo 1vv.11n.).
EQUlLlBRlUM AND EXPECTATlONS RE-EXAMlNED !
we shall aigue, that plans based heavily on knowledge types 1
and z aie veiy likely to coheie and that the opposite is tiue foi
plans that depend heavily on knowledge type !.
Befoie continuing it may be useful to appioach this fiom a slightly
dieient angle. Plans aie based, to a gieatei oi lessei extent, on ex-
pectations (knowledge type !). Expectations aie, of couise, widely
believed to inuence actions, and the essential dieience between the-
oiies is ofen to be found in the dieient way in which expectations
aie tieated. While the iational expectations (RE) appioach implicitly
assumes that eveiyone has the same expectations, at the othei extieme
Lachmann emphasizes the diie consequences of expectations that nec-
essaiily diveige. But we may now pause to ask expectations of what`
RE appioaches ielate piimaiily to piices (oi piice indexes) they iefei
to individuals expectations of piices. Lachmann is less specic except
to say that they aie bound to be disappointed, fiom which we should
infei that he is iefeiiing to expectations of the things about which
individuals diei. Realizing that expectations, like the plans in which
they aie embodied, aie multidimensional makes us iealize that the ex-
pectations concerning the vast majority of things (events) about whi
we have expectations will be fullled. We may thus question whethei
Lachmanns statement that expeiience teaches us that in an uncei-
tain woild dieient men hold dieient expectations about the same
futuie event is univeisally tiue and iealize that it depends ciucially
on the type of event in question. loi a laige numbei of events theie is
widespiead agieement of expectations.
How are Activities Synronized and Coordinated?
We may be moie specic. Expectations and plans aie, foi the most
pait, fullled because of the existence in the social woild of shaied
categoiies and standaids that facilitate the synchionization and cooidi-
nation of activities. Tese opeiate to give individuals haid knowledge
(type z) of the actions of otheis on which these plans and expectations
(type ! knowledge) depend. Tis is most obvious and most ciucial with
iegaid to the way in which we cope with time. Cuiiie and Steedman
have diawn auention to a iemaikable woik by P. A. Soiokin oiiginally
published in 1v.! (Cuiiie and Steedman 1vvuzu1zu!, Soiokin 1ve.).
!c CAPlTAL lN DlSEQUlLlBRlUM
ln this woik Soiokin points out that the devices we use to oiganize and
cope with time aie cultuial (iathei than natuial). We invent (oi, moie
accuiately, we evolve) cultural time units. Tus Soiokin contiasts
sociocultuial time with continuous, innitely divisible, unifoimly
owing, puiely quantitative time of classical mechanics (Cuiiie and
Steedman 1vvuzu1). Considei the week.
lactually, oui living time does not owevenly, is discontinuous,
and is cut into vaiious qualitative links of dieient value. Te
ist foimof this qualitative division is given by oui week. Math-
ematical oi cosmic time ows evenly, and no weeks aie given
in it. Oui time is bioken into weeks and week links. We live
week by week, we aie paid and hiied by the week, we compute
time by weeks, . . . we walk and exeicise oi iest so many times
a week. ln biief, oui life has a weekly ihythm. Moie than
that within a week, the days have a dieient physiognomy,
stiuctuie, and tempo of activities. Sunday especially stands
alone, being quite dieient fiom the weekdays as iegaids activ-
ities, occupations, sleep, iecieation, meals, social enjoyments,
diess, ieading, even iadio piogiams and newspapeis. . . . Aweek
of any kind is a puiely sociocultuial cieation, ieecting the
ihythm of sociocultuial life but not the ievolution of the moon,
sun, oi othei natuial phenomena. Most human societies have
some kind of week, and theii veiy dieience between weeks is
evidence of theii independence fiom astionomical phenomena.
Te constant featuie of viitually all . . . is that they weie always
found to have been oiiginally associated with the maiket . . .
oui week is not a natuial time peiiod but a ieection of the
social ihythm of oui life. lt functions in hundieds of foims
as an indivisible unit of time. . . . lmagine foi a moment that
the week suddenly disappeaied. What havoc would be created
in our time organization, in our behavior, in the coordination
and synronization of collective activities and social life, and
especially in our time apprehension?
(Soiokin 1ve.1vu1v!, italics added in the last sentence)
What is tiue of the week is equally tiue of othei shaied time unit cat-
egoiies, like days, months, seasons and yeais, even though these may
have an oiiginal basis in astionomical iegulaiities. ln theii evolved,
developed state they piovide us with piedictable social ihythms. And
this is even moie tiue of the division of days into houis, minutes and
EQUlLlBRlUM AND EXPECTATlONS RE-EXAMlNED !v
seconds. ln oui inteiactions we all maik time in the same way and
with iefeience to the same clock so that we aie able to synchionize
(consciously and subconsciously, oveitly and tacitly) most of oui ac-
tions oi, moie accuiately, oui activities (iefeiiing to action types oi
iepeated actions).
Te knowledge of the main kinds of sociocultuial ihythmsno
mauei whethei peiiodical oi notis by itself veiy impoitant
knowledge. . . . Stiipped of theii specic qualities, all ihythms
and punctuations would disappeai, and the whole sociocultuial
life would tuin into a kind of giay owing fog in which nothing
would appeai distinct. (ibid. zu1)
Te synchionization of activities is most obvious in contiacts, which
ofen iefei to units of time. loi example, we ient space by the day,
week, month oi yeai. But it occuis in all spheies of life wheie contiacts
aie implicit oi nonexistent. We expect people to woik between the
houis of c a.m. and e p.m. and not usually outside of that. We expect
people to be asleep between midnight and daylight. Te few excep-
tions give iise to disappointed expectations and discooidination. But
the oveiwhelming confoimity ensuies ioutine expectation fulllment.
Knowledge of these time categoiies is a pieiequisite foi, and gives iise
to, knowledge of peoples typical activities.
Tis insight may be extended to othei types of shaied categoiies.
loi example, we shaie categoiies foi measuiing spacedistance (miles
and kilometeis), aiea (acies of land), and volume (gallons of gasoline)
and weight (pounds of sugai), guiing accounts, classifying occupa-
tions,
v
diiving on the ioads, walking along pathways, and innumei-
able othei conventions, customs, habits, and the like, which make oui
actions piedictable to otheis. Tese institutionalized categoiies and
modes of behavioi (which we may designate as institutions bioadly
undeistood) aie the cumulative unintended iesults of individual ac-
tions and they iepiesent a ieal conveigence of expectations. Staiting
out fiom a position of many dieient standaids oi modes of behavioi
that conveige to one oi a few implies that individuals come to expect
ceitain kinds of behavioi, with a degiee of condence ielated to degiee
of confoimity of the paiticulai standaid. Tese institutions
v
See Ebeling (1vce.c).
.u CAPlTAL lN DlSEQUlLlBRlUM
enable each of us to iely on the actions of thousands of anony-
mous otheis about whose individual puiposes and plans we
can know nothing. Tey aie the nodal points of society, co-
ordinating the actions of millions whom they relieve of the need
to acquire and digest detailed knowledge about others and form
detailed expectations about their further action.
(Lachmann 1v1u, italics added)
Processes of Convergence
We have a faiily good idea of how social piocesses that conveige
woik. Apiototype case has been piovided in the emeigence of a single
medium of exchange (Mengei 1vez.c., Selgin 1vccch. z, Hoiwitz
1vvzch. z). Money is the unintended iesult of individuals adopting
one out of many goods as the piefeiied medium of exchange. lts
spontaneous emeigence is facilitated by the piopeity that the moie
people use it, the gieatei its advantage foi fuithei use. lt is a giaphic
case, but only one case, of similai piocesses wheie the advantages
of the adoption of a paiticulai standaidfoi example of a paiticulai
pioduct oi set of pioducts to accomplish given tasks, like playing
video casseues, woid piocessing, sofwaie developmentas well as
geogiaphical location, language, and many othei things, depend posi-
tively on the extent to which it has alieady been adopted (Aithui 1vv.,
Kiugman 1vv1, Kiiznei 1vvu, Liebowitz and Maigolis 1vv.,
1u
see also
Hoiwitz 1vvz). ln such piocesses, once a ciitical level of adoption has
been achieved adoption tends to be cumulative. lndividuals aie led
by the cleaily peiceived advantages of adoption to follow suit, and
the piocess feeds on itself until it has become an institution. Not all
institutions emeige in this way, but many do.
lt should be cleai that these conveigent piocesses do not exist in
isolation but aie ciucially ielated to each othei. So, foi example, the
emeigence of money depends on the piioi existence of established
piactices of tiade, in paiticulai the tacit oi conscious enfoicement of
contiacts. Te institution of iepeat puichase tends to enfoice ceitain
1u
Teie is a giowing liteiatuie on the many aspects and implications of these cumu-
lative piocesses. We shall have occasion latei to take note of some of them. loi now
we shall be content to note theii existence and culmination in social institutions.
EQUlLlBRlUM AND EXPECTATlONS RE-EXAMlNED .1
piactices of honest dealing. And the existence of money, of couise,
suppoits a numbei of dependent institutions, like nancial accounting
piactices (see Chaptei 1u below). Teie is, in shoit, an intiicate in-
stitutional structure. Teie is an essential complementaiity between
enduiing institutions (Hoiwitz 1vv.).
11
Te maiket system is itself
dependent on the existence of impoitant aspects of the legal stiuctuie.
Tis biings up the question of institutional change.
Te designation institution connotes an image of peimanence,
of ieliability. Te institutions that we have been talking about exist
as xed points in the landscape of time within which individuals can
make theii choices in the knowledge (knowledge type z) that they, the
institutions, at least, will iemain unchanged. We will look at this a
liule moie closely in a moment. lt is evident, howevei, that this pei-
manence must be ielative, foi we have the fact of institutional change.
Standaids come and go. Categoiies change. Rules appiopiiate to one
society ofen disappeai as the society changes. Even language evolves.
How does this aect the functioning of institutions as facilitatois of
cooidination` Te answei must be in the iapidity of change. A society
in which eveiything changed iapidly would be one devoid of any pei-
ceptible oidei. Histoiy is possible only because the histoiian is able
to know something about the enduiing oiientations inside peoples
minds. Te histoiical context is dened by the meaning of the insti-
tutions of the society undei examination. But as the context changes,
institutions may be seen at one point in time as xed points, while
at anothei they may be seen as aspects of change. lt depends on the
puipose of the analysis and the time span involved. What is xed
and what evolves is itself a mauei of context. Teie seems to be a
continuing inteiaction between the foiegiound and the backgiound,
and which is moving depends veiy much on which you have in focus,
much like a thiee-dimensional hologiaphic pictuie. Commeicial law
is necessaiy foi the conduct of economic life and indeed facilitates the
emeigence of unpiedictable novelty in economic life. But economic
(and technological) changes of ceitain types put a stiain on aspects
of the law that piompt it to change. loi example, the emeigence of
11
Company Law, as it has emeiged in the Westein woild in the couise of time, is
a delicate web within which many inteiests, some conicting, some complementaiy,
have been woven into a pauein of haimony. . . . (Lachmann 1vvz.)
.z CAPlTAL lN DlSEQUlLlBRlUM
electionic communications has suggested the acceptance of facsimile
signatuies and has iaised dicult legal questions ielating to copyiight
and piivacy on the lnteinet.
So conveigence and peimanence aie ielative phenomena. Nev-
eitheless such peimanence is necessaiy foi the existence of and foi
oui undeistanding of dynamic economic piocesses. Te hectic pio-
cession of new pioducts and pioductive piocessesthat is, the iesult
of the activities of a multitude of individuals oiganized as companies,
opeiating within the constiaints of contiact law, and so on, some of
whomsucceed in theii endeavois, many of whomdo not (as dened by
the ability to eain positive accounting piots) is dependent on these
undeilying institutions. While we cannot piedict who will succeed
and who will not, while we cannot piedict which pioducts will emeige
and be populai, while we cannot foiesee the natuie of futuie technolo-
gies, we stiongly believe that the piocess will be peaceful and will be
oideily, we condently expect those who aie unsuccessful to accept
theii losses peacefully and peihaps tiy something else, those who lose
theii jobs to move on in the hope of gieenei pastuies, and those who do
succeed to continue to tiy to do so. Te fiuits of this dynamic piocess
depend ciucially on oui willingness to accept the consequences of its
unpiedictability. Tat willingness is the vital piedictable pait. We
have the emeigence of chaos out of oidei.
1z
Te analogy with oiganized spoits has been suggested by a numbei
of theoiists (foi example Hayek 1v!11, Loasby 1vv.!z). Te game
is played accoiding to ceitain xed iules (although fiom time to time
the iules evolve to ieect new iealities). Te iules (both wiiuen and
unwiiuen) aie highly piedictable. Given a hypothetical contingency,
we can piedict its iesolution. Te actual outcomes aie unceitain and
innitely vaiiable. Tat is the point of playing the game. By outcome
we mean not only the scoie, but also the pauein of the game in its
innite detail, which is pait of the auiaction. lf we caied only about
the scoie it would be a simple beuing game, we aie also inteiested in
seeing how it is played and what unexpected vaiiations aie aiound the
coinei to delight, intiigue, shock, oi disgust us. Te game of life, and
1z
With apologies to Piogogine and Stengeis (1vc.). Te maiket piocess is not
chaotic in the colloquial sense, but it is complex and unpiedictable.
EQUlLlBRlUM AND EXPECTATlONS RE-EXAMlNED .!
the game of economic life in paiticulai, is like this in many iespects.
Most notably it depends on wiiuen and unwiiuen iules and on the
iesouices (the abilities, the equipment, and the expeiience) of the play-
eis. We hope that oui team will win, but we usually do not go to wai
if they do not. lf we did, the game would not exist and we would not
be able to enjoy it.
We cope with the complexity in the woild by conveiging on institu-
tions. Tus once the aiiival of a new iange of pioducts, made possible
by the development of a new technology, has been digested, new cate-
goiies of classication tend to be developed, into which these pioducts
aie giouped. Te categoiies emeige spontaneously out of individual
auempts to communicate the auiibutes of the new pioducts. A good
example is the pioducts of the computei industiy. A whole iange of
pioducts exist, whose woikings iemain a mysteiy to the vast majoi-
ity of people, but whose puiposes needed to be explained. Laptops
evolved into notebooks, miciocomputeis into desktops. At anothei
level a seiies of technical standaids and categoiies has been developed
in oidei to cope with the complexity. Te auiibutes of computei mon-
itois include its iefiesh iate, its dot pitch as well as simply its scieen
size. All these shoithands piovide the incieasingly infoimed public
with a way to tailoi theii expectations when choosing between piod-
ucts. Tey enhance piedictability by enhancing the inteipietability
of infoimation. But these ielatively piedictable elements change with
time and it is no accident that conscious innovation involving pioduct
dieientiation is ofen iefeiied to using the phiase categoiy killei.
Novelty and Equilibrium
About some events theie is no piedicting. Tese aie the specics of
any given (futuie) histoiical situation. Lachmanns axiom implies the
uniqueness of eveiy expeiience. Peihaps it is beuei to say that each
expeiience contains unique elements, although we aie able in ietio-
spect to desciibe it in teims of iecognizable categoiies. Desciibing a
situation is nevei the same as being theie. Each moment is unique and
theiefoie cannot be precisely piedicted. Tus plans aie nevei cooidi-
nated in eveiy detail. Such a situation is inconceivable, it is a woild
.. CAPlTAL lN DlSEQUlLlBRlUM
without time. ln that sense we aie nevei in equilibiium. Neveitheless,
in peaceful, lawful societies behavioi is ordered. Hayek, in his latei
woik, spoke less of equilibiium and moie of oidei. He quotes fiom a
distinguished social anthiopologist
that theie is some oidei, consistency and constancy in social
life is obvious. lf theie weie not, none of us would be able to go
about oui aaiis oi satisfy oui most elementaiy needs.
(Evans-Piichaid 1v1.v, quoted by Hayek 1v!!e)
lt is evident that theie must be unifoimities and iegulaiities
in social life, that society must have some soit of oidei, oi its
membeis could not live togethei. lt is only because people know
the kind of behavioi expected of them, and what kind of behav-
ioi to expect fiom otheis, in the vaiious situations of life, and
cooidinate theii activities in submission to iules and undei the
guidance of values that each and all aie able to go about theii
aaiis. Tey can make piedictions, anticipate events, and lead
theii lives in haimony with theii fellows because eveiy society
has a foim oi pauein which allows us to speak of it as a system,
oi stiuctuie, within which, and in accoidance with which, its
membeis live theii lives.
(Evans-Piichaid 1v11v, quoted by Hayek 1v!1n.)
Tus
By oidei we shall . . . desciibe a state of aaiis in which a
multiplicity of elements of vaiious kinds aie so ielated to each
othei that we may leain fiom oui acquaintance with some spa-
tial oi tempoial pait of the whole to foim coiiect expectations
conceining the iest, oi at least expectations which have a good
chance of pioving coiiect. (Hayek 1v!!e, italics iemoved)
Te (extended) oidei which is the society is cleaily a iesult of the com-
ponent oideis which we have called institutions. And the lauei indeed
aie the iesults of a piocess by which society has (without planning
to do so) conveiged towaids theii adoption. Tey aie spontaneous
oideis and they iepiesent equilibiia of a soit, in that they aie states
of conveigence (iest) aiound which expectations aie foimed and con-
foim. ln this sense, we may say that the social piocess is composed
of equilibiating, disequilibiating and non-equilibiating sub-piocesses.
Economic giowth, the aiiival of new and beuei pioducts and beuei
EQUlLlBRlUM AND EXPECTATlONS RE-EXAMlNED .
methods of pioduction is the iesult of unpiedictable, disequilibiating
and non-equilibiating piocesses. Teie is no tendency foi expectations
to coheie in these piocesses. Tey aie non-expectable, the iesults of
events that could not have been expected.
Te degiee of piedictability of any event is ielated, then, to the
extent to which it tends to exhibit iepeatable, typical, oi iecognizable
chaiacteiistics. Many ioutine events fall within the veiy piedictable
iange. Howevei, in the iealm of pioductive activity, in modein econo-
mies, many events fall veiy denitely outside of this iange. Methods of
pioduction, consumei goods, and seivices embody and depend on new
knowledge to a high degiee and theii emeigence is intimately ielated
to and ciucially dependent on the diveigence of expectations.
Predictability in one sphere is thus the necessary ingredient for coping
with its absence (novelty) in another sphere. Te amazingly wide iange
of pioducts and the peisistent impiovement in methods of pioduction
(in teims of ieducing oppoitunity costs) aie the iesults of a multitude
of unintentional expeiimentations. Of the outcomes that we obseive
in the maiket system, we cannot say that they aie the most ecient
oi the best of any that we could have had, and they aie not an equi-
libiiumin any Hayekian sense. But to the extent that we judge themto
be beuei than many alteinatives, to the extent that we judge piogiess
to be occuiiing in that oui lives aie made moie convenient and moie
exciting, we must iecognize these outcomes to be the benecial iesult
of the kaleidic changes of the modein woild.
Prices in Disequilibrium
Te piices that economic agents obseive and to which they iespond aie
not equilibiiumpiices. Tat is, they aie not piices that ieect an undei-
lying compatibility of the plans of the vaiious economic actois in the
maiket. lf expectations were consistent acioss individuals, in the sense
that they weie all destined to be fullled, then piices would ieect the
unanimous judgments of individuals of the values of the goods tiaded,
they would also accuiately ieect the tiadeos involved in tiading
one good foi anothei, oi iefusing to do so. ln this sense the piices
would lend a degiee of objective expiession to the subjective, non-
compaiable valuations of individuals. While subjective valuations aie
.e CAPlTAL lN DlSEQUlLlBRlUM
not obseivable and theie is no way of knowing subjective value scales,
in an equilibiiumsituation piices piovide haid infoimation about what
individuals aie piepaied to do and what vaiious goods and seivices
aie woith to them. ln this context, the exeicises of modein welfaie
economics, employed in the seivice of noimative investigations of al-
teinative policy scenaiios oi institutional stiuctuies, make some sense.
lt is possible then to use piice as a pioxy foi a measuie of utility
ieecting social losses and gains in some indiiect sense.
ln a disequilibiium situation, howevei, this is obviously no longei
possible. lf expectations acioss individuals diei and aie inconsistent,
then piices can no longei be used to ieect a unanimous judgment of
value. Te theoiems of welfaie economics no longei apply and, as is
widely acknowledged, albeit ignoied, notions of economic eciency
have no unambiguous meaning. One might wondei, then, what it is
that piices actually do in disequilibiium.
lt should be cleai that a piice is a social institution. When a piice is
established between a buyei and a sellei theie is a shaied undeistanding
of what it is and what it means. ln the ist instance, the piice is an
expiession simply of the teims of tiade, you give me this and l will
give you that. lt is a geneial shoithand desciiption foi expected action,
action that involves hypothetical, yet-to-be-expiessed details. loi ex-
ample, an adveitised geneial piice is an oei to do business that says
l will tiade an unspecied amount of this foi so many dollais pei unit.
And although the quantities acceptable may not be unlimited, theie is
usually undeistood to be an acceptable tiading iange. So piice is, ist, a
statement of mutual expectations and obligations involving ieal things.
Second, piices enable individual calculation. Piices make budgets
possible. ln this iegaid the iole of piices in monetaiy economies de-
pends ciucially on the existence of money as a univeisal medium of
exchange and theiefoie unit of calculation (and one piesumes, if ex-
changes aie iecoided, a unit of account, this is discussed fuithei in
Chaptei 1u below). Since money is univeisal puichasing powei it fa-
cilitates pioduction and exchange ovei time. Piices play a pivotal iole
in these pioduction and exchange activities. Without maiket piices,
calculation would not be possible (Mises 1vc1). Teie would be no
way foi an individual to estimate what someone might be willing to
EQUlLlBRlUM AND EXPECTATlONS RE-EXAMlNED .
exchange foi vaiious items. Te piices involved in any budget calcula-
tion aie eithei an expiession of past tiansactions that actually occuiied
oi they aie expected piices of hypothetical tiades that might occui in
the futuie. lt depends on whethei one is doing accounting (auempting
a judgment of past action) oi budgeting foi futuie action. Tat is,
past piices expiess past tiading achievements, while expected piices
expiess peiceived potential futuie tiading achievements. Eithei way,
and connecting the two, piices (thiid) enable tiading decisions. lf
expected piices boie no ielationship to the actual piices that mateii-
alized, they would seive no puipose. lndeed theie must be a close
ielationship, close enough to yield a positive net value to the tiadeis
involved on both sides of the maiket, if theie is to be a continuing
maiket. So enduiing tiade in something is evidence that expectations
have not been disappointed to the extent that tiading is no longei
woith while. (On the ineitia of piices, see Mises 1v11uc1z!.)
Changes in piices (actual and/oi expected) thus induce budgetaiy
adjustments. Tey enhance oi iestiict the value of a budget and pio-
duce the familiai individual demand and supply iesponses. And piice
disciepancies (if noticed) piovoke aibitiage activities that, if unim-
peded, would continue until they weie iemoved, until one piice only
weie established. But piice disciepancies aie ofen in the eyes of the
(entiepieneuiial) beholdei, the moie so when such disciepancies iefei
to a compaiison between piesent and futuie piices. Some aibitiage
(foi example, pioduction) oppoitunities may be inconsistent with
otheis and may not succeed. Once again, then, we aim the impossi-
bility of deiiving the necessity of conveiging expectations and piices
in the maiket piocess.
An individual budget has meaning only in teims of the piices that
the tiadei faces (now and in the futuie) and his subjective scale of
values. So, just as with othei institutions, the institution of piice qua
piice must exhibit some peimanence if it is to seive its puipose. lndi-
viduals undeistand what a piice, any piice, is, they undeistand piices
as a phenomenon. lndividual piices aie instances of piice as an in-
stitution. And although they do not ieect equilibiium values, be-
cause they aie contextually meaningful they motivate and facilitate
economic activity.
.c CAPlTAL lN DlSEQUlLlBRlUM
Conclusion: Predictability Together with Disequilibrium
Hayeks notion of equilibiium as peifect plan cooidination is limited
because plans can nevei be completely specied. Tus complete plan
cooidination ex ante is not even logically possible. ln a way, peihaps
iionically, Hayeks own extensive woik on the impoitance of tacit
knowledge and the inheient limits of peiception and aiticulation (foi
example 1v., 1ve) point in this diiection.
Tus we may conclude oui examination of equilibiium by saying
that the maiket piocess in geneial is not equilibiating. Teie is no
tendency foi expectations in general to become moie cooidinated. Ex-
pectations opeiate at many dieient levels, howevei. And at most
of these levels, foi most types of things theie is a tendency towaids
coheience. We tend to coheie aiound ceitain iules of conduct, stan-
daids, categoiies, and othei institutional phenomena, and most of oui
expectations aie thus fullled. We have piedictability togethei with
disequilibiium wheie the lauei iefeis to the chaiacteiistics of the mai-
ket piocess. Diveigent expectations lead, thiough iivalious activity,
to the emeigence of new pioducts and methods of pioduction. ln
this piocess, the pioduction and use of specic capital goods and the
acquisition of the knowledge that enables us to pioduce and use such
goods, play a ciucial iole. We tuin now to a closei examination of this.
PART ll
CAPlTAL, lNTEREST, AND PROllTS
ln Pait ll l considei some of the moie tiaditional aieas of capital theoiy.
Chaptei . discusses the natuie of capital. lt is a cuiious fact about the
concept of capital in economics that economists still disagiee about
what it is. A biief histoiical oveiview suggests that this piobably has
something to do with the evolution of the concept in the context of eco-
nomic evolution moie bioadly. Te tiansition fiom a piedominantly
agiicultuial economy to a piedominantly industiial one, and then to an
incieasingly infoimation-based one, has occasioned changes in the
way in which economists and otheis have thought about pioduction,
and theiefoie about capital. Sometimes concepts appiopiiate foi one
context have been tiansplanted to anothei with unfoitunate conse-
quences. We begin with a look at Adam Smiths coin economy, and
note its inuence on Ricaido and those who followed him. We contiast
the Ricaidian appioach with that of Cail Mengei and the Austiian
School. Te most space is devoted to Bhm-Baweik, aiguably the most
inuential capital theoiist of all. ln Chaptei l look biiey at modein
capital theoiy in the pioduction function liteiatuie and the woik of the
Cambiidge neo-Ricaidians. We will nd, suipiisingly, that both aie in
the Ricaidian spiiit.
ln Chaptei e l examine the iecent woik on capital theoiy of John
Hicks. Hicks stiuggled his whole piofessional life to ieconcile vaiious
appioaches to capital theoiy. ln his last extended auempt he piovides
a veiy inteiesting and useful fiamewoik foi thinking about capital
values in and out of equilibiium.
ln Chaptei l tuin to a discussion of the natuie of inteiest as a
phenomenon. Te natuie of capital is bound up with the fact that
pioduction occuis ovei time. So the question of the ielative valuations
of useful outputs at dieient points of time aiises. Does time itself
.v
u CAPlTAL lN DlSEQUlLlBRlUM
exeit an inuence in deteimining the ielative value of things` lndeed,
we nd that the fact that people aie not indieient to the date at
which they obtain useful things is the essential explanation foi the
existence of the discounting of the futuie which is the basis of all
capital valuations. Tis allows us to distinguish inteiest, which is an
expiession of this time discount (time piefeience), fiom piot.
Piot is seen to be the iesult of unceitainty. lt is the iewaid foi
being iight in an unceitain woild, foi discoveiing an oppoitunity
that otheis had oveilooked. Tiaditionally it has been appioached by
examining a woild in which it would not exist, a woild devoid of
unceitainty. ln such a woild all incomes aie ceitain and can be the
basis of known contiactual ielationships. Such incomes aie composed
in the aggiegate only of the payments foi the seivices of the oiiginal
factois of pioduction, land and laboi, which aie wages and ient, and
of puie inteiest. When we move fiom such an economy to the ieal
woild we can then undeistand that piot is what is lef ovei afei
these contiactual payments have been made. Piot is thus cleaily
distinguished fiom inteiest and ient (on physical capital).
l conclude with some obseivations connecting the capital pio-
cesses (the piocesses of pioduction) to planning piocesses moie gen-
eially and as exploied in the pievious chaptei. Tis lays an impoitant
basis foi oui discussion of disequilibiium theoiies of capital in Pait lll.
CHAPTER .
Capital in Histoiical Peispective
Introduction: e History of Capital eory is Relevant
Consideiations involving capital aie as old as economics itself. And,
peihaps moie than any othei eld in economics, cuiient capital theoiy
beais the stamp of its histoiy. Modein discussions aie veiy heavily
inuenced by the categoiies developed by capital theoiists since Adam
Smith, and by the contexts in which they wiote. Te histoiy of capital
theoiy is a histoiy of complex, ofen esoteiic, intellectual baules. And
moie ofen than not, these theoietical debates about abstiuse technical
issues mask the undeilying ideological dieiences that aie the ieal
issues. But theie is one thing that many of the piotagonists have in
common theii adheience to a fiamewoik in which equilibiium, in
some signicant sense, pievails. ln this chaptei we shall examine some
aspects of the vaiious appioaches to capital that have chaiacteiized
the histoiy of capital theoiy. ln doing so we shall seek (a) to claiify
the signicance, oi lack theieof, of the insights gained fiom the high
points in the development of capital theoiy, (b) to iemove the ambi-
guity that has suiiounded key teims like piot, ient, and inteiest,
and (c) to cleai the way foi a consideiation of capital in situations of
disequilibiiumwheie, it will be seen, many of the tiaditional issues aie
iendeied moot.
e estions
Maiket economies aie sometimes iefeiied to as capitalist economies,
suggesting the piesence of a phenomenon called capital that is in
some way iesponsible foi the chaiactei of the economy and foi its
mode of pioduction in paiticulai. At a geneial level we may want to
1
z CAPlTAL lN DlSEQUlLlBRlUM
say that capital is that which makes pioduction possible. lts oiigins
can be tiaced to the idea of a fund of puichasing powei (owned by
capitalists) which, when made available, allows foi indiiect methods
of pioduction, methods that involve pioduction (oi capital) goods.
Tis can be explained fuithei as follows.
All pioduction can be tiaced logically to the input of laboi sei-
vices and natuial iesouices, what we may call original inputs. Tese
inputs can be used to pioduce useful outputs oi they may be used to
pioduce other inputs. Tese othei inputs, which aie pioduced means
of pioduction, aie thus logically called capital goods. Tey facilitate
pioduction. And since pioducing useful outputs using capital goods
necessaiily takes moie time than pioducing outputs using only oiig-
inal inputs (fiom the vantage point of a moment in time when the
capital goods aie not yet pioduced), the capitalists fund is veiy impoi-
tant in allowing these (advantageous) indiiect methods to be adopted.
(Defendeis of the maiket system, against those who seek justication
foi the eainings of these appaiently unpioductive, non-woiking
capitalists, have ofen pointed to the necessity to iewaid the capitalists
foi paiting with theii wealth in oidei to facilitate these ioundabout
methods of pioduction. Capitalists who own the capital goods diiectly
may be thought of as lending the money to themselves.)
Capital, then, oiiginates fiom the idea of a fund of money that
facilitates the time-consuming use of pioduction goods. But is it the
fund oi the goods, oi both, that facilitate pioduction` Can it be said
that while the capitalists fund facilitates the use of pioduction goods
undei social aiiangements wheie such goods aie piivately owned, it is
the pioduction goods and not the fund that aie tiuly pioductive` lf so,
it seems logical to dieientiate between a capital fund, which is just
an accident of paiticulai histoiical social aiiangements, and capital
piopei which iefeis to the technologically necessaiy instiuments of
pioduction. lt seems natuial fiomthis peispective to think of capital as
a factoi of pioduction along with the oiiginal factois of pioduction
laboi and land. ln modein economics it is thus this physical capital
that is now implied when no qualieis aie used. lt must be iecognized,
though, that individual capital goods can accomplish nothing on theii
own. lt is togethei with othei capital goods and with laboi and land
that they may be seen to be (jointly) pioductive. How, then, aie we to
CAPlTAL lN HlSTORlCAL PERSPECTlVE !
account sepaiately foi the contiibutions of the individual capital goods
to the value that they help to pioduce` And if capital in geneial is
to be thought of as a factoi of pioduction, it seems necessaiy that a
ielationship should be established between the notion of capital in the
aggiegate and the individual capital goods involved in the pioduction
piocess. Te lauei aie diveise and heteiogeneous in natuie and it is not
immediately obvious how one should pioceed to add them togethei. A
logical method is in teims of theii values, theii piices. But, as we shall
see, it is only in equilibiium that such piices have the meaning that we
seek, and even then will not be fiee of contentious ambiguity.
Tus investigations in capital theoiy ofen ietuin iepeatedly to the
same fundamental questions
What is capital`
ls it a sepaiate factoi of pioduction`
ls it a fund`
Oi is it a physical stock`
How is capital to be measuied`
What is the natuie of the eainings of capital`
How is this ielated to inteiest`
How aie capitals eainings deteimined and justied`
What deteimines capitals eainings in ielation to eainings in
geneial, that is, how does capital featuie in the distiibution of
income and wealth geneially`
Tese questions aie ielated to the histoiical development of capital the-
oiy. We illustiate this with a biief impiessionistic histoiical outline.
1
Adam Smiths Corn Economy
Adam Smith was inteiested in the causes of economic piogiess. Teie
is a natuial and impoitant connection between capital and economic
giowth and development. Giowth theoiy had obviously not yet be-
come the technical abstiact specialization that it is today. Yet theie is
a model implicit in his woik (Hicks 1ve!e.z, Kiegel 1vezuz!,
1
Tis is obviously not meant as a detailed oi complete histoiy of thought in capital
theoiy. Such a pioject would iequiie a sepaiate, and piobably much longei, woik.
What follows heie is simply a highlighting of ceitain ideas in theii histoiical context.
. CAPlTAL lN DlSEQUlLlBRlUM
Lachmann 1vve1!u1!z).
z
Smiths woild was still laigely an agiaiian
society, but his implicit model suivived the ciicumstances of his time.
As we shall see, Ricaido in paiticulai tiied to extend Smiths insights
into a woild to which it was much less suited. Tis had signicant
consequences foi the development of capital theoiy. Most modein
economists woiking in the aiea aie inuenced (whethei they know it
oi not) by Ricaidos agenda.
We concentiate on those aspects of Smiths woik that aiise out of
his way of looking at capital in a piedominantly agiicultuial society
(Lachmann 1vve1!u), although, of couise, he was awaie of, and said
much about, the implications of the iapid industiialization that was
occuiiing. An agiaiian economy (we may designate it as a coin econ-
omy) depends laigely on haivests. Next yeais haivest depends, to
a laige extent, on how much of this yeais haivest is plowed back in
seeds and, even moie, on how much coin theie is this yeai. Tis yeais
haivest has thiee possible uses to keep the woiking population alive
and peihaps giowing, to feed the animals used in pioduction, and to
use as seed foi pioduction. Tus, this yeais haivest may be seen as a
type of capital sto. ln a modein economy it is natuial to see elements
of the capital stock at any time that aie not being used, as a iesult of
obsolescence oi incomplete adjustment to new conditions. ln a coin
economy, by contiast, all capital is used, is homogeneous, and is tuined
ovei iegulaily once a yeai. So we have an initial haivest, a woiking
population of ceitain size, and the possibility of a haivest next yeai
that is dependent on laboi and its pioductivity. lt is not cleai what
Smith thought about the deteimination of wage iates. lt is easiest to
assume that he took it to be deteimined by subsistence oi convention
(ibid.1!1).
We may foimalize Smiths model in a iathei simple way (Hicks
1ve!e.z, Lachmann 1vve1!u1.z). Teie is a ciucial ielationship
between this yeais haivest and next yeais haivest. Tis yeais output

oui capital stock foi this yeaiis divided up into seed coin, foddei,
and food pioduction. ln the simplest foimulation, the whole of the
coin that the laboieis uses foi theii (and theii animals) consumption
z
Tis model, desciibed below, is deiived by Hicks fiom Smiths Wealth of Nations,
(1vcz) book ll, ch. lll, Of the Accumulation of Capital, oi of Pioductive and Unpio-
ductive Laboi.
CAPlTAL lN HlSTORlCAL PERSPECTlVE
plus theii planting may as well be counted as theii wage. Te capital
stock then compiises a wage fund necessaiy to keep society going
until the aiiival of the next haivest. Ten if is the numbei of laboieis,
the (aveiage) wage iate =

/ oi

= , = ieal wages pei woikei

Giowth in the coin economy will thus depend on the numbei of woik-
eis and on pioductivity , the amount of coin pioduced (on aveiage)
by each woikei.

+
= =

/ oi
+
/

= /
Tus the iate of giowth is equal to / 1. Tis giowth iate vaiies
inveisely with the wage iate and diiectly with aveiage pioductivity. lf
iises fastei than population, the wage iate can iise.
Tis model neglects to account foi all sections of the economy, foi
example, the towns and the landowneis. lf we assume that < 1 of
any yeais output is set aside each yeai to feed the non-agiaiian classes,
then the wage iate must be

/ = . Te capital stock is now not

but iathei

= . So
+
= ( / )

= ( / )

, and the
iate of giowth is ( / ) 1. Obviously, as foimulated, is a measuie
of the diag on economic giowth imposed by the nonpioductive
elements of society. Tis conclusion is a iesult of foimulating output
as consisting solely of coin and gives iise to some obvious objections.
Tis aspect of Smiths model is of less concein to us at this point,
howevei, than at some otheis.
Smith did not think of , , and as constants. Economic giowth
means that the wage fund giows ahead of population. Smith believed
that would inciease ovei time as a iesult of the division of laboi, thus
causing a iise in . Tus and would giow togethei, though not nec-
essaiily at the same iate. Economic giowth and capital accumulation
in tuin made the division of laboi possible.
Te annual pioduce of the land and laboi of any nation can
be incieased in its value by no othei means, but by incieasing
eithei the numbei of its pioductive laboieis, oi the pioductive
poweis of those laboieis who had befoie been employed. Te
numbei of pioductive laboieis, it is evident, can nevei be much
e CAPlTAL lN DlSEQUlLlBRlUM
incieased, but in consequence of an inciease of capital, oi of the
funds destined foi maintaining them. Te pioductive poweis
of the same numbei of laboieis cannot be incieased, but in
consequence eithei of some addition and impiovement to those
machines and instiuments which facilitate and abiidge laboi, oi
of a moie piopei division and distiibution of employment. ln
eithei case the additional capital is almost always iequiied. lt
is by means of an additional capital only that the undeitakei of
any woik can eithei piovide his woikmen with beuei machin-
eiy, oi make a moie piopei distiibution of employment among
them.
!
(Smith 1vcz!.!)
Tus Smith iegaided saving as necessaiy foi the achievement of eco-
nomic giowth, and the eaining of piot consequent not simply upon
the accumulation of capital but signicantly upon the fiuits of the divi-
sion of laboi. ln modein teims, Smith sees accumulation and technical
piogiess as being tied togethei. And although he seems to identify a
type of diminishing ietuins, this is cleaily not in the foimof a declining
iate of ietuin to investment in a given mode of pioduction, but iathei
iefeis to the eventual possible exhaustion of investment oppoitunities
foi extending the division of laboi (that is, foi the discovery and in-
tioduction of new and impioved pioduction methods) and this leads
natuially to ieliance on foieign maikets.
Smiths coin economy is obviously a special case that iaises a num-
bei of questions. lt is not cleai, foi example, whethei he thinks of
machines, buildings, etc., as capital and how theii accumulation is to
be tieated.
.
Howevei, it is an instiuctive special case. ln this economy,
since capital is homogeneous and is identical to output, theie is no
pioblem conceining the valuation (absolutely oi ielatively) of eithei.
Tus the iate of yield oi of giowth can likewise be measuied unam-
biguously. lt is a one-commodity, subsistence fund economy in equi-
libiium wheie the capital stock unifoimly lasts one peiiod. Duiability
!
lt is woith emphasizing . . . that Smiths concein with economic giowth takes us
back in a sense to the oldest pait of the edice, namely his tieatment of the division of
laboi, the point being that the incieasing size of the maiket gives gieatei scope to this
institution, thus enhancing the possibilities foi expansion, which aie fuithei stimu-
lated by technical change in the shape of the ow of invention (geneial intioduction
in Smith 1vcz!1).
.
But see Ahiakpoi (1vv).
CAPlTAL lN HlSTORlCAL PERSPECTlVE
of capital thus plays no iole. Teie is no question about the appio-
piiate composition oi duiability of the capital stock (although Smith
was awaie of the changing shape of pioductive equipment) and past
mistakes have limited inuence. Teie aie no individual dieiences in
expectations iegaiding the type of pioduct to be expected noi the date
at which it is to aiiive (although of couise theie may be some shoit-
teim unceitainty iegaiding the haivest). Tus, although pioduction
takes time, time does not featuie in the valuation of capital and output,
except in so fai as futuie output may be discounted.

Neithei laboi
units noi time units need to be used to value the capital stock. When
we tuin to Ricaido we see how special these conditions ieally aie.
Ricardos Uniform Rate of Prot
ln the moie industiialized economy of 1c1 it was no longei
toleiable, even as an appioximation, to assume that all capital
was ciiculating capital, noi that, even in a metaphysical sense,
all capital was coin. Te self-containedness of the single pe-
iiod was neveitheless so poweiful an instiument, and so much
depended upon it, that Heiculean eoits had to be made to
ietain it. What Ricaido did, in his eoits to ietain it, can now
be undeistood (thanks to Mi. Siaa). . . . Homogeneity was to
be ietained by ieducing capital to its laboi content (the labor
theory of value), xed capital was to be ieduced to ciiculating
by consideiation of peiiods of pioduction (in the mannei to
be woiked out moie fully, decades latei, by Jevons and Bhm-
Baweik). But all the powei of these devices . . . could not save
the self-containedness. lt is appaient fiom Ricaidos own woik
that even in his hands the static method is alieady conning
itself to its piopei placeto the compaiison of static equilibiia,
even of stationaiy states, it cannot extend to the analysis of a
dynamic piocess. ln the light of the subsequent developments
theie is nothing suipiising about that. (Hicks 1ve.)
As mentioned, Smiths model was essentially a subsistence fund theoiy.
Teie is a stock of food to maintain woikeis fiom one haivest to the
next. What capital does foi the ownei is to facilitate the employment of

Smiths discussion of inteiest (book ll, ch. lV) makes it cleai that he consideis
inteiest to be something dieient fiom piots. We shall ietuin to this question below.
c CAPlTAL lN DlSEQUlLlBRlUM
a ceitain numbei of woikeis foi the pioduction of a ceitain output. All
economic consideiations aie such that one nevei has to look beyond
this one-yeai hoiizon. Tis makes the application of the static method
possible and laigely excludes the consideiation of expectations.
Ricaido had to face pioblems that Smith was able to avoid. Once
machineiy played a laige pait in the economy, Smiths assumption
of a homogeneous capital stock was no longei defensible. Te laboi
theoiy of value seived to biing all economic goods within a common
denominatoi. Ricaido used the laboi houi as a unit of measuiement,
laboi time is the common standaid of compaiison. Machines, coin, and
caule all cost laboi and aie seen to be compaiable in those teims. lf we
have a stock of ciiculating capital (foi example, a stock of coin), we can
ask howmany houis of laboi it took to pioduce it and get a value foi the
input. But if we have a machine lasting feen yeais, although we can
say its pioduction took laboi houis, the total input is not used up in one
yeai and enteis successively into the output of feen yeais. Ricaido
deals with this by iegaiding xed capital, like machineiy, as ciiculating
capital that ciiculates moie slowly. Some pait of the machine gets used
up in each of the feen yeais. lundamentally theie is no dieience.
All capital stocks iotate, it is only a mauei of degiee. lt thus becomes
possible to calculate the value of the inputs of any capital item that
matuies in any given yeai and to compaie it with the value of its output
in that yeai, thus being able to calculate a iate of ietuin.
Ricaidos main concein was with the distiibution of income be-
tween the vaiious categoiies of inputs and theii owneis. lt was in
oidei to give an account of the eainings of capital that he had to nd
some way to ieduce the heteiogeneous capital items to some common
measuie. His basic aigument conceins the tendency foi iates of ietuin
on vaiious capital investments to become equal. Tis tendency pio-
vides a mechanism foi deteimining ows of capital to vaiious types of
pioduction. ln long-iun equilibiiuma capitalistic economy establishes
a uniformrate of prot. Tis is what explains the distiibution of wealth.
ln equilibiium all capital ventuies eain the same iate of piot. Ricaido
thus staited the now common piactice of using what would be the
state of aaiis in a hypothetical situation of long-iun equilibiium, a
situation that is an end state of an indenite numbei of inteiactions
in an essentially unchanging enviionment, as if it weie the eveiyday
CAPlTAL lN HlSTORlCAL PERSPECTlVE v
state of aaiis. Tis is the equilibiium method of explanation. We
speak of the iate of piot on capital as though it weie a paiametei.
Ricaidos conceins ieected his pieoccupation with the futuie of
capitalistic economies. Te event of the Napoleonic blockade and the
consequent iise in food piices led him to wondei about the long-teim
tiend of an economy in which the population was iising. How would
the population get fed` He seemed to accept Malthuss idea that the
population would giow in such a way as to keep the wage iate at
the baie level of subsistence. But if the population was giowing, this
would lead to the use of land of piogiessively infeiioi feitility. So with
the wage iate xed at subsistence level and the maigin of pioduction
being extended to infeiioi land, the eainings (ient) of the landowneis
on the infia-maiginal land would tend to iise. Tis means that the
iate of piot is bound to fall. Pushed to its logical conclusion, the
iate of piot would fall to zeio, at which point capital accumulation
would stop. A stationaiy state would have been ieached. Teie could
be no such thing as peimanent giowth. Te only possible exception
to this iesult is in impiovements in machineiy connected with the
pioduction of necessaiies, discoveiies in the science of agiicultuie,
and inteinational tiade (Ricaido 1v!1zu, Kiegel 1vez.).
Tese exceptions notwithstanding, Ricaidos emphasis and his
legacy aie his method of concentiation on the hypothetical long iun.
lt is this that piompts Lachmann to label both the Cambiidge England
neo-Ricaidians and the neoclassical giowth theoiists as Ricaidians
(Lachmann 1v!). Tey shaie the method of compaiative static equilib-
iium analysis that deiives fiom Ricaido and his inteiest in accounting
foi the laws of distiibution. ln this way the focus is cleaily on the
mechanisms of social development and away fiom aspects of human
action and decision. lf human planning featuies at all in the capital
accumulation piocess, it is in a mechanical and implied way. Action
is ielied on implicitly to biing about the equilibiium that is assumed.
lf some capital ventuie weie to become unpiotable, capital would
be withdiawn and invested elsewheie. But wheie capital is duiable,
it can only be withdiawn veiy slowly. Tus we must assume that no
changes occui while capital is in the (long) piocess of being shifed
fiom aieas of low piotability to aieas of high piotability. And we
aie not peimiued to ask how it is known which aie the aieas of low
eu CAPlTAL lN DlSEQUlLlBRlUM
and high piotability. Somehow the economy is envisioned to giope
its way soon enough to a conguiation of capital items on which the
iate of piot is unifoim and the maximum possible. Reecting on
the discussion of the pievious chaptei, we iealize that in a woild of
continuous unexpected change, ows of capital will not be able to keep
up, and equalization will nevei occui. Piices of the vaiious capital
goods will be such that the oiiginal laboi value invested in them has
no enduiing meaning and the whole Ricaidian basis would seem to be
of dubious ielevance. Relevance iathei than iealism is the key, and
evidently ielevance is ofen in the eye of the beholdei. Ricaidos
long-iun equilibiium method, we shall see, continues to command
many adheients.
ln his discussion of the distinction between ciiculating and xed
capital, Ricaido was foiced to considei the iole of time in pioduction.
His laboi theoiy of value contains the elements of what was to become
a paiticulai appioach to dealing with the time dimension in capital the-
oiy. ln a woild of heteiogeneous capital items, time is of the essence.
A veiy dieient appioach to dealing with it was piovided by Cail
Mengei.
Mengers Time Structure of Production
Mengeis pioneeiing appioach is iesponsible foi oui thinking of capi-
tal in teims of a time structure, ieecting the stiuctuie of capital goods
employed in the pioduction piocess. Teie is no auempt in Mengei to
ieduce the vaiiety of goods and seivices available at vaiious dates to
a single dimension. At any moment in time some goods aie useful foi
immediate consumption, and some aie only useful in so fai as they con-
tiibute to the production of goods available foi immediate consumption.
And since pioduction takes time, a time element is alieady implicit in
the contemplation of a set of economic goods at any single moment in
time.
Mengei thus chaiacteiizes pioduction as a sequential piocess in
which goods of higher order (capital goods) become tiansfoimed into
goods of lower order (consumption goods). Capital goods aie vaiied in
natuie but can be classied by wheie they t, along a time continuum,
into the pioduction piocess. Te lowest oi ist-oidei goods aie, as
CAPlTAL lN HlSTORlCAL PERSPECTlVE e1
noted above, consumption goods. Te lowest-oidei capital goods aie
second oidei. Te next highest aie thiid oidei, and so on. With this
model, he makes cleai that the element of time is insepaiable fiom the
concept of capital. Any theoiy that tieats the piocess of pioduction as
instantaneous necessaiily misiepiesents ieality in an impoitant way.
Te tiansfoimation of goods of highei oidei into goods of lowei
oidei takes place, as does eveiy othei piocess of change, in time.
Te times at which men will obtain command of goods of ist
oidei fiomthe goods of highei oidei in theii piesent possession
will be moie distant the highei the oidei of these goods.
(Mengei 1ve1z)
And the iewaids to saving iesult only if moie time-consuming meth-
ods of pioduction aie adopted.
[B]y making piogiess in the employment of goods of highei
oideis foi the satisfaction of theii needs, economizing men can
most assuiedly inciease the consumption goods available to
them accoidinglybut only on condition that they lengthen
the peiiods of time ovei which theii activity is to extend in the
same degiee that they piogiess to goods of highei oidei.
(Mengei 1ve1!, italics added)
Te highei-oidei goods that people come to own must allow gieatei
pioduction if theie is to be piogiess. Tat is, they must (in combination
with othei goods) be able to pioduce a gieatei volume of consumption
goods in the futuie oi, in othei woids, they must be able to extend
consumption fuithei into the futuie. lt is inteiesting to note that, while
Bhm-Baweiks latei discussion of the gieatei pioductivity of moie
ioundabout methods of pioduction is cleaily diawn fiom Mengei,
the lauei was cleai that theie is nothing mechanical about the iela-
tionship between saving (diveiting consumption fiom the piesent to
the futuie) and pioductivity. Saving may be necessary but it is not
sucient foi economic piogiess. He envisaged the time-consuming
cieation of specic capital goods to be a necessaiy condition foi achiev-
ing economic piogiess.
Mengei ist intioduces these ideas in connection with piocesses
in natuie. People nd the fiuits of natuie valuable. But at an eaily
stage in the development of civilization they leain that they can do
ez CAPlTAL lN DlSEQUlLlBRlUM
moie than simply gathei those goods of lowest oidei that happen to
be oeied by natuie (Mengei 1ve). By inteivening in the natuial
piocesses, individuals can have an eect on the quantity and quality
of the subsequent yield.
To undeistand the objectives of the pioduceis is to undei-
stand that the eailiei a pioducei inteivenes, the gieatei aie the
oppoitunities to tailoi the pioduction piocess to suit his own
puiposes. Tis piovides an intuitive basis foi the notion that
the moie ioundabout piocesses tend to have a gieatei yield
in value teims. (Gaiiison 1vc1e)
lt is impoitant to iealize the iole of subjective value in Mengeis cap-
ital theoiy. Te value auiibuted to any capital good is prospective,
not backwaid looking as with Ricaido. Teie is no necessaiy and
diiect connection between the value of a good and whethei oi in what
quantities, laboi and othei goods of highei oidei weie applied to its
pioduction (Mengei 1ve1.e). At any point in time theie is a capital
stiuctuie chaiacteiized by capital goods of vaiious oideis whose value
is deteimined by the values auiibuted by consumeis to the consump-
tion goods they aie expected to pioduce. Te value of goods of highei
oidei is always and without exception deteimined by the piospective
value of the goods of lowei oidei in whose pioduction they seive
(Mengei 1ve1u). Tese values manifest in the maiket as piices. As
long as these piices iemain (and aie expected to iemain) constant and
as long as theie aie no technical changes in methods of pioduction,
the capital stiuctuie will iemain constant. But if theie should be a
peimanent change in the piice of even one consumption good, this
will almost always imply the need to change the capital stiuctuie in
some way. Changes and substitutions will occui in iesponse to the
peiceived changes in piospective output values.
Te level and pauein of the employment of iesouices (including
laboi) and theii eainings is deteimined and thus depends on the strong
link between the structure of consumption and the structure of production.
Changes in the demand foi one (oi some) consumption good(s) (relative
to others) cause changes in the evaluation and use of particular capital
goods, and in employment. Te implication in Mengei is that the
maiket can accomplish this smoothly.
CAPlTAL lN HlSTORlCAL PERSPECTlVE e!
Time is inevitably involved in the notion of capital. Since the
value of highei-oidei (capital) goods depends on the piospective value
of the consumei goods they aie expected to pioduce, the elapse of
time, and with it the aiiival of unexpected events, implies that some
pioduction plans aie bound to be disappointed and thus the value of
specic capital goods will be aected. Te economic consequences of
human eiioi aie implicit in Mengeis view of capital.
Mengei and Ricaido thus piesent contiasting and ieally iiieconcil-
able visions. Adopting Mengeis peispective, one cannot lose sight of
the vaiiety of goods and seivices and individual activities and choices.
Teie is no suggestion of a unifoim iate of piot. And yet theie is an
inescapable oidei within the vaiiety piovided by oui undeistanding of
the puiposes of these individuals. Te piocess of tiansfoiming goods
of highei oidei into goods of lowei oidei, . . . must always be planned
and conducted, with some economic puipose in view, by an economiz-
ing individual (Mengei 1ve1v1eu). We see heie the need to con-
sidei aspects of inteitempoial planning discussed above in Chaptei !.
No such need was suggested in oui analysis of Ricaidos appioach.
Bhm-Bawerk: Interest and the Average Period of Production
Introduction
Bhm-Baweik is piobably the economist most ofen cited in connec-
tion with the development of capital theoiy. He is thought of as the
fathei of Austiian capital theoiy and ciedited with being the ist
to intioduce the element of time and its implications cleaily into con-
sideiations of capital (Hennings 1vcdz!!). Tis conception neglects
the contiibution of Mengei. Bhm-Baweiks woik on capital was a
conscious extension of Mengeis. His depaituies fiom Mengei aie
not seen univeisally as being an advance.
e
As we shall see, some of
the latei Austiians had ieason to iegiet aspects of Bhm-Baweiks
woik on capital and, even moie so, the inteipietations to which it
gave iise. Wheieas Mengei pioduced haidly moie than twenty-odd
e
Tis statement ielates to Bhm-Baweiks woik on capital. His woik on inteiest
theoiy was cleaily an advance and maiks the beginning of the puie time piefeience
theoiy of inteiest to be dealt with below.
e. CAPlTAL lN DlSEQUlLlBRlUM
pages on capital theoiy (in spite of which it may be said that he laid
the gioundwoik foi a compiehensive theoiy of capital), Bhm-Baweik
pioduced thiee laige volumes and some shoitei woiks. lt was a majoi
pait of his lifes woik. lt is to be expected, then, that the scope foi
vaiious and dieiing inteipietations might be quite laige. Austiian,
Ricaidian, and neoclassical capital theoiists all nd much with which
they can agiee in Bhm-Baweik, albeit much also to disagiee with.
A ieading of Bhm-Baweik ieveals an uneasy amalgam of the ideas
of Mengei and Ricaido. Capital theoiists in geneial have chosen to
emphasize the Ricaidian elements.

Te Mengeiian elements might

just as easily have been emphasized, had capital theoiy developed
dieiently. As it is, modein capital theoiy, with its ieliance on pioduc-
tion function ieasoning, can, with some justication, be tiaced back to
Bhm-Baweik (along with Wicksteed and some otheis). Much of the
ambiguity suiiounding the assessment of his contiibutions ielates to
his use of a theoietical device designed to piovide a physical measuie
of the capital stockthe aveiage peiiod of pioduction.
e Advantages and Disadvantages of Capitalistic Production
Bhm-Baweiks chaiacteiization of a capital-using economy is veiy
similai to Mengeis. Pioduction is a piocess involving time. Oiiginal
factois aie tiansfoimed, with the aid of pioduced means of pioduction,
into consumption goods. Like Mengei, he too conceived of capital
goods as being ielated to one anothei in teims of the stage of the

Howevei much he denied any adheience to classical cost theoiies of value, his
view of pioduction and the iole of capital and time beai the maik of the Ricaidian tia-
dition (Hennings 1vca1u., also Hennings 1vcc). See also Hennings (1vcb11.11)
and Hennings (1vvch. c). Yet considei this same theoiists capsule assessment
A leading membei of the Austiian School, he was one of the main
piopagatois of neoclassical economic theoiy and did much to help it
auain its dominance ovei classical economic theoiy. His name is pii-
maiily associated with the Austiian theoiy of capital and a paiticulai
theoiy of inteiest. But his piime achievement is the foimulation of an
inteitempoial theoiy of value. (Hennings 1vcav, italics added)
Says Kiegel (1vezczv), Bhm-Baweiks iole in the Austiian theoiy was to combine
the Ricaidian appioach to capital in teims of laboi and time with the new maiginal
appioach to piicing thiough utility.
CAPlTAL lN HlSTORlCAL PERSPECTlVE e
pioduction piocess that they occupy. And, like Mengei, he conceived
an inciease in capital to involve a change in the time structure of produc-
tion (not his teim) in some way. lt is not simply an augmenting of each
type of capital good at each level of matuiity (each stage of pioduction),
but a change in the inteinal stiuctuial ielationships. Like Mengei, he
held that capital goods deiived theii value fiom theii usefulness in
the pioduction of consumption goods, theii value was to be deiived
fiom the value to consumeis of the goods they pioduced. All duiable
capital goods aie valued by the piesent value of theii seivices using
a subjective iate of discount (to be discussed below, see Hennings
1vv1!z). He emphasized the heteiogeneity and specicity of individ-
ual capital goods and denied that they could be aggiegated into some
physical measuie of the capital stock. Hennings quotes Bhm-Baweik
as follows
A nations capital is the sum of heteiogeneous conciete capital
goods. To aggiegate them one needs a common denominatoi.
Tis common denominatoi cannot be found in the numbei of
capital goods . . . noi theii length oi width oi volume oi weight
oi any othei physical unit of measuiement. . . . Te only measui-
ing iod that does not lead to contiadictions . . . is the value [of
these capital goods]. (Hennings 1vv1!z, his tianslation of
Bhm-Baweik 1vv)
Bhm-Baweik denies that capital goods aie individually oi intiinsi-
cally pioductive and insisted that the pioduction piocesses that they
make possible aie the souices of any incieases in value that aiise. But
since these piocesses can be chaiacteiized by a seiies of stages of
pioduction successively fuithei back fiom the ultimate consumption
goods in which they culminate, he peiceived a connection between the
numbei of such stages and the amount of value added. Tat is, theie
is a stiong intuition connecting the length of pioduction, indicated by
the numbei of stages involved (the degiee of ioundaboutness), and
the degiee of pioductiveness that iesults.
Teie aie two concomitants of the adoption of the capitalist
methods of pioduction. . . . One is advantageous, the othei disad-
vantageous. We aie alieady familiai with the advantage. With
an equal expendituie of the two oiiginaiy pioductive foices,
ee CAPlTAL lN DlSEQUlLlBRlUM
laboi and valuable foices of natuie, it is possible by well cho-
sen ioundabout capitalist methods to pioduce moie oi beuei
goods than would have been possible by the diiect noncapitalist
method. lt is a tiuism well coiioboiated by empiiical evidence.
(Bhm-Baweik 1vv Book ll, czc!, footnote iefeiences
ciediting Laudeidale and Jevons omiued)
[O]ne thing that can be stated with a ieasonable degiee of cei-
tainty is the pioposition . . . that as a geneial iule a wisely se-
lected extension of the ioundabout way of pioduction does ie-
sult in an inciease in the magnitude of the pioduct. lt can
be condently maintained that theie is no aiea of pioduction
which could not mateiially inciease its pioduct ovei the iesult
obtained by its piesent method. (ibid.c.c)
Bhm-Baweik felt that a moie time-consuming piocess of pioduc-
tion would not be chosen unless it was moie pioductive in this sense,
unless it added suciently moie value to compensate foi the longei
waiting iequiied. Te disadvantage which auends the capitalist
method of pioduction consists in a sacrice of time. Capitalist iound-
aboutness is pioductive but time consuming. lt yields beuei con-
sumption goods, but not until a latei time (ibid.cz). Tus by wisely
selecting moie ioundabout methods of pioduction, incieases in value
can be obtained and these have to be weighed against the cost of
waiting. ln addition, howevei, it is appaient that the ietuins to gieatei
degiees of ioundaboutness must eventually diminish. ln summaiy
All consumption goods which man pioduces come into exis-
tence thiough the coopeiation of human poweis with the foices
of natuie, which aie in pait of economic chaiactei, in pait fiee
natuial poweis. Man can pioduce the consumption goods he
desiies thiough those elemental pioductive poweis. He does so
eithei diiectly, oi indiiectly thiough the agency of inteimediate
pioducts which aie called capital goods. Te indiiect method
entails a saciice of time but gains the advantage of an inciease
in the quantity of the pioduct. Successive piolongations of the
ioundabout method of pioduction yield fuithei quantitative in-
cieases though in diminishing piopoitions.
(ibid.cc)
CAPlTAL lN HlSTORlCAL PERSPECTlVE e
Roundaboutness and the Average Period of Production
Bhm-Baweiks lengthy exposition is geneially impiecise. His discus-
sions can be iead as suggesting infoimal geneial piopeities of ieal cap-
italist economies. Capital accumulation involves judicious changes in
the time stiuctuie of pioduction that fuinish gieatei output value. And
output value is incieased not only by augmenting existing pioducts,
but also by pioducing beuei goods. Both output and input undeigo
qualitative change as opposed to simply quantitatively augmenting
existing piocesses (even though he seems to be assuming a given tech-
nology). And this inteipietation is stiengthened by his connecting the
fiuits of ioundabout pioduction to the division of laboi.
Oui modein system of specialized occupations does, of couise,
give the intiinsically unied piocess of pioduction the extiinsic
appeaiance of a heteiogeneous mass of appaiently independent
units. But the theoiist who makes any pietensions to undei-
standing the extiinsic woikings of the pioduction piocess in all
its vital ielationships must not be deceived by appeaiances. His
mind must iestoie the unity of the pioduction piocess which
has had its tiue pictuie obscuied by the division of laboi.
(ibid.c)
Yet, peihaps in oidei to deal with a vaiiety of ciiticisms, foi example as
to the piecise meaning of ioundaboutness, in the veiy next paiagiaph
Bhm-Baweik nowauempts to make his obseivations moie foimal and
piecise. An auempt to captuie the degiee of ioundaboutness by mea-
suiing a peiiod of pioduction fiomthe oiiginal factois to the emeigent
consumption good would be impossible and misleading in the modein
woild with its vast aiiay of inheiited capital goods. One could not, as
it weie, tiace pioduction back to the moment when the ist ngei is
stiiied in the making of the ist inteimediate pioduct that was latei
used in the pioduction of the good in question, and as continuing until
its nal completion (ibid.ce). And so he intioduces the average peiiod
of pioduction.
lt is moie impoitant, as well as coiiect, to considei the average
time inteival occuiiing between each expendituie of oiiginaiy
pioductive foices and the nal completion of the ultimate con-
sumption good. Apioduction method evinces a highei oi lowei
ec CAPlTAL lN DlSEQUlLlBRlUM
degiee of capitalist chaiactei, accoiding to whethei, on the av-
erage, theie is a longei oi shoitei peiiod of waiting foi the
iemuneiation of the expendituie of the oiiginaiy pioductive
foices, laboi and uses of land. (ibid.ce)
And he pioceeds to dene aiithmetically the aveiage peiiod of pioduc-
tion, which we may succinctly expiess as follows
=

=
( )

= (

)
wheie is the aveiage peiiod of pioduction foi a pioduction piocess
lasting calendai peiiods, , going fiom 1 to , is an index of each
sub-peiiod,

is the amount of laboi expended in sub-peiiod and

=

is the unweighted laboi sum (the total amount of laboi

time expended). Tus is a weighted aveiage that measuies the time
on aveiage that a unit of laboi is locked up in the pioduction piocess.
Te weights ( ) aie the distances fiom nal output. depends
positively on , the calendai length of the pioject, and on the ielation
of the time pauein of laboi applied (the points in time at which
laboi inputs occui) to the total amount of laboi invested .
c
Since this
foimula is in units of time it may be added acioss vaiious piocesses to
yield an oveiall measuie of ioundaboutness. ln this way Bhm-Baweik
hoped to have solved the pioblem of measuiing ioundaboutness.
lt is highly piobable . . . that some fiaction of a woiking day will
have been expended centuiies ago. But because of its minute-
ness it would be a magnitude which would inuence the av-
eiage so liule, that it can almost always simply and safely be
disiegaided. (ibid.c)
And he seemed to place a high ieliance on this foimulation.
Wheievei l have spoken in this oi pieceding chapteis of a pio-
longing of the ioundabout method of pioduction, and of the
c
ln the special case wheie theie is an even ow on inputs so that the same amount
of laboi time,

, is applied in each peiiod,

=
( )

= (/) ( + )

and

and theiefoie = / + / oi simply / (when is laige enough so that the

/ can be ignoied, oi when is expiessed in continuous time wheie it is absent). So,
CAPlTAL lN HlSTORlCAL PERSPECTlVE ev
degiee of capitalist chaiactei, l would have it undeistood that
l mean this in the sense just set foith [the aveiage peiiod of
pioduction] . . . [T]he measuie must be the mean duiation of
the piocess, and that mean must be computed by aveiaging
units, each of which iepiesents a peiiod of time. . . . loi want
of a beuei teim, l shall use aveiage peiiod of pioduction to
distinguish it fiom the absolute pioduction peiiod. (ibid.c)
ln this way Bhm-Baweiks lengthy, intuitive discussion of the natuie
of capitalist pioduction as an incieasing ieliance on pioduced means
of pioduction in specialized pioduction piocesses became associated
with this iathei specic and limited foimula. Tough in actuality a
small pait of his woik as a whole, and aiguably an abeiiation in his
bieadth of vision, it became the focus foi many piolonged and enei-
getic debates in capital theoiy.
Criticizing the Average Period of Production
Some obvious obseivations can immediately be made. Te foimula is
ciucially dependent on being able to identify the stages of pioduction.
lt is assumed that the piocess begins at stage 1 and ends at stage . ln
this way any kind of looping (coal is used in the pioduction of iion
and vice veisa), wheie the output of one stage becomes available as an
input of an eailiei stage, is iuled out. Second, if the output is a ow (as
it usually is), then we must also have some way to connect inputs that
occui at time peiiods with piecisely that output that aiiives at
time peiiod and sepaiate them fiom those that need to be connected
to outputs occuiiing at time peiiods + wheie is an index of time
peiiods occuiiing afei . ln othei woids, if the pioduction piocess is
a ow inputow output piocess, a set of inputs aie used to pioduce
jointly a set of outputs occuiiing ovei time and the measuiing of
becomes moie pioblematic. Similaily, we must be able to identify the
amount of laboi time that is used. Tis obviously piesumes that it is
possible to ieduce any laboi heteiogeneity to compaiable teims, like
eciency units, and then to measuie the numbei of such units supplied
pei peiiod of time. Also, as it is foimalized, the seivices of land aie
when inputs occui at the same iate ovei time, each unit is locked up on aveiage foi
half the length of the pioduction peiiod.
u CAPlTAL lN DlSEQUlLlBRlUM
omiued, although veibally they aie denitely consideied to be pait
of the piocess. Bhm-Baweik adds paienthetically, Let us ignoie the
coopeiating uses of land, just foi the sake of simplicity (ibid.ce). ln-
cluding the seivices of land, while mathematically simple, would iaise
the piactical piospect of accounting foi the vaiying pioductivities of
each unit of land used pei peiiod of time.
v
Tiaditionally Bhm-Baweiks aveiage peiiod of pioduction con-
stiuct, though widely ciiticized, has been populaily used (paiticulaily
in mathematical models, wheie it is easily conveited to a continuous
time foimulation (see labei 1vv, Oiosel 1vc)) as a puiely laboi-time
foimulation, with land neglected. Tus it has come to seem that time
itself plays a iole in the cieation of value, and not the contingent
activities (of humans oi natuie) that must necessaiily occui in time if
value is to be cieated. Oi alteinatively it could, iionically, be iead as an
expiession of the laboi theoiy of value, as suggesting that the essence
of any value is the labor time that went into it. Te aveiage peiiod of
pioduction constiuct thus gave iise to a vision of pioduction quite out
of chaiactei with Bhm-Baweiks vision. His geneial chaiacteiization
of a capital-using economy is in no way dependent on being able to
measuie, piactically oi conceptually, the degiee of ioundaboutness by
the aveiage peiiod of pioduction oi any othei measuie. But, in using it
in the way that he did, Bhm-Baweik (inadveitently) encouiaged the
inteipieting of his woik as suggesting a type of mechanical pioduction
function, in which pioduction time could be used as a measuie of
capital itself, and, theiefoie, of capital intensity. Te pivotal ingie-
dient foi the inteinal consistency of this appioach is the piesence oi
absence of (Hayekian) equilibiium. Tis can be seen by consideiing the
ciiticism leveled by Claik (and in slightly dieient foim a geneiation
latei by Knight against Hayek).
v
lt should also be cleai that this foimula does not allow foi a unique oi monotonic
expiession of ioundaboutness. ln othei woids, (a) this measuie may yield a numbei
that is consistent with an innite numbei of input paueins, dieient amounts of laboi
time occuiiing soonei oi latei in the piocess, and (b) when consideiations involving
inteiest aie included, this measuie may not iise oi fall unifoimly in any ianking of
ioundaboutness as we add laboi-time units at vaiious points, it may change diiection
(in its ianking) at some points undei ceitain conditions if we change the inputs at
vaiious points in the pioduction piocess. Tese types of consideiations played an
impoitant iole in latei ciiticisms of any auempt to measuie capital in physical teims
in the Cambiidge debates which we will examine below.
CAPlTAL lN HlSTORlCAL PERSPECTlVE 1
Bhm-Baweik had auempted to incoipoiate Mengeis vision of
time in the pioduction piocess using a quantiable concept. Claik
(1cv!) (and latei Knight) auacked this concept as meaningless and
indefensible, and, in the piocess, suggested a view of capital in which
time as we know it seemed to play no ieal pait at all. We have seen
that the aveiage peiiod of pioduction can only be calculated when the
pioduction piocess is desciibable in a veiy paiticulai way. A favoiite
example in the liteiatuie is the case of wood pioduction fiom a foiest
in which a xed numbei of young tiees aie planted while the same
numbei of tiees aie cut down each peiiod. lt should be cleai that
it is possible to say that, since pioduction and consumption go on
steadily each peiiod,
1u
they aie in eect simultaneous.
11
Pioduction
and consumption aie synchionized and occui togethei all the time
(Claik 1cv!!1!, 1vcc1.1c, see also Hayek 1v.111.1., 1c1, 1v).
ln this case, it is possible to calculate the peiiod of pioduction. lt is
the time that it takes, on aveiage, foi a tiee to giow fiom a seedling
into a matuie tiee ieady to be cut. lf we assume that this time is the
same foi each tiee, we have an even cleaiei measuie. Claiks ciiticism
can be undeistood to say that this time peiiod is iiielevant since the
foiest is, afei all, a peimanent souice of wood. Since pioduction
and consumption aie in eect simultaneous, the ielevant peiiod of
pioduction is zeio. Tis is the kind of vision that one is oeiing in
suggesting that capital should be thought of as a peimanent fund
1u
ln this case, as in many otheis, pioduction consists in hainessing the piocesses
of natuial biological giowth foi economic puiposes. Tese weie the ist, and in some
ways aie the most fundamental, capital piocesses. Consequently much economic the-
oiizing about capital pioceeds fiom these ist cases to aigue by extension and, moie
ofen, by analogy to othei, moie complex cases.
11
ln this example consumption is equated with the haivesting of tiees. Of couise,
in ieality, tiees aie inputs foi fuithei pioduction piocesses that iesult in consumption
at a latei date, foi example, the manufactuie of pencils. Te essential point, how-
evei, is that the woodlot example above piovides a case of peifectly synchionized
inputs and outputs that, in piinciple, could chaiacteiize othei piocesses wheie inputs
lead ultimately to consumption. Once such a piocess is completely established and
becomes peimanent, an endless and unchanging succession of inputs and outputs
iesults, making it appeai that pioduction and consumption aie indeed simultaneous.
As explained in the text, howevei, this way of looking at the woild is supeicially valid
only as long as theie aie no changes in the paueins of consumption and pioduction.
At any point of time, in any ieal capital-using economy, the capital stiuctuie that
exists will be only paitially adapted to the evei changing pauein of consumption.
z CAPlTAL lN DlSEQUlLlBRlUM
yielding a ow of income. A capitalist economy is then one in which
capital plays this iole.
Accoiding to Knight (1v!e), the peiiod of pioduction, as applied to
the economy as a whole, is always innite oi always zeio, depending
on the peispective that one adopts. ln the foimei case, theie is no
such thing as an oiigin to the peiiod of pioduction. Te infiastiuctuie
of capital goods dates back to Adam and Eve. Teie must always
have been pioduction with the help of some capital goods, and pait
of gioss output was always used to maintain cuiient capital goods and
pioduce otheis. Output is a continuous owthat nevei ends. All social
pioduction is continuous. ln the second case (wheie = 0), time
inteivals aie seen as iiielevant. ln othei woids, we can eithei think
of the pioduction piocess as stietching back fiom the beginnings of
human histoiy and foiwaid into the unending futuie, oi we can think
of the pioduction piocess as essentially timeless, since pioduction oc-
cuis simultaneously with consumption. Tus, Claik and Knight aigued
that it is quite wiong to say that theie aie time inteivals in pioduction.
Consumption and investment take place at the same timethe two aie
concuiient, simultaneous. Te whole thing is a misconception.
lt is cleai, howevei, that this view is valid only foi an economy
that has ieached a state of stationaiy equilibiiuma situation in which
the capital stock has been built up, is suitably maintained, and yields
a continuous income (net of maintenance cost). lt is a woild wheie
unexpected change is absent and all pioduction techniques aie unam-
biguously known. Tis implies that all pioduction plans aie consistent
with one anothei. ln teims of the foiest example, the foiest is alieady
giown and yielding a steady output when oui analysis begins. lt tells
us nothing about the decisions to giow the foiest in the ist place,
when questions ielating to the peiiod of pioduction must have been
impoitant. Pioduction and consumption only appeai to be simulta-
neous to the obseivei who does not caie about the pioduction plans
that gave iise to the pioduction piocess in the ist place. One plants
seedlings today not in oidei to cut tiees today but in oidei to cut tiees
some yeais fiom now. One cuts tiees today only because one planted
seedlings some yeais ago. One cannot ignoie the time element. Wheie
the capital stiuctuie and the aiiay of consumption goods is continually
changing, pioduction and consumption fiequently do not even appeai
CAPlTAL lN HlSTORlCAL PERSPECTlVE !
to be simultaneous. Even wheie we have a simultaneous and peifectly
synchionized pioduction piocess, consideiations of the time stiuctuie
and the decisions ielated to it must still entei. Te posited simultane-
ity of inputs and outputs liteially leaves no time foi an equilibiating
piocess to take [oi have taken] place (Gaiiison 1vc1zv).
Claiks (and afei himKnights) emphasis on the technical and logi-
cal aspects of peiiod of pioduction concepts had the eect of making
capital debates appeai to be about abstiact technical issues iathei than
about ieal economic issues. To concentiate on Bhm-Baweiks (and
latei Hayeks) way of measuiing pioduction peiiods was to diveit at-
tention away fiom his (and Mengeis) vision of the capital stiuctuie as
involving time in the decisions made by producers. lt is these decisions
that aie the ioots of the changes in the capital stiuctuie. Te peiiod of
pioduction that is ielevant is that which is peiceived by eveiy pioducei
individually in the piocess of making a decision. Time enteis into
decisions thiough pioduceis subjective evaluations of the constiaints
and possibilities. Te peiiod of pioduction as an objective constiuct
is inheiently pioblematic, but this is iiielevant foi undeistanding the
impoitance of time, of the fact that dieient consumption goods aie
oi weie available at dieient times. Te capital stiuctuie implies a
time stiuctuie of pioduction. Bhm-Baweik, following Mengei, un-
deistood this even though the Ricaidian aspects of his woik pointed
in a dieient diiection.
Bhm-Bawerk as Neoclassical and Ricardian
Modein iefoimulations of Bhm-Baweik, focusing on his aveiage pe-
iiod of pioduction, have shown how a connection can be made be-
tween his model and a classical and neoclassical appioach (Doifman
1vv, see also Lachmann 1vve1!1.u). lf a measuie exists foi the
capital stock and the iate of ow of output, then the aveiage peiiod of
pioduction can be measuied as / , wheie is the capital stock and
is the output emeiging fiom the pioduction piocess in each peiiod.
(Alteinatively, if the aveiage peiiod of pioduction, , is known oi can
be computed by ieducing all inputs to laboi time, the value of the
capital stock, , can be calculated as we shall see below). Doifman
uses the example of a ieseivoii in a stationaiy situation, wheie the
. CAPlTAL lN DlSEQUlLlBRlUM
inow equals the outow, implying a constant watei level. Cleaily
the quantity of watei can be expiessed in teims of time. loi example,
with 1uu million gallons of watei, z million pei day owing in and out,
this would imply that the aveiage diop of watei was in the ieseivoii
foi ve days. Te iatio of stock to outow is , which is the peiiod of
ietention of each diop. Te same basic logic can then be applied to the
capital stock.
ln teims of the laboi theoiy of value, will be equal to the value of
the laboi expended to pioduce it. Using the same notation intioduced
foi Smiths coin model above, we have = , and the aveiage peiiod
of pioduction = / oi
/ =
Accoiding to Lutz, inteipieting Bhm-Baweik, An inciease in cap-
ital pei woikei in the piocess of pioduction [is] identical with the
adoption of a longei, moie ioundabout method (Lutz 1vev). So, in
modein teiminology, the capitallaboi iatio is veiy simply ielated to
the aveiage peiiod of pioduction and the wage iate. ln a neoclassical
fiamewoik, wheie capital and laboi can be continuously substituted
foi one anothei, changes in and must be in opposite diiections foi
any level of output. is a diiect function of ( is a pioxy foi ), and
(the iate of piot on ) diminishes with . So / = (/ ), with
the ist deiivative positive. lmplicit in this appioach is a pioduction
function wheie output is a diminishing function of the aveiage
peiiod of pioduction , = () (see Hayek 1v.11.u1.1, 1cv, zuc). So
Bhm-Baweik can be seen as pait of the neoclassical tiadition leading
diiectly to modein giowth theoiy, to be exploied below. (See also
Hennings 1vv1..1.c.)
Alteinatively in a classical woild, with a given capital stock and
a given numbei of woikeis, if the wage iate iises, the aveiage peiiod
of pioduction will fall. lf falls, it becomes possible to extend the
peiiod of pioduction. Given the subsistence fund and given the
technique of pioduction, the shoitei the peiiod, the less pioductive
it is. As long as and inciease piopoitionately nothing will change.
and will not be aected. But if , foi example, incieases ielatively
to , oi oi both will iise. Tus capital accumulation puts upwaid
piessuie on the level of wages and the aveiage peiiod of pioduction. ln
CAPlTAL lN HlSTORlCAL PERSPECTlVE
this way, Bhm-Baweik can be seen to have added a new dimension,
a time dimension, to Ricaidos theoiy of distiibution. lf is taken
to be constant (as with Smith and Ricaido), a datum of the constant
technique of pioduction, then the classical conclusion of an inveise
vaiiation between the wage and piot iates and the eainings of laboi
and capital follows.
Further Considerations: Value, Labor, and Equilibrium
Consideiation of Bhm-Baweiks woik as ieducible to symbolic, quan-
titative iepiesentation illuminates some fuithei inteiesting aspects of
peiiod-of-pioduction analysis. Although he pieviously denied that
this was possible, Bhm-Baweik has been inteipieted as pioposing
the aveiage peiiod of pioduction constiuct in oidei to piovide a purely
physical measuie of capital. As we have noted, this involves nessing
the qualitative aspects of laboi and land. But it also ignoies the heteio-
geneity of outputs. Essentially it assumes eithei that the mix of outputs
is xed, oi that pioduction techniques foi the dieient commodities
aie identical and xed, oi that only one output is pioduced. Whichevei
it is, since these assumptions violate the essence of an economy wheie
exchange plays a iole in deteimining value, these consideiations sug-
gest (1) the impossibility of a puiely physical measuie of capital, (z) the
lack of validity of the laboi theoiy of value, and (!) the limitations of
equilibiium analysis.
1. e impossibility of a purely physical measure of capital. Actu-
ally, at an eaily stage Bhm-Baweiks ciitics pointed out that, even in
his simple case of one output and one input (laboi), it is impossible
to obtain a puiely physical measuie when the iole of implicit intei-
est is consideied. Bhm-Baweik puipoitedly showed that if output
is pioduced by homogeneous laboi time ovei a peiiod of time in a
continuous and unchanging fashion, then the accumulated value of
that output can be calculated as a weighted aveiage of that laboi time.
lmplicit in this is the idea that capital acts as a subsistence fund which
has the appiopiiate time stiuctuie to feed the necessaiy laboi. Tat
is, the iight amount of subsistence is available at exactly the iight
time to sustain the laboi necessaiy at each moment in time. Now, if
theie aie alteinative uses foi this subsistence fund, we must conceive
e CAPlTAL lN DlSEQUlLlBRlUM
of it eaining at least a ietuin equal to its next best use. Tat is to say,
the subsistence fund can be imagined to be eaining inteiest ovei time.
When this inteiest is calculated as simple inteiest, acciuing only once
eveiy peiiod, it can be easily shown that it cancels out of the foimula
foi , but when it is acciued continuously, as compound inteiest, as it
should be, then the foimula foi depends on the iate of inteiest (see,
foi example, Lutz 1vezuz1).
1z
Since Bhm-Baweik used the size of
the capital stock as a deteiminant of the iate of inteiest, showing that
the foimei depended on the lauei seemed to involve catching Bhm-
Baweik in a hopeless ciiculaiity. Te unsuipiising tiuth is that the
seaich foi a puiely physical measuie of the capital stock was hopeless
fiom the beginning. Tis was to be belaboied latei by the Cambiidge
(England) capital theoiists who pointed to the fact that (in pait) the
distiibution of wealth deteimined the ielative piices of outputs, and
paiticulaily deteimined the level of wages ielative to piots. So if the
iate of piot equals the iate of inteiest which enteis into the value of
the capital stock, then the lauei is not independent of the distiibution
of wealth. Tus the same physical quantities of vaiious capital goods
will not have a unique value. And, accoiding to the Cambiidge neo-
Ricaidians, since capital thus cannot be measuied in puiely physical
teims, the notion of its maiginal pioduct is meaningless and its eain-
ings aie thus lef unexplained. We shall considei this fuithei in due
couise.
z. e la of validity of the labor theory of value. Tis question,
having been dealt with adequately in the liteiatuie, need not detain us
too long (see, foi example, Hausman 1vc11zu). Signicant foi oui
puiposes is the iole of time. lf two piocesses of pioduction have identi-
cal laboi inputs at identical moments in time, but one must be allowed
some extia time to matuie (like glue diying, oi wine aging), how
1z
Tis can be easily seen as follows. lf units of pioductive inputs aie applied in the
ist and the second peiiods and if only simple inteiest is consideied, then we may use
the equation (+) = (+) +(+) wheie is the iate of inteiest to solve foi the
unknown aveiage peiiod of pioduction . Tis gives . units, which is the same value
as yielded by Bhm-Baweiks foimula, (+) / . Using compound inteiest, howevei,
the equation changes to ( + )

= ( + )

+ ( + ). lf we solve this foi we get

= ((++

)) / (+) which contains the iate of inteiest, (Lutz 1vezuz1).

CAPlTAL lN HlSTORlCAL PERSPECTlVE
can we say that neveitheless they have the same value` lf iesouices
othei than laboi, foi example, physical space, aie needed ovei time,
and these iesouices have alteinative uses, then the extia time taken
will mean that the output iequiiing moie puie time will command
a highei value in the maiket if it is to be pioduced. Time itself does
nothing, but pioduction that occuis ovei time (natuially oi with the
aid of oiiginal non-laboi iesouices) has a value unaccounted foi by
the laboi theoiy of value. Tis ciiticism could peihaps be deected by
a iefoimulation in which all oiiginal inputs aie suitably valued. As
such it amounts to oeiing a cost of pioduction theoiy of value and
goes to the heait not only of issues of piime concein to capital, but also
of issues of the entiie coipus of economic theoiy. loi oui puiposes we
meiely note that cost of pioduction can only be said to deteimine
value in some sense when equilibiium exists, that is, when the value
of the output in the maiket is (as expected) exactly equal to all the
payments to the inputs. Teie can be no capital gains and losses. Tis
biings us then to oui thiid obseivation.
!. e limitations of equilibrium analysis. Te symbolic iepiesen-
tation of Bhm-Baweikian analysis and the ciiticisms that suiiound
it only make sense in an equilibiium context. By this we mean a
context in which pioduction occuis in a continuous and unchanging
fashion ovei time. Teie can be no disappointments iegaiding the
pioduction piocess. Pioduction plans must be explicit and must dove-
tail. lf this weie not the caseif pioduceis, foi example, had dieient
conceptions of what constituted the coiiect method of pioduction
we could not speak sensibly of an aveiage peiiod of pioduction to be
computed fiom a consideiation of input iequiiements. At the veiy
least theie would be as many such aveiage peiiods as theie weie opin-
ions. Similaily, and even moie ielevant, theie can be no innovations
in pioduction methods that iendei iesouices obsolete (in whole oi
in pait). Eveiy such innovation changes the pauein of inputs and
the aveiage peiiod of pioduction implicit in the equilibiium situation
appiopiiate to it. We may wondei what ielevance this ietains in a
woild in which a laige pait of the piocess of capital accumulation is
associated with technological innovation. Tis is something that will
occupy us at some length.
c CAPlTAL lN DlSEQUlLlBRlUM
Conclusion: e Many Faces of Austrian (Bhm-Bawerkian)
Capital eory
Austiian capital theoiy has become synonymous in the liteiatuie with
Bhm-Baweikian capital theoiy. Ricaidians, neoclassicals, and modein
Austiians nd much with which they can agiee and fiom which they
can diaw in Bhm-Baweik. But they aie not the same things. Both
the Ricaidians and neoclassicals focus on some of the technical ques-
tions that suiiound Bhm-Baweiks empiiical insights on the gieatei
pioductivity of ioundabout methods of pioduction. And they inteipiet
these within an equilibiium fiamewoik. Te modein Austiian (maiket
piocess) theoiists, following Mises, Hayek, Lachmann, Kiiznei, and
Rothbaid (and also leuei), focus on some of Bhm-Baweiks less foimal
pionouncements and diaw some ciucial insights fiom them. ln paiticu-
lai these involve the iole of time in pioduction and the natuie of piots
and inteiest. We shall examine this below. But ist we must take note
of some developments aiising out of these vaiious inteipietations of
Bhm-Baweik, notably giowth theoiy and neo-Ricaidian distiibution
theoiy.
CHAPTER
Modein Capital Teoiy
Wicksell and otheis auempted to defend and extend Bhm-Baweiks
appioach (Lutz 1ve, Ebeling 1vv). With the advent of the Keyne-
sian ievolution, howevei, inteiest in capital theoiy waned. lt ievived
slowly in the post-wai peiiod. ln ietiospect we may identify two main
lines of development. One is the familiai neoclassical appioach, in
which capital simply came to be undeistood as an amoiphous stock of
pioduction potential equal to as an aigument in a pioduction func-
tion. Te othei is the iesuigence, emanating fiom the contiibutions
of Joan Robinson (1ve) and Pieiio Siaa (1veu), of the Ricaidian clas-
sical appioach (the neo-Ricaidian School), in which capital and laboi
aie not continuously substitutable foi each othei, and the eainings of
laboi ielative to capital (the piime focus of this liteiatuie) aie seen to
be deteimined by social iathei than economic conditions. Modein
capital theoiy contioveisy consists laigely in the clash of these two
peispectives. lionically, as explained above, both of these appioaches
can be tiaced to the Ricaidian aspects of Bhm-Baweiks woik.
e Production Function Approa
e Production Function as Metaphor
Te pioduction function is a metaphoiical device (Lewin 1vvzcczvu).
lt is a mathematical shoithand expiession foi an input-output piocess.
1
lts use was motivated piimaiily by an auempt to account foi the way
1
[T]he veiy idea of a pioduction function involves the astonishing analogy of
the subject (the fabiication of things, about which it is appiopiiate to think in teims of
ingenuity, discipline, and planning) with the modiei (a mathematical function, about
which it is appiopiiate to think in teims of height, shape, and single valuedness)
(McCloskey 1vcv).
v
cu CAPlTAL lN DlSEQUlLlBRlUM
in which economies giow. lt is the basis of modein giowth theoiy and
of giowth accounting, of the auempt to answei the question What
factois account foi the obseived giowth in the economy, and to what
extent` As such it also answeis the question What explains the eain-
ings of the vaiious inputs and theii owneis` Aggiegate output
is seen to iesult invaiiably and inexoiably fiom the application of
aggiegate inputs and . All thiee have been identied with vaiious
statistical aggiegates. Te classic tieatment is Solows seminal aiticle.
= () (, ) (.1)
wheie the multiplicative factoi () measuies the cumulated eect of
shifs ovei time (Solow1ve.uz). Te shifs in the pioduction function
to which he iefeis imply technical change.
As with the foimulations associated with Bhm-Baweiks theoiy,
it is possible to get caiiied away with the technical aspects of the
pioduction function and to spend time in detailed examination of its
vaiious possible foims (Cobb Douglas, CES, etc.) and theii implications.
A moie chaiitable, and peihaps moie enlightening, way to inteipiet
the giowth theoiy liteiatuie is as an invitation to a conveisation. Te
conveisation is about the best way to desciibe economic piogiess.
Tis is cleai fiom the veiy stait. ln the above foimulation, Solow is
unable to account foi the giowth obseived in (measuied) output by
consideiing inputs of (measuied) and alone. As a iesult he must
look to something else to explain the iesidual. ln this case it is (),
the technical change paiametei. So giowth is a iesult of inputs of
capital, laboi, and technical piogiess. Te subsequent conveisation
is basically about what this means and what these things (capital, la-
boi, and technical piogiess) ieally aie. Te conveisation has, indeed,
been consideiably bioadened in iecent yeais with a ievival of giowth
theoiy which has concentiated on these questions. Because it has
tuined to an explanation of technical piogiess in teims of economically
motivated decisions, iathei than as an exogenous (unexplained) shif
paiametei, it has been called endogenous giowth theoiy (foi suiveys
see Giossman and Helpman 1vvu, 1vv., Lucas 1vvu, Romei 1vvu, 1vv.,
Solow 1vv.). ln the piocess, the meaning and natuie of the pioduction
function and its aiguments (capital, laboi, and technical change) have
MODERN CAPlTAL THEORY c1
come undei closei sciutiny. We can examine this fuithei by taking a
closei look at the implications of the pioduction function appioach.
Constant Returns to Scale and Endogenous Growth eory
Essentially the pioduction function depicts a piocess of physical tians-
foimation of inputs into outputs. To be of any piactical use, the foimof
this tiansfoimation must be indicated. Tat is, it must be able to specify
how the output vaiies in iesponse to changes in the inputs. Te notion
of constant ietuins to scale (CRS) comes to mind. lt seems logical that
if all of the ielevant inputs weie doubled, the output should, as a iesult,
double. And if CRS does pievail, it then follows that ietuins to any one
input factoi that can be continuously vaiied while the otheis aie held
constant will diminish. Tus the eainings of the factoi inputs (and, by
implication, of theii owneis) can be explained by assuming that they
aie paid in teims of the value of theii declining maiginal pioducts.
CRS iests, as Romei (1vvuvc, 1vv.1z) has put it, on the notion of
ieplication. lf all of the ielevant inputs aie coiiectly identied, then it
is possible, in piinciple, to ieplicate (theiefoie duplicate) the piocess.
Te most basic piemise in oui scientic ieasoning about the
physical woild is that it is possible to ieplicate any sequence of
events by ieplicating the ielevant initial conditions. (is is both
a statement of faith and a denition of the relevant conditions.)
loi pioduction theoiy, this means that it is possible to double
the output of any pioduction piocess by doubling all of the iival
inputs. (Romei 1vvuvc, italics added)
Te notion of physical causation (deteiminism) is at the veiy basis
of pioduction theoiy. Tis notion is suiely, as a piinciple, not open
to dispute. lt is almost tautological. lf all the ielevant conditions
(including the necessaiy individual actions, following upon conscious
decisions) that gave iise to (caused) any situation, weie to somehow
be ieinstated, then the veiy same situation wouldalmost by deni-
tionaiise again. Tis is held to be tiue without exception, except foi
the passage of time. ln the physical sciences, when dealing with easily
veiiable and classiable events (like the full moon, the emeigence
of a homogeneous pioduct fiom a pioduction line), the numbei of
cz CAPlTAL lN DlSEQUlLlBRlUM
ielevant (initial) conditions is manageably small. Replication, identi-
cation, oi pioduction of the same event is thus quite simple. ln the
social sciences, howevei, eveiything depends on coiiectly identifying
these ielevant conditions. Although simple, well-undeistood, phys-
ical piocesses, like some pioduction piocesses, aie easily ieplicated,
the tiansition fiom these to the aggiegate economy level is extiemely
pioblematic.
At the veiy simplest level theie is the insuimountable pioblem of
aggiegation of the diveise outputs and inputs and the coiiespondence
of the aggiegate statistical values to the theoietical symbols (suppos-
edly in puiely physical teims). Yet, as indicated above, it is peihaps not
necessaiy to take these foimulations so liteially. Looking at the pio-
duction function as a metaphoiical device inviting conveisation and
speculation, the above consideiations suggest that the conveisation
is about the ielevant initial conditions. Tis can be seen (and has
been cleai, foi example, in application of the HecksheiOhlin theoiy
of inteinational tiade foi many yeais) by consideiing the ielationship
between factois of pioduction and technical piogiess.
Considei a CRS pioduction function in thiee aigumentsland, la-
boi, and capital (, , and ) so that
= (, , ) and = (, , ) (.z)
wheie is a positive scalai. Call this a complete production function. lt
is complete in the sense that it includes eveiy ielevant and necessaiy
input foi the pioduction of the pioduct. loi a complete pioduction
function it is possible to wiite
=

(.!)
wheie indicates the piopoitional iate of giowth of the symbol and

( = 1, . . . , 3) is the shaie of the factoi in (contiibution to) the

giowth of the output .
z
lt must be tiue that

= 1, so that
the factoi shaies fully exhaust the pioduct (accoiding to Euleis law,
if the factois aie paid accoiding to theii shaies, that is, accoiding to
theii maiginal pioducts, theii combined eainings would equal the total
z

, wheie

is the factoi in question.

MODERN CAPlTAL THEORY c!
pioduct). Now if one weie to mistakenly omit one of the aiguments,
say land, , and wiite the function
= (, ) (..)
then this function would have diminishing ietuins to scale. Call this
a partial production function. lt is inconceivable that any actually ob-
seived (measuied) pioduction function should not in some way be a
paitial pioduction function. When we use a pioduction function to
make infeiences fiomobseived statistics, we aie, no doubt, hoping that
the paitial function that we have postulated behaves, in some ciucial
iespects, like a complete one. Doubling and would less than double
since is not doubled. Some giowth would then be unaccounted
foi. lf we auiibuted it to a shif paiametei (), as in the Solovian
function,
= () (, ) (.)
then it would appeai as though giowth weie in pait due to some ex-
ogenous cause (technical piogiess), when in fact it is due to the pio-
ductivity of . Te same exeicise can be applied to a situation in which
some input, call it , acts on output by enhancing the pioductivity
of . Ten a complete function,
= (, , ) (.e)
that omits , as in equation (..) above, will be shifed by exteinal
changes in .
A ielated consideiation is the question of noniival inputs (foi ex-
ample Romei 1vvuv, 1vv.1z). Noniival inputs, of which theie aie
many examples, aie valuable inputs in pioduction that can be used
simultaneously in moie than one activity (Romei 1vvuv). Chemical
piocesses, computei chip design, a mechanical diawing, a metalluigi-
cal (oi othei) foimula, computei sofwaie, etc., aie examples of nonii-
val inputs (ibid.) Tey may be excludable (appiopiiable) oi not. lf is
a set of noniival inputs and is a set of iival inputs (like , ), then
= (, ) (.)
has the piopeities that
(, ) > (, ) = (, ) (.c)
c. CAPlTAL lN DlSEQUlLlBRlUM
that is, theie aie incieasing ietuins to scale because of the exteinal
benets to the piivate accumulation of . Te () in Solows ba-
sic equation (.1) above can also be undeistood as the expiession of
noniival inputs. ldentifying and talking about them iendeis them en-
dogenous.
Growth eory, Input Categorization, Knowledge, and
Equilibrium
Te implications of this discussion should be cleai. liist, tautologically,
all pioduction functions aie CRS when specied coiiectly, that is when
all of the relevant arguments are included. Tus technical piogiess can,
in piinciple, be ieduced to the discoveiy of a pioductive input, oi to
the accumulation of knowledge of how to use existing inputs, and so
on. ln piinciple, it is possible to always account foi any output by a
coiiect identication of all of the ielevant inputs. Second, and moie
impoitant, omission of any ielevant input implies that CRS becomes
much less likely. Solow has iesponded that CRS is not necessaiy.
[T]he model can get along peifectly well without constant ie-
tuins to scale. Te occasional expiession of belief to the con-
tiaiy is just a misconception. Te assumption of constant ie-
tuins to scale is a consideiable simplication, both because it
saves a dimension by allowing the whole analysis to be con-
ducted in teims of iatios and because it peimits the fuithei
simplication that the basic maiket foim is competitive. But
it is not essential to the woiking of the model.
(Solow 1vv..c)
ln othei woids, in the absence of CRS one can still use the notion of
the pioduction function to discuss the natuie and causes of economic
giowth, but the content of the conveisation will be somewhat dieient.
lndeed this is what has happened.
Tiid, this discussion suggests that although one may go to gieat
pains to include in ones measuiements all of the ielevant inputs, one
may not be able to do so adequately because of the multiple dimensions
(the unavoidable qualitative aspects) of the identied factois. So, to be
moie specic, when one includes laboi as a factoi of pioduction and en-
deavois to measuie it by counting the numbei of people woiking and
while adjusting foi the pioductivity of dieient types of laboi, one may
MODERN CAPlTAL THEORY c
miss some vital human capital. luithei, we need not dwell on the
diculties of collapsing the multitude of capital items into a categoiy
called . And with iegaid to land, the simple fact that climate plays
a vital and yet elusive iole in many pioductive piocesses illustiates the
pioblem of the existence of unique, xed factois. One is diawn back
to the pioblem of aggiegation and heteiogeneity. Te pioblem is to
tiy to nd a satisfying categoiization of inputs and outputs such that
economic giowth (piogiess) is consideied to be explained.
Two bioad empiiical obseivations featuie in the liteiatuie as be-
ing impoitant in stimulating economists to ie-examine the tiaditional
categoiizations (Lucas 1vvu, Romei 1vv.). Te ist is the lack of convei-
gence between iich and pooi countiies in economic peifoimance. Te
second is the fact that human capital ows towaid the wealthy econo-
mies in puisuit of highei ietuins. Considei a complete pioduction
function in two countiies, identical in eveiy iespect. ln the absence
of baiiieis to factoi mobility and competitive factoi piicing (so that
each factoi eains a ient equal to its known maiginal pioduct), fac-
toi input iatios should tend to equality as capital ows to its highest
eaining location. Tis should iesult in capital owing to the pooiei
countiies wheie it is scaice, in tuin pioducing a highei iate of giowth
in the pooiei countiies. Te fact that this does not occui suggests that
something is being lef out of consideiation. Te same consideiations
apply to the ow of human capital. As Romei has put it, lf the same
technology weie available in all countiies, human capital would not
move fiom places wheie it is scaice to places wheie it is abundant and
the same woikei would not eain a highei wage afei moving fiom the
Philippines to the U.S. (Romei 1vv.11).
Vaiious explanations have been given. ln one way oi anothei they
involve the bioad notion of dieiences in technology, which means,
in teims of this fiamewoik, dieiences in the pioduction functions
oi the availability of the inputs. But iathei than stop theie, giowth
theoiists have tiied to considei the foices behind the technology diei-
ences. Again Romei Technological advance comes fiom things that
people do (ibid.1z). Technical change, once consideied beyond the
scope of the discussion, has now emeiged as an uigent ieseaich topic.
lt has nally become appaient that economic advance is the iesult of
detailed and dicult, and fiequently seiendipitous, expeiimentation
leading to diamatic but piecemeal innovations, and ways have been
ce CAPlTAL lN DlSEQUlLlBRlUM
sought to incoipoiate this into the analysis of giowth. Te ielationship
of human capital to R&D expendituies and to public goods has been
consideied. ln paiticulai, it has been noted that innovation (of piod-
ucts and techniques) is inextiicably bound up with the manufactuiing
and distiibution piocess (leaining by doing), so that one pioduceis
expeiience may benet anothei. Teie aie exteinal eects to the pio-
duction piocess that manifest in the accumulation of social knowl-
edge, which is a noniival input. Tis suggests, among othei things, that
piivate incentives foi sucient investment in R&D may be lacking
because of fiee-iidei pioblems, but these conclusions have been tem-
peied by the extent of oui ignoiance in this aiea (ibid.1vzu). (Oui
examination of the natuie of knowledge and of innovation will suggest
that the whole pioduction function fiamewoik, as helpful as it may be
as an oiganizei of ideas, is inadequate foi this type of assessment.) Te
existence of exteinal eects, as we have seen, may mean the piesence
of incieasing ietuins to scale and incieasing ietuins to single factois,
like capital. ln these ciicumstances, the accumulation of capital may
be self-ieinfoicing, that is, it may not iesult in a decline in its maiginal
pioduct. Tis is one way to explain the lack of conveigence noted
above.
!
Limitations of the Production Function Framework
Te limitations of the pioduction function fiamewoik aie ielated to
its existence inside of an equilibiium woild. It is in equilibrium in
that the production function is presumed to represent knowledge that is
available not only to the theorist but also, in some way, to the economic
agents of the model. Te outputs aie assumed to follow in a technically
known way fiom the application of the inputs, and the value of the
!
Te pioduction function is used at both the macio and micio levels. lt is
the coie concept in the neoclassical micioeconomic theoiy of the im. As such it
has iecently come undei incieasingly ciitical sciutiny. lf the im is poitiayed as a
complete CRS pioduction function in a competitive maiket then one is at a loss to
explain what limits its size and what makes it dieient fiom othei ims. One is led
natuially then to a discussion of scaice (inimitable) factoi inputs that piovide the
im with a (tiansient oi peimanent) competitive advantage. Te natuie of special
knowledge, ioutines, capabilities, and the like featuie heavily in this exciting liteiatuie.
loi a biief oveiview see Chaptei v below.
MODERN CAPlTAL THEORY c
outputs is likewise known, so that the inputs aie paid the value of theii
maiginal pioducts. Teie is no ioom foi oi analysis of dieiences in
individual valuations of inputs and outputs. (lt will not do to assume
that things aie only known piobabilistically, since this piesumes that
a nite numbei of possible outcomes and theii distiibution is known.)
Teie is no competition as a discoveiy piocess. As noted, giowth
theoiists have tiied to extend this inheiently static appioach in an
auempt to incoipoiate technological change and innovation. Tey
have done this by consideiing R&D, foi example, as anothei (in pait
noniival) input, like , with a known measuiable maiginal pioduct. ln
so fai as R&Dleads to the discoveiy of new techniques and pioducts,
this is a contiadiction in teims. We cannot have futuie knowledge
in the piesent. We may have a geneial expectation (based on past
expeiience) oi a hope that expendituies on R&D will beai fiuit, but
we cannot know ahead of time exactly in what way. lf we did, the
R&D expendituies would be unnecessaiy. While the new giowth
economics has done much to biing these impoitant aspects once again
within the scope of economics, the tiaditional equilibiium fiamewoik
it has used must be judged inadequate to account foi these impoitant
phenomena.
.
Te pioduction function appioach to giowth amounts to noting
that ceitain things (inputs) were (histoiically) piesent that might ac-
count foi the giowth expeiience and aiguably could featuie similaily
in futuie giowth. lt is a black box appioach to the extent that it does
not fully explain the connection, the piocess in time. ln paiticulai it
.
Solowhas peiceptively and piovocatively noted Te idea of endogenous giowth
so captuies the imagination that giowth theoiists just inseit favoiable assumptions
in an uneained way, and then when they put in theii thumb and pull out a plum
they have inseited, theie is a tendency to think that something has been pioved. A
theoiy of easy endogenous giowth implies something like [S]pend moie iesouices
on R&D, theie will be moie innovations pei yeai, and the giowth iate of [in
equation (.1)] will be highei (Solow 1vv.!). lt is Solows judgment that theie is
piobably an iiieducibly exogenous element in the ieseaich and development piocess,
at least exogenous to the economy (ibid.1). As we shall indicate at some length,
innovation, although it may be fosteied oi inhibited by the existence of ceitain insti-
tutional enviionments, cannot be explained in the same way that physical laws and
outcomes can. ln this sense it is exogenous oi, as l piefei to say, autonomous. Tis is
not meant to undeivalue in any way the impoitance of the shif of focus that the new
giowth economics has occasioned.
cc CAPlTAL lN DlSEQUlLlBRlUM
ignoies any extia-economic factois like the political and institutional
enviionment oi, moie accuiately, these aie, at best, implicit in the
analyses. (Howevei, foi an auempt to account explicitly foi these phe-
nomena while iemaining within the pioduction function fiamewoik,
see Scully 1vvz.)
Te pioduction function is a black box also to the extent that it
subsumes individual decision-making. As Kiiznei has noted
A pioduction function can be looked at positively. As such
it iepiesents simply a set of technological ielationships. On
the othei hand, a pioduction function can be looked at as iep-
iesenting opportunities, fiom among which a human being is
able to make a choice. Cleaily an economics in which maiket
events aie seen as the iesults of delibeiately planned actions,
ought to view pioduction possibilities, in this second way, as
alteinatives fiom among which planned couises of action may
be constiucted. (Kiiznei 1vee., see also Hayek 1v.11.)
And in a footnote to this Cuiient piactice geneially (and, as it seems
to us, unfoitunately) follows the technological view. Tis is especially
the case with iespect to aggiegate models . . . this piactice is especially
unfoitunate in the capital theoiy context (Kiiznei 1vee.).
e Neo-Ricardian Challenge
Te pioduction function has pioven to be a veiy iesilient metaphoi.
Even piioi to the emeigence of the new giowth economics, the pio-
duction function appioach was seveiely and, accoiding to some, ef-
fectively, ciiticized by the neo-Ricaidians. Tis debate between the
Cambiidges (England and United States) is well known and has been
widely suiveyed (Blaug 1v., Haicouit 1vv1, Haicouit and Laing 1v1,
Yeagei 1ve, just to mention a few). l will accoidingly not auempt yet
anothei compiehensive suivey oi evaluation heie. Rathei we will visit
this appioach only to take note of an episode in the histoiy of capital
that is instiuctive foi what both sides of the debate took foi gianted,
namely, equilibiium.
ln many ways the challenge mounted by the neo-Ricaidians ie-
vived familiai ciiticisms of the Bhm-Baweikian auempt to measuie
capital. Giowth theoiy is an implicit capital theoiyit includes
as a factoi of pioduction, wheie is some measuie of the pioduced
MODERN CAPlTAL THEORY cv
means of pioduction. ln addition, giowth theoiy appeais to addiess
the ielated question of income distiibution. Because capital, like any
othei input, is subject to diminishing ietuins, it will be accumulated
up to the point wheie the value of its maiginal pioduct just iepays
the oppoitunity cost of its employment, conveniently expiessed, foi
example, by the inteiest cost of the nancing that facilitates it. ln
this way, the neoclassical (pioduction function) appioach suppoits the
impiession that thiif, by pioviding funds foi investment, is a positive
contiibutoi to giowth, in a measuie diiectly ielated to the pioductiv-
ity of capital. Tis, incidentally, also piovided a justication foi the
eainings of capital (owneis of capital) which needed to be paid the
value of its maiginal pioduct if it weie to be wisely invested. Te neo-
Ricaidians auacked these conclusions by auacking the veiy concept
of capital employed. Tey maishaled new and vaiied examples to
show (as we have seen in oui examination of Bhm-Baweiks theoiy)
that capital as a measuiable quantity cannot be conceived of as be-
ing independent of income distiibution and piices. Tey showed, foi
example, that a measuie of the quantity of capital used in any tech-
nique of pioduction vaiied with the inteiest iate at which the inputs
aie accumulated. Tus the same physical items will have a dieient
measuie at dieient inteiest iates. lt is not possible to sepaiate the
value and the quantity of capital. Moieovei, while one technique may
piove optimal at one inteiest iate and give way to anothei at a lowei
inteiest iate, a paiadoxical ie-switching may occui at an even lowei
inteiest iate, wheie the ist technique again may become piefeiied.
Tus, no mauei how one ianked the techniques in teims of capital
intensity (a ciucial notion foi the pioduction function that ielied on
vaiiations in the capitallaboi iatio), one could not, in geneial, say that
lowei inteiest iates would induce moie capital-intensive techniques
of pioduction to be adopted, and one was thus lef without a theoiy
to explain the eainings of capital. (lt is also possible to show that
theie aie cases, even without ie-switching, wheie a fall in the inteiest
iate iesults in a less capital-intensive technique, a phenomenon of
capital ieveising.) Te distiibution of eainings between wages and
piots appeais to be aibitiaiily exogenous to the economy.
Tis is a veiy quick oveiview of the neo-Ricaidian appioach. lt
does not captuie the intiicacies with which its pioponents weie able
to ll many pages. At the end of the day they succeeded in convincing
vu CAPlTAL lN DlSEQUlLlBRlUM
the neoclassicals with theii technical viituosity that, fiom a technical
standpoint, tiuth was on theii side. lndeed, a puiely physical mea-
suie of capital is not to be had in a multicommodity woild wheie
incomes and piices may change. And, indeed, capital ieveising and
ie-switching weie theoietical possibilities. But, as Hicks put it, they
looked like being on the edge of the things that could happen (Hicks
1v!b..). Te neoclassicals ietieated into the woild of the piactical
and appealed to the use of the pioduction function as a self-evidently
useful metaphoi (a paiable, Samuelson 1vez). ln so fai as the question
of how one decides on the peisuasiveness of this metaphoi was lef
unansweied, the debate must be judged as having been inconclusive.
lt is impoitant to note, howevei, the iules of the game undei which
it pioceeded. Neithei side in the debate iaises any questions ielating to
the availability oi use of knowledge oi expectations iegaiding pioduc-
tion techniques. Both adopt the Ricaidian assumption of a unifoim
iate of piot on capital invested equal to the iate of inteiest. Tis
enables both sides to talk about capital eainings as inteiest oi piots as
though these weie the same things. Teie is the implied piesumption
that all economic agents shaie knowledge about investment oppoitu-
nities, so that capital maikets aie always at all times fully aibitiaged.
Teie is no ioom foi dieiences and inconsistencies in plans and valu-
ations. ln fact the ie-switching and ieveising that occuis does not
happen in time. lt is a question of the compaiison between alteinative
equilibiia, between alteinative steady states. As Yeagei has iemaiked
lt is loose but convenient to speak of inteiest iate movements
and of switches between techniques. Stiictly speaking, the dis-
cussion conceins not changes oi events but alteinative states of
aaiis. Tey might best be thought of as pievailing in sepaiate
economies identical in all iespects except those necessaiily as-
sociated with dieient inteiest iate levels.
(Yeagei 1ve!1!n.)
Teie is no analysis of tiansition fiom one equilibiium to anothei.
Tus, although the debate seemed to be about issues in ieal-woild
economies, the ielevance of the models used is veiy questionable. Te
neoclassicals seemed to think that it was a question of the degiee of
substitutability between inputs, which the neo-Ricaidians assumed to
be low (theii models involved disciete substitutability by switching
MODERN CAPlTAL THEORY v1
fiom one xed technique to anothei). Neithei side wondeied about
the ielevance of theii fiamewoik to the maiket piocess as we know it.
Teie is a ielated point (see Kiiznei 1vve). Te neo-Ricaidian cii-
tique is dependent on the idea that inteiest is a ietuin to capital. Te
neoclassical appioach identies inteiest as the suiplus value geneiated
by pioductive capital. Tis piovides a justication foi the incomes
eained by capitalists who aie meiely enjoying the value of what theii
capital has cieated foi consumeis. Te neoclassicals aie then ciiti-
cized because capital cannot be shown to be a factoi of pioduction
whose piice vaiies inveisely with the quantity employed (owing to ie-
switching, ieveising, etc.) Now theie aie two ielated pioblems with
this ciitique, in addition to the question of ielevance noted above. liist,
it should not be suipiising that no measuie of the capital stock that
is independent of piices (the distiibution of income) exists. Capital
piocesses aie composed of a vaiiety of fundamentally incommensu-
iable components applied ovei time. Changes in the iate at which
values aie capitalized and discounted aie bound to yield ambiguous
iesults. Tis, in itself, says nothing about the justication of the eain-
ings of pioduceis. But, second and moie impoitant, the neoclassicals
aie mistaken in theii view that inteiest is the ietuin to capital. We will
show below that it is beuei undeistood as an inteitempoial piice iatio
that expiesses the phenomenon of time piefeience. lf this is coiiect,
then the eainings of pioduceis aie to be undeistood as something
completely dieient. Pioduceis as woikeis eain wages (oi salaiies)
and as entiepieneuis, who add value by fullling consumeis hith-
eito unpeiceived needs, they eain piots. We shall thus have to look
moie closely at the natuie of inteiest, piots, and wages. l do this in
Chaptei .
Summary Conclusion
ln this biief histoiical oveiview we have seen how some of the iecui-
iing questions in capital theoiy have been answeied. We have become
awaie of the iole of time. Capital desciibes a piocess in time. Te
passage of time has implications foi knowledge and expectations. Dif-
feient theoiists have auempted to wiestle with this in dieient ways.
ln Smiths coin economy, with a iegulai known cycle involving one
vz CAPlTAL lN DlSEQUlLlBRlUM
homogenous pioduct, it was haidly ielevant. Ricaido tiied to maintain
the simplicity of the coin economy in a multicommodity woild with
duiable capital (vaiiable pioduction cycles) by imagining the economy
to seule down to some known state of aaiis which is duplicated eveiy
peiiod. Mengeis appioach avoided any explicit consideiation of equi-
libiium and highlighted cleaily the iole of time in any conception of
the pioduction piocess. Bhm-Baweik tiied to combine Mengei and
Ricaido, but since they oeied essentially iiieconcilable views of the
woild, he ended up with moie than one theoiy of his own which, not
suipiisingly, gave iise to a vaiied piogeny. Te pioduction function
appioach as well as the appioach of its most seveie ciitics, the neo-
Ricaidians, aie both, in an impoitant sense, Ricaidian theoiies.
One capital theoiist who dees categoiization is John Hicks. While
woiking in the foimalistic idiom of neoclassical economics he was
always sympathetic to those aspects of the subject that deed foimal-
ization. He was also a giand synthesizei and his woik thus ieects
aspects of many tiaditions. ln his last extensive woik he developed a
fiamewoik that pioves extiemely useful in undeistanding a vaiiety of
issues. Tis is examined in the next chaptei.
CHAPTER e
Te Hicksian Maiiiage of Capital and Time
Reviving the Austrian eory of Capital
John Hicks has wiiuen extensively on capital. ln addition to his thiee
veiy inuential books which have capital in the title (1v.e, 1ve, 1v!b)
he has published numeious aiticles. He was a scholai who ietuined
many times in his life to the same questions, sometimes with dieient
answeis.
1
ln Value and Capital (1v.e, ist edition 1v!v) he ciitically
consideied Bhm-Baweiks aveiage peiiod of pioduction. His Capital
and Growth (1ve) was a seiies of exeicises in giowth theoiy. But,
as with all of Hickss woik, this book contains much discussion of
an infoimal natuie. Tese extended discussions show that he was
thinking caiefully about the implications of time foi the theoiy of
capital. We see it in his intioductoiy iemaiks on methodology, pai-
ticulaily his discussion of equilibiium, we see it in his suivey models
of Smith and Ricaido (summaiized above) and we see it in his concein
about how to poitiay the transition fiom one equilibiium steady state
giowth to anothei, the pioblem of the tiaveise. And then in a seiies
of contiibutions in the 1vus, including his book Capital and Time
(1v!b, also 1ve), he became veiy conceined with time as a topic in
economics. Along with this came a ievived inteiest in the Austiian
theoiy of capital.
Hicks called his new appioach to capital a neo-Austrian appioach.
Tis label does not seem to have been auspicious foi the acceptance
[Tis section uses mateiial fiom Lewin (1vvd).]
1
Capital (l am not the ist to discovei) is a veiy laige subject, with many aspects,
wheievei one staits, it is haid to biing moie than a few of them into view. lt is just
as if one weie making pictuies of a building, though it is the same building, it looks
quite dieient fiom dieient angles. As l now iealize, l have been walking iound my
subject, taking dieient views of it (Hicks 1v!bv).
v!
v. CAPlTAL lN DlSEQUlLlBRlUM
of his appioach. Te modein Austiians did not embiace it (Lachmann
1v!), and the mathematical Bhm-Baweikians (labei 1vv) ciiticized it
foi othei ieasons. ln this chaptei l ie-examine this new appioach. l nd
that it is quite ievealing in a way that peihaps Hicks himself did not fully
iealize, and that much of what we have discussed above in the impies-
sionistic histoiical oveiview comes togethei in Hickss nal tieatment.
His and Time
Hicks had an abiding inteiest in, and a fascination with, the implica-
tions foi economics of the passage of time. His tieatment is ambiguous,
howevei. Hickss auitude to time paiallels in many ways his ielation-
ship to the Austiians (paiticulaily of the maiket piocess vaiiety). lew
economists have been moie inuential. Yet few defy categoiization
as he did. He was at once Keynesian, neoclassical, and, in his veibal
iemaiks if not in his foimal models, he made impoitant concessions
to the Austiians. His ciitics thus had an easy taiget, being able to
nd numeious inconsistencies. liom the one side he was ciiticized foi
being too foimal and mechanistic. liom the othei he faced technical
challenges to his foimal models. He continually walked a tightiope.
We see this in his tieatment of time. He believed in the impoitance
of the iiieveisibility of time. Time is not stiictly analogous to space.
Conceining this iealization he says l have not always been faithful
to it, but when l have depaited fiom it l have found myself coming
back to it (1veze!). One cannot escape the fact that the futuie is not
deteimined in the same way as the past is. How easy it is [howevei]
to foiget, when we contemplate the past, that much of what is now
past was then futuie. Tis has piofound implications foi the meaning
of any time seiies.
Action is always diiected towaids the futuie, but past actions
when we contemplate them in theii places in the stieam of
past events, lose theii oiientation towaid the futuie which they
undoubtedly possessed at the time when they weie taken. We
aiiange past data in time-seiies, but oui time seiies aie not fully
in time. Te ielation of yeai v to yeai 1u looks like its ielation
to yeai c, but in yeai v yeai 1u was futuie while yeai c was
past. Te actions of yeai v weie based, oi could be based, upon
knowledge of yeai c, but not on knowledge of yeai 1u, only on
THE HlCKSlAN MARRlAGE Ol CAPlTAL AND TlME v
guesses about yeai 1u. loi in yeai v the knowledge that we have
about yeai 1u did not yet exist. (ibid.ze., italics added)
One of the fai-ieaching implications of this conceins the theoiy of
capital. Considei changes in the value of the capital stock.
Te value that is set upon the opening stock depends in pait
upon the value which is expected, at the beginning of the yeai,
foi the closing stock, but that was then the futuie, while at the
end of the yeai it is alieady piesent (oi past). Teie may be
things which weie included in the opening stock because, in the
light of infoimation then available, they seemed to be valuable,
but at the end of the yeai it is cleai that they aie not valuable,
so they have to be excluded. Tis may well mean that the net
investment of yeai 1, calculated at the end of yeai 1, was ovei-
valuedat least it seems to be ovei-valued fiom the standpoint
of yeai z. (ibid.ze)
We see heie much with which Lachmann, foi example, would agiee
(see Chaptei c). And similai statements aie to be found thioughout
Hickss woik, paiticulaily in this lauei peiiod. Yet when he ieviewed
Hickss Capital and Time Lachmann focused ciitically on Hickss moie
foimal out of time analysis (Lachmann 1v!). Lachmann all but ig-
noies the potential of the ist two chapteis and much of Pait lll foi a
moie subjectivist appioach, one that incoipoiates aspects of the con-
nection between time and knowledge that he had woiked out.
z
ln what
follows in this chaptei l examine the essentials of Hickss conceptual
z
lt is cleai that Hicks was sensitive to Lachmanns ciiticisms
Most of my ciitics have been . . . equilibiists, but theie is one, foi whom
l have the gieatest iespect, who has opened ie fiom the othei ank.
Piofessoi Ludwig Lachmann . . . is (like Piofessoi Hayek) a chief sui-
vivoi of what l distinguished as the Mengeiian sect of the Austiian
school. lt is cleai that his view of me is like Mengeis view of Bhm-
Baweik. He cannot of couise abide the steady state. Even the modest
uses of it which l have made . . . ll him with dismay. Even the explana-
tions which l have nowbeen giving (and which aie meant, incidentally,
to assuie him that l am moie on his side than on the othei) will, l feai,
fail to placate him. His ideal economics is not so fai away fiom my
own ideal economics, but l iegaid it as a taiget set up fiom heaven.
We cannot hope to ieach it, but we must just get as neai as we can.
(Hicks 1vez, footnote omiued)
ve CAPlTAL lN DlSEQUlLlBRlUM
fiamewoik (fiom Capital and Time) and auempt to diaw out some
of the implications and insights that emeige when inteipieted fiom a
subjectivist (Mengeiian) point of view. Tis fiamewoik is a convenient
and ecient oiganizing device in which all of the vaiious inuences
on the capital foimation piocess come togethei.
A Simple Conceptual Framework
Hicks begins by noting the dieient kinds of capital and dieient kinds
of capital piocesses in which they aie found.
Teie aie dieient theoiies of capital because theie aie vaii-
eties of capital. Te capital, the real capital, of any economy
extends the whole way fiom veiy duiable instiumentsalmost
land, and some would say that land itself should be includedto
goods that aie in the pipeline, goods in piocess of pioduction.
(Hicks 1v!av)
Te old Austiian theoiy (of Mengei and the Mengeiian elements of
Bhm-Baweik) is a goods-in-the-pipeline appioach while the pioduc-
tion function appioaches aie of a quasi-land, xed capital vaiiety. A
satisfactoiy theoiy of capital should be able to encompass both. Bhm-
Baweiks auempt to captuie Mengeis vision used a ow-inputpoint-
output appioach and Wicksell extended this to a point-inputpoint-
output (aging wine) appioach. Tese models aie models of time. Tey
chaiacteiize the pioduction piocess in terms of time (oi, as in the case
of Wicksell, in teims of a capital quantity deiived using time units
quantities of dated inputs). Hicks is conceined to piovide a theoiy
of capital that is in time. Such a theoiy would have to be a ow-
output theoiy. Goods that aie pioduced by the use of xed capital
aie jointly supplied. lt is the same capital good which is the souice
of the whole stieam of outputsoutputs at dieient dates (ibid.vc,
see also Hayek 1v.1e). We have alieady discoveied this pioblem in
ieviewing Ricaidos theoiy.
lf it weie not foi joint supply we could, on the whole, get on
veiy well with a cost of pioduction theoiy of value. So it is
heie. lf it weie not foi the joint supply that is implied in the
use of xed capital, we could get on veiy well with the Bhm-
Baweikian model, in which we associated with eveiy unit of
THE HlCKSlAN MARRlAGE Ol CAPlTAL AND TlME v
nal output a sequence of pievious inputs which have led to
that output, so that the cost of the nal output is iepiesentable
as a sum of the costs of the associated inputs, accumulated foi
each by inteiest foi the appiopiiate length of time. ln an econ-
omy which uses xed capital such imputation is not possible.
(ibid.vv)
!
So Hicks pioposes the abandonment of the peiiod of pioduction
appioach. Teie is no measuie of ioundaboutness.
What we must not abandon aie Bhm-Baweiks (and Mengeis)
tiue insightsthe things that aie the stiength of the Austiian
appioach. Pioduction is a piocess in time . . . the chaiacteiistic
foim of pioduction is a sequence, in which inputs aie followed
by outputs. Capital is an expiession of sequential pioduction.
Pioduction has a time stiuctuie so capital has a time stiuctuie.
(ibid.1uu)
Tus, we dene a production process as a stieamof inputs, giving iise to
a stieam of outputs. A pioduction piocess may be thought of also as a
tenique (foi conveiting inputs into outputs) oi a project. lt may take
many conciete foims, like the building of a factoiy, oi the constiuction
of a machine, oi the exploiation foi oil, etc., followed by the ow of
a paiticulai output (oi set of outputs). Many (most` all`) pioduction
piocesses can be chaiacteiized in this way. lnputs and outputs aie to
be thought of in teims of value (oi expected value), so outputs could
be negative, but it is haidly conceivable that outputs should piecede
inputs at the stait. Hicks asks a fundamental motivating question
What, in geneial, aie the conditions that must be satised in oidei
that the piocess should be viable` (ibid.1uu).
Consideied in this way the question can be answeied by the use of
some simple and familiai aiithmetic which, though simple, has some
!
ln a footnote to this Hicks notes
Te point, it may be iemaiked . . . , is well undeistood by the intelli-
gent accountant. He is well awaie that in the case of pioducts that
aie jointly supplied, the allocation of oveihead costs is aibitiaiy, and
he is also awaie that the depieciation allowances which he makes aie
aibitiaiy, foi they similaily involve an allocation of common costs to
the jointly pioduced outputs at dieient dates. (Hicks 1v!avvn.)
vc CAPlTAL lN DlSEQUlLlBRlUM
impoitant implications. We stait by looking at the situation faced by
the individual decision-makei ex ante. So the input and output values
aie prospects. ln this way we aie auempting to uncovei ceitain geneial
piinciples that aie implicit in any pioduction plan.
Eveiy piocess (oi pioject) has a capital value (familiai as the net
piesent value, NPV). Tis is the discounted ow of the sum of the net
values yielded by the pioject ovei its life. Hicks shows that a necessaiy
condition foi the viability of any piocess as a whole is that its capital
value should be positive (oi at least non-negative) at every stage in
its life (Hicks 1v!a1, 1v!b1uu). ln othei woids the NPV should be
positive whatevei the date foi which we make the calculation. Te
capitalized value of the output ow must always be at least as gieat as
the capitalized value of the owof inputs. lf this weie not the case then
the piocess would be abandoned at the point at which the NPV ceased
to be positive. At eveiy stage in the life of the pioject the question
of its continuation may be iaised. At each point this is essentially an
investment decision. So the pioject will not be continued if the value
of what iemains (the iemaindei) at any date, and contemplated from
any date, is not positive (non-negative). Contemplated at the date of
inception, it is possible to calculate a capital value at each imagined
futuie date in the life of the pioject. What we aie saying heie is that
each and eveiy such capital value, as contemplated by the decision-
makei, must be non-negative. lf even one of them weie negative, that
would indicate that the pioject should teiminate at that date. ln fact
that denes the teimination date.
While this geneial piinciple (we may call it the positive iemaindei
piinciple) must be tiue as an implication of iational planning, as of
the point in time of the decision, it may of couise happen that in
the execution of the pioject the capital value at some point befoie
planned teimination unexpectedly becomes negative. Tis does not
imply that the pioject should be immediately abandoned (although in
ietiospect it would seem that it should not have been staited). Te
piinciple of the iiielevance of sunk costs applies and one would have
to considei it as a newpioject wheie the costs of abandonment (long-
teim contiactual costs, foi example) have to be compaied against the
costs of continuing (Hayek 1v.1cv). Similaily, the capital values at
any point may, duiing the execution of the pioject, tuin out to be
unexpectedly high. Tus we may dene a successful plan as one whose
capital values tuin out as expected (oi beuei).
THE HlCKSlAN MARRlAGE Ol CAPlTAL AND TlME vv
Of couise piesent-value ciiteiia aie well known and aie implied in
all discussions of capital. What Hicks makes explicit heie is the way
in which piesent-value appiaisals change ovei time, specically ovei
the life of the pioject. He addiesses the intertemporal value structure
of a pioject, the logic within a single human plan conceining the ie-
lationship of the capital values at vaiious contemplated dates to one
anothei. So when Lachmann asks What can we say about the ims
pioduction plan in geneial and the pauein of use piesciibed to its
capital combination in it` and answeis, We might say of couise that
the im will act in such a mannei as to maximize the piesent value
of its expected futuie income stieam, but such a desciiption of the
equilibiium of the im is of veiy liule use to us (Lachmann 1vcee.),
he may be undeiestimating the usefulness of thinking in teims of the
inuences on the (piesent) capital value of any plan.
Each plan (oi capital pioject) will have an implicit yield, beuei
known as the inteinal iate of ietuin (lRR). lf the capitalization piocess
is conducted using this iate then the initial value will be zeio, it is the
iate that causes the NPV at the inception date to be zeio. lf the same
iate, the lRR, is used to calculate the capital values at all othei dates,
they will become positive, iise to a peak (oi peihaps a seiies of peaks)
and eventually fall again to zeio at the teimination point. Hicks also
shows that foi piojects dened in this way the lRR is unique (Hicks
1v!bzz, but see the discussion below following the next section). Te
foiegoing can be gieatly claiied with some basic algebia.
Formalization
We denote input values and output values at time (contemplated at
time u) as

and

. Also,

wheie

is the piice and

is the quantity of input at time , assum-

ing a set of ( = 1, . . . , ) inputs.
.
loi convenience we will suppiess the
.
One may think heie of a pioduction function like

= (

, . . . ,

) at each
point in time . Te meaning of the

will depend on the context. Wheie we think of

all factoi inputs as ieducible to the original inputs in a soit of macio context, then
they aie of the foimof laboi and land. Consideied as a component of an individual
pioduction plan the

must include pioduced inputs, that is capital goods.

1uu CAPlTAL lN DlSEQUlLlBRlUM
subsciipt, assuming only one type of input, and wiite

without
loss of geneiality (alteinatively and may be thought of as vectois).
Similaily, we wiite

, wheie is the piice and the quantity

of the output.

loi convenience we dene

as the net output

value at any date . We denote the capital value at time by

+
+

+
+

+ +

()
=

+
= (

) +

+
(e.1)
wheie = 1 + , and is the pei peiiod iate of inteiest, oi moie
accuiately, iate of discount. Tis says that the capital value at the
beginning of any sub-peiiod (

), which is the discounted value of all

of the iemaining net outputs, can also be calculated as the net value
of the output of that peiiod (

) plus the capital value of the

iemaindei, foi sub-peiiods afei (

+
). And this holds foi any
value of .
Hicks now oeis what he calls the lundamental Teoiem it is
always tiue that a fall in the iate of inteiest (iate of discount) will iaise
the capital value of any pioject thioughout (that is, as calculated at any
date ), while a iise will lowei it. Te pioof follows fiom equation (e.1)
and it is instiuctive to iepioduce it heie at some length.
[S]uppose that the s aie unchanged but that falls, so that
the discount factoi iises. We see at once . . . that

is bound to
iise, piovided that
+
is positive, and piovided that
+
is not
ieduced by the fall in inteiest. But a similai aigument applies to

+
. Tus we may go on iepeating, up to the end of the piocess,
wheie

. Tus

is unaected by the fall in , so

must
be iaised, and theiefoie

must be iaised, and so on, back to

. So long as all the

s aie positive (as we have seen that they

must be, in oidei that the piocess should be viable), eveiy

(0
to 1) must be iaised by the fall in the iate of inteiest.
. . . We have taken it foi gianted that the duiation of the
piocess iemains at (+1) weeks [sub-peiiods], even though the
iate of inteiest falls. But it is immediately cleai that even if the
duiation is vaiiable, it cannot be shoitened. loi since we have

loi a multipioduct im,

, wheie theie aie , . . . , outputs. As with

may be conceived of as the vectoi pioduct of the vectois

and

.
THE HlCKSlAN MARRlAGE Ol CAPlTAL AND TlME 1u1
shown that with unchanged duiation, eveiy

( < ) will be
raised, it must still be advantageous to go on foi at least the
same duiation, at a lowei iate of inteiest. All that is possible is
that the piocess may be lengthened.
But the piocess will only be lengthened if
+
(which was
zeio at the highei iate of inteiest) becomes positive at the lowei.
Tat can happen, if the lengthening iequiies some net input
(iepaiis, foi instance, which only become piotable when the
iate of inteiest falls). lf it happens, howevei, all eailiei

must
be iaised, a fortiori. So the Teoiem continues to hold when
duiation is vaiiable. (Hicks 1v!bzuz1)
Tis chaiacteiization of a capital plan thus shows, in the ist instance,
how the planneis appiaisal will be aected by changes in the discount
iate applied. But it is equally cleai that this appiaisal will depend on
all of the othei conditions that chaiacteiize the pioject. loi example,
if the piices of the inputs

weie to iise (oi be expected to iise) the

capital values would fall. Similaily a iise (expected iise) in the piice of
the pioduct would iaise all

. Changes in technology may aect these

piices, by aecting piocesses elsewheie in the economy, oi they may
change the pauein of inputs,

, iequiied.
Te value of foi which

= 0 is the lRR. Tis can be thought

of as the yield of the pioject. lt iepiesents the minimum that would
have to be eained on any alteinative pioject if this one weie to be
abandoned in its favoi. lf wages

weie to iise (unifoimly) all of

the

would be ieduced. Tis implies that the yield of the pioject, its
lRR, would fall. Tus foi a given pioject (oi set of piojects) theie is
a tiade-o between changes in and , othei things constant. Tis
is the sense in which the neo-Ricaidians peiceive the existence of a
factoi piice fiontiei dening dieient equilibiium distiibutions of
income between the factois of pioduction. Consideiing hypothetical
changes in and changes in necessaiy to compensate foi these
changes (by keeping

= 0), one can imagine situations in which one

technique, while dominant at a given level of , loses its dominance as
falls and then iegains it again as continues to fall with iises in . Te
signicance of this is fai fiom cleai, howevei, given that any pauein of
inputs

is, in piinciple, possible. Also, theie is no unambiguous way

in which we can decide which pioject, oi technique, is moie capital
intensive (see the discussion in Chaptei ).
1uz CAPlTAL lN DlSEQUlLlBRlUM
Moieovei, it is impoitant to note that in the context we have devel-
oped above, cannot be taken to be the price or rate of earnings (prots)
of capital. Te vaiiable is the iate of discount applied to the oveiall
eainings of the pioject at dieient dates. ln fact the identication of
as wages is a teiminological simplication that in no way assumes
that all of the inputs aie ieducible to laboi. lncluded among the

inputs aie pioduced means of pioduction. Te vaiiable

ieally iefeis
to wages and rents on capital goods. Te neo-Ricaidian fiamewoik
thus (fiom oui peispective) seems to be piedicated on an untenable
view of the natuie of the eainings of capital. We shall ietuin to this
below.
Looking Forward and Looking Baward
lt should be emphasized that the view of the pioduction piocess pie-
sented above is a foiwaid-looking one. All of the values aie piospec-
tive. We may even think of each pioject as a capital prospect. As such
theie is an unavoidable, but ofen suppiessed, speculative element to it.
Teie is at least one othei possible way to look at pioduction piocesses
in time, that is, retrospectively, as a result of capital invested. liom
equation (e.1),

+ +

()
+

(e.z)
foi any value between 0 and . Using the lRR in ,

= 0, so,

= (

+ (

+ + (

) (e.!)
Looked at this way,

is the sum of the net inputs,

, fiom 0
to 1, accumulated by inteiest up to peiiod . Tis captuies the idea
of inputs matuiing at a iate equal to the lRR and emeiging as a nal
output.
loi plans that aie successful, in the sense that the capital values

tuin out to be exactly equal to what they weie expected to be, when
discounted or accumulated using the lRR, it should be cleai that the
two ways of looking at capital (piospective and ietiospective) aie ex-
actly equivalent, they desciibe an ongoing and, in an essential sense,
unchanging piocess. Tis is what the assumption of a steady state buys
THE HlCKSlAN MARRlAGE Ol CAPlTAL AND TlME 1u!
us, namely that the piocessall piocesseslook the same at all points
of time and for all points of time. ln the steady state, since all plans
aie successful in this sense, the inteiest iate on loans must be equal to
the (known) yield on piojects, and the lauei must be unifoim (foi any
given investment peiiod) acioss piojects. We aie back to a Ricaidian
woild.
We note in passing that the neoclassical pioduction function ap-
pioach is a steady-state appioach in this sense. Equation (.1) can be
wiiuen

() (

) (.1

)
inseiting time subsciipts to indicate an ongoing piocess in time, oi

() (

)
if we allow foi time lags.
We thus have an identical seiies of inputs (piopoitional to the
stocks of factoi of pioduction) and outputs in eveiy peiiod . Changes
in the inputs will cause changes in the outputs once and foi all. Te
piocess looks the same fiom all points of time.
Hicks is ciitical of the steady state
l am veiy skeptical of the impoitance of such steady state
theoiy. Te ieal woild (peihaps foitunately) is not, and nevei
is, in a steady state. . . . A steady state theoiy is out of time,
but an Austiian theoiy is in time. (Hicks 1v!b1uv)
And he goes on to explain that a theoiy that is in time would have
to take note of histoiy, would have to include inheiited histoiy, in-
cluding the inevitably less than optimal capital stock, as a cause of
subsequent events.
loi a theoiy that is in time, peispective maueisthings look veiy
dieient fiom dieient points of time. Most specically, any piocess
having a yield that is gieatei than the maiket iate of inteiest on loans,
which it would have to have to be undeitaken in the ist place, would
have the piopeity that the capital value measuied foiwaid (piospec-
tively) will be gieatei than the backwaid (ietiospective) measuie. And
this will be tiue even at point 0 wheie

= 0 measuied foiwaid. Tis

is a basic implication of iational planning. lf a piocess is successfully
1u. CAPlTAL lN DlSEQUlLlBRlUM
being caiiied out, and if its yield is gieatei than the inteiest iate, a
capital gain will accrue at ea stage of the process. Suiely this is the
ieal meaning of piot. Te existence of piot, in this sense, absolutely
depends on a disequilibiium between the yield and the inteiest iate.
And this can peisist only if theie is no steady state, if theie is no
unifoim (zeio by this denition) iate of piot. Te existence of piots
implies dieient (vaiying) expectations.
Technical piogiess will imply that the yield on new piocesses (em-
bodying the new knowledge) will be above old piocesses (those pio-
cesses that do not). Old piocesses will, if theie is enough time, be
ieplaced by new ones. Te capital stock, the stock of tangible things,
will, at any point of time, ieect the accumulated iesults of past gains
in knowledge. Although this is inimical to the steady state, eveiything
that has been said above iegaiding the chaiacteiization of piojects,
techniques, and piocesses that make up capital, iemains valid.
Social accounting, howevei, can only be done consistently in a
steady state. Out of the steady state (a limiting case of which is the
Ricaidian stationaiy state) it is stiictly impossible to deiive aggiegate
values foi capital and theiefoie foi output (since the value of output de-
pends on the value auiibuted to capital maintenance). Hicks explains
this and then pioceeds to assume a steady state in oidei to exploie
aspects of social accounting and tiansitions between such states. Tis,
no doubt, is the ieason foi his less than waim ieception at the hands
of modein Austiians. Neveitheless, his simple aiithmetic fiamewoik
ieveals a lot, even foi those who believe that the maiket piocess should
be analyzed as a disequilibiium phenomenon. Hickss fiamewoik sum-
maiizes nicely the vaiious inuences on the individual valuations of
any capital piojects, including the valuations of any components of
that piocess, like the individual capital goods, and aleits us to be cau-
tious in concluding too ieadily what the eects of changes in inteiest
iates, wage iates, pioduct piices, oi technologies might be. Similaily,
it can accommodate consideiation of qualitative changes such as the
discoveiy of a new input oi pioduct. Ultimately eveiything can be
analyzed in teims of the eect on the valuation of the paiticulai pioject
undei consideiation. loi the economy as a whole, the vaiiables in
the fiamewoik, iathei than being paiameteis, will be inteiielated. An
inciease in the demand foi a paiticulai pioduct, foi example, will have
implications foi the piices of the inputs into its pioduction. But the
THE HlCKSlAN MARRlAGE Ol CAPlTAL AND TlME 1u
piecise eects will depend on the paueins of complementaiity and
possibilities foi substitution that chaiacteiize the pioduction piocess.
Teie is no simple law of deiived demand foi the economy as a whole
(Hayek 1v.1appendix !, many of the questions consideied by Hayek
1v.1 can be analyzed much moie succinctly within Hickss fiamewoik).
We shall be able to make fuithei use of Hickss appioach.
Conclusion: Capital Planning
Hickss fiamewoik piesented above is a convenient way to think about
capital. lt is fully consistent with a modein Austiian appioach as
developed, foi example, by Lachmann and Kiiznei. Accoiding to this
appioach, capital must be thought of in teims of inteitempoial plans.
We must make a distinction between capital goods and capital as an
abstiact categoiy. Te lauei iefeis to the value to be auiibuted to a
paiticulai plan oi set of pioduction plans. Te piots oi losses to
be auiibuted to a pioduction plan aie the iesult of changes (oi the
absence theieol) in the capital values auiibuted to it ovei time. Tese
appieciations (oi depieciations) in value aie, in tuin, the iesult of (aie
deiived fiom) changes in consumeis evaluation of nal pioduction.
Te meaning and the value of any paiticulai capital good deiives
fiom its position in a paiticulai pioduction plan. Te identication
of a iesouice as distinct fiom othei physical things, cannot be made
without iefeience to human puiposes (Kiiznei 1vee!c). All capital
goods aie, in eect, an expiession of unnished plans (ibid.ch. 1).
As such, these capital goods can be valued by what they add to the
value of the plan. Te value of any income souice is deiived fiom
the income it is expected to pioduce, so the value of any capital good
is familiaily thought of as being equal to the discounted value of the
estimated income it adds to any pioduction planthe discounted value
of its maiginal pioduct.
All pioduction plans aie aected by, among othei things, changes
in the iate of discount that is peitinent to the plan. A fall in the
discount iate will inciease its value, a iise will deciease it. Tus if
iates of discount aie aected geneially by macioeconomic changes,
notably changes in inteiest iates, these may be expected to have a
geneial eect on the expected value of existing and planned capital
piojects. ln paiticulai, those piojects with the longest time hoiizon
1ue CAPlTAL lN DlSEQUlLlBRlUM
will be most aected. (Tis is well known and expiessed in the piopo-
sition that the elasticity of piesent value is highei, the highei the time
hoiizon.) lt is impoitant to iemembei that the discount iate is only one
of the vaiiables that aects the capital values of any and all piojects.
Hickss appioach has the viitue of pioviding us with a paiticulaily
cleai fiamewoik in which the vaiious inuences may be ievealed. So
we might wiite a geneial capital value (vectoi) function as

(, , , , , )
indicating that is only one of the deteiminants of

, is peihaps
especially impoitant because of its macioeconomic signicance as the
indicatoi of the ielationship between piesent and futuie piices of con-
sumption goods. Howevei, the stiuctuie of piices and wages in geneial
may aect the pioject (thiough and ) and technology obviously
maueis ( and ). Hickss appioach gives a compiehensive pictuie.
Appendix: e Meaning of the Internal Rate of Return
Te iate of ietuin on any investment is a concept that is widely used
and has high intuitive appeal. We pause heie to considei it a liule
moie caiefully. We shall see that it is not quite as stiaightfoiwaid as it
appeais on the suiface, and that many aspects of its meaning aie, and
must be, imposed on it by the decision-makei.
Hicks piesents aiguments foi the existence and uniqueness of the
lRR. Any viable piocess must be viable foi = 0, if its inputs and
outputs aie undiscounted, its

must eithei be zeio (in which case = 0

is its inteinal iate of ietuin) oi it must be positive. But in the lauei case,
if the iate of inteiest iises . . .

steadily diminishes, and must nally

be ieduced to zeiosave in one special case . . . when

is positive
(oi zeio) which is a case of pioduction without capital. lf

is
negative, and

is positive (as it must be if

is not to be negative), it
is inevitable that

should ultimately be ieduced to zeio by a iise in the iate of inteiest.

So an lRR exists. Te lRR is unique because the lundamental Teoiem
applies as much to

as to any othei

. lf we stait fiom a iate of

THE HlCKSlAN MARRlAGE Ol CAPlTAL AND TlME 1u
inteiest which is such that

is zeio (the othei s being positive), any

ieduction in the iate of inteiest must inciease

. So

cannot be zeio
again at any lowei iate of inteiest (Hicks 1v!a1.u and 1.un.)
lt seems that Hicks obtains this iesult because of the way that he
denes a pioject as a seiies of positive yields ovei time (foi each peiiod
except the ist). Tus a negative yield (positive outlay) can be used to
demaicate the stait of a new pioject. liom a moie geneial peispective
the lRR need not be unique.

+ +

= 0
=

= 0 (looking foiwaid fiom 0 to )

thus

= 0
oi
0 =

+ +

(looking backwaid
hypothetically fiom )
Te last line can be wiiuen
0 =

+ +

(e..)
Wheie the

aie lineai combinations of the

and , and, it will be

iemembeied, = (1 + ). Equation (e..) is an th oidei polynomial,
with the ioots equal to the lRR(s). Geneially theie will be moie than
one ioot the numbei of ioots will be equal to the numbei of changes
in sign of the coecients (

) at most (l owe this appioach to the

lectuie notes of Piofessoi L. Sjaastad of the Univeisity of Chicago).
Since Hicks has assumed one change in sign, theie is only one lRR.
Te use of an lRR is, at bouom, a mauei of convention. lt de-
pends not only on how one divides up a pioject ovei time, but also
on assuming that the inteinal yield is the same foi each subpeiiod.
lt seems intuitively cleai, howevei, that the individual plannei must
have in mind some benchmaik against which to test (subjectively) the
auiactiveness of a pioject in compaiison, foi example, with investing
in the maiket. Each plannei will dene his own boundaiies.
CHAPTER
Te Natuie of lnteiest and Piots
Introduction
Te above discussion claiies, l hope, the natuie of capital and some
of the issues that suiiound its chaiacteiization. lt will be iemembeied
that the iate of discount featuied in consideiing the capital value of
any plan. Tis is sometimes also iefeiied to in the liteiatuie as the
iate of inteiest oi the iate of piot. Te question aiises then as to
the natuie of inteiest as a phenomenon, and the ielationship between
inteiest and piot. As basic as this is, it iemains a souice of confusion
in economics. Once again, the iole of time is cential. What is the con-
nection between inteiest and time` Many theoiists have seen inteiest
as being deteimined by the technological chaiacteiistics of pioduction,
by pioductivity, in ielation to the willingness of consumeis to abstain
fiomconsumption, to save. ln the conventional wisdom, inteiest is the
iesult of pioductivity and thiif. While theie is a sense in which
this is tiue, a closei and deepei examination ieveals that, in a moie
fundamental sense, the phenomenon of inteiest per se has nothing to
do with pioductivity. Rathei, inteiest is the iesult of the essential
natuie of time and the way that we expeiience it. Tis viewpoint
is sometimes called a puie time piefeience theoiy (PTPT) of inteiest.
And inteiest is to be cleaily distinguished fiom piot which, as we
have tiied to show, is the iesult of changes in capital values that ieect
the implementation of successful capital investments in an unceitain
woild, wheie expectations diei.
ln this chaptei l ie-examine and ie-evaluate the PTPT of inteiest.
While l endoise it in the main, it seems to me that some of its piopo-
nents have peihaps fosteied confusion by the way in which they have
piesented it. l then tuin to a discussion of piot.
1uv
11u CAPlTAL lN DlSEQUlLlBRlUM
e Pure Time Preference eory of Interest
e Interest Problem and its Resolution in Terms of PTPT
Restated
Te PTPT is notable foi its obscuiity (fiom the viewpoint of modein
iival theoiies)
1
and foi its iesilience. lnteiest in it has iecently iesui-
faced as pait of the development of Bhm-Baweikian capital theoiy
(see labei 1vv, Pellengahi 1vcea,b, 1vve) and has been peiiodically
ievisited in the piocess of the development of Austiian maiket pio-
cess theoiy (Yeagei 1vv, Gaiiison 1vva,b, 1vcc), and most iecently by
Kiiznei (1vv!). Muiiay Rothbaid is well known foi his defense of the
PTPT (see foi example Gaiiison 1vcc) deiived fiom Mises. We begin
heie with a biief iestatement.
lf an income souice (a capital asset) is known to yield a steady
income foi a nite peiiod of time, why does the piice of the souice not
equal the sum total of the incomes eained ovei the life of the asset` So,
to be moie specic, a machine may be assumed to yield a net income
of s1uu a yeai foi ten yeais and then be ieplaced by a new model.
z
Why can the machine not be sold foi s1,uuu` Tis is a simple way of
foimulating the geneiic pioblem. lf the value of an income souice is
deiived fiom the value of the income it yields, why is the souice not
[ln this section l use mateiial fiom Lewin (1vvb).]
1
At the veiy heait of the teiminological thicket is the use of the woid inteiest in
at least two dieient contexts. Te same woid is used foi a desciiption of the iates
eained and paid on money loans in actual ieal-woild economies and foi a desciiption
of the value piemium of piesent ovei futuie goods in a hypothetical woild devoid of
unceitainty and change, although in the case of the lauei, qualieis like oiiginaiy,
puie, neutial, and natuial aie sometimes added (notwithstanding that these quali-
eis aie used as well by dieient theoiists to mean dieient things). See, foi example,
Rothbaid (1v11c). On the one hand the phenomenon of inteiest is something
with which we aie all, in oui eveiyday lives, veiy familiai. On the othei hand, if we
study economics we aie told by PTPT theoiists that inteiest, while ubiquitous and
ciucial to the functioning of any maiket economy, is nothing we can actually obseive
because it is hopelessly mingled with piots and losses, ination (piice) piemiums,
and unceitainty piemiums (Mises 1veez!, Rothbaid 1vu!z1).
z
We leave aside the question of how we know that the machine is the souice of
the income. Stiictly speaking, we should say that the use of the machine togethei with
othei pioduction goods adds s1uu to income each yeai. ln familiai teims the maiginal
pioduct of the machine is valued at s1uu pei yeai. Tis will be exploied fuithei below.
THE NATURE Ol lNTEREST AND PROllTS 111
valued at the sum total of the income yielded ovei its life` Suiely, at
any piice below s1,uuu someone could buy the machine and eain an
income in excess of the piice paid, a suiplus. Why is this suiplus not
competed away`
Te answei piovides the identication, and indeed the denition,
of inteiest as a phenomenon. One hundred dollars today is not valued
the same as $100 a year from now. Tey aie economically dieient
goods. ln teims of the consumeis subjective piefeience ianking, the
maiginal utility of s1uu today is gieatei than the maiginal utility today
of s1uu a yeai fiom now. Tis is time preference whose expiession is
inteiest.
!
We may note some assumptions and implications. Te income
at vaiious dates must be that whi would be valued the same at the
same date. Te only dieientiating factoi is time (although it may be
admiued that the passage of time itself cannot be without signicance,
of which moie below) it is a pure time preference. Second, it is im-
poitant to keep all notions of inteiest iates, such as we obseive in the
loan maiket, out of the pictuie. To admit them into the individuals
choice theoietic context would be to fall piey to an all too common
ciiculaiity. We cannot explain inteiest iates in teims of individual time
piefeiences if we assume an inteiest iate alieady to exist. Tis is no dif-
feient in piinciple fiom iealizing that individuals piefeience iankings
exist piioi to and independently of the piices of the items they aie
ianking. Time piefeience is a subjective phenomenon like individual
piefeience iankings and as such is unobseivable. But it is neveithe-
less quite ieal and exists even in the ieal woild of unceitainty and
ination and is ieected (togethei with iisk and unceitainty) in maiket
inteiest iates, just as othei piices expiess othei aspects of individual
piefeiences (inteiest iates being deiived fiom a iatio of inteitempoial
piices). Tiid, it is appaient that inteiest does not depend in any way
on the pioductivity of capital. lt does not even depend on the existence
!
Specically, using a neoclassical appioach, we may say that the inteiest iate is
the iatio of the maiginal utilities minus 1. Symbolically

/
+
= + wheie
equals the iate of time piefeience. Oi, moie geneially,

/
+
= +

, wheie

is the iate of time piefeience foi time hoiizon . Maiginal utilities aie undeistood
to be as of time . So
+
is the maiginal utility of the piospect in question to be
enjoyed at time + but contemplated at time .
11z CAPlTAL lN DlSEQUlLlBRlUM
of pioductive assets (whose combined value is identied as capital).
lndeed the piice of a capital asset, its capital value, would fully ieect
the (discounted) value (by its ownei and as expectedly evaluated by
consumeis) of its pioduct, so that a moie pioductive asset would cost
moie. Te rental return to capital is conceptually quite distinct fiom
inteiest. lnteiest is not the ietuin on capital. lnteiest would exist in a
puie exchange economy as long as theie was a positive time piefeience.
A positive time piefeience is a necessaiy and sucient condition foi
the existence of inteiest. ln fact, in this context, inteiest and time pief-
eience aie viitually synonymous. lnteiest is thus explained by the
piopensity of individuals to discount the futuie. And, since inteiest,
by denition and by intuition, would not exist in the absence of this
piopensity, it makes sense to say that the phenomenon of inteiest is
due to and only due to time piefeience. Te essence of inteiest is
time piefeience.
So fai so good. lt would seem that, stated in these teims oi similai
ones (foi example Kiiznei 1vv!, Gaiiison 1vcc), PTPT would be cleai,
if not unobjectionable, and objections would be in teims of aiguing foi
othei conceptual schemes. lt is appaient, at least to this authoi, that
the PTPT account of inteiest is not well undeistood, even by eminent
theoiists. lt seems that a plausible explanation foi this is the way in
which the PTPT has been developed in the liteiatuie. lt may be helpful
to examine ceitain aspects of the development of the theoiy. Te most
inuential theoiists aie piobably Bhm-Baweik (1vv), leuei (1v),
Mises (1vee), and Rothbaid (1vu).
Bhm-Bawerk, Fetter, Mises, and Rothbard
Bhm-Baweiks exhaustive (and exhausting') suivey of inteiest theo-
iies establishes cleaily the piimacy of time piefeience. He eectively
disposes of pioductivity accounts in explaining the phenomenon of
inteiest. His account of time piefeience is much admiied. But then in
his latei volume (1vv), when he tuins to an examination of the determi-
nants of time preference, he advances thiee ieasons foi the existence of
a positive iate of time piefeience. Two of these aie psychological (im-
patience and myopia), while the thiid is technological (the technical
supeiioiity of piesent goods ovei futuie goods). What he meant by
THE NATURE Ol lNTEREST AND PROllTS 11!
this thiid ieason was the pioductivity of capital goods that iepiesent
the iesults of ioundabout methods of pioductionbecause of pioduc-
tivity, piesent goods could be used to obtain a gieatei volume of futuie
goods and so weie demanded at a piemium. ln this way he involved
himself in an unfoitunate and celebiated contiadiction.
.
To many
latei theoiists it appeaied as though Bhm-Baweik had come to em-
biace a kind of lisheiian eclecticism, one that established the duality of
time piefeience and pioductivity in the deteimination of inteiest iates.
ln fact much of the iecent mathematical woik on modein Austiian
capital theoiy seems to ieect this (labei 1vv, 1vce). ln a way the
contiadiction became obscuied because the question changed. PTPT
was nevei ieally about the deteimination of maiket inteiest rates, it
was about explaining inteiest as a phenomenon (Kiiznei 1vv!1c!.).
As we shall see, the fact that pioductivity may play a iole in the foimei
in no way diminishes its iiielevance foi the lauei.
liank leueis ieputation as being unique among economists in
his cleai giasp of the PTPT owes a gieat deal to Rothbaid (Rothbaid
1v). But, accoiding to Rothbaid, while leuei aiticulated a valid
ciiticism of Bhm-Baweiks inconsistency, at the same time he failed
to giasp ceitain impoitant aspects that weie valid in Bhm-Baweiks
theoiy.

lt was lef to Mises to establish a valid theoiy using what

was valuable fiom Bhm-Baweik and leuei and puuing it in his own
unique fiamewoik.
Te leading economist adopting leueis puie time piefeience
view of inteiest was Ludwig von Mises . . . Mises amended the
theoiy, in two impoitant ways. liist, he iid the concept of its
moialistic tone which had been continued by Bhm-Baweik . . .
Mises made cleai that a positive time piefeience iate is an es-
sential auiibute of human natuie. Secondly, and as a coiollaiy,
wheieas leuei believed that people could have eithei positive
oi negative iates of time piefeience, Mises demonstrated that a
positive rate is deducible from the fact of human action, since by
the veiy natuie of a goal oi an end people wish to achieve that
goal as soon as possible. (Rothbaid 1vc.z1, italics added)
.
See, howevei, Maclachlan (1vv!!v.u) foi a slightly dieient inteipietation.

So, foi example, among othei things, he nevei fully iealized the impoitance [of
distinguishing] between land (the oiiginal pioduceis good) and capital goods (cieated
oi pioduced pioduceis goods) (Rothbaid 1ve).
11. CAPlTAL lN DlSEQUlLlBRlUM
So, accoiding to Rothbaid, Mises has the denitive PTPT of inteiest.
Rothbaid claims (a) that Mises has demonstiated that a positive iate
is deducible fiom the fact of human action, since by the veiy natuie of
a goal oi an end people wish to achieve that goal as soon as possible
and theiefoie (b) that time piefeience can nevei be negative.
lt is these claims that iendei the PTPT of inteiest obscuie. A closei
examination of Mises woik and Rothbaids ieveals that they aie not so
easily established. Mises and Rothbaid wanted to establish (positive)
time piefeience as a puie (nonempiiical) categoiy, like action, some-
thing that was impossible to deny. But because of its link to time and
because of the connection of time to unceitainty (the gaining of new
knowledge), the auempt to do so involved Mises (and by extension
Rothbaid) in a logical contiadictionthat is, he assumed the absence
of unceitainty in oidei to piove the necessity of time piefeience as
an implication of action, when action in a woild without unceitainty
is, by his own denition, impossible (Lewin 1vvb). Te distinction
between assumption and empiiical judgment also seems to be bluiied
by Mises diculty in establishing a cleai denition of time piefeience
(see also Pellengahi 1vve).
e PTPT of Interest Reformulated
Tis is a dicult and contioveisial subject. No doubt otheis will intei-
piet Mises dieiently and this is not the place foi a lengthy defense
of my own view (which is available in Lewin 1vvb). lnstead l will
simply oei a iefoimulated account of the PTPT of inteiest, one that
does not claimtime piefeience as a puie categoiy. leueis and Bhm-
Baweiks empiiical appioaches look much beuei fiom this peispec-
tive.
Time piefeience is dicult to dene. Te piospects being com-
paied ovei time must in some sense be the same things but for the
passage of time. What, then, makes them the same things` Aie they
the same goods` ln this case the denition of a good is pioblematic
ice cieam in summei veisus ice cieam in wintei aie not the same good.
But then, aie we talking about moie ultimate goods, like satisfaction
obtained fiom eating ice cieam` lf so, we aie compaiing a piesent
satisfaction with the contemplation of an identical satisfaction in the
THE NATURE Ol lNTEREST AND PROllTS 11
futuie. How aie we to calibiate these` An alteinative way to expiess
time piefeience, one that is puiged of any hedonic elements, is as
follows
Compaiing the puichase of (a) a piospect that is ianked 1 today
with (b) a piospect that would be ianked 1 today if it weie avail-
able today but is only available tomoiiow, since (as indicated
by the ianking) (a) is piefeiied to (b), time piefeience exists.
A key point can be made time preference is strongly intuitively con-
nected to the presence and type of uncertainty in the world. Considei
the simple expeiiment that one ofen uses in teaching the concept of
time piefeience. Te teachei takes out a ten-dollai bill and asks the
class which they would piefei (1) the ten dollais iight now oi (z) the
same ten dollais this time next week. He adds that the students may
not eain any inteiest on the ten dollais. Of couise, eveiyone opts
foi (1). Ten the teachei changes option (z) to (z

), ten dollais plus

this time next week. At some level of , (z

) will just be piefeiied (oi

the students will be indieient between the two). Tis is then used
as an indication of, and as a measuiement of, time piefeience. Now
if you change the choice a liule by adding the assumption that the
piospect of ten dollais next week is a ceitain piospectthe teachei is a
peifectly safe bet, while the students ability to keep the ten dollais safe
ovei the couise of the week is less than ceitain (foi example, we could
imagine a dangeious society in which piedatoiy behavioi iegulaily
thieatens peoples savings) then (z) could veiy well be piefeiied to (1).
Alteinatively, if we assume that (z) and (1) aie equally and completely
ceitain, then a piioii it does not seemto be possible to say that one will
be piefeiied to the othei. Te knee-jeik piefeience of (1) ovei (z) seems
to be ciucially bound up with the fact that the students automatically
iealize that the passage of time biings with it unexpected events and
that a biid in the hand is woith two in the bush. Resoiting to con-
stiucts that banish the essential natuie of time seems to hindei iathei
than help in undeistanding time piefeience.
lt should be noted that among some wiiteis sympathetic to the
time piefeience appioach theie is no assumption that it need always be
positive oi that it is a logical iathei than an empiiical phenomenon.
We have alieady noted leueis contiibution. ln Kiizneis iecent aiticle
he implicitly expiesses doubts about Mises tieatment, when he says,
11e CAPlTAL lN DlSEQUlLlBRlUM
Tis theoiy solves the inteiest pioblem by appeal to widespiead possi-
bly universal positive time piefeience (Kiiznei 1vv!11, italics added),
and again PTPT accounts foi this phenomenon [value pioductivity]
by iefeience to widespiead possibly universal piefeience foi the eailiei,
iathei than the latei, achievement of goals (ibid.1vz, italics added). ln
consideiing why (maiket) inteiest iates cannot be negative, Lachmann
explains
Te ultimate ieason foi this lies in the simple fact that stocks
of goods can be caiiied foiwaid in time, but not backwaids. lf
piesent piices of futuie goods aie highei than those of piesent
goods, it is possible to conveit the lauei into the foimei unless
the good is peiishable oi the cost of stoiing excessive, while fu-
tuie goods cannot be conveited into piesent goods unless theie
aie ample stocks not otheiwise needed which theii holdeis aie
ieady to ieduce foi a consideiation. And as theie aie always a
numbei of goods foi which the cost of stoiage would be small,
money being one of them, a negative iate of inteiest would be
eliminated by a high demand foi piesent goods which aie easy
to stoie and a laige supply of easily stoiable futuie goods, at
least as long as the stocks caiiied aie coveied by foiwaid sales.
(Lachmann 1vcc)
So, given that the passage of time is what it is, and given that (in oui
society) geneially some goods can be tiansfeiied to the futuie intact
(notably money), we would expect time piefeience and inteiest iates
to be positive.
Conclusion: Interest is not Prot
Eveiy pioduction plan involves capital values. Tese depend ciucially
on the iate of discount used to obtain them. Tis iate of discount is an
expiession of a positive time piefeience, although it may be aected
by othei things. Time piefeience is its essential explanation. Since
capital involves time it also involves time piefeience. Obseived in-
teiest iates which, depending on the context, aie sometimes used to
obtain capital values, do not measuie the ietuin to capital. Capital
is in this iespect no dieient fiom any othei input. Te contiibution
of any and all inputs will be similaily discounted in any pioduction
plan. Payment to the inputs would tend to ieect theii oppoitunity
THE NATURE Ol lNTEREST AND PROllTS 11
costs. Tus any suiplus iemaining afei the payment to the inputs of
wages and ients is piot. We now take a closei look at this.
e Nature of Prot
Prots In and Out of Equilibrium
One way to examine the natuie of piot is to examine a hypothetical
situation in which it would be absent. Tis has been the basis of a
numbei of similai appioaches in neoclassical as well as Austiian eco-
nomics in the foimei, the steady state and its extieme, the stationaiy
state, in the lauei the evenly iotating economy.
ln an economy in which theie was no unceitainty (if one could
imagine such a woild) theie would be no piot. All pioduction plans
in such a woild would be successful in the sense explained above. All
capital values

would look the same fiom all points of view and to

all individuals. ln such a woild the iate of discount would equal the
unifoim inteinal iate of ietuin on all capital piojects and this in tuin
would equal the iate of inteiest foi the time peiiod in question. Tis is
the woild of geneial equilibiium. lf we assume no giowth, no capital
accumulation, it is a stationaiy geneial equilibiium and also an evenly
iotating economy (ERE) (see Rothbaid 1vuz..). ln this kind of
woild it is possible to do some simple social accounting.
Te stiuctuie of pioduction will be constant and will ieect the
best use of the geneially known pioductive techniques. Tis is the
state to which we aie to imagine the economy will tend to move in the
absence of any change. Teie aie no piots and losses. Te piices
of capital goodsieecting the value of theii discounted maiginal
pioductsaie fully captuied by the piices of the oiiginal piimaiy
factois used to pioduce them. And theie aie only two such piimaiy
factois of pioduction(giound) land and (iaw) laboi. Eveiything else
in the economy is ultimately pioduced using these two piimaiy factois,
eithei diiectlyat the highest stageoi indiiectly, combining with
alieady pioduced capital goods to add value to the next stage. All
othei incomes can be analytically swept back to those of the oiiginal
factois. Te incomes of land and laboi aie incomes in the natuie of a
ient, and in the ERE only laboi and land eain puie ient.
11c CAPlTAL lN DlSEQUlLlBRlUM
A ient is the unit piice of the seivice yielded by a long-lived asset.
ln the case of a nonduiable good it is equal to its piice. ln the ERE the
ient on a paiticulai physical asset will equal its discounted maiginal
value pioduct (DMVP). Tus all duiable assets that have a value in
pioduction (and can be bought and sold) have capitalized values that
will deteimine theii piices. loi a peipetual income stieam the capital-
ized value will be equal to the ient divided by the discount iate. Since
all ients, except those paid to land and laboi, balance outsince the
piices paid foi capital inputs by a pioducei of capital goods at any stage
of pioduction must be oset against the piices of the goods pioduced
the only puie capitalized values aie foi land and laboi. Since laboi
cannot be bought and sold in a fiee societyit can only be ientedthe
only puie capitalized value that would be obseived is that of land.
Tus, in this woild, theie is a ciucial distinction to be made be-
tween capital, land, and laboi, since capital eains no net (puie) income
and the distinction between land and laboi has to do with the lack of a
maiket foi the laueia mauei we take up biiey below (and in detail
in Chaptei 11). To ieiteiate, capital goods iefeis to pioduced means
of pioduction, wheieas land iefeis to the nonpioduced iesouices of
natuie. Tis distinction is likely to tiouble the modein ieadei who
might nd it dicult to imagine any pioductive land that has not been
alteied in some way in the inteiests of pioductive activity. Also the
fact that at a ceitain time in the distant past unspoiled land enteied into
the pioduction of a paiticulai consumption good is, fiom an economic
point of view, iiielevant. Economic agents take the woild as they nd
it and look foiwaid when making decisionsthey inheiit a vaiiety of
capital goods whose value depends not on theii histoiy but on theii
futuie usefulness. loi both of these ieasons the distinction between
capital and land needs to be caiefully foimulated. Whethei a piece
of land is oiiginally puie land is in fact economically immateiial,
so long as whatevei alteiations have been made aie peimanentoi
iathei so long as these alteiations do not have to be iepioduced oi
ieplaced. Peimanence is not ieally the key.
Te key question is whethei a iesouice has to be produced, in
which case it eains only gross ients. lf it does not oi cannot,
it eains net ients as well. Resouices that aie being depleted
THE NATURE Ol lNTEREST AND PROllTS 11v
obviously cannot be ieplaced and aie theiefoie land, not capital
goods. (Rothbaid 1vu.eu n. 1)
So land is any nonhuman iesouice that cannot be pioduced oi ie-
pioduced. And capital goods aie pioduced means of pioduction that
iequiie (allow) maintenance oi iepioduction. As such, they include
the stiuctuies on land, agiicultuial land, and valuable human-made
featuies of the landscape that need to be maintained. Land, then, in-
cludes less than what we aie accustomed in common usage to mean,
one impoitant element being location. [Tis] concept of land . . . ,
then, is entiiely dieient fiom the populai concept of land (ibid..1,
see also Hayek 1v.1ch. V).
An ERE at any time, then, will have as pioductive factois land,
laboi, and capital in the sense discussed. Land does not iefei to the
iesouices of natuie in theii piistine oiiginality, but iathei to any non-
iepioducible iesouices that may happen to exist at the time that the
economy aiiived at the stationaiy state of the ERE. (Rothbaid is awaie
that the ERE cannot abide depletable iesouicesthat would otheiwise
qualify as landand bemoans this as an unfoitunate shoitcoming of
an otheiwise useful constiuct.) ln this economy, the only net incomes
eained will be the wages of laboi, the ients of land, and puie inteiest.
Te value of the nal pioduct will be accounted foi by the contiibu-
tions of land (in the iestiicted sense explained), laboi, and inteiest.
So in this discussion, piots and losses (which aie conceptually com-
pletely distinct fiom inteiest) have the necessaiy function to coiiect
the ubiquitous malinvestments and misallocations that occui outside
of the paiticulai (zeio piot) ERE to which the economy is assumed
to be tending. Piots aie an index that maladjustments aie being met
and combated by the piot-making entiepieneuis (ibid..ec, italics
iemoved). And in a continually giowing economy, land may eain an
income in teims of an incieasing capitalized value.
eory and Reality
Tis appioach is useful in soiting out some common but fundamen-
tal confusions, like the dieience between inteiest and piot, and is
stiong, foi example, on the explanation of the concept of ient. Caieful
ieadeis come away with a much beuei undeistanding of fundamental
1zu CAPlTAL lN DlSEQUlLlBRlUM
categoiies like inteiest, wages, ient, and piot. Tey aie thus able to
demystify much of capital theoiy. Piot is seen as a disequilibiium
phenomenon, a iesult of uctuations in capital values in iesponse to
diveise entiepieneuiial visions and actions. lt is not inteiest, it is not
ient, and it is not a ietuin to any single factoi of pioduction, unless
entiepieneuiship be iegaided as a factoi (something that is haid to
defend). We shall ietuin to this. Once we leave the ceitain woild of the
ERE (oi any steady state), howevei, it is useful to considei wages, intei-
est, and ient as categoiically sepaiate fiompiots along the same lines
as discussed above, in that they aie contractual in natuie, being the
iesult of the fulllment of (implicitly oi explicitly) contiactual aiiange-
ments between employeis and employees oi boiioweis and lendeis.
Piots aie familiaily undeistood, then, as the residual noncontractual
payment to the equity holdeis in the pioduction piocess. Tis is a
valuable insight suggested fiom ERE steady-state type ieasoning and,
of couise, also confoims to the vision of the modein piopeity iights
appioach to the im. (See Chaptei v.)
PART lll
CAPlTAL lN A DYNAMlC WORLD
l have, to this point, exploied aspects of the histoiy of capital theoiy,
and the natuie of inteiest, piot, and ient. One should distinguish
between capital goods and capital as an abstiact categoiy. Te lauei
iefeis to the value to be auiibuted to a paiticulai plan oi set of pio-
duction plans. Te piots oi losses to be auiibuted to a pioduction
plan aie the iesult of changes (oi the absence theieol) in the capital
values auiibuted to it ovei time. Tese appieciations (oi depieciations)
in value aie, in tuin, the iesult of (aie deiived fiom) changes in con-
sumeis evaluation of nal pioduction.
Te meaning and the value of any paiticulai capital good deiives
fiom its position in a paiticulai pioduction plan. Pioduction plans aie
like any othei human plans (as discussed in Pait l). Tey aie dened
by paiticulai puiposes and they aie infoimed by paiticulai kinds of
knowledge. Eveiy pioduction plan must envisage a combination of
iesouicesa capital combination. Capital goods and laboi and land
woik togethei to fulll the plan. Tis combination must be made by
someone with the knowledge of how to do it. Tis involves knowledge
of the natuial woild, technological knowledge (knowledge type 1), and
knowledge of social habits and institutions (foi example, if individuals
have to be cooidinated and motivatedknowledge type z). lt may also
involve specic expectations (knowledge type !) conceining individual
behavioi (can we iely on a paiticulai woikei`) oi natuie (will the
weathei be favoiable`). But it seems ieasonable to assume that ofen
most of the knowledge involved in the implementation of the pioduc-
tion plan is heavily weighted in favoi of knowledge types 1 and z.
Teie aie notable and impoitant exceptions those pioduction plans
that depend heavily on the speculative actions of otheisfoi exam-
ple, on the supply of a yet to be discoveied souice of iaw mateiials,
1z1
1zz CAPlTAL lN DlSEQUlLlBRlUM
etc. oi those pioduction plans that depend heavily on the implemen-
tation of innovative (untiied) pioductive techniques and the iesults of
ieseaich piogiams (as in the seaich foi a new chemical substance oi
medical diug). ln geneial, pioduction plan implementation iests heav-
ily on typical events and, peihaps to a lessei extent, on specic ones. ln
addition to successfully cooidinating the inputs, the successful imple-
mentation of any pioduction plan iests, howevei, on the successful sale
of its output. And it is this aspect that is most likely to be dependent
on the paiticulai pioduceis expectations (knowledge type !).
ln a woild in which the pioduction and sale of outputs was pait of
a plan that was assumed to be consistent with all othei ielated plans, so
that theie weie no disappointments in pioduction schedules oi, most
notably, in the sale of output, the value of the iesouices that weie
pait of the plan would cleaily be ceitain. And if eveiyone shaied
in the knowledge of the value of the output and the contiibution of
each input, then, in some sense, these values would be ieected in
piices of the inputs. ln such a situation of peifect plan cooidination,
a meaningful capital aggiegate could then be obtained.
1
lt should be
cleai, howevei, that such a constiuction abstiacts not only fiom time,
but also fiom those aspects of a capital-using economic piocess that
aie iesponsible foi its dynamic, innovative chaiactei.
lf it is tiue, by contiast, that pioduction plans typically iest on
expectations of the sale of paiticulai outputs, sometimes of new piod-
ucts, sometimes involving new pioduction techniques, then we should
not ieasonably expect such plans to be consistent and cooidinated
with all othei plans in the economy. ln paiticulai, capitalistic pio-
duction involves iivalious activity that cleaily implies the piuing of
one entiepieneuiial vision against anothei. ln such a woild the value
of pioductive iesouices, indeed the value of pioductive ventuies as a
whole, cannot be known to all and cannot be added togethei. Many
will depend on mutually exclusive outcomes. Tese outcomes might
be simple maiket shaies in the case of similai but dieientiated (biand
named) pioducts oi they may be the piogiessive adoption of paiticulai
1
lt is not cleai that piices would exist in a woild of peifect ceitainty such as that
postulated heie. ln such a woild eveiyone would know ahead of time who should
have which iesouices, etc. But iesouices could unambiguously be imputed values
which may be thought of as piices.
CAPlTAL lN A DYNAMlC WORLD 1z!
standaids like Windows veisus Unix oi VHS veisus Beta. loi example,
we can imagine two video stoies, one ienting VHS casseues, the othei
Beta casseues, ieasonably basing theii expansion plans on inconsistent
expectations, each beuing on the giowing adoption of theii paiticulai
standaid.
Pioduction plans, consideied as a whole, aie typically in disequi-
libiiumaie based, at least in pait, on inconsistent expectations, not
iegaiding the iules of the game but iegaiding the viability of the
pioduct oi the pioductive technique. Teie is no way to deiive an
aggiegate measuie of capital in this situation. Te net piesent values
as (assumed to be) computed by each individual plannei aie based on
inconsistent futuies. Howevei, this absence of equilibiium in no way
piecludes actionno moie so than the absence of knowledge of the
outcome of a football game pievents the playeis fiom playing. All
action occuis within an institutional enviionment that includes the
knowledge of the actois, and, as we have seen, much of this knowledge
does imply a consistency of expectations.
ln Pait ll l impiessionistically tiaced the development of capital
theoiy fiom Adam Smith thiough Ricaido to modein times. l diew a
distinction between the Ricaidian and Mengeiian tiaditions. ln Pait lll
l tuin to a discussion of some non-Ricaidian appioaches to capital
theoiy and ielated topics. Some of these may be seen to deiive fiom
Mengei (Hayek, Lachmann), while otheis (essentially complementaiy
to the Mengeiian line) may be teimed post-Maishallian (Peniose,
Richaidson, Teece, Williamson, Loasby, Langlois, and otheis). What
these appioaches have in common foi oui puiposes, is a piocess ap-
pioach to the accumulation of capital. Capital decisions aie seen as
occuiiing within an evolving economic enviionment and aie embed-
ded within individual pioduction plans. Te success oi failuie of these
plans is inevitably linked to the oiganization of pioduction. Tis leads,
theiefoie, to a discussion of the natuie of economic oiganization moie
geneially, paiticulaily to the economics of the im. lndeed we shall
see that capital theoiy cannot be sepaiated fiom a consideiation of the
economics of business oiganization.
CHAPTER c
Modein Mengeiian Capital Teoiy
Introduction
Oui consideiations in Pait ll suggest the following conclusions fiom
which we shall pioceed in this pait.
1. Capital theory historically involved misleading physical analogies.
Examples aie
(a) Biological analogies iepioductive piocesses in which giowth
occuis automatically (the Ciusonia plant, the woodlot), incuba-
tion peiiods, wheie capital piocesses aie likened to physical ones
that depend piimaiily on the passage of time (although implicitly
it is what happens in time that maueis) like aging wine.
(b) Notions of inteiest that aie linked with physical oi biological ac-
cietion the idea that inteiest is that implicit inciease in value that
occuis continuously and inexoiably ovei the pioduction peiiod.
An appioach to capital theoiy disconnected fiom its unhelpful histoi-
ical baggage must iealize that the pioduction piocess is a piocess of
value enhancement ovei (in) time. lt may involve physical piocesses
(tiansfoimations) but its essential chaiacteiistic and diiving foice is
the cieation of value, the iegiouping of physical iesouices into moie
valuable combinations as a iesult of delibeiate pioduction decisions
(not to imply that all oi even most of these decisions aie successful).
We shall be conceined to discovei how pioduction decisions aie made.
We iealize also that inteiest is a phenomenon that is ciucially distinct
fiom pioductivity (although we need not deny that the rate of inteiest
may be inuenced by pioductivity, ofen in non-obvious ways).
z. We can dispense with time period of production approaes to
capital. While we cannot but note and emphasize the impoitance of
the connection between time and pioduction, and the intuitive validity
1z
1ze CAPlTAL lN DlSEQUlLlBRlUM
of the idea that in oidei to ieap the fiuits of moie pioductive specializa-
tions we have to adopt pioduction methods that aie moie ioundabout
(moie complex, moie indiiect), neveitheless we cannot captuie this
idea in the foim of any simple notion of peiiod of pioduction. Noi
need we do so.
ln this iegaid we shall nd a numbei of modein theoiists leading
the way. Te Austiian tiadition emanating fiomMengei in the woik of
Mises, Rothbaid, Hayek, Kiiznei, and Lachmann has piovided impoi-
tant insights. We shall focus heie piimaiily on the woik of Lachmann
but we must take note biiey of the impoitant woik of Hayek on
capital theoiy, if only foi the subsequent woik which it inspiied. We
will then tuin to a discussion fiom anothei tiadition, that emanating
fiom Alfied Maishall. A gioup of theoiists who have been iefeiied to
as post-Maishallian (loss 1vv., 1vv, 1vvea,b) has done consideiable
woik on the economics of the im which beais a cleai connection to
consideiations of capital stiuctuie. One of the contiibutions of this
pait will be to illustiate the connections between these two liteiatuie
stiands and how one can infoim the othei.
Hayek and the Fundamental estions of Capital eory
ln his woik on capital Hayek stands, in a sense, between the Bhm-
BaweikianRicaidian appioach and the Mengeiian and post-Maishal-
lian appioach. His woik on capital theoiy dating fiom the eaily 1v!us
and culminating in the publication of e Pure eory of Capital (1v.1),
was piompted by a concein with the business cycle. ln Monetary e-
ory and the Trade Cycle (1v!!) and Prices and Production (1v!b) he de-
veloped what came to be known as the Austiian (MisesHayek) theoiy
of the business cycle. Tis is essentially a monetaiy theoiy of uctua-
tions, but one that emphasizes a (monetaiily induced) distoition of
the capital stock. Hayek thus natuially diew fiom the woik of Bhm-
Baweik and the ielation between the capital stock and time. ln so
doing he simplied and glossed ovei many of the subtleties and compli-
cations ielating to capital aggiegation. ln his subsequent woik, in the
enviionment of the gatheiing momentum of the Keynesian ievolution,
he sought to claiify and develop the capital theoietic undeipinnings
to this woik, which he saw as the viable alteinative to the awed and
supeicial Keynesian appioach (see the collection of aiticles in Prots,
Interest and Investment (1v!v)). linally, his wiiting of the Pure eory
MODERN MENGERlAN CAPlTAL THEORY 1z
ieects his initial deteimination to lay out fully the fundamentals of
capital theoiy and to make plain why he maintained that an undei-
standing of capital was vital to a valid appioach to (macio)economic
policy.
1
ln the actual implementation of the pioject he became awaie
of the enoimity of the task he had set himself, and the nished pioduct,
though intiicate and involved (by fai his most dicult woik in eco-
nomics), was seen by himas an unnished compiomise (as is veiy cleai
fiom his iemaiks on pages viiix of the pieface). (Hayek had planned
a second volume that would have applied the Pure eory analysis to
tiade cycles.)
Te basic appioach of the book is an equilibiium appioach along
the lines of (the Ricaidian) Bhm-Baweik, Wicksell, and Jevons (all of
whom he ciedits as having anticipated in all essential ways what he has
to say). But, in his voluminous side comments and geneial discussions,
he makes it veiy cleai that he undeistands the limitations of this (equilib-
iium) appioach, and points the way to a moie dynamic disequilibiium
tieatment. Tus this woik contains not only a faiily eaily woiking out
of what was latei to become a ieseaich aiea of neoclassical economics
undei the iubiic of inteitempoial equilibiium theoiy, but also a wealth
of impoitant obseivations on the meaning of capital maintenance in a
dynamic, changing woild and othei impoitant insights that seived as
iaw mateiial foi Lachmanns latei woik on capital theoiy. lt is the lauei
contiibutions in which we will be inteiested.
Wheieas the classical (Ricaidian) theoiy of capital (as we saw in
Pait ll) had become conceined with explaining the deteimination of the
iate of piot eained on an abstiact categoiy of iesouices (oi a fund)
known as capital, the Mengeiian appioach suggested paying auention
to the structure of capital. Hayeks sympathies lie cleaily with the lauei.
Oui main concein will be to discuss in geneial teims what type
of equipment it will be most piotable to cieate undei vaiious
conditions, and howthe equipment existing at any moment will
be used, iathei than explain the factois which deteimined the
value of a given stock of pioduction equipment and the income
that will be deiived fiom it. (Hayek 1v.1!)
z
1
Tis inteipietation of Hayeks woik on capital theoiy is my own.
z
lt is a pioblem foi the ieadei that, having stated this geneial objective, Hayek then
tuins to a piotiacted examination of capital undei equilibiium conditions ieminiscent
of the classical appioach, and nevei ieally fullls his oiiginally stated objective. lt has
been suggested (by Hayek, among otheis) that Lachmann did just that (see Lewin 1vva).
1zc CAPlTAL lN DlSEQUlLlBRlUM
Hayeks compositive sympathies aie cleaily stated
Te pioblems that aie iaised by any auempt to analyze the
dynamics of pioduction aie mainly pioblems connected with
the inteiielationships between the dieient paits of the elab-
oiate stiuctuie of pioductive equipment which man has built
to seive his needs. But all the essential dieiences between
these paits weie obscuied by the geneial endeavoi to subsume
them undei one compiehensive denition of the stock of cap-
ital. Te fact that this stock of capital is not an amoiphous
mass
!
but possesses a denite stiuctuie, that it is oiganized in
a denite way, and that its composition of essentially dierent
items is much moie impoitant than its aggiegate quantity, was
systematically disiegaided. (ibid.e, italics added)
!
ln this appioach it is cleai that both Lachmann and Hayek benet fiom Schum-
peteis pionouncements. ln his lectuies on capital theoiy Lachmann states
Schumpetei has a succinct statement of the compositive school ap-
pioach. Whenevei we aie talking about a given situationmeaning
given tastes, iesouices and technologyiesouices must exist in a cei-
tain stock of inherited goods, i.e., goods piovided in the past. Tey aie
simply theie, like land. Tese iesouices aie limited in the way that
they can be used. Te stock of existing goods constitutes a constiaint
on human action going foiwaid. Te stock of capital is neither homo-
geneous, nor is it an amorphous heap. lts components complement one
anothei. Some goods must be available foi the opeiation of otheis. Te
natuie of the composition of the stock is vital it constitutes a given
stiuctuie. (Lachmann 1vve1ze1z, see also 1..)
Tis is an allusion to the woids of Schumpetei. ln a section entitled Te Stiuctuie of
Physical Capital, Schumpetei seems to anticipate much that is ielevant to Lachmanns
(and Hayeks) viewpoint.
Te initial stock of goods is neithei homogeneous noi an amoiphous
heap. lts vaiious paits complement each othei in a way that we ieadily
undeistand as soon as we heai of buildings, equipment, iaw mateiials,
and consumeis goods. Some of these paits must be available befoie we
can opeiate otheis, and vaiious sequences oi lags between economic
actions impose themselves and fuithei iestiict oui choices, and they
do this in ways that diei gieatly accoiding to the composition of the
stock we have to woik with. We expiess this by saying that the stock
of goods existing at any instant of time is a structured quantity or a
quantity that displays structural relations within itself, that shape, in
pait, the subsequent couise of the economic piocess.
(Schumpetei 1v.e!1e!z, italics in oiiginal)
MODERN MENGERlAN CAPlTAL THEORY 1zv
Hayek explains the pioblems associated with any auempt to aggiegate
the capital stock in value teims oi in teims of units of laboi oi time and
intends to woik systematically towaids a theoiy in which this is not
necessaiy. He begins, howevei, with a discussion of how an economy
diiected by a cential dictatoi might make decisions iegaiding the foi-
mation and use of capital goods in an economy devoid of change. Tis,
of couise, abstiacts fiom any issues ielated to the ielative evaluation of
consumption goods, since the only valuations that mauei aie the dicta-
tois. Tus the solution is essentially the same as the classical one. Teie
is, by assumption, no disequilibiium pioblem, heteiogeneity is seen not
to mauei. Of couise, Hayek does this as a foil, a ielief against which
to illuminate the ieal-woild pioblems of heteiogeneity and change. His
method is ist to get the abstiact pioblem iight. Unfoitunately, but
undeistandably, much of the liteiatuie that iefeis to this woik concen-
tiates on these equilibiium exeicises, iathei than on the oiiginal focus
that Hayek sought to maintain, that is, of inquiiing into the decisions
goveining the use of the vaiious capital iesouices at oui disposal.
.
e Problem of Imputation
Essentially Hayek was conceined with the question howaie iesouices
made and used` Oi, moie accuiately, how are these decisions made?
Tat is, we seek to undeistand the decision-making piocess which
leads to the adoption of ceitain types of capital equipment in combina-
tion with otheis. Obviously, decision-makeis have to foim a judgment
as to the woith of any capital combination and its vaiious components,
they have to impute a value to the capital goods they have oi aie
consideiing acquiiing oi pioducing. Tis is cleai fiomMengeis notion
(developed fuithei by Wiesei, who seems to have invented the teim
imputation)

that the value of any iesouice is deiived fiom the value

.
ln the nal section of the book (pt lV) Hayek tuins to some dynamic consideia-
tions. While this section is veiy useful, paiticulaily in its tieatment of fundamental
issues conceining saving and investment, it does not ieally deal with capital and could
be seen peihaps as an extended and eective (but laigely ignoied) ieply to Keynes.

Te imputation question was an impoitant issue foi the second geneiation of

Austiian economists (the inteiwai peiiod) and may have been iesponsible foi a less
than accuiate undeistanding of Mises contiibution to the socialist calculation debate
on the pait of some Austiian economists. See Kiiznei (1vv.bvol. ll zu, also chs 1
and 1v theieol).
1!u CAPlTAL lN DlSEQUlLlBRlUM
of the nal output foi which it is iesponsible. But, as we have noted
in pievious chapteis, the question iemains as to how we aie to decide
which unit of output is auiibutable to which unit of input. ln the neo-
classical liteiatuie this pioblem is solved by assuming that pioduction
methods can be vaiied continuously in such a way that the maiginal
contiibutions (pioducts) of each unit of input can be easily discoveied.
Tis is also Hayeks assumption in his discussion of a centially diiected
economy. Tis way of dealing with the pioblem abstiacts fiom the
most inteiesting questions in capital theoiy, questions that tuin out to
be ielevant to consideiations of economic oiganization.
lt would seem, howevei, that theie is a necessity to invoke some no-
tion of maiginal (value) pioduct. Te pioducei must have in mind some
oppoitunity cost when assigning a iesouice in one paiticulai way iathei
than anothei and thus must also have in mind the supposed contiibution
that its (maiginal) assignment makes. As we shall make cleai, howevei,
in a woild of unceitainty and change, theie is an inescapable element of
judgment and speculation involved in this. Dieient decision-makeis
will see things dieiently and will (implicitly) impute dieient values
to the capital iesouices at theii disposal fiom what otheis would. Tese
dieiences pioduce the capital valuation piocess that is pait of the
maiket piocess and which iendeis economic calculation possible.
Te economists desciiption of the imputation piocess, wheie the
decision-makei has iecouise to the value maiginal pioduct schedule,
is an idealized constiuct. Te piocess of actual decision-making must
miiioi in an implicit way this idealization. But it does so by using cei-
tain simplifying conventions (foi example, based on accounting piac-
tices) that foimpait of an institutional stiuctuie iendeiing the decision
manageable (tiactable). And in so fai as these conventions ieect a
widespiead shaiing of foims of appiaisal, they supply the decision-
makei with knowledge (type z) of how to do it (as distinct fiom what
to decidetype !). We shall ietuin to this.
Lamanns Conceptual Framework
e Structure of Capital
Peihaps the most impoitant development of Hayeks oiiginal pioject
is to be found in Lachmanns capital theoiy. ln 1ve, Lachmann, who
[Tis section uses mateiial fiom Lewin (1vva).]
MODERN MENGERlAN CAPlTAL THEORY 1!1
had been a student and colleague of Hayeks at the London School of
Economics, published Capital and its Structure (Lachmann 1vc).
e
Tis
woik was ieally the culmination of his eailiei woik on capital, the most
complete of which was his 1v. aiticle (see Lachmann 1v!c, 1v!v, 1v.1,
1v.., 1v., 1v.c, see also Lewin 1vva).
Accoiding to Lachmann
Te geneiic concept of capital without which economists can-
not do theii woik has no measuiable counteipait among mate-
iial objects, it ieects the entiepieneuiial appiaisal of such ob-
jects. Beei baiiels and blast fuinaces, haiboi installations and
hotel ioom fuinituie aie capital not by viitue of theii physical
piopeities but by viitue of theii economic functions. Something
is capital because the maiket, the consensus of entiepieneuiial
minds, iegaids it as capable of yielding an income. . . . [But] the
stock of capital used by society does not piesent a pictuie of
chaos. lts aiiangement is not aibitiaiy. Teie is some oidei
to it. (Lachmann 1vcxv)
Te value of the capital stock, being dependent on individual expec-
tations and evaluations (time piefeiences included), is not an objec-
tively obseivable phenomenon oi necessaiily even a meaningful con-
cept. Only in equilibiium, wheie all individuals expectations weie
consistent one with the othei, would such a value have any meaning.
Lachmann chooses to develop his analysis in a disequilibrium fiame-
woik. ln othei woids, Lachmann consideied the notion of a capital
stock (which made sense in an equilibiium context) to be untenable
and unhelpful in a disequilibiium woild. He thus oeis a theoiy of
the capital structure iathei than the capital sto.
Lachmann thus emphasizes the heterogeneity of the capital stock.
Te fact that capital goods aie physically veiy dissimilai is signi-
cant piecisely because of the existence of disequilibiium. Physical
heteiogeneity could be ieduced to value homogeneity if the values
e
As mentioned above, theie is some evidence to suggest that both Hayek and Lach-
mann saw Lachmanns woik as a continuation of Hayeks pioject. When asked about
the Pure eory Hayek once iemaiked, l think the most useful conclusions diawn fiom
what l did aie ieally in Lachmanns book on capital (Kiesge and Wenai 1vv.1.z). Also,
it is cleai that Lachmanns inspiiation was Hayeks woik on capital (of which e Pure
eory was the culmination). ln his 1v.c aiticle he iefeis to Hayek (1v!a) and says,
Te ideas set foith by Piofessoi Hayek have been the main inspiiation of this papei
(Lachmann 1v.c).
1!z CAPlTAL lN DlSEQUlLlBRlUM
of the vaiious capital goods could be simply added togethei. Wheie
disequilibiium means that individuals have dieient and frequently
inconsistent expectations, one cannot simply add togethei individual
valuations. Te physical heteiogeneity is not the essence of the mauei.
Dieient physical goods that peifoim the same economic function
could be counted as the same good. lt is the dieience in economic
function that maueis. loi the most pait dieient capital goods look
dieient because they aie designed to peifoimdieient functions. But
the same capital good could peifoim dieient functions undei diei-
ent ciicumstances. Heteiogeneity in use is the key.
Although the capital stock is heteiogeneous, it is not an amoiphous
heap. Te vaiious components of the capital stock stand in sensible
ielationship to one anothei because they peifoim specic functions
togethei. Tat is to say, they aie used in vaiious capital combinations.
lf we undeistand the logic of capital combinations, we give meaning
to the capital stock and, in this way, we aie able to design appiopiiate
economic policies oi, even moie impoitantly, avoid inappiopiiate ones
(foi example Lachmann 1vc1z!).
Complementarity and Substitutability
Undeistanding capital combinations entails an undeistanding of the
concepts of complementarity and substitutability. ln neoclassical mi-
cioeconomics, these concepts aie developed within a maiket equilib-
iium pioduction function fiamewoik. Pioduction goods aie substi-
tutes oi complements foi one anothei to the degiee to which, and
in the mannei in which, theii maiginal pioducts aie ielated. Te
maiginal pioducts of complements aie positively ielated while those
of substitutes aie negatively ielated. What is envisaged is a situation in
which pioduction goods aie combined in a technological ielationship
of known and well-undeistood inputs and outputs. Te values of
all possible outputs aie known with ceitainty (oi with piobabilistic
ceitainty), and fiom this it is possible to calculate the values of the
maiginal pioducts undei all conceivable ciicumstances. Hence, we
have the pictuie of a given budget line (oi hypeiplane), foimable
out of the given equilibrium piices of the pioduction goods and the
quantities used, confionting a given isoquant. Substitution is then
simply a mauei of moving aiound the isoquant in two-dimensional
MODERN MENGERlAN CAPlTAL THEORY 1!!
oi multidimensional space. Substitution occuis because of a change
in the piice of a pioduction good. Teie is no analysis of any events
that occui in disequilibiium, i.e., of events that occui between the time
that a piice change occuis, is peiceived, is acted upon, and iesults in
the establishment of a new equilibiium. Te same soit of analysis is
applied to changes in technology, which aie analyzed as changes in
the positions oi shapes of the isoquants.
As a mental pictuie of a single pioduction plan at a point of time,
the isoquant diagiams (oi algebias) may be enlightening. Tey sum-
maiize a ceitain logic of choice. But they have liule to do with
Lachmanns conception of what substitution and technical piogiess
mean in ieality. His concepts peitain to a woild in which peiceived
piices aie actual (disequilibiium) piices, in the sense that they ieect
inconsistent expectations and in which changes that occui cause pio-
tiacted visible adjustments. Capital goods aie complements if they
contiibute togethei to a given production plan. A pioduction plan is
dened by the puisuit of a given set of ends to which the pioduction
goods aie the means. As long as the plan is being successfully fullled,
all of the pioduction goods stand in complementaiy ielationship to
one anothei. Tey aie pait of the same plan. (lt is not inconsistent to
say that theii peiceived maiginal pioducts aie positively ielated, in the
sense that theii joint outputs depend on each otheis peifoimance. An
incieased availabilityieduction in piiceof any one input iaises the
potential outputs of the plan auiibutable jointly to all of the inputs and
may inciease the (joint) demand foi all of them.) Te complementaiity
ielationships within the plan may be quite intiicate and may involve
dieient stages of pioduction and distiibution. Substitution occuis
when a pioduction plan fails (in whole oi in pait). When some element
of the plan fails, a contingency adjustment must be sought.

Tus
some iesouices must be substituted foi otheis. Tis is the iole, foi
example, of spaie paits oi excess inventoiy. Tus, complementaiity
and substitutability aie piopeities of dieient states of the woild. Te
same good can be a complement in one situation and a substitute in
anothei.

lt is easy to see how his appioach ielates to the analysis of the individual plan-
ning piocess suggested in Chaptei z, that is, that plans depend on dieient kinds of
knowledge, and aie multilayeied and necessaiily vague.
1!. CAPlTAL lN DlSEQUlLlBRlUM
Lachmann uses the example of a deliveiy company (Lachmann
1v.1vv, and Lachmann 1vce). Te company possesses a numbei
of deliveiy vans. Each one is a complement to the otheis in that they
coopeiate to fulll an oveiall pioduction plan. Tat plan encompasses
the ioutine completion of a numbei of dieient deliveiy ioutes. As
long as the plan is being fullled, this ielationship pievails, but if one of
the vans should bieak down, one oi moie of the otheis may be diveited
in oidei to compensate foi the unexpected loss of the use of one of the
pioductive iesouices. To that extent and in that situation they aie
substitutes. Substitutability can only be gauged to the extent that a
ceitain set of contingency events can be visualized. Teie may be some
events, such as those caused by signicant technological changes, that,
not having been piedictable, iendei some pioduction plans valueless.
Te iesouices associated with them will have to be incoipoiated into
some othei pioduction plan oi else sciappedthey will have been
iendeied unemployable. Tis is a natuial iesult of economic piogiess
which is diiven piimaiily by the tiial-and-eiioi discoveiy of new and
supeiioi outputs and techniques of pioduction.
What deteimines the fate of any capital good in the face of change
is the extent to which it can be ued into any othei capital combination
without loss in value. Capital goods aie regrouped. Tose that lose
theii value completely aie sciapped. Tat is, capital goods, though
heteiogeneous and diveise, aie ofen capable of peifoiming a numbei
of dieient economic functions. Lachmann calls this piopeity multiple
specicity.
e Capital Structure is Composed of Complementary
Heterogeneous Items
Lachmanns woild is consciously similai to Schumpeteis woild
(Schumpetei 1ve1) of cieative destiuction, except that foi Lachmann
the innovating entiepieneui is not disiupting some pieexisting geneial
equilibiium. His woild is one in which a continuous evolutionaiy
piocess of changing paueins of capital complementaiity is occuiiing.
At any point in time, dieient entiepieneuis will have dieient and
fiequently incompatible pioduction plans. Ovei time the maiket pio-
cess will validate some and invalidate otheis. Lachmann sees the
MODERN MENGERlAN CAPlTAL THEORY 1!
maiket piocess as tending to integiate the capital structure, in othei
woids, iendeiing plans moie consistent, although he is caieful to
add (as we saw in Chaptei z) that the foices of equilibiium may be
oveiwhelmed by the foices of change.
Te concept of the capital stiuctuie (to be explained fuithei below)
is built out of the notion of capital complementaiity. Apioduction plan
is a constiuction of the human mind. As such it exhibits a necessaiy
inteinal consistency. liom the point of view of the individual planner,
it might be said that the plan is always in equilibiium. Te plan is
always in equilibiium in the sense that eveiy plannei, being iational,
may always be counted on to do the best that he can, given all the iele-
vant constiaints, wheie such constiaints include the time available to
adjust to any unexpected changes. Tat is to say, at any given point of
time any individual plannei is in equilibiium with iespect to the woild
as he sees it at that point of time. All pioductive iesouices employed
in that plan stand in complementaiy ielationships to one anothei. Be-
tween any two points of time, duiing which unexpected changes will
necessaiily have occuiied, iesouice substitutions will have been made
in an auempt to adjust to the changes. Complementaiity is a condition
of plan equilibiium (stability), substitutability is a condition of plan
disequilibiium (change).
Te notion of the capital stiuctuie does encompass a soit of eco-
nomy-wide equilibiium as an ideal type. At the individual level, dis-
paiate elements of the pioduction plan aie biought into consistency
by the plannei. Tese elements aie all piesent in a single human mind.
Teie is no such mechanism guaianteeing consistency between dif-
feient pioduction plans. Te maiket piocess does, howevei, tend to
eliminate inconsistencies between plans in so fai as not all of them can
succeed. ln this way plans that aie consistent with (complementaiy to)
one anothei tend to pievail ovei those that aie not.
c
So wheieas the
c
Tis would seem to imply that the pioduction plans of individual ims aie iden-
tical with the plans of one oi othei individual in that im. Tis is not necessaiily the
case, howevei. liims must nd a way to haimonize the dieient visions of its vaiious
planneis. Piesumably the laigei the im, the moie dicult this is. But those ims
that do so moie successfully and adopt successful supia-plans will tend to suivive.
Te maiket piocess woiks its way into the im in this way. ln this way Lachmanns
woik on capital is ielevant foi and ielated to the post-Maishallian theoiies of the im
that we shall examine below.
1!e CAPlTAL lN DlSEQUlLlBRlUM
individual plannei ensuies the complementaiity of all of the iesouices
within a pioduction plan, the maiket piocess tends towaids a situation
of oveiall plan complementarity. Tis is what constitutes the capital
stiuctuie. Te heteiogeneous assoitment of capital goods stands at
any time in a kind of oideied stiuctuie dened by theii functions and
by the ielationships that the vaiious plans have to one anothei. Te
lauei is a iesult not of any supia-plan, but of the maiket piocess. A
capital stiuctuie in which this tendency weie complete, in which eveiy
capital good and eveiy pioduction plan weie complementaiy to eveiy
othei, would be a completely integrated capital stiuctuie. ln summaiy
ln a homogeneous aggiegate each unit is a peifect substitute
foi eveiy othei unit, as diops of watei aie in a lake. Once
we abandon the notion of capital as homogeneous, we should
theiefoie be piepaied to nd less substitutability and moie com-
plementaiity. Teie nowemeiges at the opposite pole, a concep-
tion of capital as a structure, in which each capital good has a
denite function and in which all such goods aie complements.
lt goes without saying that these two concepts of capital, one
as a homogeneous fund, each unit being a peifect substitute foi
eveiy othei unit, the othei as a complex stiuctuie, in which each
unit is a complement to eveiy othei unit, aie to be iegaided as
ideal types, puie equilibiium concepts neithei of which can be
found in actual expeiience. (Lachmann 1v.1vv)
Lachmann chose to desciibe the woild in teims of a capital structure
iathei than a capital sto. Tis choice ieects a judgment that to ob-
scuie capital complementaiity thiough aggiegation would iesult in an
inaccuiate and misleading pictuie of the iole of capital in the economy.
Tis can be seen in his account of how the maiket piocess woiks.
e Market Process and the Production Process
At any moment in time individual planneis hold inconsistent expecta-
tions. Tis means that the passage of time must disappoint some of
them. Some pioduction plans must fail (in pait oi in whole) while oth-
eis, of couise, may succeed beyond theii expectations. Tis is ieected,
accoiding to Lachmann, in two ciucial waysin capital ie-evaluations
(capital gains and losses) and in anges in cash balances. Wheieas
the wealth eects of neoclassical economics aie usually assumed
to be small enough to be neglected, the capital gains and losses of
MODERN MENGERlAN CAPlTAL THEORY 1!
Lachmanns woild aie the most impoitant foices diiving changes in
the capital stiuctuie. Tese maiket evaluations of the piospects of
success oi failuie of the im and its capital combination aie ieected
in the nancial assets associated with the im. Te nancial assets (foi
example, debt and equity) foima supeistiuctuie ovei the capital assets
of the company and constitute its asset structure. Tey aie claims to the
physical assets of the company and as such ieect theii value (oi oth-
eis opinions of theii value). Tus, theie is an economy-wide nancial
structure (composed of the individual asset stiuctuies) that is ielated
to and ieects the capital stiuctuie of the economy. Te capital stiuc-
tuie and the capital combinations of which it is composed aie in tuin
ielated to the plan stiuctuie. At each of these levelsplans, physical
assets, and nancial assetsvaiious institutions exist that help dene
the vaiious stiuctuies. A vitally impoitant institution in the nancial
stiuctuie is the stock maiket. On the stock maiket assets aie valued
and ievalued eveiy day in accoidance with companies peifoimances.
Te stock maiket ieects a daily balance of expectations conceining
the eaining piospects of companies. lt is piobably faii to say that
Lachmann consideied the stock maiket to be the most impoitant in-
stitution of the maiket economy (he did not shaie Keyness view that
it was basically iandom in natuie (Lachmann 1vcec1)) and the one,
moie than any othei, that dieientiated it fiom socialized economies
the institution that, togethei with otheis in a piivate nancial capital
maiket, was iesponsible foi facilitating the adoption of those capital
combinations that contiibute to economic piogiess (Lachmann 1vvz).
Capital gains and losses piovide entiepieneuis with feedback
fiom the maiket. Ventuies that continue to sustain capital
losses will eventually have to iegioup oi stop opeiating. ln this
way the nancial stiuctuie and the capital stiuctuie inteiact to
pioduce a continuing ieshaping of the lauei.
(Lachmann 1vcv.)
Cash Balances as Excess Capacity and Constraint
A moie immediate foim of feedback comes in the foim of changes in
the cash balances of the company. Te company holds cash as a foim
of excess capacity in oidei to pieseive exibility. ln a sense, cash is
the most substitutable of the companys capital assets. Tus changes
1!c CAPlTAL lN DlSEQUlLlBRlUM
in cash balances, like changes in inventoiy, piovide an impoitant indi-
catoi of the iesults of the opeiation ovei a peiiod of time. A peisistent
negative cash ow is the ultimate long-teim discipline and ofen also
the ist indicatoi of a pioblem.
v
Lachmann sees the tiaditional neoclas-
sical poitfolio appioach to cash balance and nancial asset holding as
misleading. While it is tiue that pioduction plans must include deci-
sions about nancial asset mix (the optimum mannei of nancing), to
assume that observed cash and asset poitfolios ieect optimal choices
is to lose sight of the feedback piocess discussed above. Tat is to say,
empiiically obseived changes in cash holdings and asset values ieect
not only intended outcomes but they also ieect iesults that aie unin-
tended (mistakes oi suipiisesgood and bad). ln the poitfolio equilib-
iium view, the poitfolio ieects the iesults of poitfolio selection based
on undeilying piefeiences and shaied knowledge. ln Lachmanns (dis-
equilibiium) maiket piocess view, the poitfolio value ieects poitfolio
iesults which aie ofen dieient fiom what was intended and cannot
be assumed to ieect accuiately the piefeiences and intentions of the
planneis. Rathei it is a baiometei of the viability of the oveiall plan.
Capital gains and losses. . . . [E]ssentially . . . ieect in one spheie
events, oi the expectation of events, the occuiience of which in
anothei spheie is indicated, and knowledge of which is tians-
miued, by changes in money ows.
(Lachmann 1vcv)
Capital Accumulation Ordinarily Involves a Changing Capital
Structure
Peihaps the most impoitant geneial implication of a disequilibiium ap-
pioach to capital is the pioposition that all capital accumulation entails
a anging capital structure. Tis follows fiom the obseivation that
most technical change is embodied in new (impioved) capital goods
and/oi involves the pioduction of new consumption goods. Capital
accumulation that accompanies economic giowth as we know it is
not simply the addition of the same kinds of capital goods doing the
v
Of couise, negative cash ows occui ioutinely and aie planned foi in stait-up
businesses, some of whom go on to become coipoiate giants. lt seems as though a
distinction between planned and unplanned might be useful heie.
MODERN MENGERlAN CAPlTAL THEORY 1!v
same things. Lachmanns view of capital accumulation and economic
piogiess is in many ways veiy piophetic of the ievolutionaiy kind
of economic change that has chaiacteiized the twentieth centuiy, in-
cluding the last quaitei of the centuiy. lt is, in this view, impossi-
ble to sepaiate the phenomena of technical piogiess and capital ac-
cumulation, capital accumulation always pioceeds hand in hand with
technical change. By the same token, failed pioduction plans imply
holes in the capital stiuctuie that signal investment oppoitunities
foi otheis. An appioach to economic giowth that visualizes capital
as a homogeneous aggiegate to which investment expendituie adds in
an indisciiminate way, so that a goveinment policy adding diiectly to
investment expendituie is, in essence, no dieient fiom an inciease
in piivate entiepieneuiial investment expendituie, is not only unten-
able but also has fai-ieaching consequences. Te capital stiuctuie
will be irreversibly dieient in these two cases. lt is veiy likely that
goveinment expendituie ciowds out not only piivate sectoi expen-
dituie but also piivate-sectoi-induced technical piogiess. Te shape
of the capital stiuctuie will be dieient and, because capital assets aie
heteiogeneous, specic, and duiable, will iemain dieient fiom what
it would otheiwise have been. lt takes a lot of faith in the abilities
and objectives of the goveinment agents involved to imagine that no
saciice in entiepieneuiial discoveiy is involved.
1u
e Disequilibrium Method is Particularly Applicable in a World
of Rapid Changes
Te woild aiound us abounds with pioblems to which a stiuc-
tuial theoiy of capital of the type outlined in this book is gei-
mane. lt is hoped that a numbei of them will auiact the auen-
tion of economists.
(Lachmann 1vcxi)
Te choice of how to chaiacteiize capital is dependent on the kind of
woild in which one lives. ln a woild in which unexpected changes oc-
cui ielatively iaiely and in which methods of pioduction, distiibution,
1u
Lachmanns capital theoiy fiamewoik blends nicely with Kiizneis views on
entiepieneuiship and Hayeks views on infoimation to yield some veiy specic in-
sights on investment policy.
1.u CAPlTAL lN DlSEQUlLlBRlUM
and inteiaction aie veiy stable (Adam Smiths coin economy), it might
make sense to chaiacteiize capital as an equilibiium stock, a fund of
moie oi less agieed-upon value. But in a woild in which change is
iapid and unpiedictable, Lachmanns chaiacteiization of capital as a
stiuctuie of heteiogeneous items becomes even moie appiopiiate. ln
paiticulai, with iegaid to the eect of change on incomes, employ-
ment, and lifestyles, Lachmanns changing capital stiuctuie gives in-
sights that aie not available fiom an equilibiium appioach.
lt is geneially agieed that we aie living in an age of piofound
changes. lt is not the fact of changes in technology that is ievolu-
tionaiy, it is the speed with which it is occuiiing that is new. Te
pace of change is not only quickei, it is acceleiating. At the same
time, howevei, oui ability to absoib and adjust to change has incieased
many-fold.
Undeilying viitually all of the majoi developments of this centuiy
is the ievolutionaiy change in the way in which we geneiate and use
infoimationhence the phiase infoimation age. ln some iespects
this is only the latest in a line of similai ievolutions like the oiiginal
emeigence of language and the development of wiiting, accounting,
and piinting. Te latest, and to date most piofound, development in
this line of developments is electionic communication, of which the
telephone, the computei, and the video and audio iecoidei aie all
pait. Electionic communication in all of these aspects is iesponsible
foi the developments of global maikets, of desktop publishing, of fuel
injectois foi automobiles, of computei aided design of eveiything fiom
miciochips to aiiplanes, and so on.
To undeistand the phenomenon of acceleiating change occuiiing
togethei with oui enhanced abilities to adapt to change we must iealize
that the scope and pace of tenological ange itself is governed by our
ability to generate and process relevant information. Tis means that
the cuiient pace of technical change is dependent on past technical
advances, paiticulaily the ability to geneiate and piocess infoimation.
lf technological change is seen as the iesult of many tiial-and-eiioi
selections (of pioduction piocesses, of pioduct types, of modes of distii-
bution, etc.) then the ability to geneiate and peiceive moie possibilities
will iesult in a gieatei numbei of successes. lt will, of couise, also
iesult in a gieatei numbei of failuies. Lachmanns pioposition that
capital accumulation, pioceeding as it does hand in hand with techno-
MODERN MENGERlAN CAPlTAL THEORY 1.1
logical change, necessaiily biings with it capital iegiouping as a iesult
of failed pioduction plans, appeais in this peispective to be paiticulaily
peitinent. [E]conomic piogiess . . . is a piocess which involves tiial
and eiioi. ln its couise new knowledge is acquiied giadually, ofen
painfully, and always at some cost to somebody (Lachmann 1vc1c).
Today new knowledge acquisition is not so giadual.
e Market Process has Discernible Phases: Imitation and
Innovation
Te maiket piocess is one of continual ux. Te shaping and ieshaping
of the capital stiuctuie is diiven by the changing shape of the mix of
consumei pioducts. Tis peispective led Lachmann to a chaiacteiiza-
tion of maiket activities in teims of two distinct phases. Acompetitive
piocess taking place within the maiket foi a good consists typically
of two phases, and in it the factois of innovation and imitation may
be isolated as iteiative elements (Lachmann 1vce1). Te successful
intioducei of a new pioduct oi new biand of pioduct gains tempoiaiy
monopoly powei. Te spieading knowledge of this success auiacts im-
itatois. Te leaining cuive foi the lauei is shoitei. Piices tend to fall as
maigins aie competed away. Tis biings fuithei piessuie foi pioduct
dieientiation and capital ieshuing (ieoiganization). Te piocess is
insepaiable fiom technological change. Maiket shaie and im size at
any point of time thus have veiy liule to do with monopoly powei.
Tey aie both tiansitoiy states of a continuing innovationimitation
cycle. Tis view nds close application in the electionics industiy and
the development of peisonal computeis, fax machines, copy machines,
cameias, cellulai phones, and so on. Notably the innovationimitation
cycle is shoitening. Tis is anothei aspect of the iapidity and accelei-
ation of change. liom this peispective the classical doctiine of capital
ows establishing a unifoim iate of piot is found seiiously wanting.
From Bhm-Bawerk to Lamann and Ba: e Division of
Labor and the Division of Capital
An impoitant aspect of the infoimation ievolution is that it allows foi
the foimation and management of evei moie complex capital stiuc-
tuies. ln his woik on capital Lachmann pioposed a ieinteipietation
1.z CAPlTAL lN DlSEQUlLlBRlUM
of a contioveisial aspect of Bhm-Baweiks theoiy, his famous piopo-
sition conceining the supeiioi pioductivity of ioundabout pioduction
(i.e., of pioduction piocesses that aie moie indiiect, that take moie
pioduction time) (Lachmann 1vc ch. V). Lachmann iegaided Bhm-
Baweiks use of time as a unit of measuiement foi the capital stock
as untenable and seiiously misleading. He felt stiongly, howevei,
that Bhm-Baweiks intuition about the souices of economic piogiess
was coiiect. [T]he intuitive genius of Bhm-Baweik gave an answei
[that], to be suie we cannot fully accept and which, moieovei, is
maiied by an excessive degiee of simplication, yet an answei we
cannot aoid to disiegaid (Lachmann 1vc!). Teiefoie he suggests
dispensing with the notion peiiod of pioduction and ieplacing it with
the notion degiee of complexity. Wheieas Bhm-Baweik aigued
that the peiiod of pioduction incieased with capital accumulation,
Lachmann aigues that capital accumulation iesults in the incieasing
complexity of the pioduction piocess. ln this way he hoped to have
given a new and moie appiopiiate meaning to the notion of incieased
ioundaboutness. Lachmann aigued that Bhm-Baweiks ideas weie
closely ielated to those of Adam Smith (Lachmann 1vcv). Both
weie conceined about the souices of economic piogiess. Both lived in
a woild that was neithei a stationaiy noi a fully dynamic woild
(1vcv). Oui woild is, howevei, a dynamic woild, one in which
technical piogiess is an outstanding featuie. loi Bhm-Baweik, iound-
aboutness was not a foim of technical piogiess. Technical piogiess
iequiies new foims of knowledge spieading thiough the economic sys-
tem while Bhm-Baweik assumes as given knowledge equally shaied
by all (1vcv).
loi Adam Smith the division of laboi was the most impoitant
souice of piogiess. Te same piinciple can be applied to capital.
As capital accumulates theie takes place a division of capital,
a specialization of individual capital items, which enables us to
iesist the law of diminishing ietuins. As capital becomes moie
plentiful its accumulation does not take the foim of multiplica-
tion of existing items, but that of a change in the composition
of capital combinations. Some items will not be incieased at
all while entiiely new ones will appeai on the stage. . . . Te
capital stiuctuie will thus change since the capital coecients
MODERN MENGERlAN CAPlTAL THEORY 1.!
change, almost ceitainly towaids a highei degiee of complexity
i.e. moie capital items will now be included in the combina-
tions. Te new items, which eithei did not exist oi weie not
used befoie, will mostly be of an indivisible chaiactei. Com-
plementarity plus indivisibility aie the essence of the mauei.
lt will not pay to install an indivisible good unless theie aie
enough complementaiy capital goods to justify it. Until the
quantity of goods in tiansit has ieached a ceitain size it does
not pay to build a iailway. A pooi society theiefoie ofen uses
costliei (at the maigin) means of tianspoit than a wealthiei one.
Te accumulation of capital does not meiely piovide us with
the means to build powei stations, it also piovides us with the
means to build factoiies to make them pay and enough coal to
make them woik. Economic piogiess iequiies a continuously
changing composition of social capital. Te new indivisibilities
account foi the incieasing ietuins.
(Lachmann 1vcvcu, italics in oiiginal)
11
Bhm-Baweiks thesis about the highei pioductivity of ioundabout
pioduction is an empiiical geneialization. lt can be applied, ieintei-
pieted, to oui own woild. We have achieved, and will continue to
achieve, gieatei pioductivity, that is, the pioduction of moie and bet-
tei consumption goods and seivices, by the continuing intioduction
of new indivisible pioduction goods (which embody new pioduction
techniques). Tis can be cast in teims of Bhm-Baweiks idea of stages
of matuiity. Bhm-Baweik aigued that capital accumulation will take
the foim of an inciease in the numbei of stages of pioduction. Te
iichei a society the smallei will be the piopoition of capital iesouices
used in the latei stages of pioduction, the stages neaiest to the con-
sumption end, and vice veisa (Lachmann 1vccz). (We leave aside
the question of identifying a stage of pioduction concentiating on
the intuitive meaning of Lachmanns point.) Te incieased numbei of
stages is indicative of incieased complexity, which, in tuin, is indica-
tive of incieased pioductivity. lncieased complexity implies an evei
moie complex pauein of capital complementaiity (ibid.c).
11
ln an impoitant sense duiability is an aspect of indivisibility. While it might
be technically possible, the cost of pioducing a one-blow hammei would be ceitain
to exceed the value of this task (Steele 1vve1..). Te piotability of pioducing a
hammei thus depends on theie being sucient demand foi its multiple uses.
1.. CAPlTAL lN DlSEQUlLlBRlUM
We conclude that the accumulation of capital iendeis possible
a highei degiee of the division of capital, that capital specializa-
tion as a iule takes the foim of an incieasing numbei of piocess-
ing stages and a change in the composition of the iaw mateiial
ow as well as of the capital combinations at each stage, that
the changing pauein of this composition peimits the use of
new indivisible iesouices, that these indivisibilities account foi
incieasing ietuins to capital, and that these incieasing ietuins
to the use of capital are, in essence, the highei pioductivity of
ioundabout methods of pioduction.
(Lachmann 1vcc.c, italics in oiiginal)
1z
linally, Lachmann contends that the incieased complexity of the capi-
tal stiuctuie also implies an incieased vulneiability.
A household with six seivants each of whom is a specialist and
none of whom can be substituted foi anothei, is moie exposed
to individual whims and the vagaiies of sickness than one that
depends on two oi moie geneial maids. Tus an expanding
economy is likely to encountei pioblems of incieasing com-
plexity . . . [among which aie] dispiopoitionalities and the ie-
sulting maladjustment of the capital stiuctuie [which] may give
iise to seiious pioblems in economic piogiess.
(Lachmann 1vcc)
Concluding Summary
Lachmanns capital theoiy seems to have been ahead of its time. lt
was mostly ignoied. Yet, when consideied in the light of iecent devel-
opments in the theoiy of oiganizational stiuctuie, one nds a stiiking
numbei of commonalities (without any iefeience to Lachmann, how-
evei).
1!
Lachmanns capital theoiy can be seen as a kind of unintended
1z
Te iefeience heie to incieasing ietuins is especially notewoithy in light of the
cuiient iediscoveiy of the phenomenon in the context of a vaiiety of new initiatives
in economics. Tese include the new focus on nonlineai economics (Day and Chen
1vvz), the economics of lock in (Aithui 1vcv, 1vv.), institutions and economics, and
evolution and economics (Hodgson 1vcc, 1vv!). Economists aie now beginning to
place gieatei emphasis on the impoitance of paiticulai histoiical events in explaining
the emeigence of technologies in a mannei that Lachmann cleaily foieshadowed in
his capital theoiy. On the topic of incieasing ietuins see Buchanan and Yoon (1vv.).
1!
At the time of this second edition, this has changed diamatically. Te manage-
MODERN MENGERlAN CAPlTAL THEORY 1.
pielude to some of this woik. ln addition, these commonalities ieect
back on Lachmanns woik in giving a new, and aiguably moie com-
plete, view of capital and its stiuctuie.
Lachmann establishes that the competitive piocess and capital ac-
cumulation aie inextiicably linked. luitheimoie, capital accumulation
(the piogiessive cieation of capital value ovei time) necessaiily implies
an evolving capital stiuctuie, that is, a capital stiuctuie that is becom-
ing moie complex. Te degiee of specialization and inteidependence
giows. He captuies this inteidependence by the notion of comple-
mentaiity. Resouices that depend on each othei in joint pioduction
aie complementaiy. ln the face of unexpected changes such joint
ventuies (capital combinations) ofen have to be iegiouped. Much
depends, theiefoie, on the degiee to which existing iesouices can be
adapted to oiiginally unintended uses, a piopeity that Lachmann calls
multiple specicity. Te vaiiations in the degiee of specicity aie ie-
ected in the capital gains and losses expeiienced as a iesult of the
changes that occui and aie the ciucial diiving foice of the maiket
piocess.
Lachmanns theoiy is thus a theoiy of piogiess in which such
piogiess is ieected in and achieved by a continuing specialization of
economic activities, a giowing division of capital to supplement (and
complement) Adam Smiths division of laboi, we have, in geneial, an
incieasing division of function. What is noticeably absent fiom the
theoiy is an explanation, apait fiom a kind of black box iefeience to
the maiket, of how this is accomplished. Tat is to say, we aie not told
how this piogiessing complexity is managed.
1.
How, to use Hayeks
famous phiase, is the necessaiy division of knowledge implied by the
incieasing division of function to be oiganized` Lachmanns theoiy
subsumes, and does not explain, an oiganizing function, which he del-
egates to the entiepieneui. Lachmann would suiely agiee, howevei,
ment and oiganizational liteiatuie is now ieplete with iefeiences to Hayek, Kiiznei
and, most iecently, Lachmann, most piominently in the giowing aiea of entiepie-
neuiial studies. See foi example Chiles, Bluedoin, and Gupta (zuu) foi an appiecia-
tion of Lachmanns woik. See also Chiles, Tuggle, McMullen, Bieiman, and Gieening
(zu1u).
1.
He seems to imply that a piogiessive veitical disintegiation takes place, thus
suggesting an immanent theoiy of the size of the im. ln this way his theoiy is ielated
to the liteiatuie on the dynamics of the im to be discussed below.
1.e CAPlTAL lN DlSEQUlLlBRlUM
that the evolving capital stiuctuie is necessaiily pait of an evolving
oiganizational stiuctuie.
Since all pioduction in the modein woild is joint pioduction involv-
ing capital combinations (that is, combinations of iesouices in geneial,
including capital), pioduction necessaiily involves oiganizing oi cooi-
dinating the vaiious activities of the iesouices involved. How is this
done` Who owns the iesouices and why` Moie specically, ielating
to the imputation pioblemanticipated above, theie is always a pioblem
of how to shaie the fiuits of any joint ventuie. All pioduction activ-
ities aie joint (coopeiative) ventuies, diiectly oi indiiectly, between
individuals (woikeis, capital owneis, entiepieneuis). So the question
of oiganizational stiuctuie aiises logically out of Lachmanns woild-
view.
CHAPTER v
Capital and Business Oiganizations
[l]n capitalist ieality as distinguished fiom its textbook pictuie,
[the] . . . kind of competition which counts [is] the competition
fiom the new commodity, the new technology, the new souice
of supply, the new type of organization.
(Schumpetei 1v.c.c, italics added,
quoted in Peniose 1vv11.n.)
Bhm-Baweik aigued that economies piogiess by the piogiessive
adoption of wisely chosen ioundabout methods of pioduction. Lach-
mann ieinteipieted this to mean the evolution of abilities enabling the
use of moie and moie complex pioduction stiuctuies. How is it that
Bhm-Baweiks wise choices get made and that such abilities to use
moie complex methods evolve`
ln this chaptei l investigate the ielationship between capital and
business oiganizations. Te classical appioach to capital that devel-
oped out of the economics of Ricaido (whethei in its neo-Ricaidian
oi neoclassical vaiiety) did not featuie capitalist institutions in any
way. And although Cail Mengei was among the ist, and most pio-
found, of economists to analyze the diveise natuie and function of
institutions, he did not tie up his insights into the compositive natuie
of capital with the decision-making functions of business institutions.
Hayek and Lachmann, woiking in the Mengeiian tiadition, elaboiated
on Mengeis insights, but did not develop a theoiy of oiganizational
stiuctuie to complement the theoiy of the capital stiuctuie examined
in the pievious chaptei.
A laige liteiatuie on the stiuctuie of business oiganizations has
iecently developed. lt has been vaiiously chaiacteiized as the new
institutional economics (Langlois 1vceb), tiansaction cost economics,
1.
1.c CAPlTAL lN DlSEQUlLlBRlUM
evolutionaiy economics, and post-Maishallian economics.
1
ln many
ways it is most accuiately thought of as an alteinative to (ciitique of,
extension ol) the neoclassical theoiy of the im. lt is beyond oui
puipose to undeitake heie a ieview oi evaluation of this liteiatuie.
We examine, howevei, its implications foi an undeistanding of how
a capitalist economy woiks.
Tat theie aie indeed such implications is peihaps the explana-
tion foi the scaicity in modein economics of contiibutions that can
be classied in the eld of capital theoiy. Te highly abstiact debates,
exploied in Pait l, take on an incieasingly steiile appeaiance in the
light of these mounting contiibutions on the peiipheiy of mainstieam
economics ielating to an undeistanding of the oiganizations that ac-
tually accumulate and use capital. Tis liteiatuie has only iecently
auempted a connection to the theoiy of capital moie bioadly. We
begin by examining two pioneeiing contiibutions.
Capabilities and Capital
Tis new liteiatuie on business oiganizations is sometimes also iefeiied
to as the capabilities liteiatuie.
z
Tis is in iefeience to the conception
of a im as a iepositoiy of ceitain kinds of evolving abilities that aie
the key to undeistanding the why and how of the im (Demsetz
1vv1). lt is in oidei to oiganize the necessaiy capabilities in a ieliable
mannei that the im is seen to deiive its puipose. So in a fundamental
way, this liteiatuie giows out of the pioblemoiiginally posed by Ronald
Coase (1v!) in his classic aiticle piobing the essential iationale of the
im (Williamson and Wintei 1vv1). Using the maiket to puichase the
necessaiy inputs (capabilities) is costly, involving tiansactions costs (the
need to locate, identify, and baigain foi inputs and constiuct and en-
foice contiacts) which have to be balanced against the costs of inteinal
owneiship and diiection of iesouices (the costs of tiaining, monitoiing,
1
Te invocation of Maishalls name is ielated not to his neoclassical theoiy of
costs and supply, but iathei to his insistence that biology and evolution aie moie
enlightening in the business enviionment than aie mechanics and physics, and to his
many discussions of the iole of institutional factois (like tiade piactices and agiee-
ments) in the oidinaiy business of life.
z
lt is closely ielated to, and ofen oveilaps with, contiibutions in manageiial eco-
nomics and coipoiate stiategy and is sometimes iefeiied to as the iesouice-based
view of the im. See, foi example, Collis and Montgomeiy (1vvc). loi an impoitant
pioneeiing aiticle see Teece (1vcz).
CAPlTAL AND BUSlNESS ORGANlZATlONS 1.v
and policing). Te natuie of these vaiious costs have been the substance
in much of the discussion of this liteiatuie. lt is not suipiising, as we
shall emphasize below, that they involve consideiations ielating to the
natuie and acquisition of dieient types of knowledge.
A paiallel souice of oiigin of this capabilities liteiatuie, and the
one fiom which it deiived its name, is the pioneeiing woik of G. B.
Richaidson (1vvu, 1vz)
!
and Edith Peniose (1vv). Tis appioach is
moie conceined with the way in which ims function and giow than
in explaining theii existence, although the lauei emeiges by implica-
tion. So this second souice has adopted a moie dynamic, evolutionaiy
appioach and one that is moie obviously ielated to the question of
capital accumulation.
Capabilities and Equilibrium: G. B. Riardson
ln common with Lachmanns appioach to capital, Richaidsons exam-
ination of investment in business institutions is an avowedly disequi-
libiium appioach. ln stiikingly similai fashion to Lachmann (but ap-
paiently independently),
.
Richaidson mounts a devastating ciitique
(peihaps the nest to be found) of the ielevance of the model of pei-
fectly competitive equilibiium (1vvupt 1). Teie aie, as we will see,
othei infoimative commonalties.
Richaidson advocates
the seuing aside of the concept of peifect competition, both as
an explanatoiy device and as an ideal, my aim being to demon-
stiate that, even as a hypothetical system, it has one quite funda-
mental aw, the exposuie of which will point the way in which
constiuctive ievision can most piopeily be made.
(Richaidson 1vvu1)
Tis fundamental aw is the inability of entiepieneuis (investois in
capital) to get the necessaiy infoimation, in oi out of equilibiium. lf
they weie in equilibiium, how would they know it, how would they
know theii actions weie optimal` lf they weie out of equilibiium,
how would they get the infoimation necessaiy foi them to take the
actions that would pioduce a tendency towaid equilibiium` (Recall
oui discussion in Chaptei !.)
!
Te teim capabilities in this context was invented by Richaidson.
.
lt seems that the common denominatoi is Hayek (1v!a).
1u CAPlTAL lN DlSEQUlLlBRlUM
Given the manifest inconsistencies and implausibilities of the equi-
libiium model, Richaidson sets himself the task of explaining how
it is that investment activities actually pioceed in a highly oideily
fashion in which the activities of supplieis, manufactuieis, and con-
sumeis aie in gieat measuie highly cooidinated, even in the face of
changes in the economic enviionment. He begins by distinguishing be-
tween two kinds of ielevant investment infoimation market informa-
tioninfoimation about the activities of othei maiket paiticipants
customeis, competitois, oi supplieiswhich obviously inuences the
piotability of investment, and tenical informationinfoimation ie-
lating to the physical tiansfoimation possibilities. lt is the availability
of maiket infoimation that Richaidson sees as most pioblematic.
lt is evident an entiepieneui could iationally undeitake an in-
vestment decision only if he had some minimum infoimation
about what othei entiepieneuis would oi would not do, if he
weie assuied that competitive investment would not exceed
and complementaiy investments would not fall shoit of, ceitain
ciitical levels. (Richaidson 1vvu!z)
Since a geneial piot potential, which is known to all, and equally
exploitable by all, is, foi this ieason, available to no one in paiticulai
(ibid.1.), Richaidson is conceined to deteimine how entiepieneuis ob-
tain the minimum necessaiy infoimation. lnvestois in capital piojects
need infoimation about complementaiities and about substitutes. We
considei these in tuin.
Complementaiities occui at two levels. On one level they iefei to
necessaiy complementaiy activities iequiied to complete the pioject.
Tis includes the supply of mateiials by supplieis, the piovision of sei-
vices by contiactois, and similai activities. And, obviously, these com-
plementaiy activities must be available at the iight time in the iight
sequence. We see heie a manifestation of the time stiuctuie of pio-
duction. At anothei level theie aie complementaiities in consumption
that will deteimine the piotability of any investment pioject taken in
isolation.

Te sale of iadios will depend on the availability of electiic-

ity. (One may iecall heie Lachmanns discussion of indivisibilities and
the scale and scope of investments, a theme echoed by many theoiists

Activities aie complementaiy in the sense that theii combined piotability when
undeitaken simultaneously, exceeds the sum of the piots to be obtained fiom each
of them if undeitaken by itsell (Richaidson 1vvuz).
CAPlTAL AND BUSlNESS ORGANlZATlONS 11
in this liteiatuie.) Computeis must be sold in oidei foi the pioduction
of piinteis and of sofwaie to be piotable (and vice veisa). We see
heie a manifestation of a stiuctuie of consumption activities, which
has its own logic in time and space and which will concein us latei.
Richaidson is giappling with the evolution of the capital stiuctuie
fiom the bouom up, as it weie. Like Lachmann, he peiceives this
stiuctuie as held togethei by complementaiities at vaiious levels, no-
tably levels inteinal and exteinal to the im.
e
But he is much moie
explicit iegaiding the micioeconomics of the evolution of this capital
stiuctuie. Te capital stiuctuie exists within and is dependent on a
bioadei decision-making stiuctuie that addiesses the pioblem of how
the minimum infoimation necessaiy foi the making of decisions is
made available to the decision-makeis. Richaidson identies a numbei
of helpful impeifections that constitute this decision-making stiuc-
tuie. Among competitois we nd numeious types of tiade agieements
(dening aspects of the iules of the game), joint ventuies, and tacit
undeistandings that ensuie that peiceived oppoitunities aie not squan-
deied. Much evidence exists (Chandlei 1v, 1vvu, 1vvz) to suggest that
caitel foimation, antitiust conceins to the contiaiy notwithstanding,
weie ciucial stages in the emeigence of modein capitalism.

A dieient kind of impeifection exists that helps to ensuie that

iesponses by competitois to peiceived piot oppoitunities do not
e
An entiepieneui will have to iecognize that the piotability of his own invest-
ment will depend on the teims on which he can obtain inputs, and theiefoie indiiectly
on the volume of the investment which has been, oi will be, undeitaken elsewheie.
Tus the same kind of complementarity whi exists between the application of dierent
resources within the rm, exists also between the application of resources by dierent
rms. ln the foimei case cooidination, designed to ensuie the best combination of
complementaiy factois, is biought about diiectly by the entiepieneui in contiol, in
the lauei, it has to be achieved by dieient means (Richaidson 1vvu!, italics added).
And in consideiing the inteidependence as well as the cost stiuctuies of dieient
ims, he notes, Te whole economy one may piesume, is united by bonds of this
kind, the stiength of which will vaiy widely accoiding to ciicumstances (ibid..).

As l have suggested iepeatedly, and shall have occasion to iepeat again, these
evolved devices aie made necessaiy by the dynamic natuie of the woild in which
investment decisions aie taken. ln a woild in which no signicant changes weie
taking place they would be (oi would become) unnecessaiy. And indeed, in such a
woild, caitel and piice xing/maiket shaiing agieements might indeed be a concein
foi eagei policy-makeis. But a woild of peisistent technological change invites and
iequiies peisistent oiganizational change and, in any case, is not conducive to such
anticompetitive agieements enduiing ovei time.
1z CAPlTAL lN DlSEQUlLlBRlUM
negate them (the oppoitunities). Tese fall into the categoiy of fac-
tois limiting the ability of individual ims to expand in iesponse
to peiceived oppoitunities. Unlike the neoclassical im,
c
ims in
a dynamic woild aie idiosynciatic, they possess unique (inimitable)
and limited capabilities that they have developed ovei the couise of
theii histoiies (not always in a conscious mannei).
v
Richaidson iefeis
heie to economies of expeiience that seive as natuial and helpful
baiiieis to entiy (ibid.eu). Tus not eveiy would-be investoi is in a
position to take advantage of a peiceived oppoitunity at any point
of time oi within the ielevant peiiod (indeed the very perception of
the opportunity may depend on paiticulai capabilities). Emphasis is
laid heie on the impoitance of investments in specic and specialized
assets, that is assets whose value is somewhat unique to the imwithin
which they aie combined with othei specic assets in a complementaiy
ielationship.
Te moie specic the iesouices iequiied foi the manufactuie
of the pioduct, and the smallei theii elasticity of supply, the
gieatei will be the likelihood that scaicities and boulenecks will
detei fuithei expansion. Expansion in the capacity of some
industiy may be tempoiaiily held up, that is to say, by delay
in undeitaking complementaiy investment elsewheie.
(ibid.e1)
Te infoimation iequiiements implied by complementaiities aie simi-
laily mitigated by infoimation netwoiks and specic capabilities. Ev-
eiy investment pioject can be conceived of as a conscious, if necessai-
ily and delibeiately vague (because of the need foi adaptability), plan.
c
lt is inteiesting to note that in the neoclassical liteiatuie the pioduction function
does double duty, seiving as a tool of analysis foi both the economy as a whole and
foi the individual im. Given the assumption of CRS in ieadily identiable inputs,
this is not suipiising, since theie is nothing to limit the size of im. ln an impoitant
sense the economy is simply the im wiit laige.
v
lt is dicult to avoid the use of anthiopomoiphic language that suggests the im
possesses some soit of collective consciousness. l aim stiongly, howevei, that it is
ultimately the individuals in the im, at any point in time, in theii vaiious capacities
that aie the decision-makeis and the peiceiveis of infoimation and in whom the capa-
bilities of the im must ultimately ieside. l hope to make cleai in what way the oiga-
nization (the im) may manifest these capabilities in dieient individuals at any point
of time yet piovide foi theii caiiying foiwaid thiough time and acioss individuals.
CAPlTAL AND BUSlNESS ORGANlZATlONS 1!
Eveiy business can be iegaided as having to foimulate, with
gieatei oi lessei piecision, an investment piogiam consisting
of a set of planned activities ielated thiough some piocess of
pioduction oi tiansfoimation. lt will be based on an assessment
of the vaiious technical and maiket conditions upon which the
piices at which the im will buy its inputs and sell its outputs
will depend. As this assessment is likely to be in the foim, not
of ceitain knowledge, but of expectations of vaiying degiees
of ieliability, an entiepieneui will wish his piogiam to be as
exible oi adaptable as possible, in oidei that it can be modied
to take account of changing and unexpected ciicumstances.
(Richaidson 1vvuv)
Tat plan will usually include contiacts of vaiious teims and condi-
tions, which will tend to ieduce the degiee of unceitainty auaching
to the pioduction plan, but only at the saciice of adaptability. ln
addition, the fieedom of choice of the entiepieneui is fuithei likely
to be iestiicted by the fact that ceitain woik is alieady in piogiess
and ceitain specic inputs have alieady been puichased. One may
assume that the entiepieneui will auempt to balance adaptability and
unceitainty in a dynamic way as time unfolds. Tis unceitainty is of
a iadical oi stiuctuial natuie (Langlois and Robeitson 1vv), that
is, it is not piobabilistic unceitainty, but unceitainty about the veiy
stiuctuie within which decisions will have to be made in the futuie. lt
includes unceitainty about the paiticulai factoi combinations which,
at some futuie date, it will piove most advantageous to adopt (Richaid-
son 1vvuc!). Richaidson is thus emphasizing the element of tiial and
eiioi piesent in eveiy ieal-woild pioduction piocess. Tus we can say
theie is no unique single way in which complementaiy investments
come to be cooidinated (ibid.c.). And theie is ceitainly no unique
way that is known ahead of time to all pioduceis, as suggested by a
simple pioduction function foimulation. ln teims of the maiket (oi the
economy) as a whole, then, the imcannot be said to be in equilibiium.
Teie is no oveiall plan consistency. [D]ieient people may foim
dieient expectations oi beliefs on the basis of identical infoimation
(ibid. 1cc).
Richaidson does not dwell on the necessaiy failuies that must oc-
cui as a iesult of these inconsistenciesthe tiial-and-eiioi piocess at
the level of the maiketand is moie conceined to showhowsuccessful
1. CAPlTAL lN DlSEQUlLlBRlUM
pioduction decisions can be made. His analysis is iich and (although it
was ielatively neglected foi some time) has laid the basis of a numbei
of impoitant contiibutions to oui undeistanding of the woikings of
oiganizations and investment piocesses.
Penrose and the Growth of the Firm
Peihaps an equally impoitant, and in veiy many ways complementaiy,
pioneeiing woik, is that of Edith Peniose (1vv). Penioses woik is
conceined with the dynamics of ims. What exteinal and inteinal
factois aie iesponsible foi the way in which ims develop ovei time,
the activities they undeitake (oi contiact with otheis to undeitake),
the techniques they adopt, the pioducts they choose to pioduce and
so on`
1u
Te im is viewed as a specialized pool of iesouices (cf.
capabilities)
11
whose natuie (pioductive potential) changes ovei time
in iesponse to events inteinal and exteinal to the im. Peniose has a
compelling bona de theoiy of endogenous change.
With the passage of time, the knowledge possessed by the employ-
ees in any im changes. Tis knowledge, which includes pioductive
and oiganizational skills ielated to the ims paiticulai expeiience,
is a pioductive iesouice specic, in some degiee, to the im. Tus,
with time and expeiience, the imaccumulates pioductive capabilities
that piovide it with an impoitant souice of excess capacity. loi
example, in the eailiei stages of the pioduction and intioduction of
a new pioduct, employees aie in the piocess of tiial and eiioi leaining
about the pioduct. As they accumulate expeitise, much of which is of
an infoimal, noncommunicable natuie, they will nd that they need
less eoit to achieve the iesults. Te accumulated skills will piesent
the im with a foim of incieasing ietuins and indivisibilities that ciy
out to be used and piovide an iiiesistible inteinal impetus to expansion.
Much of what was novel becomes ioutine, leaving capacity foi the
development of new endeavois. Tis expansion occuis natuially into
the pioduction of new pioducts and seivices that use similai skills (a
point emphasized also by Richaidson (1vz)). Skills, howevei, aie con-
1u
We note again the caveat about using language that suggests that the im per se
chooses.
11
Peniose iefeis to these as competencies.
CAPlTAL AND BUSlNESS ORGANlZATlONS 1
tinually changing. Since expeiience geneiates new knowledge, the
pioductive oppoitunity of a im will change even in the absence of
any change in exteinal ciicumstances oi in fundamental knowledge
(Peniose 1vve, see also Loasby 1vv1ez).
Expansion may occui thiough meigei and acquisition, which is a
way to acquiie specialized human capital, oi thiough inteinal expan-
sion. But, howevei it occuis, in a competitive, technologically piogies-
sive industiy, a im specializing in the pioduction of given pioducts
can hope to maintain its position with iespect to those pioducts only if
it is able to develop an expeitise in technology and maiketing sucient
to enable it to keep up with and paiticipate in the intioduction of
innovations aecting its pioducts (Peniose 1vv1!z).
Expansion is also ofen necessaiy in a giowing maiket because
a ims shaie in the maiket is sometimes itself an impoitant
competitive consideiation. ln some industiies, foi example in
the pioduction of ceitain types of duiable consumei goods, con-
sumei acceptance of the pioduct is inuenced by whethei the
pioducei can ieasonably claim to be one of the leading pio-
duceis. lt is undei these conditions that giowth is ofen said
and with good ieason, to be a necessaiy condition of suivival.
(Peniose 1vv1!!)
Tis insight may be desciibed as a giow oi die hypothesis.
ln common with Richaidson, Peniose notes the impoitance of com-
plementaiities in consumption in sometimes inuencing the natuie of
im expansion, especially when similai skills aie called foi in pioduc-
tion, maiketing, oi distiibution. Te same ims that make washeis
tend to make diyeis. ln the nal analysis, howevei, it is the ability of
the im to maintain the pioductive value of its basic abilities, its hu-
man and physical iesouices, that deteimines its ability to suivive. Cap-
ital investment takes place within a peiceived decision-making stiuc-
tuie, only pait of which consists of the technical inteitempoial impei-
atives of pioduction. ln a veiy ieal sense, piospective demand has to
be manufactuied thiough inteinal oiganization, maiket agieements,
distiibution aiiangements, and maiketing eoits, and these will have
to be continually adapted.
ln the long iun the piotability, suivival, and giowth of a im
does not depend so much on the eciency with which it is able
1e CAPlTAL lN DlSEQUlLlBRlUM
to oiganize the pioduction of even a widely diveisied iange
of pioducts as it does on the ability of the im to establish one
oi moie wide and ielatively impiegnable bases fiom which it
can adapt and extend its opeiation in an unceitain, changing,
and competitive woild. (Peniose 1vv1!)
Each business is thus a kind of ieseaich piogiam (Loasby 1vv1) in
which pioducts, piocesses, and methods of pioduction and oiganiza-
tion aie continually being tiied out.
Organizations in a Dynamic World
Joint Production is the Key
Peniose and Richaidson laid the basis foi much of the woik that fol-
lowed in exploiing the natuie of business oiganizations in a dynamic
woilda woild of incessant, unpiedictable technological change. Tese
oiganizations can be seen as evolved iesponses to the need to make
decisions in such a woild. lt may be doubted that oiganizations such
as the im would have any enduiing iationale oi would suivive in a
woild of stable equilibiium. Seen fiom the peispective of the evolving
capital stiuctuie of the economy as a wholethe matiix of valuable,
ielated pioductive capabilitiesims aie incubatois and lteis thiough
which these capabilities become available to the economy as a whole.
Te natuie of the im is thus ielevant to the natuie of the pioduction
piocesses. What is the iationale of the im and what deteimines its
boundaiies and how they change ovei time`
A ciucial featuie of the im, fiom oui peispectiveindeed in
many ways its dening chaiacteiisticis the fact of joint production.
(We iecall Hickss (1v!b) emphasis of jointness as the key dening
chaiacteiistic of (the pioblem ol) capital.) Te fact that iesouices
have to be combined in diveise and sometimes mysteiious (not fully
peiceived) ways, in oidei to be pioductive, can be seen to be the cential
piinciple aiound which ims function. liims aie in the business of
making, monitoiing, and alteiing pioductive capital combinations (cf.
Lachmann 1vc). We must include in the capital of these capital
combinations, the human capabilities (skills, peiceptions, judgments,
etc.) to which we iefeiied above and which we shall examine fuithei
in Chaptei 11.
CAPlTAL AND BUSlNESS ORGANlZATlONS 1
Te pioblemthat the imfaces is quite simply the imputation piob-
lem. (Te imputation pioblem contains within it othei (sub)pioblems,
like foiecasting the level of sales. Tis will emeige fiom oui discus-
sions below.) When a numbei of iesouices coopeiate jointly in the
pioduction of a common output, unless we aie dealing with a faiily
divisible, iepeatable piocess, in which the levels of output and input
can be vaiied along a bioad continuum so as to isolate in an objective
way the contiibution at the maigin of each input (physical and human),
theie is bound to be a substantial degiee of indeteiminateness about
the ielative input contiibutions.
We may contiast this with the neoclassical competitive model in
which the pioductive piocesses aie, in eect, standaidized. Te pioduc-
tion function appioach is one in which, by assumption, input and output
can be easily connected, thus facilitating the identication of maiginal
pioduct. Competition thus ensuies that eainings of the factoi owneis
will tend to equal the values of the maiginal pioducts, and this of couise
also militates in favoi of the most ecient use of iesouices. Eciency
and faiiness aie bound togethei. lt is also a woild in which the capital
values of the individual capital items that constitute the capital stock can
be easily and conveniently calculated as the piesent value of the stieam
of value maiginal pioducts thus identied. And in this woild the pei-
ception of capital in teims of aggiegate economic values makes sense.
But in su a world there is no reason for the rm. All iesouices
could be sepaiately owned in a state of complete decentialization and
could be biought togethei when necessaiy in oidei to fulll piotable
joint ventuies. Since the maiginal pioducts aie known to all, the
mauei can be handled by contiacting with each of the factoi own-
eis. Laboi could be seen to hiie capital just as validly as the othei
way iound.
1z
lt is natuial, theiefoie, that, in seeking to explain the
1z
Joseph Saleino points out (following Mises) that, given that pioduction takes time,
it is natuial that capital employs laboi as it is the capitalist that saves and advances
the iesouices with which laboi must woik. So piopeity iights consideiations can also
be seen to be implied by the tempoial natuie of pioduction. But suiely this would be
the case only in a woild of unceitainty. ln a woild wheie eveiything was accuiately
foieseen, complete contiacts could be wiiuen foi the advancement and use of the
capitalists savings. No hieiaichical ielationship need be implied. An employment
ielationship seems to be the iesult of the need to adapt to open-ended futuies, in
which discietionaiy command (in oidei to adapt to unexpectable contingencies) must
ieside with one oi othei paity, as discussed below in the text.
1c CAPlTAL lN DlSEQUlLlBRlUM
existence of the imin a mannei basically consistent with the peifectly
competitive model, iecouise should be had to the costs of contiacting
and exchangingtiansactions costs.
Yet, as we shall see, when examining this appioach in gieatei de-
tail, the existence of the im must lead to an abandonment of the
essentials of the competitive model and to the embiace of the im as
a iesponse to pioductive piocesses which have an iiieducible degiee
of indeteiminateness (and aibitiaiiness). Te seminal aiticle in which
Coase (1v!) sought an explanation foi the existence of the im, and
which has been the seed of a voluminous and diveise liteiatuie on
the im and its natuie and development, was at its base an appeal to
pioblems piesented by the incompleteness, in some sense, of infoima-
tion. Tiansactions costs aie intioduced as fiictions in the otheiwise
smooth functioning of the economic system. As has been noted many
times, howevei, all tiansactions costs aie at base infoimation costs
(Langlois and Robeitson 1vv!u, iefeiencing Dahlman 1vv).
e Existence of the Firm and its Boundaries
1!
lollowing Alchian and Woodwaid (1vcc) and Langlois and Robeitson
(1vv) we note that the tiansactions costs liteiatuie can be divided
into at least two (appaiently) distinct appioaches. One emphasizes
the costs of administiation, diiection, negotiation, and monitoiing of
the joint pioductive activities, while the othei emphasizes moie specif-
ically the pioblems of assuiing quality oi peifoimance of contiactual
obligations. Langlois and Robeitson call the foimei the measuiement
cost view and the lauei the asset specicity view.
1!
Te dimension along which the boundaiies of the im aie diawn may be an issue.
Te usual one is owneiship. Tis is a legal distinction (Masten 1vv1). But it is not the
only one. Anothei is contiol. loi example, the ownei of the im does not own the
laboi that it employs. ln what sense aie the employees woiking within the im`
Te usual answei is that theie exist long-teimcontiacts that eectively give the ownei
of the im owneiship ovei the outputs of the laboi employed and contiol ovei theii
inputs. Howevei, they do not always go togethei. Along the contiol dimension, con-
tiol ovei iesouices may exist even in the absence of owneiship, as in the case of joint
ventuies between two sepaiate legal entities. Alteinatively, divisions within ims
may behave with a gieat deal of autonomy, eectively like sepaiate ims. We shall
ietain the familiai dimension of owneiship, iealizing that the dividing line between
the maiket and the im is in many ways quite fuzzy.
CAPlTAL AND BUSlNESS ORGANlZATlONS 1v
Te cential notion of the measuiement cost appioach is connected
to the indeteiminateness of joint pioduction. Te diculties in (in-
ability to) isolate individual input contiibutions lead to a vaiiety of
impoitant organizing pioblems, which the business organization is de-
signed to solve. Tis appioach focuses on the indivisibilities inheient
in team pioduction which may lead to shiiking oi fiaud, which is
costly to monitoi and detect (Alchian and Demsetz 1vz). An appaient
implication of this is the suggestion that the iesidual claimant be the
one to monitoi and contiol since he has the most incentive to do so.
Tis begs the question of who the iesidual claimant should be. Yoiam
Baizel (1vcz) has suggested it be the ownei of the input whose contii-
bution to the joint output is most dicult to measuie. Tis is the input
factoi whose ownei is most tempted by the potential fiuits of moial
hazaid and, theiefoie, most in need of self-policing. Tis peison then
becomes the piincipal, leaving the inputs moie easily measuied to be
owned by the agents. But this in tuin iests on the piesumption that
we know, ahead of time, which contiibutions aie easiest to measuie
and monitoi. ln some situations this may be obviously tiue, but suiely
not geneially, suggesting that a ceitain degiee of aibitiaiiness (noneco-
nomic consideiations) may be inevitable in deteimining the stiuctuie
and boundaiies of owneiship.
Te asset specicity appioach, as its name implies, focuses on the
infoimation pioblems associated with the fact that joint pioduction
ielies to a laige extent on assets that aie specic to theii cuiient em-
ployment. Tis is an (unconscious) application of Lachmanns concept
of multiple specicity. An asset is specic when its oppoitunity cost
is substantially below the value of its cuiient contiibution to pioduc-
tion. ln othei woids, the piice that the asset could fetch in the mai-
ket foi employment in its next best use is substantially below (the
discounted sum ol) its cuiient maiginal value pioduct(s).
1.
lt is pio-
ducing a ient (suiplus). Te gieatei the specicity, the gieatei the
ient. Tis means that it (its ownei) is both poweiful and vulneiable,
1.
Of couise, as l point out, an impoitant aspect of using the im to oiganize pio-
duction is that maiginal pioducts aie not easy to deteimine. Still, wheie an asset is
specic in natuie it is cleai to all those involved in the pioduction piocess that the
value of its maiginal contiibution is substantially above its oppoitunity cost, even if
a degiee of aibitiaiiness auaches to the measuiement of these values.
1eu CAPlTAL lN DlSEQUlLlBRlUM
depending on which contingency one consideis. On the one hand,
the ownei of a specic asset can engage in piotable oppoitunistic
behavioi, the moie essential the asset is to the joint pioduct, by thieat-
ening to hold up the pioduction piocess unless the teims of the joint
pioduct agieement (contiact) aie alteied in its favoi. On the othei
hand, the othei factoi owneis could behave oppoitunistically by thieat-
ening to cut out the specic factoi, thus subjecting its ownei to a
capital loss diiectly piopoitional to the degiee of specicity, unless
the ient appiopiiation is alteied in theii favoi. Te outcome will
thus depend on the (peiceived) balance between these two iisks and on
the costs of enfoicing (at law oi otheiwise) any piioi existing explicit
contiacts. Teie is a laige liteiatuie on these questions which includes
discussions of specic histoiical examples, like Geneial Motois and the
lishei Body Company (foi oveiviews see Williamson and Wintei 1vv1,
Langlois and Robeitson 1vv).
Both of these appioaches suggest that the im is an oiganization
whose puipose is to cope with the inevitable infoimation pioblems
of joint pioduction. lf infoimation weie completely available, albeit
at a (known) cost, then all pioduction could be handled in a seiies of
spot and long-teim contiacts. When contingencies can be adequately
specied, oi when the decisions of the coopeiating paities dont af-
fect one anothei, contiacts aie possible and integiation [into ims]
is unnecessaiy (Langlois and Robeitson 1vvzc). As it is, contiacts
aie necessaiily and delibeiately incomplete. Teie is no way to ac-
count completely foi all of the possible contingencies. ln the liteiatuie
this is sometimes desciibed by saying that agents aie boundedly ia-
tional and/oi that infoimation is impacted (contains unfathomable
implications). Tese aie vaiiations aiound the Hayek/Poppei/Polanyi
theme conceining the special chaiacteiistics of knowledge (and the
infoimation fiomwhich it deiives), which we discussed above in Chap-
tei z. ln this context the knowledge pioblem is veiy specically
ielated to the indeteiminacies of team pioduction, involving as it does
complementaiity, specicity, indivisibility, and change. Pioduction
not only involves complementaiy specic assets that aie indivisible,
but these ielationships change ovei time. Te impoitance of change
is not always suciently emphasized and we shall ietuin to it in a
moment.
CAPlTAL AND BUSlNESS ORGANlZATlONS 1e1
As suggested, one way to cope with the necessaiy incompleteness
of the joint pioduction contiact is thiough the distinction between
iesidual iights and specic (contiactual) iights. All factoi owneis be-
sides the iesidual claimant aie paid a pieagieed iate of eainings. Te
suiplus ovei and above this is counted as piots (as suggested in oui
discussion on the natuie of piots in Chaptei above). Piots then
seive as the baiometei by which a ims peifoimance is judged. Te
im is owned by the iesidual claimant who contiacts with othei factoi
owneis. Te iesidual claimant must make a judgment as to which
factois to own and which to buy (oi ient).
Tus wheie one diaws the line between the im and the maiket
depends on a vaiiety of consideiations that deiive fiom the natuie
of joint pioduction. Te same indeteiminacies and unceitainties of
joint pioduction that piovide foi oppoitunistic behavioi also account
foi and piovide clues to coping with the diculties of fiaming, mon-
itoiing, and enfoicing explicit contiacts. As Langlois and Robeitson
(1vv) suggest, howevei, these consideiations aie likely to be contin-
ually changing ovei time and thus the boundaiies of the im aie un-
likely to be static.
1
Production and Change
Pioduction is a joint venture and pioduction takes time. Tese two
chaiacteiistics account foi many (peihaps all) of the inteiesting and
pioblematic aspects of the pioduction piocess. When we say that
pioduction is a joint ventuie, this includes not only the fact that pio-
duction piocesses may involve combining inputs in close pioximity
oi undei centialized contiol, but the moie geneial fact that, whethei
undei centialized contiol oi not, pioduction is a piocess of value cie-
ation (when successful) that depends on a vaiiety of complementaiy
inputs. Pioduction is chaiacteiized by an implicit (and evolving) input
and output stiuctuie that tianscends the boundaiies of the im. Te
1
ln ielation to the question of the boundaiies and existence of the im, and the gen-
eial discussion found in this section, l have been asked whethei l thought unceitainty
was a necessaiy and sucient condition foi the existence of the im. While l cannot
auempt a complete answei heie, it seems to me that while it may not be sucient,
it is suiely necessaiy. loi, as indicated above, in a woild of peifect ceitainty theie
would be no need foi the im.
1ez CAPlTAL lN DlSEQUlLlBRlUM
institutional (oiganizational) stiuctuie oveilays and is intimately ie-
lated to the pioduction stiuctuie in such a way that it is impossible to
chaiacteiize accuiately the pioduction stiuctuie without biinging in
business oiganizations. Organization maers for production. lt is pait
of the capital of any economy. Syneigies of joint pioduction (in this
geneial sense) undeilie the emeigence of excess capacity (economies
of expeiience) that Peniose desciibes and piovide the basis foi the
helpful impeifections identied by Richaidson, which constiain the
actions of competitois and inuence the noims of tiade. Syneigies
of joint pioduction aie also at the ioot of the tiansactions costs of
negotiating and monitoiing aims-length contiacts foi joint outputs
and of avoiding the moial hazaids of holdups.
Joint pioduction would not be a pioblem weie it not foi the fact
that pioduction occuis ovei time. Time and knowledge belong to-
gethei. Tis is Lachmanns axiom, discussed in Chaptei z. As soon
as we peimit time to elapse, we must peimit knowledge to change
(Lachmann 1vea1z1zc, italics iemoved). lt is inconceivable that
time should elapse without leaining. Tis is as tiue of the pioduction
piocess as of anything else. We can see how time and change entei
into the pioduction piocess in at least foui dieient ways.
1e
1. As we have discussed, ongoing piocesses of joint pioduction con-
tain an element of iiieducible indeteiminateness in deciding the
relative contiibutions of the inputs. lt is not possible to know at
any point of time what the ielative contiibutions of the vaiious
inputs aie with any denite objectivity.
z. Rewaiding the factoi inputs in teims of the value of theii maiginal
pioducts assumes knowledge of the value of the nal output pei
peiiod of time. Yet, since input necessaiily piecedes output, the
value of the lauei is a mauei of speculation, even assuming that
theie aie no unceitainties auaching to the technical aspects of
the piocess.
1e
As Petei Boeuke points out, time, jointness, and multiple specicity aie all nec-
essaiy to explain the foui indeteiminacies (and the implied need foi oiganizational
devices to cope with them). lf iesouices weie completely homogeneous, no combi-
nation pioblem would exist, similaily, if iesouices weie completely specic, theie
would be no choices involving vaiiations in the components of combinations. Wheie
iesouices aie heteiogeneous and multiply specic, my conclusions follow.
CAPlTAL AND BUSlNESS ORGANlZATlONS 1e!
!. Technical and oiganizational aspects aie, howevei, bound to be
unceitain to a gieatei oi lessei degiee conceining the quantity
oi quality of any output. Ovei time, as leaining pioceeds, things
get done dieiently, and in ways no one could have expected.
.. Even assuming that 1, z, and ! above weie not pioblems, theie
iemains the pioblem of connecting units of specic input with
specic units of output ovei time, something we discussed in
Chaptei . above.
Echoing some aspects of oui discussion of Bhm-Baweikian capital
theoiy, if the piocess weie faiily divisible and if it weie unchanging
ovei time, then with enough time one could (oi the maiket would) vaiy
the input conguiations ovei a suciently wide iange to be able to
solve the imputation pioblem. Competition would then tend to ensuie
that each factoi was paid the value of its maiginal pioduct. When the
woild is one of constant innovation, and the innovations ofen come in
lumps (embodied in indivisible units oi noniival inputs), this is not
possible. We shall encountei these issues in oui consideiation of how
ims engage in pioductive activities below.
Organizations and Change
ln a numbei of contiibutions, Richaid Langlois (foi example, 1vvz,
1vv, Langlois and Robeitson 1vv) has extended the capabilities ap-
pioach to business oiganizations to piovide a dynamic theoiy of the
boundaiies of the im. He consideis the im to be a device foi ac-
quiiing and economizing on useful knowledge (see also Demsetz 1vv1).
liims aie able to do this because they aie institutions. lnstitutions,
bioadly undeistood, aie systems of iule-following behaviois. As we
discussed in Chaptei !, iules (oi, in the context of the im, ioutines)
piovide a way of acquiiing infoimation about the futuie actions of
otheis, within paiticulai domains (we condently expect eveiyone
in the United States to diive on the iight side of the ioad). Tese
iules can be undeistood sometimes as an aspect of human behavioi,
in the foim of tacit knowledge (people follow them unconsciously),
oi, alteinatively, as constiaints exteinal to the individual (like piivate
piopeity). ln both cases they aie conducive to an oideily pauein of
behavioi (Langlois 1vvz1ee).
1e. CAPlTAL lN DlSEQUlLlBRlUM
A im is an oiganization embodying a system of (sometimes unai-
ticulated) iules and ioutines (Vanbeig 1vvz, also ielevant is Nelson and
Wintei 1vcz). Vanbeig consideis a im as a constitutional system
within which behaviois aie conditioned by the wiiuen oi unwiiuen
iules of the constitution. Tis constitutional aspect is made necessaiy
by the natuie of joint (team) pioductionthe dependencies of team-
woik necessitate contiactual constiaints of ceitain kinds and duiation.
Tus the ims constitution, like Biitains political constitution, is im-
plicit and composed of the undeistood iules of conduct that facilitate
conceited and coopeiative action. Te pioceduial iules that undeilie
oiganized oi coipoiate action can justly be viewed as a constitution
because they constitute oiganizations as coipoiate actois (Vanbeig
1vvz1!e). Peihaps one way to think of the eect of the constitution of
a im (oi any oiganization) is to suppose that the behavioial iesponse
(choice) to ceitain categoiies of events is independent of the iespond-
ing (choosing) individual in that oiganization. Tis iequiies that the
individuals of an oiganization have inteinalized the iules, ioutines,
pioceduies, etc., that constitute its constitution, its cultuie. Langlois
connects this with the capabilities of the im by applying the ideas of
iule-following to questions of oiganizational foim . . . the iulesthe
ioutinesthat agents follow within an oiganization embody (ofen
tacit) knowledge that is useful foi action. Tis knowledge constitutes
the capabilities of the im (Langlois 1vvz1).
Although the founding of a im may have been the iesult of a
well-aiticulated plan (and puipose), theie is a sense in which ims
aie oiganic iathei than piagmatic oiganizations (Mengei 1vc). lol-
lowing Vanbeig (1vcv), Langlois (1vvz, 1vv) has added a dimension to
Mengeis well-known distinction between oiganic and piagmatic insti-
tutions. Te distinguishing featuie in Mengei was the question of oii-
gin. He distinguishes between piagmatic institutions (like ims, clubs,
legislation) that weie cieated foi specic puiposes and oiganic institu-
tions (like common law, language, money) that aie the unintended ie-
sults of behavioi. Hayek, woiking along this Mengeiian theme, distin-
guishes between oideis and oiganizations accoiding to whethei they
seive a specic puipose oi not. Te iules of an oidei aie abstiact
and independent of puipose, wheieas the iules of an oiganization aie
conciete and diiected towaid a common puipose oi puiposes (Lang-
lois 1vvz1ec, Hayek 1v!!c).
CAPlTAL AND BUSlNESS ORGANlZATlONS 1e
Orders Organizations
Spontaneous Oiganic oideis (law,
language, money)
Oiganic oiganizations
(ims`, buieauciacies)
Planned Piagmatic oideis
(designed constitutions
oi contiacts)
Piagmatic oiganizations
(ims`, clubs)
Table 9.1: Types of institutions
Tus instead of a single-dimensional line we have a two-dimensional
matiix of institutional types (see Table v.1).
Langlois wiites
Both paits of the teim spontaneous order aie of inteiest. What
makes a system of iules spontaneous iathei than planned is,
in eect, a question of oiigin. . . . Unlike an oiganic system of
iules, a piagmatic stiuctuie is one set in motion by conscious
intention, and thus, in a sense . . . is a cieatuie of planning. At
the same time, a system of iules in Hayeks theoiy can be eithei
an order oi an organization. ln an oidei, the iules that guide
behavioi aie abstiact and independent of puipose, in an oigani-
zation, those iules guide behavioi towaid moie oi less conciete
ends.
1
(Langlois 1vvz.v)
lt is cleai that the im should be in the iight column in Table v.1. But
it is not cleai that it ts obviously into eithei the top oi bouom iow
exclusively and, in an impoitant sense, it is a hybiid. Although it may
be a cieatuie of the conscious design of its ownei/foundei, it almost
nevei develops in a piedictable way, especially if it is to be adaptable
enough to suivive in a dynamic woild. As Langlois conjectuies, the
moie dynamic the enviionment, the moie abstiact the natuie of the
oiganizations constitution needs to be foi it to suivive, the moie it
needs to be like an oidei. Hence the im is moie akin to an oiganic
oiganization.
To see moie specically how ims evolve, one needs to focus on
the capabilities and ioutines that constitute it. ln Langloiss theoiy the
1
liom a Gods eye peispective oi fiom a public choice peispective the oi-
ganic/piagmatic dimension might collapse. [O]ne might easily poitiay the entiie
Public Choice theoiy of politics as undeimining a conception of goveinment as a
piagmatic institution (Langlois 1vvz1ev).
1ee CAPlTAL lN DlSEQUlLlBRlUM
deteiminants of oiganizational stiuctuie aie the natuie of the capabilities
both within and outside the im on the one hand, and the natuie of
change and unceitainty that it faces on the othei. Te stoiy of economic
piogiess and development is the stoiy of the intioduction of innovations
of vaiious types at vaiious levels new pioducts, new chaiacteiistics of
existing pioducts, new methods of pioduction, oi some combination of
these. ln teims of theii eects we may distinguish between two types of
innovation systemic innovations and autonomous (l piefei stand alone
oi decomposable) innovations (Teece 1vce, Langlois 1vv). Systemic in-
novations have system-wide implications, they iequiie (if they aie to be
successful) changes in seveial ielated stages of pioduction. Tis implies
that some existing assets would be iendeied obsolete and capabilities not
pieviously valued, oi peihaps not yet available, would become useful.
Tis iegiouping of capital combinations (Lachmann 1vc) which
constitutes the changing (mutating) capital stiuctuie caiiies with it
implications foi the oiganizational stiuctuie. Existing capabilities may
be undei sepaiate owneiship.
Undei this scenaiio, the business imaiises because it can moie
cheaply iediiect, cooidinate, and wheie necessaiy cieate the
capabilities necessaiy to make the innovation woik. Because
contiol of the necessaiy capabilities in the im would be iela-
tively moie concentiated than in a maiket-based oiganizational
stiuctuie, such a imcould oveicome not only the iecalcitiance
of asset holdeis, whose capital would be the victim of cieative
destiuction, but also the dynamic tiansaction costs of infoim-
ing and peisuading new input holdeis with necessaiy capabili-
ties. (Langlois and Robeitson 1vvz)
Dynamic tiansactions costs aie the costs of not having the capabilities
you need when you need them (ibid.zn.)
Accoiding to Langlois this scenaiio is an accuiate desciiption in
geneial teims of the histoiical development of many of the enteipiises
that featuie in the second lndustiial Revolution in Noith Ameiica
and Geimany in the late nineteenth and eaily twentieth centuiies as
chionicled in the woik of Alfied Chandlei (Langlois 1vv1, Chandlei
1v, 1vvu, 1vvz). Systemic innovations like the loweiing of tians-
poitation and communication costs cieated piot oppoitunities foi
those who could cieate mass maikets and take advantage of pioduction
economies of scale and scope (steel, faim machineiy, meat, soap, and
CAPlTAL AND BUSlNESS ORGANlZATlONS 1e

time
Figure 9.1: Ciaf pioduction
many otheis). ln an impoitant sense, we see in ietiospect that a seiies
of innovations weie connected in a complementaiy way, but these
piotable impiovements implied the destiuction of existing decential-
ized systems of pioduction and distiibution in favoi of integiation
into laige-scale pioduction. lntegiation is seen in many cases to be
necessaiy to oveicome the opposition of vested inteiests (Langlois
1vvzz), of people doing things the old way.
Oiganizational stiuctuie is heie seen to be the iesult of entiepie-
neuiial innovation. ln oidei to exploit peiceived oppoitunities, entie-
pieneuis had to change the existing oiganizational stiuctuies in addi-
tion to pioduction stiuctuies, oi, moie accuiately, in oidei to eect
the lauei they had to accomplish the foimei. An excellent geneiic
example of how alteiing the oiganization of pioduction can be a value-
cieating innovation is piovided by Axel Leijonhufvud (1vce, see also
Langlois and Robeitson 1vvch. !). Leijonhufvud shows that it is not
just (oi even necessaiily) a mauei of using laige-scale machineiy that
accounted foi the piotability of factoiy pioduction. To make the
point schematically he contiasts ciaf pioduction with factoiy pioduc-
tion. ln ciafs pioduction, ciafspeople sequentially complete all the
opeiations necessaiy to make the pioduct. ln factoiy pioduction, by
contiast, each woikei specializes in one opeiation. We iecall Adam
Smiths pin factoiy wheie the impoitant business of making a pin
is . . . divided into about eighteen distinct opeiations which, in some
manufactoiies, aie all peifoimed by distinct hands (Smith 1vcz.,
quoted by Leijonhufvud 1vcezuc).
loi example, imagine ve distinct opeiations being peifoimed by
ve dieient ciafspeople. Each one woiks at theii own pace and
dieis in skill (both absolutely and ielatively) acioss the dieient op-
eiations. Tis is depicted in liguie v.1.
1ec CAPlTAL lN DlSEQUlLlBRlUM

time
Figure 9.2: lactoiy pioduction
Now suppose that we simply ieaiiange the woik as depicted in
liguie v.z. Woik pieviously done in paiallel now pioceeds in seiies.
Woikei A specializes in peifoiming opeiation 1, woikei B in peifoim-
ing opeiation z, and so on. We have intioduced joint oi team pioduc-
tion. Each individual now has to woik at the pace of the team, making
supeivision easiei. lt is impoitant to note, howevei, that the engineei-
ing paiameteis of the pioduction piocess have not been changed. Te
tools aie the same in kind (although each woikei no longei needs a
complete set)
1c
and the woikeis aie the same people. Yet we may
expect an inciease in pioduct. Pioduction is not simply a mauei of
identifying and combining the inputs (in an unspecied way), unless
we bioaden what we mean by input so as to empty it of all analyt-
ical powei. As Leijonhufvud peitinently notes, this sequencing of
opeiations is not captuied by the usual pioduction function iepiesen-
tation of pioductive activities, noi is the degiee to which individual
agents specialize. . . . Smiths division of laboithe coie of his theoiy
of pioductionslips thiough modein pioduction theoiy as a ghostly
technological-change coecient oi as an equally ill-undeistood econo-
mies-of-scale piopeity of the function (Leijonhufvud 1vcezuv).
Te economies achieved by moving fiom ciafs to factoiy pioduc-
tion aiise fiom an incieased division of laboi, a move fiom individ-
ual to team pioduction. Leijonhufvud enumeiates thiee aspects of
this. liist, team pioduction iesults in product standardization, woikeis
1c
ln this sense the innovation is capital saving iathei than iequiiing capital of
laigei scale. Also, it is possible that the new piocess may need less goods in piocess
inventoiy. ln ciafs pioduction, woikeis may leave goods unnished as they move
fiom one opeiation to anothei, woiking on a few goods at a time. ln team pioduction
this does not happen (Leijonhufvud 1vcez1u).
CAPlTAL AND BUSlNESS ORGANlZATlONS 1ev
pioduce the same pioduct. Second, gieatei cooidination is achieved in
time sequencing, supeivision undei a shaied set of iules, ioutines and
tacit undeistandings (that impiove ovei time). Tiid, the laboi of in-
dividual woikeis becomes complementaiy inputs iathei than compet-
itive activities. Te absence of any woikei will disable the pioduction
piocess.
Recalling the context of Adam Smiths oiiginal obseivations, it has
ofen been noted that human capital is intimately involved. Smith
explains howspecialization impioves dexteiity, saves time and leads to
woikei-inspiied innovations. To this we should add that specialization
may iesult in the saving of ceitain kinds of human capital. Woikeis
need no longei possess the skills necessaiy to make a pin fiom begin-
ning to end (Leijonhufvud 1vcez11). Te division of laboi is also, in
an impoitant sense, a division of (human) capital. ln this context it is
easy to see how the assumption of a homogeneity of human capital is
eveiy bit as misleading as the assumption of homogeneity of physical
capital. As the society and the economy piogiesses, people obviously
leain moie and the knowledge of the society is, in a veiy ieal sense,
gieatei. But it is also tiue that, in anothei sense, individuals do not
have to know as much in so fai as they aie moie specialized. Tis is
something we shall examine fuithei in Chaptei 11.
An inteiesting aspect of this example is the fact that the inciease
in output occuis without any change in the types of inputs (and with
fewei capital goods and goods in piocess) oi any change in techno-
logy. Although changes in technology may follow upon, oi piecede,
oiganizational changes, as this example shows, oiganizational changes
themselves can sometimes biing impiovements in pioductivity. Tis
undeilines the pioblems associated with physical notions of the capital
stock. ln this example, consideiing capital as being composed of the
types and quantities of the inputs fails completely to captuie the souice
of any inciease in value that aiises. Tis suggests that organizational
structure is a crucial aspect of the capital structure in general.
Obviously this example is suggestive of paiticulai types of oigani-
zational innovation, one employing a veitical division of laboi. lt gives
one ieason that integiation of woikeis may piove piotable. But othei
foims of piotable oiganizational change may not be so cleai in theii
implications foi oiganizational type.
1u CAPlTAL lN DlSEQUlLlBRlUM

time
Figure 9.3: Paiallel piocesses and indivisibilities
Leijonhufvud notes that economies aie to be gained fiomjudicious
hoiizontal divisions as well. Tis can iesult fiom the indivisibilities
that come with piioi innovations. So, foi example, imagine that one
of the stages of pioductionstage .is iunning at half capacity (a iail-
way cai, a telegiaph system). lmagine iunning two paiallel pioduction
piocesses as shown in liguie v.!. Teie is twice the output of just one
piocess, but the double output comes at the expense of less than twice
the inputs, a cleai economy of scale of the Lachmann vaiiety. Tese
economies of scale come fiom oiganizational change iathei than fiom
technology, although the indivisibility that makes it possible may be
the iesult of a technological innovation.
ln this example the two industiies oi ims oi piocesses shaie
opeiation .. Tey may not even be the same piocesses. Tey may have
a common need foi opeiation . (like tianspoitation, communication,
oi electiicity) and be quite dieient in othei iespects. Tis is a dieient
type of division of laboi. Stage . has become a specialized activity on
its own. lt is cleai that these economies of scale depend in a ciucial
way on the extent of the maiket oi on the thioughput (Lachmann
1vve1.1.c), that is, on the size of the demand foi the seivices of the
vaiious stages that aie supplied in indivisible multiples. lt is also cleai
that moie complex paueins will most likely emeigewith indivisibil-
ities and ciosspiocess connections at moie than one stage. Te degiee
of ietuins to scale depends on the amount of excess capacity at each
stage. (A similai obseivation is made by Peniose consideiing iesouice
combinations within the im that have to be made up to the lowest
common multiple (Peniose 1vvz!)). lf the numbei of stages is
held constant, these economies become less and less signicant as out-
put is incieased and, in this case, appioach constant ietuins to scale
in the limit (Leijonhufvud 1vcez1.). Howevei, an aspect of economic
CAPlTAL AND BUSlNESS ORGANlZATlONS 11
piogiess is an incieasing numbei of inteiielated activities oi stages of
pioduction (Lachmann 1vcch. V, see also Chaptei c). Puisuing this
line of ieasoning, theie is then an unending souice of scale economies
in the maiket piocess.
As Leijonhufvud explains (inteipieting Smith and Maix), the pio-
cess of the division of laboi is connected to the piocess of technological
change. As one subdivides the piocess of pioduction veitically into
a gieatei and gieatei numbei of simplei tasks, some of these tasks
become so simple that a maine could do them. . . . [We aie led to]
the discovery of . . . oppoitunities foi mechanization (Leijonhufvud
1vcez1). lf we think of each of the oiganizational schemes of pio-
duction such as those discussed above as being one of many possi-
ble schemes, then we can easily see the pait they could play in an
evolutionaiy piocess towaid gieatei complexity (a laigei and laigei
numbei of inteidependent pioductive activities and stages). ln eect
(paiadoxically), gieatei complexity in pioduction leads to the achieve-
ment of gieatei simplicity and convenience in consumption. (Te moie
complex the cential piocessing unit of the computei, the moie usei
fiiendly it can be made.)
So, ietuining to Langloiss dynamic theoiy of the im, changes
in oiganizational stiuctuie lead (diiectly and indiiectly) in a plausible
way to changes in pioduction costs. ln the move fiom ciaf pioduction
to a factoiy this implies a foimof veitical integiation, as did the kind of
changes iequiied in the Second lndustiial Revolution. lntegiation is fa-
voied in situations wheie changes aie systemic and iequiie laige-scale
entiepieneuiial ieoiganization of existing capabilities and wheie new
iequiied capabilities aie not easily available fiomthe maiket. But moie
geneially, foi example in the case of indivisible shaied iesouices, it is
not so cleai that change leads to integiation and may lead in the oppo-
site diiection to disintegiation oi spinos. ln many cases the innova-
tions may be local oi decomposable. Peihaps the most impoitant exam-
ples occui in modular systems, like peisonal computeis, steieo sound
systems, telephone systems, and the like. loi piesent puiposes, the
key featuie of a modulai system is that the connections of inteifaces
among components of an otheiwise systemic pioduct aie xed and
publicly known. Such standaidization cieates what we might call ex-
ternal economies of scope (Langlois 1vvzz!). Tis is a phenomenon of
complementaiities in consumption (household pioduction) that both
1z CAPlTAL lN DlSEQUlLlBRlUM
Richaidson and Peniose noted. lt allows component manufactuieis to
specialize theii capabilities independently but condent of a sucient
maiket (cf. Richaidson 1vvu).
As economies develop, the capabilities needed foi innovation aie
moie likely to be found in the maiket, and Chandlei-type integiation
may be unnecessaiy. Even if at ist the im may nd it necessaiy
to develop its own maiketing and distiibution netwoiks and special-
ized pioduction capabilities, ovei time, with the giowth of knowledge,
outside specialists may develop. So integiation may be a phase that be-
comes supeiseded by disintegiation (as happened, foi example, in the
case of loid Motoi Company). ln addition, some of the obsolete exist-
ing capabilities may alieady exist inside the im and iequiie excision,
as in the case of downsizing caused by technological iestiuctuiing.
On the othei hand, this situation may account foi an element of ineitia
in some coipoiations, making it moie dicult foi them to adapt. As
in the computei industiy and the illustiative case of lBM, economic
change has in many ciicumstances come fiom small innovative ims
ielying on the capabilities available in the maiket iathei than existing
ims with ill-adapted inteinal capabilities (Langlois 1vvz!).
1v
Accoiding to Langlois, the boundaiies of the im aie thus not
only a mauei of tiansactions costs and moial hazaid, but must be
seen within a changing enviionment as a foim of stiategic adapta-
tion. ln the absence of change, knowledge of piices, pioducts, abilities,
ieputations, and anything else that is impoitant to the (unchanging)
pioduction piocess becomes geneial, and the need foi the im as an
oiganizing device piogiessively disappeais. (Oppoitunistic behavioi,
foi example, is less piotable when the same game is iepeated many
times (Langlois 1vvz)). But in a dynamic woild the capital stiuctuie
evolves within an evolving institutional and oiganizational stiuctuie.
Implications and Conclusion
As discussed, Langloiss woik piovides a fiamewoik foi inteipieting
the tiend towaid laige-scale integiation of industiial stiuctuies that
1v
Te make oi buy decision may also be inuenced by the iegulatoiy stiuctuie
in the face of competition and change as, foi example, in the case of the decision to
outsouice to non-union specialist manufactuieis.
CAPlTAL AND BUSlNESS ORGANlZATlONS 1!
occuiied at the tuin of the centuiy, as well as the opposite soit of
tiend towaid disintegiation oi divestment as companies move towaids
concentiation on theii coie competencies. Some of the specic in-
sights that emeige fiom this dynamic tiansaction cost fiamewoik aie
as follows
1. Organization maers for production. Te discussion of the aiticle
by Leijonhufvud above shows cleaily how a simple ieoiganiza-
tion of the same inputs can sometimes lead to incieases in output.
z. Indivisibilities that result from systemic innovations imply exter-
nal economies of scale and scope. Tis iesonates with Lachmanns
(1vc) analysis of the evolution of the capital stiuctuie. Tese in-
divisibilities also explain the emeigence of specialized industiies,
like powei, communications, and computing.
!. When innovations occur whirender existing capabilities obsolete
or redundant, the response will be either (a) retraining or reorien-
tation, if possible, or (more likely) (b) downsizing or (c) inertia
and failure, or some combination of the three.
.. Product life cycles are oen accompanied by organizational-type
life cycles. loi example, at the stait of the implementation of an
innovation a im may need to develop its own suppoiting capa-
bilities, sometimes to oveicome ineitial vested inteiests, like the
pioduction of spaie paits oi technical suppoit. As the innovation
and its implications aie diused and, ovei time, the knowledge
spieads and output giows, these capabilities come to be found in
specialists in the maiket (outside the im). So the oiganization
ist inteinalizes and then spins o these paiticulai capabilities.
. e nature of the organization is inuenced by the type of knowl-
edge embodied in the capabilities required and by the nature and
type of innovations that it faces. Examples at two extiemes aie
the hieiaichical oiganization wheie infoimation ows mainly
fiom the top downwaids (iequiiing that supeivisois have as
much oi moie knowledge than theii suboidinates of what the
suboidinates need to do) and the paiticipatoiy oiganization
(wheie infoimation ows in all diiections because team mem-
beis aie highly specialized and use highly specialized knowl-
edge, the usefulness of which depends on the willing contiibu-
tions of all team membeis).
1. CAPlTAL lN DlSEQUlLlBRlUM
ln summaiy in this chaptei we have seen that the neoclassical im
as a black box pioduction function beais veiy liule iesemblance to
that dynamic, enigmatic, evei changing business oiganization that we
know fiom oui eveiyday expeiience as the im. lnstead we have
leaint fiom a numbei of theoiists to view it in a dieient light, as a
iemaikable oiganizational device foi the achievement of pioductive
activity. Te im, in this view, is a device foi the cooidination and
use of paiticulai kinds of knowledge, including the cooidination of
knowledge geneiation, by the imposition of an inteipietive fiame-
woik (Loasby 1vv1v). lt is an impoitant example of the coexistence
of equilibiium and change discussed in Chaptei !. As a system of
(sometimes tacit) iules, ioutines, pioceduies and cues, it evolves ovei
time, but it does so suciently slowly, if it is to succeed, to piovide
a stable, undei-standable enviionment within which decision-makeis
can act, can conjectuie about pioduct types, methods of pioduction,
types of inputs, the meanings of maiket signals, and the like. Each
im, based on its expeiience (the expeiience of its membeis) acquiies
a unique chaiactei as an inteipietive system, constiuing events and
acting on the basis of its inteipietations (Loasby 1vv1eu). Te decision
outcomes aie thus the iesults of idiosynciatic inteipietation combined
with commonly obseived infoimation, like maiket piices, in a genei-
ally undeistood decision-making piocess that we can chaiacteiize as
the ongoing calculation of capital value.
Te same evolved capabilities that have seived some ims in good
stead in favoiing it to adapt to paiticulai ciicumstances, may, in othei
ciicumstances, piove to be its undoing. liims used to a paiticulai way
of doing things may exhibit a degiee and type of ineitia oi naiiowness
of appioach that may iendei it unsuitable foi paiticulai enviionments.
ln such situations we get iadical oiganizational change. And this may
occui at the maiket level, wheie those oiganizations that happen to
have the iight conguiation and appioach will be favoied, and at the
im level wheie those ims that aie able to adapt suivive. An exam-
ple might be the emeigence of the M-foim stiuctuie of coipoiation
(Williamson 1vc), oi the move towaid nonhieiaichical oiganizations
(Minklei 1vv!).
zu
Ofen the ciucial factoi in these shifs is the changing
natuie of the knowledge utilized by business oiganizations.
zu
Minklei piovides an inteiesting analysis of oiganizations with knowledgeable
CAPlTAL AND BUSlNESS ORGANlZATlONS 1
Knowledge is a key concept in analyzing all pioductive activity
and its oiganization. Tis haiks back to oui discussion of knowledge
types in Chaptei z and suggests a closei look at the meaning and iole
of pioductive knowledge in ielation to capital,
z1
which we considei in
Chaptei 11 on human capital.
woikeis, that is to say woikeis who possess not only a degiee of know-how
but moieovei the capacity to make decisions in hitheito unencounteied situations
initiative. Such oiganizations would, undei most situations, tend to be paiticipatoiy
iathei than hieiaichical. So as the natuie of pioductive knowledge changes, so must
the natuie of the oiganization. See also Diuckei (1vv!) and (Nonaka and Takeuchi
1vv).
z1
Tis chaptei neglects the impoitant ielationship between capital and knowledge
that emeiges when we considei capital goods as embodying the knowledge of how
to do ceitain specic and specialized things. With some justication, capital can be
viewed as embodying pioductive knowledge in the same way as human capital em-
bodies pioductive knowledge. Tis leads to a capital-based view of the im. loi
fuithei explanation and investigation of the impoitant implications of this view, see
Lewin and Baetjei (zu11).
CHAPTER 1u
Oiganizations, Money, and Calculation
Introduction: Firms and Calculation
Te discussion in the pievious chaptei suggests that ims deiive theii
iationale fiom the fact that the oiganization of pioduction maueis
foi its iesults. By the same token, as the economy changes, and the
pioduction stiuctuie changes along with it, the advantages of dieient
types of oiganization will also change. Still, with all the fai-ieaching
economic changes that have occuiied, the im as a categoiy (the mod-
ein business coipoiation) has iemained a dominant foim of economic
oiganization. lt is an institution that is unique to a maiket (capitalist)
economy. ln an impoitant way the maiket economy owes its success
to the business im.
ln his discussion on the feasibility of cential planning undei state
socialism, Mises pointed to the ability of piivate owneis (investois)
to calculate piotability as being the indispensable ingiedient of a de-
centialized system, the absence of which accounted foi the inevitable
failuie of a centially planned one (Mises 1vzu, 1vc1, 1vee). Tis was
pait of the famous socialist calculation debate (Hayek 1v!a, Ho 1vc1,
Lavoie 1vca, Ramsay-Steele 1vvz) which has iecently shown signs of
iesuifacing (Hoiwitz 1vve, Ramsay-Steele 1vve). Accoiding to Mises,
in a centially planned economy (in which the means of pioduction
weie collectively owned) the planneis would lack any basis on which
to piice the means of pioduction. Without piivate owneiship, alteina-
tive outputs would not have piices, noi would the inputs iequiied to
pioduce them. Without this, the value of alteinative uses would not
be disceinible. Te scope of the debate was consideiably bioadened by
Hayek (in the 1v!us) in his consideiation of what infoimation would be
[Tis chaptei uses mateiial fiom Lewin (1vvc).]
1
1c CAPlTAL lN DlSEQUlLlBRlUM
necessaiy foi piivate owneis in theii calculation of piospective piots,
and the obseivation that much of this infoimation was not simply
available to be collected but, in fact, emeiged fiom the maiket piocess
itself. Abolishing piivate owneiship thus abolished the souice of this
ciucial infoimation, much of it ieected in piices, necessaiy foi basic
economic calculation (Hayek 1v!az1uz11). Mises wiote in 1vz
Tis is the decisive objection that economics iaises against the
possibility of a socialist society. lt must foigo the intellectual
division of laboi that consists in the coopeiation of all entiepie-
neuis, landowneis, and woikeis as pioduceis and consumeis in
the foimation of maiket piices. But without it, iationality, i.e.
the possibility of economic calculation, is unthinkable.
(Mises 1vz)
Hoiwitz (1vve) has iecently pointed to the connection between these
insights and the iole of money. ln a maiket economy the existence
of money togethei with the institution of piivate piopeity facilitate
the emeigence of money piices which foim the basis of the necessaiy
economic calculation that diives the maiket piocess. ln the light of
oui discussion about business oiganizations above, how does the im,
a dominant maiket institution, t in with this`
We should iecall that the advantages of coipoiate oiganization
deiive fiom incentive, contiol, and infoimation issues. By combining
iesouices within the oibit of a single im, it is sometimes possible
to ieduce the costs of monitoiing and contiolling pioduction teams
and of avoiding the need to monitoi and enfoice the fulllment of spe-
cic aims-length contiacts between independent paities. lnstead, the
impiovides the necessaiy ielative piedictability and stability of long-
teim open-ended contiactual obligations with employees.
1
Te bound-
aiies of the imaie dynamically and expeiimentally balanced by these
advantages weighed against the advantages of using specialists fiom
the maiket. Juxtaposing this line of thinking with the Mises/Hayek
iejection of the feasibility of socialist planning and pioduction iaises
some inteiesting questions.
1
We have not mentioned the limitation on individual liability piovided by the
modein joint stock coipoiation that may also be a factoi.
ORGANlZATlONS, MONEY, AND CALCULATlON 1v
1. On the one hand, if socialism is indeed iiiational, in the sense
of piecluding the ability to peifoim the necessaiy calculations,
how is it that the im is not similaily encumbeied` Afei all,
is not a state socialist system simply one laige im` And aie
ims not islands of socialism in a maiket sea` lf so, how does
calculation pioceed inside the im`
z. On the othei hand, if the maiket is necessaiy because it pio-
vides the necessaiy piices foi pioductive calculation, why aie
ims necessaiy at all` Why not simply conduct all tiansactions
thiough maiket spot and foiwaid contiacts`
We have alieady answeied question z. ln a nutshell, theie aie costs
to using the maiket that aie avoided by using the institution of the
coipoiate im. And these tiansaction costs aie ultimately ielated to
the piesence of ceitain types of iiieducible unceitainty. Te answei
ofen given to question 1 is moie inteiesting. Of couise, it is a non-
sequitur to conclude that if state socialism is impossible then anything
iesembling cential planning, such as a im, should also be impossible.
ln fact, they aie not the same things. Planning within rms proceeds
against the necessary badrop of the market. Planning within ims can
occui piecisely because the maiket fuinishes it with the necessaiy
piices foi the factoi inputs that would be absent in a fullblown state
owneiship situation.
z
And we have alieady seen what soits of consid-
eiations deteimine the boundaiies between the im and the maiket.
e Firm Provides the Necessary Structure for the
Calculation of Prot
Tese answeis, howevei, aie not fully satisfactoiy and iaise some fui-
thei inteiesting issues. We stait by making the impoitant asseition
that if the maiket is necessaiy foi the viability of the im, the opposite
z
Petei Klein has iecently used this type of ieasoning in inteipieting Rothbaid (who
in tuin was extending Mises on the impossibility of socialist calculation). [N]o im
can become so laige that it is both the unique pioducei and usei of an inteimediate
pioduct, foi then no maiket based tiansfei piices will be available, and the imwill be
unable to calculate divisional piot and loss and theiefoie unable to allocate iesouices
coiiectly between divisions (Klein 1vve1).
1cu CAPlTAL lN DlSEQUlLlBRlUM
appeais to be just as tiue. Tat is, the rm is necessary for the smooth
operation of the market process. Tis asseition is based on noting the
cential impoitance of economic calculation in the maiket piocess and
the way in which the im piovides foi such calculation. We see this
by examining the calculation of piots. Te calculation of piots is
both simple and indispensable foi pioduction decisions. lt is simple in
the sense that the aiithmetic is simple, even though the elements that
constitute the evaluation aie ofen highly speculative. lt is indispensable
in that it piovides the basis foi disciimination between viable and non-
viable pioduction piojects (cf. Hicks 1v!b, as discussed in Chaptei e).
Retrospective Prots
liist, considei piot in a ietiospective context. Tat is, how do we de-
cide whi projects have been protable` Piot is ievenue minus cost.
!
Revenue is the pioceeds fiom the sale of the ielevant outputs, and is
ielatively easy to measuie in a monetaiy economy. Costs, howevei,
piesent foimidable pioblems that go to the heait of the natuie of team
pioduction. ln a maiket economy, when inputs aie puichased theii
puichase piice seives as the accounting cost. liom an economic point
of view, it can be seen to iepiesent the maiket value of oppoitunities
foigone as a iesult of puichasing the input in question. But what
about inputs owned by the im` How does one deteimine the costs
of using them` What we iequiie is an estimate of the oppoitunities
foigone by using inputs in one combination iathei than anothei (the
next best alteinative). Tis iequiies an estimate of the hypothetical
ielative contiibutions of inputs undei alteinative scenaiios. We have
alieady seen that the natuie of team pioduction is such that it is impos-
sible to measuie objectively the piecise contiibution of any membei
of the team (physical oi human). lf one weie iequiied to deteimine
completely accuiate contiibutions and to use these contiibutions as
the basis of cost calculations the pioblem would be insoluble, as with
fullblown state owneiship devoid of monetaiy calculation wheie no
clue at all is piovided.
!
Recall oui discussion of piot as a categoiy of eainings in Chaptei . Piot de-
pends ciucially on the piesence of unceitainty. ln the piesent discussion the absence
of unceitainty would imply that all eainings (wages, ients, and inteiest) could and
would be contiacted foi and theie would be no iesidual.
ORGANlZATlONS, MONEY, AND CALCULATlON 1c1
Te question is what is the ielevant oppoitunity foigone` Should
it be the value of the net ievenue foigone by the im by doing things
one way iathei than anothei, oi is it alteinatively the net ievenue that
would be added elsewheie in the economy by iedeploying the input
in question` Tis lauei measuie is an indication of what the input
might fetch in the maiket if it weie iented out, and is closei to what
we usually undeistand by cost in the accounting sense. lt is also the
cost that is ielevant foi the (actual oi piospective) investoi in the im,
whose hypothetical alteinatives involve moving between ims undei
the assumption that the im takes caie of the inteinal allocations. But
fiom the point of view of ecient allocation as seen by the im, the
foimei measuie, using the next best alteinative wheievei it occuis, is
the moie ielevant.
Tus, in the case of the maiket im, the laboi inputs aie paid
accoiding to a(n) (implicit oi explicit) monetaiy contiact, and similaily
with physical inputs (capital goods) that aie iented thiough the mai-
ket. We leave aside foi the moment the deteimination of these iental
values. liom the peispective of the decision-makeis in the im they
aie given by the maiket. loi capital goods that aie owned, howevei,
the costs associated with theii use aie moie pioblematic and have to
be estimated accoiding to ceitain accounting conventions. Tese con-
ventions use pioceduies to estimate (implicitly) the value of the asset
in the cuiient iathei than in alteinative uses. Tis implies that a basic
ingiedient foi this conventional calculation is, and appaiently must
be, the value of the asset itself, which in some way is deiived fiom the
estimated value of its estimated alteinative possible contiibutions to
output. An alteinative way of looking at this is to say, having aiiived at
a cost foi the assetdeiived (again mostly implicitly) as the discounted
value of its estimated next best outputone must then estimate (in
oidei to aiiive at an accuiate usei-cost measuie) how much of this
value is used up (pei peiiodits displaced maiginal value pioduct)
oi saciiced in cuiient pioduction. Tis is an estimate of how much
value is foigone by puisuing this line of pioduction as compaied to the
ielevant alteinative (howmuch ievenue net of ieplacement could have
been eained by this asset in the ielevant peiiod). Teie is obviously
no coiiect way to do this. So again we aie faced with the pioblem
of measuiing the ielative contiibutions of the inputs. And we iecall
again the imputation pioblem.
1cz CAPlTAL lN DlSEQUlLlBRlUM
ln sum, then, wheie maikets exist, the value of the joint output foi
any pioject as a whole, once measuied (oi estimated), is much easiei
to deteimine than in the absence of maikets. ln a sense, one half of
the pioblem is solved that of valuing an output howevei measuied.
As foi measuiing the (contiibution to) output, theie is no avoiding
ceitain elements of convention (judgment). What the institution of the
rm does (together with the institutions of money and accounting) is to
provide these conventions. By distinguishing between contiactual and
owned inputs, one avoids the need to estimate the alteinative maiginal
pioducts of the foimei. Te judgment involved in measuiing the lauei
aects the piot calculation and lends it an unavoidable element of
aibitiaiiness. Tis means that piot, even measuied ietiospectively,
necessaiily contains elements of subjective judgment oi convention.
We should distinguish, howevei, two impoitantly dieient aspects
of the piot calculation. Piot, undeistood as the iesidual afei all
contiactual obligations have been met, but making no allowance for
the costs of use of owned resources, is, fiom the peispective of the im,
not aibitiaiy in the sense just discussed. Maiket piices piovide the
necessaiy objective ingiedients foi a simple calculation. liom the
long-teim peispective, theiefoie, wheie all capital assets must be
used up oi completely ieplaced, piot appeais less aibitiaiy. lt is
the division between tiue piot and piot unadjusted foi usei cost
that is the pioblem. Howevei this division is done, it cleaily does
get done. And the piot calculations that emeige piovide a widely
accepted (peaceful) way of adjudicating between viable and nonviable
piojects. Tis is ieinfoiced in the long teim by the presence or absence
of cash ow. lf the shoit-teim division is injudiciously made, the cash
ow will eventually become negative as the undeiestimation of usei
costs becomes appaient and cash is absoibed in the ieplacement oi ie-
paii of capital assets. So, in this way, the im and the maiket togethei
piovide the indispensable basis foi the calculation of piots.
We asseited that maiket piices piovide the cost signal foi contiac-
tual inputs, while leaving aside how the maiket piice is deteimined.
Of couise, in the nal analysis, even when a iental piice of a duiable
asset (like a physical capital asset oi the piice of laboi (human cap-
ital) seivices) is deteimined by contiactual aiiangement, the teims
ORGANlZATlONS, MONEY, AND CALCULATlON 1c!
of the contiact, most especially the piice, must be deteimined with
iefeience to exactly the same consideiations that aie ielevant in the
case of owned iesouices, namely the value of oppoitunities foigone.
Te maiket is, afei all, just a shoithand iefeience to the iesults of
decisions taken by eveiyone else. So what deteimines these othei peo-
ples decisions aie the same things that deteimines the ims. Maiket
piices emeige when assets aie geneiic enough, have enough multiple
uses in the maiket, that peoples judgments of theii woith become
embodied in the stock of infoimation available to decision-makeis in
geneial (good examples aie the published set of piices foi used cais
oi ceitain kinds of pioduction equipment oi wages foi ceitain kinds
of laboi seivices). As such they ieect to some extent the tiial-and-
eiioi expeiience of many decision-makeis. And as such this kind of
infoimation is not available without the maiket.
Tus, though necessaiily subjective and involving elements of
entiepieneuiial judgment, calculations of piot, involving as they
must the imputation pioblem, aie facilitated by the fiamewoik pio-
vided by at least thiee inteiacting institutions, namely the im, money,
and accounting piactices, all within the umbiella institution of piivate
piopeity. Te indispensable element of judgment involves the auiibu-
tion of ielative shaies (contiibutions) to the inputs, which is necessaiy
to aiiive at an estimate of what each input costs, that is what saciice
each input entails.
Prospective Prots
Tis fiamewoik piovides the basis foi the prospective calculation of
piots as entiepieneuis pioject, on the basis of past infoimation and
conjectuie, the emeigence of piots in the sense just discussed. And
by compaiison between piospective piojections and ietiospective cal-
culations fuithei decisions can be made ovei time.
Two impoitant notes liist, theie is nothing in this account to
suggest that the decisions taken with iegaid to piotability aie in
a global sense optimal. Successful piojects aie viable, not optimal.
Teie is no way to decide, in this open-ended fiamewoik, whethei
Paieto optimality will emeige oi not. Tis is ielated to the second
1c. CAPlTAL lN DlSEQUlLlBRlUM
point (alieady discussed above in connection with the unceitainties
suiiounding team pioduction). Te piices of contiactually puichased
factoi inputs (laboi and capital oi land) aie sometimes said to be equal
to, oi to tend to be equal to, theii maiginal pioducts. ln so fai as team
pioduction does not admit of any simple solution to the imputation
pioblem it is dicult to see how this could happen in any simple way.
To be suie, in a maiket enviionment of negative feedback, that is to
say when ceitain key aspects of the enviionment, like the available set
of techniques of pioduction, consumei tastes, etc., aie unchanging, oi
changing veiy slowly, then sucient vaiiations in adopted techniques
aie likely to iesult in the giavitation towaids valuations of maiket
tiaded inputs that, in a meaningful sense, iepiesent the values of theii
maiginal pioducts. Tis is because, undei the postulated conditions,
the maiket piovides foi continuous vaiiations in input and iesultant
vaiiations, ceteris paribus, in output.
.
But this is by no means assuied,
and in the absence of such stable piocesses, the piices of the factois
must be seen to iepiesent simply the maikets assessment of theii
woith. Tat is, these piices aie what people, given theii best guesses
and estimates, have been willing to pay. As time passes, the piices will
change as the piojects in which the inputs aie employed succeed oi fail
and to the extent that they aie specic to those piojects as discussed
above. Te maiket piices foi inputs aie not equilibiiumpiices, but they
do fuinish an impoitant and indispensable basis foi the calculation of
piots. Without maiket piices, ims could not plan as they do.

.
Tis is, of couise, a nutshell evolutionaiy aigument with a stable equilibiium.
lt contains the necessaiy elements of mutation (vaiiation), selection (competition),
and ieplication (continuity in the im as an institutional entity that ieplicates ceitain
kinds of behaviois). See Vioman (1vv).

ln the Hicksian fiamewoik developed eailiei we might wiite a geneial (and nec-
essaiily subjective) capital value (vectoi) function as

(, , , , , )
indicating, in a geneial way, the deteiminants of capital value

of any pioject. Te
vaiiable is peihaps especially impoitant because of its macioeconomic signicance
as the indicatoi of the ielationship between piesent and futuie piices of consumption
goods. Howevei, the stiuctuie of market prices and wages in geneial may aect the
pioject (thiough and ) and tenology ( and the types and combinations of
inputs and outputs) obviously maueis. All of the insights oeied by Hicks in teims
of inteitempoial behavioi of

follow.
ORGANlZATlONS, MONEY, AND CALCULATlON 1c
Money and Production: Ba to Menger
Te ability to calculate piot (both expected and past) is essential to the
woiking of the maiket piocess as we know it. lt cannot be duplicated
by a cential planning system. lt is a tiial-and-eiioi piocess in which
the vaiiables aie not only the vaiied and ofen spontaneously emeig-
ing techniques of pioduction, but also the vaiious incentive infoima-
tion alignments that come with dieient combinations of im shapes
and sizes and contiactual obligations that chaiacteiize the maiket. ln
addition, the piices foi the factoi inputs, though not equilibiiumpiices,
beai a ciucial connection to the piices of the outputs that they help
to pioduce and, theiefoie, to the piefeiences of the consumeis who
buy them. Pioduceis take theii signals fiom piospective ievenues
and (implicitly) impute values to inputs when they exeicise judgment
in the foimation of capital combinations. Without the institution of
money, this could not happen.
Without money and money piices, pioduceis could not make the
calculations necessaiy foi pioduction piocesses to be initiated and con-
tinued. While cential planneis could use administeied piices as the
basis foi capital piojects, the values of these piojects would lack any
basis in teims of the values of the outputs they pioduced. Te ad-
ministeied piices would not be economically meaningful, not having
emeiged fiom a piocess of individual evaluations. Te existence of
money, togethei with piivate piopeity and the division of laboi and
capital, is thus indispensable foi economic development.
Te phenomenon of money piesupposes an economic oidei in
which pioduction is based on the division of laboi and in which
piivate piopeity consists not only of goods of the ist oidei
(consumption goods) but also in goods of highei oideis (pio-
duction goods). ln such a society pioduction is anaichistic.
(Mises 1vc1.1)
Tis statement can be inteipieted supeicially as suggesting that these
vaiious ingiedients (money, piivate piopeity, division of laboi, and
capital goods) could exist independently and that it is theii joint occui-
ience that ensuies decentialized pioduction. An advocate of cential
planning might wondei why each of these ingiedients is so jointly
necessaiy and concoct vaiious substitutes foi one oi the othei (see
1ce CAPlTAL lN DlSEQUlLlBRlUM
Couiell and Cockshou 1vv!). Tis is a misconception. Te institutions
on which economic development is based do not only exist togethei,
they aie inextiicably bound up with one anothei. Tey aie, in an
impoitant sense, pait of the same institutional nexus, if any one is
compiomised, they all collapse. So nationalizing the means of pio-
duction will inevitably lead to a collapse of the monetaiy system and
the uniaveling of the fiuits of the division of laboi and capitalistic
pioduction. We can see this by consideiing how money develops, and
of couise foi this we must go back to Mengei.
ln Mengeis woik (1ve) we nd a full tieatment of the question
of the oiigins and development of money. Mengei explains how, with
the development of tiade, ceitain commodities come to be tiaded moie
fiequently than otheis. Tese pioducts have a high level of maiketabil-
ity. At some point individuals begin to accept these commodities not
in oidei to use oi enjoy them but foi the puipose of tiading them at
a latei date foi what they ieally want. At that point the pioduct has
become money.
Goods deiive theii value fiomindividuals appiaisal of them. Since
dieient people value dieient goods dieiently, tiade is mutually
advantageous. Wheievei people gathei togethei in society, they de-
velop tiade. But tiade without the benet of money is seveiely limited
by the need to uncovei a double coincidence of wants. ln peihaps
moie ievealing teims, tiade without money is limited by oveiwhelm-
ing infoimation iequiiements. By pioviding a geneialized means of
puichase, money diamatically ieduces the infoimation necessaiy to
conclude any numbei of tiansactions. Tis means that a monetaiy
economy is fundamentally dieient fiom a baitei economy. lt is diei-
ent piecisely because a barter economy in whi the same transactions
are accomplished as in an existing monetary economy is literally incon-
ceivable. lt is inconceivable because without money individuals could
not acquiie the infoimation necessaiy to conclude the necessaiy tians-
actions. And without an explanation of how individuals could come
by this infoimation we have no methodological basis foi postulating
such an economy.
What Mengei shows, then, is that money facilitates exchange. But
he goes fuithei. He shows that money also facilitates pioduction.
Without money the degiee of specialization would be gieatly auen-
ORGANlZATlONS, MONEY, AND CALCULATlON 1c
uated because of the incieased iisks involved. Specialized economic
activity (like all economic activity) is conditioned by the individuals
peiceptions of the iisks and benets available. Specialization implies
pioducing foi exchange, i.e., pioducing moie than one intends to
consume. ln a baitei economy specialization is thus limited by what
pioduceis believe consumeis will be willing to exchange foi theii (the
pioduceis) suiplus and to what extent this coiiesponds to theii desiies.
By commiuing ones iesouices to the pioduction of only one oi a few
commodities a pioducei iisks the accumulation of unwanted stocks
because of the inability to nd consumeis willing to exchange what
the pioducei needs. Tis iisk is consideiably ieduced in a monetaiy
economy since what the pioducei (in common with all pioduceis)
needs is money. Oi moie accuiately, with money pioduceis can be
suie of obtaining what they need. Pioduceis may also postpone theii
consumption decisions. ln this way the existence of money supplies
the degiee of condence necessaiy foi pioduceis to undeitake an in-
cieasingly complex set of specialized activities. Tey need nevei woiiy
about communicating theii desiies as consumeis to the puichaseis
of theii pioducts. Tus money seives not only to sepaiate the acts
of puichase and sale but also to sepaiate the acts of pioduction and
consumption.
When Mises wiites, Te phenomenon of money piesupposes an
economic oidei with the division of laboi, etc., he means, as Mengei
has shown, that the phenomenon of money develops along with these
things and, as Steven Hoiwitz coiiectly points out, [l]iom the stait,
the existence and use of money is inherently linked with piivate piop-
eity in the means of pioduction (1vvc, italics added, see also Hoiwitz
1vve).
lt is thus dicult to exaggeiate the impoitance of money in the
smooth functioning of a modein economy. Te institution of money
is intimately ielated to eveiy othei economic, and many noneconomic,
institutions. Hoiwitz (1vvz) has done some woik on the analogies
between money and language. But this is not so much an analogy
as a vital connection. Money could not exist without language, it is, in
a sense, a deiivative of language. Te use of money, in fact all tiade,
implies veibal communication. lt also implies the use of aiithmetic
and this biings us back to the question of calculation.
1cc CAPlTAL lN DlSEQUlLlBRlUM
Money and Calculation: e Ability to Budget
Mises claims that the inability to calculate the economic signicance of
capital piojects is what dooms cential planning with public owneiship
of the means of pioduction. Hoiwitz aigues that Mises bases this
claim on his undeistanding of the fundamental piopeities of money
and the emeigence of money piices foi the heteiogeneous means of
pioduction. We have discussed above the moie piecise context of
these money piices. loi Mises they aie aids to the human mind in
peifoiming the calculations on which actions aie based. Te ciucial
point heie, it seems to me, is that the institution of money and money
accounting allows decision-makeis to budget. Without the ability to
budget, pioduction could not occui, it could not be oiganized. Bud-
geting implies an inteitempoial fiamewoik, the tiacking of value ovei
time. lt piovides the individual plannei with meaningful oiientation
points against which to measuie action. Te meaningfulness deiives
fiom the fact that money piices within the fiamewoik of money ac-
counting aie socially meaningful, they aie undeistood by all maiket
paiticipants, they aie pait of a shaied language oi oiientation. When
money is functioning noimally (that is to say when theie is no ina-
tion), money piices iepiesent a shaied sense of what things aie woith
in the maiket, what can be got foi them. Tus, meaningful money
piices in the absence of piivate piopeity is a contiadiction. And it is
piivate piopeity that allows foi the oideily development of pioduction
activities. By oideily we mean widely undeistood and accepted
peaceful.
We can undeistand this (once again) in teims of the simple ideal-
ized piesent-value aiithmetic that we imagine decision-makeis to use
when appiaising capital piojects. Te prospective capital value of any
pioject (good oi piocess) is thought of as the discounted piesent value
of all of the useful outputs which it is expected to yield ovei its life.
Te retrospective capital value of the same pioject is the accumulated
value of the investments actually made. Any dieience between the
two is a capital gain oi loss (see Hicks 1v!b and Chaptei e). As a
iesult of the occuiience of capital gains and losses, pioduceis altei
the capital stiuctuie. Successful ventuies displace unsuccessful ones.
Te whole piocess pioceeds peacefully, though not painlessly, as the
ORGANlZATlONS, MONEY, AND CALCULATlON 1cv
economy engages in a foim of implicit expeiimentation whose iesults
aie calibiated in the foim of money.
ln a single ims accounting statement itemizing the total costs
of a pioject and compaiing this total to the ievenues ieceived
is contained a wealth of scaicity infoimation that neithei the
accountant not any othei agent in the system could evei gathei.
Each piice of puichased, iented, and hiied factois ieects a
complex tension among diveise plans that have tiied to pull
the ielevant factoi into alteinative uses. Te piot and loss
calculus itself then deteimines whethei the paiticulai combi-
nation of inputs undei consideiation yields an output that is
expected to pay its way in the maiket. Te fact that all this
scaicity infoimation is expiessed in quantitative foim peimits
each decisionmakei to test extiemely complex combinations of
factois foi theii piotability while simultaneously ielying on
similai tests being conducted by iival decisionmakeis.
(Lavoie 1vcb1)
e Eect of Macroeconomic Policy on Capital Calculation
One well-known application of Austiian capital theoiy is the Austiian
theoiy of the business cycle. Tis theoiy, developed in dieient ways
by Mises and Hayek, makes use of Bhm-Baweiks theoiy of capital as
ioundabout pioduction. As suggested above (Chaptei c), Hayek uses a
simplied veision of Bhm-Baweiks theoiy to explain howthe capital
stock becomes distoited as a iesult of inappiopiiate monetaiy policies
that ieduce the maiket inteiest iate below the level that is consistent
with the time piefeiences of the consumeis in the economy.
Tis theoiy is well known and will not be suiveyed oi evaluated
heie. Te vision of capital oeied in the piesent woik is one that is
less abstiact, less quantitative, and less aggiegative than that of Bhm-
Baweik. ln addition, oui focus is piimaiily on the way in which a
dynamic society evolves, how its capital stiuctuie changes in a peace-
ful but unpiedictable way against the backdiop of a stiuctuie of in-
stitutions that include a sucient commitment to the piinciples of
piivate piopeity. And in this chaptei we have consideied how it is
that individuals aie able to make capital pioject decisions in such an
1vu CAPlTAL lN DlSEQUlLlBRlUM
enviionment. lt is of some inteiest, howevei, to considei biiey how
shoit-teim goveinment policy actions might aect this ability.
We have alieady noted that ination, by compiomising the ability
of money to connote value, will aect the ability of decision-makeis to
make successful decisions. lnation, by compiomising the institution
of money, in eect compiomises all of the ielated institutions, most
notably the institution of accounting. ln the extieme, in situations of
hypeiination, no capitalist pioduction will take placethe economy
will ieveit to a baitei system. But what about less extieme monetaiy
policies that aim only to stimulate economic activity by keeping in-
teiest iates low`
While it is dicult in a dynamic complex economy to know with
any degiee of condence what the typical eects of such a policy
might be (as contiasted with the degiee of knowledge suggested by the
Austiian business cycle theoiy), we can see immediately how individ-
ual business decisions might be aected. We iecall that eveiy capital
investment decision can be geneially chaiacteiized by a (necessaiily
subjective) capital value (vectoi) function as

(, , , , , )
indicating, in a geneial way, the deteiminants of capital value

of any
pioject. We can thus say two things about the ieduction of inteiest
iates on the peiceived value of any pioject
1. As Hicks has explained, a ieduction in will, ceteris paribus,
inciease the value of any pioject.
z. Tis eect will (usually, depending on the piecise natuie of the
income ow) be gieatei foi those piojects that have a longei
time hoiizon.
Tus, in a situation in which theie is a geneially peiceived deciease in
the iate of discount, one may expect a shif towaid piojects of longei
time hoiizon. ln othei woids, theie will be a change in the capital
stiuctuie and a concomitant change in the pauein of employment.
lnteiest has centeied aiound whethei this change is a sustainable one,
oi whethei, because it was piecipitated by a change in the supply of
money iathei than a spontaneous fall in individual time piefeiences,
it is based on an illusion and must necessaiily be only tempoiaiy.
ORGANlZATlONS, MONEY, AND CALCULATlON 1v1
Cleaily, if one makes the assumption that individual time piefei-
ences, as expiessed on the maigin in the maiket, iemain unchanged
in the face of the policy, oi, at least, iemain above the (equivalent)
maiket iate of inteiest, then it follows tiivially, since the shif is based
on an illusion, it must be tempoiaiy. Te inciease in pioduction and
employment will be ieveised and theie will be a cycle. Te assumed
illusion is of the foim that the planned time stiuctuie of pioduction,
the planned aiiival times of vaiious pioducts, is out of sync with the
planned time stiuctuie of consumption. So the discooidination will
become appaient when consumei demands in the shoitei iathei than
the longei teim go unsatised at pievailing piices, and when piices
iise the capital values of the longei-teim piojects will, in geneial, be
adveisely aected (as shown in the capital value vectoi function above,
consideiing and ). So pioduction plans become undone.
Teie is no guaiantee, howevei, that the decline in maiket iates,
piecipitated by cheap monetaiy policy, will indeed be taken by in-
vestois as a signal of a deciease in time piefeience. ln othei woids,
theie is no guaiantee that pioduceis in geneial will decide that , the
appiopiiate iate of discount foi theii piojects, has fallen. lf they ie-
gaid the policy as inationaiy they may well decide that a highei is
appiopiiate. Te policy may be doomed fiom the stait.
Neveitheless, it does seem possible to diaw the conclusion that
such policies, and paiticulaily anges in policies, do intioduce an
added degiee of unceitainty (noise) into individual decision-making.
Te woild is full of changes anyway. Most capital piojects will fail in
pait. To have to factoi in an expectation of changes in goveinment poli-
cies (inteiest iates, taxes, iegulations, etc.) and theii eects places an
added buiden on the decision-makei. Te policies aect not only the
viability of capital piojects in teims of theii stiaightfoiwaid incentive
eects (by making them moie oi less expensive) but they aect theii
viability also by inuencing the degiee and type of iisk that auaches
to the piojects. loi iisk-aveise individuals, the auiactiveness of any
capital value is ieduced. And this eect is likely to be gieatei the
longei the time hoiizon of the pioject.
ln geneial, shoit-teim macioeconomic policies may be seen to dis-
iupt the longei-teim adaptations that we have been analyzing in this
book, and aie likely to aect adveisely the cieative dynamism of the
1vz CAPlTAL lN DlSEQUlLlBRlUM
economy. lnteiest iate policy is only one kind of a set of policies
wheieby the goveinment, to a gieatei oi lessei extent, encioaches on
the decision-making teiiitoiy of piivate consumeis and investois. All
of these policies iest on pioblematic assumptions about the natuie of
knowledge and incentives. We will ietuin to this in the nal chaptei.
Conclusion
ln this chaptei we have investigated the iole of money and monetaiy
calculation in the deteimination of the pioduction stiuctuie of the
modein economy. We have found that the social institution of money
is inextiicably bound up with othei social institutions like piivate piop-
eity and business oiganizations. Te possibility of conceiving theoiet-
ically of a system without money, in which all calculation is done in
some aibitiaiy numeiaiie, should not blind us to the ieality that in
business oiganizations it is the ability to calibiate plans and iesults in
the foimof money that allows it to function smoothly. Money piovides
the iepoit caid foi business. Anything that compiomises the ieliabil-
ity of the monetaiy system thus compiomises the functioning of the
pioduction system. Tis is as tiue foi the auempt to impose a collec-
tivist economy without the use of money, ieminiscent of the Bolshevik
expeiiment, as it is of the many expeiiences of ination. So much
has been asseited many times. What we have undeilined heie is the
ciucial dependence of oidinaiy business calculations, foi the puipose
of undeitaking capital investments, on a ieliable monetaiy system.
Te ability to make useful calculations to guide decisions thus de-
pends on the stability of ceitain ciitical elements of the institutional en-
viionment of which money is one and piivate piopeity is anothei. Te
coipoiate stiuctuie also ciucially facilitates calculation in pioviding a
cognitive fiamewoik, a set of iules and ioutines (some of them tacit)
goveining individual behavioi of im membeis, to guide the decision-
makeis expectations. lt is impoitant to note that, in addition to these
consideiations, useful calculation assumes the ability to calculate. Mak-
ing useful calculations piesupposes not only some basic aiithmetic and
accounting, but also othei forms of knowledge and understanding ielat-
ing to the vaiious aspects of the business. Tus in the next chaptei we
tuin to an examination of the natuie and impoitance of human capital.
CHAPTER 11
Human Capital
Hayek (1v.) did not emphasize an even moie signicant im-
plication of his analysis, although he must have been awaie of
it. Te specialized knowledge at the command of woikeis is
not simply given, foi the knowledge acquiied depends on incen-
tives. Centially planned and othei economies that do not make
eective use of maikets and piices iaise cooidination costs, and
theieby ieduce incentives foi investments in specialized knowl-
edge. (Beckei and Muiphey 1vv!!ue)
Introduction: Human Capital and the Nature of Knowledge
Maiket economies aie chaiacteiized by complex capital stiuctuies, in
which individual complementaiy capital goods combine, eithei diiectly
oi indiiectly thiough the maiket piocess, to pioduce valued outputs. All
pioduction is essentially team pioduction. We have noted, at vaiious
points, the iole of knowledge in this piocess. Knowledge is necessaiy
foi action, and, indeed, motivates action. Multipeiiod plans involving
capital aie infoimed in vaiious ways by the knowledge of the planneis.
ln this chaptei we examine in moie detail the impoitance and natuie
of knowledge in the pioduction of valued outputs. We shall see that
the human capital liteiatuie, which has developed in the last thiee oi
moie decades, has much that is ielevant to an undeistanding of capital
in geneial, even moie so when a disequilibiium fiamewoik is assumed.
We have seen that most pioduction involves the ow of input
seivices foi the puipose of pioducing a ow of valued outputs (oi
seivices). (Simple point inputpoint output piocesses aie quite iaie.)
Tis input ow is piovided by the eoits of physical oi human ie-
souices, tiaditionally iefeiied to as laboi and capital. Sometimes
the identifying dieience between laboi and capital is the distinction
1v!
1v. CAPlTAL lN DlSEQUlLlBRlUM
between oiiginal and pioduced means of pioduction.
1
When con-
sideiing the iole of knowledge in pioduction, one comes quickly to
iealize, howevei, that theie is liule that is oiiginal in the type of
laboi eoit that is typically piovided in modein pioduction piocesses.
lt is obvious, ist, that human eoit in pioduction must be goveined
by ceitain types of veiy specic oi geneial knowledge and that, sec-
ond, much of this knowledge is intentionally acquiied. One is faced,
theiefoie, eithei with abandoning the distinction between oiiginal and
pioduced means (foi othei ieasons this distinction as applied to land
is of dubious value), oi of tieating knowledge per se as a sepaiate,
pioduced input. Tis lauei stiategy is essentially what the human
capital appioach does. Knowledge conditions (deteimines) the type of
seivice that gets put in, whethei fiom laboi oi capital. So knowledge
is embodied in both physical and human iesouices,
z
although theie
aie some impoitant distinctions in the way in which this happens.
And knowledge takes time to acquiie. Seen as the ability to pioduce
oi contiibute (diiectly oi indiiectly) towaid the pioduction of some
valued output, knowledge emeiges as a special and veiy impoitant
type of capital. (Education consideied as a puie consumption good can
be accommodated in the above fiamewoik if one consideis household
pioduction, as will become cleai below.)
ln some ways the teim human capital is unfoitunate. lt oiig-
inates piobably fiom the fact that, in an essential way, knowledge
must be embodied in the human mind. Teie is no human knowledge
without a human knowei. Tis aspect of knowledge suggests that it
must be thought of as subjective, although infoimation, fiomwhich it
deiives, is objective. Knowledge and infoimation, though ofen used
inteichangeably, aie distinct phenomena.
!
lt is knowledge that im-
bues infoimation with value. Disembodied infoimation, infoimation
1
See the discussion in Chaptei .
z
See Baetjei (1vvc), Lewin and Baetjei (zu11).
!
We shall use the woids infoimation and knowledge iespectively to mean the
tiadable mateiial embodiment of a ow of messages, and a compound of thoughts an
individual is able to call upon in piepaiing and planning action at a given point in
time. Oui distinction between the two teims thus iests in pait . . . on that between a so-
cially objective entity and a piivate and subjective compound of thoughts (Lachmann
1vce.v, see also Lewin 1vv.z!z!e). Also Whethei applied to compiehensive
oi noncompiehensive planning, the knowledge pioblem aigument ciucially depends
on the view that knowledge is not the same as data, that is, given pieces of explicit
infoimation (Lavoie 1vcb).
HUMAN CAPlTAL 1v
without cognition, is valueless. ln a sense, knowledge is infoimation
tiansfoimed into capital and, in fact, all capital has a similai knowl-
edge dimension. ln this sense, all capital is human. Capital is re-
sources (infoimation and othei iesouices) plus meaning, the meaning
that humans, by viitue of theii puiposes, impose on the iesouices at
theii disposal. Since knowledge must ieside in the human mind, the
enhancement in value that it occasions, when applied by humans to
physical iesouices, is natuially iefeiied to as human capital.
Knowledge, of couise, in many ways dees chaiacteiization. While
we may think of it as capital, knowledge as such is nevei tiaded, al-
though infoimation is. Knowledge is inevitably dispeised among indi-
viduals and can nevei be collected in a single place. lt has aspects that
aie inexpiessible even by the knowei, aspects that aie tacit (Polanyi
1vc). Tis beais on the familiai implications foi the impossibility of
socialist planning made famous by Hayek (1v.). ln addition, as Kail
Poppei has shown, knowledge has an open-ended natuiehe iefeiied
to knowledgepeihaps unfoitunately, given oui chaiacteiization of
knowledge as subjectiveas being objective in natuie, meaning
that, as we shall show, it has implications beyond the compiehension
of any subjective mind (Poppei 1vz). So when we think of human be-
ings as intentionally acquiiing knowledge that is embodied completely
within the human mind, we shall have to be a bit caieful. Knowledge
(oi potential knowledge) exists outside of the human mind in the sense
that ceitain machines, foi example, embody the potential to pioduce
ceitain outcomes only if used by someone who knows how to use
it, but does not necessaiily know why, in a moie fundamental sense,
ceitain iesults aie pioduced. Tis lauei type of knowledge is embodied
within the machine. lt was put theie by someone who piesumably
knew how to make the machine so that it would woik as intended.
.
Te question of wheie ultimately the knowledge actually iesides would
appeai to be a metaphysical one, whose answei maueis less foi oui
puiposes than the fact that knowledge is necessaiy foi pioduction,
wheievei we may visualize it iesiding. We need machines of ceitain
physical conguiations, embodying ceitain pioduction potentials, and
we need the know-how to opeiate them. Knowledge of some type,
at some level, must always be available in any pioduction plan. lt
.
See Baetjei (1vvc).
1ve CAPlTAL lN DlSEQUlLlBRlUM
is inconceivable that a pioduction plan could exist without human
knowledge. lt is not simply anothei analogous type of capital in the
same way as physical and human iesouices, which supply the eneigy
and eoit foi its implementation. So a beuei teim might have been
knowledge capital. While beaiing this in mind, foi ease of iefeience
and compaiison we shall continue to use the teim human capital.
ln this chaptei l will examine some impoitant aspects of human
capital that deiive fiom the existing liteiatuie, especially fiom the
woik of T. W. Shultz and Gaiy Beckei. We shall see that many of the
valuable insights suivive when consideied outside of the neoclassical
equilibiium woild of fully consistent plans. Moie impoitantly, addi-
tional implications emeige as a iesult of this tiansplant. l then ietuin,
in the next chaptei, to the inimitable natuie of knowledge touched on
above.
Human Capital and the Firm
Business oiganizations piovide foi the cooidination of iesouices in
pioduction. Tese iesouices may be physical oi human. ln consideiing
eithei of these types of iesouices, decision-makeis face exactly the
same type of decision. ln paiticulai, they aie conceined about the capi-
tal value of any combination of iesouices, whethei they be physical oi
human, and must take cognizance of the fact that the value of human
iesouices may be enhanced by tiaining and expeiience. Ceitainly
theie aie impoitant and signicant dieiences between investments
in human as compaied to physical iesouices, but theie aie impoitant
similaiities as well.
Knowledge, as we have seen (Chaptei !), comes in many foims.
Some knowledge is helpful in all oi many dieient pioduction set-
tingswe will call this general human capital. Te ability to iead
and wiite, to follow instiuctions, to communicate instiuctions, etc.,
aie examples. Some knowledge is of value in a limited numbei of (in
the extieme, only one) pioduction seuings. We will call this specic
human capital. Knowledge that ielates uniquely to the pioceduies and
ioutines of a paiticulai im oi to paiticulai pioduction piocesses aie
examples. Some foims of geneial human capital aie obtained thiough
HUMAN CAPlTAL 1v
specialization in education, in othei woids, thiough the devoting of
whole units of time (yeais of schooling) to the acquisition of ceitain
kinds of knowledge. And some foims of geneial tiaining aie piovided
by ims. On the othei hand, specic human capital is obtained mainly
on the job, although full-time tiaining couises in specialized subject
aieas aie an exception to this. With both geneial and specic tiaining,
an impoitant dieience between human and physical capital is that the
ownei must be piesent at the investment stage and the implementation
stage. Physical capital can be (and mostly is) pioduced and used away
fiom its ownei. But, at least in an economy without slaveiy, human
capital is tied to its ownei. Tis has some veiy impoitant implications.
lt means, ist, that ims cannot own human capital, they can only
ient its seivices. As a coiollaiy, it means also that any decision the
im might make with iegaid to tiaining must be a joint decision taken
togethei with the employee ieceiving the tiaining. So, it is of some
inteiest to ask when and undei what ciicumstances a im might pay
foi specic oi geneial tiaining (Beckei 1vv!ch. lll).
We can examine this by consideiing the elements of the individual
investment-in-tiaining decision. Te most impoitant elements ielate
to eainings. Te benets of tiaining come mainly fiom enhanced eain-
ings in the post-tiaining peiiod, while the costs come mainly fiom
ieduced eainings duiing the tiaining peiiod. loi simplicity we may,
foi the meantime, ignoie the nonpecuniaiy aspects of tiaining, that
is, we ignoie any diiect satisfaction that the employee may deiive
fiom the tiaining piocess oi its iesults (satisfaction of cuiiosity, self-
esteem, etc.)

Also, we assume that the employeis best estimate of the

maiginal value of the employees seivices is ieected in the wage iate
paid. ln this way, we shall see, both the employees and the employeis
valuation of the costs and benets of the tiaining aie ieected in wage

Tis can be easily accommodated by adding the net nonpecuniaiy gains to the
value of the investment. Adam Smith iecognized that dieiences in nonpecuniaiy
aspects of dieient jobs would be ieected in maiket wages. Tis iemains tiue foi
jobs that iequiie tiaining. Tus, iates of ietuin fiom obseived wages do not always
tell the whole stoiy, not only because outcomes will diei fiom expectations, but also
because wage dieiences must be adjusted foi piefeiences foi and against dieient
kinds of jobs, if the ietuins aie to be taken to imply a net gain to the investoi. Still,
consideiing laige gioups acioss dieient occupations does yield impoitant insights.
1vc CAPlTAL lN DlSEQUlLlBRlUM
iates. We iecall equation (e.1), the foimula foi the capital value of any
piospective stieam of ietuins fiom the peispective of point 0

+ +

(11.1)
wheie

aie the net ietuins, benets (

) minus costs (

)
and
= (1 + )
wheie is the iate of discount (time piefeience). ln oidei to calculate
the inteinal iate of ietuin (lRR) we put

= 0.
ln the case of investments in tiaining, the costs and benets have
a special pauein. Te costs of the investment will be captuied by
the (estimated) eainings piole that would have been eained in the
absence of the tiaining, and this must include any diiect out-of-pocket
costs. Using oui pievious notation,

wheie

aie the wage

iates of the employees seivices,

, in the absence of tiaining, and

, wheie

aie the wage iates of the employees seivices

(adjusted foi any out-of-pocket tiaining costs),

, with the benet of

tiaining. Since

and

iefei to the seivices of the employee (befoie

and afei tiaining), these aie most conveniently expiessed in teims of
time units, that is numbei of houis of input of a paiticulai type of
employee seivice. Tus we may noimalize by taking the basic unit to
be one (houi, day, yeai, etc.), then (since

= 1) equation (11.1)
becomes

=
(

(11.z)
Te piojected gain fiom tiaining consists of the piospective annual
wage dieientials each yeai ovei the woiking life ( yeais) of the em-
ployee. Te inteinal iate of ietuin (lRR) oi peiceived yield is obtained
by puuing

= 0, oi

=
(

)
(1 + )

= 0 (11.z

)
HUMAN CAPlTAL 1vv
Call this iate of ietuin

. Ten the tiaining will be undeitaken when-

evei

> , wheie is the best peiceived alteinative, due account being

taken of iisk, unceitainty, and othei ielevant factois. lt is cleai that

depends not only on the peiceived alteinative eainings stieams, but

also on the peiceived length of the payo peiiod, . And this payo
peiiod is inuenced by the length of life and the degiee of laboi-foice
paiticipation of the employee. (We shall considei latei how human
capital investments may inciease the value of time moie geneially, that
is, foi time used in- and outside of the laboi maiket.)
We may note at this point two othei impoitant dieiences between
investment in human and physical capital. Again this is ielated to the
fact that this human capital must be embodied in the human body.
1. Since human life and human woiking life is nite, it has an
impoitant eect on the peiceived iate of ietuin in investment
in human capital. lt is, in geneial, highei in youngei people,
and they aie likely to piedominate in tiaining piogiams. Te
niteness of the payo peiiod is an impoitant ieason foi the ex-
istence of diminishing ietuins to investments in human capital.
As yeais of tiaining and schooling aie added, the payo peiiod
diminishes by an equal extent (unless the investment lengthens
lifespan, as in the case of investments in health, but even then
the degiee of exibility is veiy limited).
z. With each successive investment in human capital, the value
of the employees time in the maiket is iising. So the value
of eainings foigone tends to iise along with the benets. loi
example, in the case of foimal schooling, a giaduate student
foigoes moie while in school than a high-school giaduate.
Tus although, as we shall aigue, signicant complementaiities exist
between dieient types of human capital that aie likely to iaise the
iate of ietuin as investment pioceeds, diminishing ietuins to maiginal
investments in individuals must eventually obtain, because of the two
ieasons just given. Tis is in maiked contiast to investments in phys-
ical capital in geneial oi in human capital fiom the economy-wide
macio-level point of view, when investments acioss dieient individ-
uals can be consideied.
lt should also be noted, howevei, that these dieiences can be
oveistated, especially in a iapidly changing economy. ln a dynamic,
zuu CAPlTAL lN DlSEQUlLlBRlUM
iapidly changing woild the ielevant payo peiiod foi any investment
is, moie ofen than not, not the physical life of the human oi physical
asset, but iathei its (shoitei) economic life. Te sciapping oi ietooling
of machines ofen comes not so much fiom the physical depieciation
of the asset as fiom its technological obsolescence. And this is moie
and moie tiue also of human capital, wheie individual skills lose theii
value not so much fiomphysical deteiioiation oi handicap, as fiom(un-
expected, unplanned foi) technological change. As the pace of change
acceleiates, the likelihood that the economic life of a skill is less than
its physical life incieases, and the need foi midlife ietiaining (with a
ieduced payo peiiod) incieases. We shall see this phenomenon in oui
discussion of specic tiaining below. Capital losses (and gains) occui
with both physical and human capital in categoiically identical ways.
e
Perfectly General Training
We may now considei the question of who is likely to pay foi tiaining.
ln the case of peifectly geneial tiaining, it should be cleai that the
im is less likely to pay than the employee. Te ieason is that geneial
human capital is peifectly poitable. Te tiaining incieases (and is
known to inciease) the value of the employees seivices as much in
e
Lachmann asseits
Te fundamental dieience between laboi and capital as factois of
pioduction is of couise that in a fiee society only the seivices of laboi
can be hiied while as iegaids capital we usually have a choice of hiiing
seivices oi buying theii souice, eithei outiight oi embodied in titles
to contiol. Te chief justication of a theoiy of capital of the type
piesented heie lies in the fact that in the buying and selling of capital
iesouices theie aiise ceitain economic pioblems like capital gains and
losses. (Lachmann 1vccn.)
Te distinction that Lachmann makes heie is suiely without substance. Te fact that
human capital cannot be tiansfeiied does not pievent it fiom being valued in the mai-
ket by its owneis and by its ienteis. Te capital value will vaiy diiectly with the iental
iate (eainings). Most impoitant, exactly the same consideiations that apply to the
theoiy of capital and make it inteiesting in Lachmann s view apply to human capital.
Capital gains and losses most denitely auach to human capital in an unceitain woild
and aie pait of the maiket piocess of continual ie-evaluation of pioduction plans. We
shall ietuin to this below.
HUMAN CAPlTAL zu1
othei (competitive) ims as it does in the one pioviding the tiaining.

Since ims cannot own human capital, they cannot capitalize the value
cieated by buying it, as is the case with physical capital. So the moial
hazaid pioblem cannot be solved by inteinalizing the investment
piocess. lt is possible foi ims to piovide the tiaining if they can
be insuied against the likelihood that the employee will quit and take
his skills elsewheie. loi these puiposes contiacts aie sometimes fash-
ioned, an example being the aimed foices,
c
but enfoicement costs can
be piohibitive. An easiei solution is foi the employee to pay. Te
inalienable piopeity iight that the employee has in his skills is the
souice of his incentive to invest in tiaining by taking a tempoiaiy cut
in eainings.
Tus foi ims pioviding geneial tiaining with the employee pay-
ing, the employees eainings duiing the tiaining peiiod would be ie-
duced by the cost of tiaining. Employees pay foi geneial tiaining by
ieceiving wages below what they could ieceive elsewheie. ln this way,
cuiient eainings (negatively) include capital investment items. So,
unlike foimal educational couises (schooling), expendituie foi tiaining
on the job is automatically deducted fiom eainings. All costs then
appeai as the value of foigone eainings to woikeis ieceiving geneial
on-the-job tiaining and an estimate of theii value depends on expecta-
tions of futuie post-tiaining eainings.
Perfectly Specic Training
Specic tiaining illustiates an aspect of the heteiogeneity of human
capital. As with physical capital, heteiogeneity implies complemen-
taiity. Specic human capital is valuable in specic combinations of
geneial and specic human capital and physical capital.

One does not iequiie a situation of equilibiium heie. liiespective of whethei

plans exactly match outcomes oi not, peifectly geneial tiaining, like liteiacy, benets
the individual in a geneial way, that is, in a vaiiety of situations, to the same extent.
Even though the piecise benet may be unceitain, the dierential benet, as between
one woik situation and anothei, is zeio.
c
Wheie the militaiy pays foi geneial tiaining, foi example foi pilots, and does
not pay the maiket wage foi giaduate tiainees, theie is a pioblem of ie-enlistment
and losses in favoi of businesses in the piivate sectoi, like the piivate aiilines (Beckei
1vv!!v).
zuz CAPlTAL lN DlSEQUlLlBRlUM
Peifectly specic tiaining incieases the expected eainings of the
employee only in the im pioviding the tiaining. ln this case, the
employee has a substantially ieduced incentive to pay foi the tiaining.
On the othei hand, since the skills obtained aie not poitable, the im
has a substantially incieased incentive to pay foi its acquisition. Since
the employees post-tiaining skills aie moie highly valued in the im
that has piovided the tiaining than in the maiket, they have a much
ieduced incentive to quit. Qiuing would necessitate taking a pay cut.
lf the imcould be condent that the employee would not quit in spite
of this ieduced incentive, it would be piepaied to pay the full cost
foi this tiaining. Since, howevei, no such absolute assuiance could be
obtained, the tiaining costs aie likely to be shaied, even in the case of
peifectly specic tiaining.
Wheie the im pays all oi pait of the costs of tiaining, wages
duiing the tiaining peiiod aie likely to be moie than the full woith
of the maiginal value to the im of the employees seivices and to be
less than this full woith in the post-tiaining peiiod (wheie such val-
ues can be estimated). Tis will most likely manifest in the employee
eaining moie than the maiket foi his cuiient skills will pay duiing
the tiaining peiiod. And since his skill is specic to the im, he will
eain moie than the maiket in the post-tiaining peiiod as well.
v
Multiple Specicity in Training
ln ieality, tiaining is seldom likely to be peifectly specic to a paitic-
ulai im. Rathei, the tiaining may have a gieatei oi lessei degiee of
specicity and this may vaiy acioss space and (impoitantly) acioss
time. A im that is technologically innovative and pioneeis a pai-
ticulai piocess oi pioduct, might, foi example, have to piovide all
v
As Beckei notes, Maishall was cleaily awaie of the dieience between geneial
and specic tiaining.
Tus the head cleik in a business has an acquaintance with men and
things, the use of which he could in some cases sell at a high piice to
iival ims. But in othei cases it is of a kind to be of no value save to the
business in which he alieady is, and then his depaituie would peihaps
injuie it by seveial times the value of his salaiy, while he could not get
half that salaiy elsewheie.
(Maishall 1v.veze, quoted in Beckei 1vv!..n.)
HUMAN CAPlTAL zu!
of a paiticulai type of tiaining itself and would be piepaied to do so
since the tiaining was of use only to it. As time passed, howevei, and
the benets of the new piocess oi pioduct became diused thiough
the economy and imitated by competitois, the tiaining would become
moie geneial in natuie. Tis is a iisk of which innovative ims aie
well awaie and may be a ieason foi endeavoiing to shif some of the
tiaining costs onto the employee. As a geneial iule the fiaction of the
tiaining costs paid by ims would be inveisely ielated to the peiceived
impoitance of the geneial component of the tiaining and positively
ielated to the peiceived enduiing specicity of the tiaining. liims pay
geneially tiained employees the same wage and specically tiained
employees a highei wage than they would get elsewheie.
An impoitant implication of this consideiation of specic tiaining
is that tuinovei depends on the wage iate and the degiee of specicity.
liims aie conceined about the tuinovei of woikeis with specic tiain-
ing and would theiefoie be piepaied to oei a piemium to pievent it.
By the same token, employees aie conceined about the possibility of
being laid o (oi ied). Qits and layos in tuin aect the expected
ietuins to ims and woikeis iespectively of investments in tiaining.
Employees with specic tiaining have less incentive to quit and ims
have less incentive to ie them. Accoidingly, the quit and layo iates
aie inveisely ielated to the amount of specic tiaining possessed, othei
things constant.
Tus, an unexpected (and isolated) decline in demand could be
expected to aect geneially tiained woikeis moie than those with
specic tiaining. Geneially tiained woikeis would be laid o befoie
specically tiained ones foi two ieasons. liist, ims have sunk invest-
ments costs in specically tiained employees that may be paitially
iecouped in the event that the decline in demand is tempoiaiy. Sec-
ond, if it is indeed tempoiaiy, newly hiied woikeis would have to be
ietiained in the specics possessed by existing employees, weie the
lauei to be let go. ln this sense, laboi can be seen as a quasi-xed
factoi of pioduction (see Oi 1ve1, Beckei 1vv!.e). Specic tiaining
thus implies the existence of a bond between employee and employei
which piovides a measuie of secuiity of seivice to the im and job
secuiity to the employee. lt is, howevei, a double-edged swoid. loi
the im, investing in specic tiaining iepiesents a iisk in the event
zu. CAPlTAL lN DlSEQUlLlBRlUM
that, as noted above, the specicity does not enduie. loi the employee,
investing in specic tiaining is iisky to the extent that it ties the em-
ployee to a specic employei and its fate. To the extent that a specic
pioduct oi piocess loses out in the maiketplace and sueis bankiuptcy
oi downsizing, the loss to specically tiained employees is gieatei
than to geneially tiained ones.
luitheimoie, both paities (employees and employeis) aie subject
to the thieats of oppoitunism and holdups noted above in Chaptei v
(Rosen 1vv1). Shaied investment costs iequiie shaiing latei ietuins
and can lead to pioblems ielating to oppoitunistic behavioishiiking
(thus pieventing the collection of the ietuins) and/oi thieatening to
hold up pioduction. As with specic physical capital, it should be cleai
that holdup thieats can occui on both sides of the maiket. Te imcan
hold out the thieat of teimination of a specically tiained employee
in an eoit to secuie post-contiact ieductions in eainings, and the
employee could thieaten to quit and take a valuable skill with himin an
eoit to secuie highei eainings. ln this iegaid the situation iepiesents
a bilateial monopoly.
1u
Pension plans that incoipoiate giadual vesting piovide a type of
insuiance to ims against piematuie quiuing of specically tiained
woikeis. Consequently, specically tiained woikeis would nd such
plans moie valuable than geneially tiained ones. Similaily, ims aie
moie likely to pay the moving expenses of employees who aie oi will
be specically tiained. Migiation is a foim of human capital invest-
ment, and migiation costs aie likely to be shaied in piopoition to the
degiee of specicity of the employees skills. Similai consideiations
auach to the ims contemplation of investments in the health of its
employees. linally, to the extent that dieient types of oiganizational
aiiangements aect the motivation and peifoimance of employees,
this must be seen as a type of (knowledge) capital. Tus, foi exam-
ple, wheie the conditions aie iight, ims may be expected to take
an inteiest in and subsidize the consumption of its employees. ln
less developed countiies an inciease in consumption [may have] a
1u
Tis is ieally just anothei aspect of the geneial imputation pioblem auaching to
teampioduction. Peifectly ecient imputation would facilitate peifect leaining of
pioduction piocesses and would thus facilitate peifect cooidination and enfoicement
ovei time in competitive maikets.
HUMAN CAPlTAL zu
gieatei eect on pioductivity . . . and a pioductivity advance [may
iaise] piots moie theie than in moie developed countiies (Beckei
1vv!).
Human Capital and the Individual
Te investment appioach to human capital outlined above thus pio-
vides many insights to the type of decisions that ims and employees
togethei face in the pioduction piocess. Tis appioach can also be
used to investigate aspects of individual behavioi moie geneially. ln-
dividuals face human capital decisions not only in, oi in ielation to, the
woikplace, although tiaditionally and logically this is the place to stait
in any investigation. Te oppoitunities available to individuals in the
woikplace condition and constiain them in the othei aspects of theii
lives. We must begin this moie geneial discussion by visualizing the
ielationship between individual woikeis and theii eainings ovei time.
AgeEarnings Proles
As noted, the human aspect of human capital is iesponsible foi im-
poitant dieiences between investments in physical and human assets.
Both involve consideiations of timeinteitempoial planning and the
evaluation of eainings at dieient points in time. loi investment in
individual human capital, howevei, the elapse of time necessaiily sug-
gests aging that cannot be ieveised. Te tiacking of eainings ovei time
is thus ofen iefeiied to as an ageeainings piole.
Typically, ageeainings pioles (with eainings on the veitical and
age on the hoiizontal axes) aie concave to the hoiizontal axis, suggest-
ing that eainings iise ovei time at a decieasing iate. Tis shape sug-
gests that expeiience has value as a foim of on-the-job tiaining even
in the absence of foimal (conscious) tiaining, as eainings inciease with
tenuie and job expeiience. Te fact that the inciease tapeis osuggests
the inuence of nite life. Te typical shape of the ageeainings pio-
le is a veiy iobust obseivation, found widely wheie statistics exist
(Beckei 1vv!1z). Howevei, the height and iate of change of the piole
vaiies with ciicumstances. liom a human capital peispective, ceitain
implications emeige.
zue CAPlTAL lN DlSEQUlLlBRlUM
Te ageeainings pioles of less tiained woikeis aie likely to be
auei (iise moie slowly) than those of tiained woikeis. Tis is be-
cause the ageeainings piole includes the ietuins to tiaining. Te
pioles of geneially tiained woikeis aie likely (othei things constant)
to be steepei than the pioles of specically tiained woikeis. With
specically tiained woikeis the im pays foi all oi pait of the tiaining,
thus paying the woikei moie than theii oppoitunity cost duiing the
tiaining peiiod and less than theii oppoitunity cost afei tiaining, thus
auening out the piole. Ageeainings pioles and investments in hu-
man capital go a long way towaids explaining the peisonal distiibution
of eainings (Beckei 1vv!1uv, Mincei 1v., moie below).
lull-time schooling is ofen a foimof investment in geneial human
capital (although theie aie degiees of specicity that auach to it, the
degiee of specicity iising usually with the level of education). Tus
schooling may be expected to steepen ageeainings pioles. Typically,
foi example, the ageeainings pioles of college giaduates stait latei
and below those of high school giaduates, iise much moie steeply and
iapidly oveitake the lauei. Te same pauein is obseived by compaiing
giaduate and college degiee eainings pioles. Tis suggests a phe-
nomenon that we shall examine moie closely below, namely that hu-
man capital investments aie likely to be (sequentially) complementaiy
in natuie. College giaduates, though saciicing some eainings giowth
while in college and thus having to stait at a wage below that of theii
moie expeiienced cowoikeis who enteied the woik foice iight afei
high school, aie able to catch up iapidly as a iesult of the knowledge
that they have accumulated.
11
Investments and the Allocation of Time over Time
Te human capital appioach to ageeainings pioles shows that an
individuals eainings aie not simply given to him as an exogenous
constiaint. Rathei, it is a iesult of theii actions ovei time with iegaid to
the time he devotes to investing in human capital and othei activities.
11
We do not considei heie alteinative explanations, like the scieening hypothesis
that foimal education seives meiely to weed out alieady existing abilities. loi a
convincing (to me) iejection of these types of explanations, see Beckei (1vv!c).
HUMAN CAPlTAL zu
ln this way, the human capital appioach integiates many aspects of
individual behavioi.
Te amount of time an individual spends investing in human capi-
tal would tend to decline with age foi two ieasons that we have alieady
discussed.
1. Te numbei of iemaining peiiods, and thus the piesent value of
futuie ietuins, would decline with age.
z. Te cost of investing would tend to iise with age as human capi-
tal accumulation pioceeded because the foigone eainings of the
individual would iise.
We note now that the iise in the value of the individuals time applies
with equal foice to the time spent within the household and geneially
outside of the woikplace. Assuming that woik was not an end in
itself, an inciease in the amount of time spent woiking oi investing in
human capital would iaise the maiginal value of consumption time
to the individual. Te ageeainings piole implies an age investment
piole. Geneially an individuals investment time will iise with age at
a decieasing iate, miiioiing the path of eainings, but would most likely
peak befoie the peak in eainings. (loi a moie piecise discussion see
Beckei 1vv!uc.) Duiing time peiiods when an individuals value
of time was iising most, they would tend to economize on othei uses
of theii time. Tis implies, in addition to foigoing woik time and the
eainings that come with it, foigoing leisuie oi consumption time.
Leisuie time appeais most expensive when one could be buying laige
incieases in caieei advancement with it. As incieases in eainings
potential tapei o, the tiadeo against leisuie time becomes less auiac-
tive, and eventually the pendulum swings in the othei diiection with
moie time being devoted to consumption and leisuie at highei ages.
Te capital theoietic decision is thus seen to apply to this maigin of
time as well.
e Illiquidity of Human Capital
Te above discussion suggests that the investment appioach to human
capital iesouices is a poweiful and simple tool foi explaining a wide
iange of phenomena. lt is piedicated on liule moie than the basic
logic of capital value and individual iationality (in the Misesian sense
zuc CAPlTAL lN DlSEQUlLlBRlUM
of inteinal consistency between means and ends). lt iequiies that the
individual weigh, in a consistent mannei, the costs and benets of
alteinative decisions as they see them. Of couise, all decisions aie
taken within a social fiamewoik and we have implicitly assumed that
these imagined and piojected costs and benets coiiespond closely to
mateiialized ieality. To be suie, investments in human capital, like
all investments, may have outcomes that diei to a gieatei oi lessei
extent fiom the planned outcomes on which they weie based. As with
all actions, they aie based, to some extent, on dispaiate plans and aie
thus, in pait, bound to fail. We shall examine some implications of this
below. Teie aie, in addition, some special consideiations that auach
to human capital, of which we take note at this point.
Since human capital is a veiy illiquid assetit cannot be sold
and is iathei pooi collateial on loansa positive liquidity piemium,
peihaps a sizable one, would be associated with such capital (Beckei
1vv!v1). Tis is a consequence of the inalienability of human capital
and the niteness of human life. Loans to nance investments can
be obtained with gieatei oi lessei ease (on beuei oi woise teims) de-
pending on the degiee of condence that the nancieis have in the
investment and on the degiee to which the alteinative value of the in-
vestment assets themselves piovide some safeguaid against the failuie
of the investment. Assets of a failed business can be sepaiated fiom
the business and sold (iedeployed) to help oset the loss. ln the case of
human capital, howevei, the asset is insepaiable. luitheimoie, loans
foi investment in assets depend on the ieputation of the investoi. A
young investoi, anxious to stait his own business, must convince the
nanciei that he is cieditwoithy. lf necessaiy he can postpone the
investment a while in oidei to accumulate a tiack iecoid and some
peisonal capital. Human capital investments cannot be so easily post-
poned (Beckei 1vv!v.). Relevant to this is the fact that foi investment
in human capital the individual must of necessity use his own time
(in addition to any othei iesouices and othei peoples time that may
be necessaiy) in a iathei iigid mannei in oidei to accomplish the in-
vestment. ln othei woids, theie is no substitute foi being theie foi
a minimum amount of time.
1z
ln the case of physical capital, a pioject
1z
Te necessity of the individuals own time in the investment piocess piompted
Beckei to liken the piocess to the Austiian peiiod of pioduction model. His model is
HUMAN CAPlTAL zuv
pieviously postponed can ofen be expedited latei by incieasing the
iate of application of inputs.
loi these ieasons human capital is likely to be much moie illiquid
and less easily nanced. Like othei investments theie is a gieatei oi
lessei degiee of unceitainty, depending on the situation. Some of the
elements that contiibute to unceitainty in the case of human capital
have been analyzed.
Teie has always been consideiable unceitainty about the length
of life, one impoitant deteiminant of the ietuin. People aie
unceitain about theii ability, especially youngei peisons who
do most of the investing. ln addition, theie is unceitainty about
the ietuin to a peison of given age and ability because of nu-
merous events that are not predictable. Te long time iequiied
to collect the ietuin on an investment in human capital ieduces
the knowledge available, foi the knowledge iequiied is about
the enviionment when the ietuin is to be ieceived, and the
longei the aveiage peiiod between investment and ietuin, the
less such knowledge is available.
(Beckei 1vv!v1vz, italics added)
1!
said to be almost identical to those used in the Austiian theoiy of capital to explain
optimal aging of tiees oi wine. lndeed the main ielevance of the Austiian appioach in
modein economies is to the study of investment in human capital (Beckei 1vv!11!n.).
One may appieciate the point being made heie, namely, that in a consideiation of
investments of human capital one comes to appieciate the impoitance of time in the
investment piocess and, also, that theie is veiy liule scope foi substitution when it
comes to individual time. One can leain moie oi less intensively, but ciash couises
aie less eective (pioductive) than moie leisuiely ones. Neveitheless, as with the
Austiian peiiod of pioduction appioach, it can be fundamentally misleading. Time,
as such, is nevei put in to anything. Time is not a substance oi a iesouice. Rathei it
is what happens ovei time that is impoitant. Sometimes, as with the aging of wine, it
happens almost incidentally. Mostly it is a mauei of conscious eoit oi a by-pioduct
of such eoit, as in the case of the acquisition of tacit skills oi expeiience.
1!
Beckei iefeis heie again to Maishall
Not much less than a geneiation elapses between the choice by paients
of a skilled tiade foi one of theii childien and his ieaping the full iesults
of theii choice. And meanwhile the chaiactei of the tiade may have
been almost ievolutionized by changes, on which some piobably thiew
long shadows befoie them, but otheis weie such as could not have
been foieseen even by the shiewdest peisons and those best aquainted
with the ciicumstances of the tiade . . . the ciicumstances by which the
eainings aie deteimined aie less capable of being foieseen [than aie
those foi machineiy]. (Maishall 1v.v1, Beckei 1vv!vz)
z1u CAPlTAL lN DlSEQUlLlBRlUM
Tese iemaiks suggest that nancial maikets cannot be ielied on as
ieadily with human as with physical capital. Te ielative illiquidity
of human capital also explains aspects of the peisonal distiibution of
eainings.
Human Capital and the Personal Distribution of Earnings
Compaiison of dieient ageeainings pioles suggests that dieient
people invest dieient amounts in human capital. lt is cleai also that
dieient people invest in dieient types of human capital. lf people
weie identical in theii abilities and oppoitunities (ieected in an ac-
cuiate assessment of the ietuins), we would expect to see eveiyone
investing in the same way and eaining the same ietuins. An explana-
tion of dieiences in eainings (fiom woik) natuially, theiefoie, should
tuin to an examination of dieiences in abilities and oppoitunities
(including luck). Tis is the appioach taken by Beckei in a seminal
lectuie (the Wyotinsky lectuie, iepiinted in Beckei 1vv!1uv.).
ln this appioach dieiences in the amounts invested by dieient
people in human capital aie ielated to dieiences in the iates of ie-
tuin available fiom investing and in the oppoitunities to nance such
investments. Beckei calls the foimei, the dieiences in iates of ietuin
available, dieiences in ability. lt should be cleai that ability heie
does not necessaiily mean dieiences in innate capacities, like cogni-
tive ability oi lQ, although these may play some pait.
1.
Rathei, it iefeis
to the dieiential capacities that individuals have foi leaining and
foi tuining that leaining into economically advantageous outcomes,
which is obviously a much moie complex set of phenomena than abil-
ity as measuied by any one-dimensional ciiteiion.
1
1.
Recent ieseaich into the connection between tiaditional measuies of intelligence
and economic success have cast doubt on any simple connection. See, foi example,
Goleman (1vvch. !).
1
lt is possible, of couise, that dieiences in amounts invested in human capital
and in type of human capital ieect dieiences in piefeiences (howevei caused). Te
analysis in the text abstiacts fiom this, in eect assuming that such dieiences in pief-
eiences aie less impoitant than dieiences in abilities and oppoitunities. Ceitainly
both foices aie at woik, aecting the demand foi human capital. Teie is veiy liule
that one can say systematically about dieiences in piefeiences. One suspects that
the laigei the population undei discussion, the less likely that systematic dieiences
HUMAN CAPlTAL z11
Considei, then, a situation in which all individuals had the same
oppoitunity to invest. Dieiences in the amounts invested and in
eainings fiom human capital would then be explained solely by dif-
feiences in peiceived iates of ietuin. lndeed, foi the same amount
invested, moie able individuals would eain moie. But moie able
individuals would be inclined to invest moie (theii demand cuives foi
human capital would be highei). Tus, if the maiginal cost of investing
in human capital weie iising (an upwaid-sloping supply cuive) then
moie able investois would be obseived to eain a highei iate of ietuin
and would invest moie. And the moie elastic the supply of human
capital (oi the supply of nancing foi human capital), the gieatei will
be the vaiiance in eainings and human capital investment.
lf, on the othei hand, eveiyone was equal in abilityinvesting the
same would biing the same iate of ietuinthen dieiences in eainings
and iate of ietuin would be explained by dieiences in oppoitunities.
Tis view goes back at least to Adam Smith
Te dieience of natuial talents in dieient men is, in ieal-
ity, much less than we aie awaie of, and the veiy dieient
genius which appeais to distinguish men of dieient piofes-
sions, when giown up to matuiity, is not upon many occasions
so much the cause, as the eect of the division of laboi. Te
dieience between a philosophei and a common stieet poitei,
foi example, seems to aiise not so much fiom natuie, as fiom
habit, custom, and education. (Smith 1vczzczv)
Smith quotes David Hume as follows Considei how neaily equal
all men aie in theii body foice, and even in theii mental poweis and
faculties, eie cultivated by education (ibid.zc, quoting David Hume).
Oppoitunities to invest in human capital will be deteimined by access
to nancial maikets and by socioeconomic backgiound. Because hu-
man capital is iathei pooi collateial, much human capital investment
is nanced by paients and othei family membeis. Tus people with
the same ability but a supeiioi (moie auent) backgiound would tend
in piefeiences will explain dieiences in (aveiage) eainings. lt is also impoitant to
note that dieiences in iates of ietuin (and theiefoie eainings) that aie obseived foi
individuals who invest the same amounts in the same type of human capital cannot
be explained by dieiences in piefeiences.
z1z CAPlTAL lN DlSEQUlLlBRlUM
to accumulate moie human capital. Conveisely, scholaiships based on
need would woik in the othei diiection.
1e
ln ieality, both abilities and oppoitunities diei acioss individ-
uals. Ablei peisons tend to invest moie than otheis and the distii-
bution of eainings would be veiy skewed to the iight even if ability
weie symmetiically distiibuted and people had equal access to -
nance. ln fact, abilities and oppoitunities may even be positively
coiielated, in that moie able people aie moie likely to have access
to loans and othei types of nancial assistance. Tis would tend to
ieinfoice the explanation of why eainings distiibutions aie positively
skewed.
Human capital investments seive paitially as inheiitances.
lnheiitances appeai to be ieceived by only a small and select
pait of the population because small inheiitances aie invested
in human capital and theiefoie aie not iepoited in inheiitance
statistics. As the amount inheiited by any peison incieased, a
laigei and laigei fiaction would be invested in physical capital.
Tis can explain the sizable inequality in iepoited inheiitances
and can contiibute to the laige inequality in physical capital
and piopeity income. (Beckei 1vv!1.c)
Ageeainings pioles togethei with the above consideiations explain
also why eainings inequality appeais to inciease with age. Ablei and
moie foitunate people who invest moie (and foi a longei time) in hu-
man capital take longei to ieach theii peak eainings. Te absolute gap
(though not necessaiily the piopoitional gap) between people with
dieient amounts invested in human capital iises with age.
1e
Te piesence of state subsidies foi education and othei human capital investment
would noimally set up compensating vaiiations in piivate investments. loi example,
paients might be inclined to spend less of theii afei-tax dollais on human capital in-
vestment in the piesence of subsidies to theii childien. As we have discussed, human
capital is pooi collateial. Teiefoie investments aie unlikely to be nanced to the full
extent desiied by pooiei paients (weie they beuei collateial) in the absence of state
assistance. Tus, state assistance is likely to iesult in moie (of ceitain types) of human
capital (at the expense of othei types of expendituie) than would be accumulated
otheiwise.
HUMAN CAPlTAL z1!
Conclusion
Tis common fiamewoik helps explain many aspects of individual hu-
man behavioi and theii outcomes.
1
We have yet to considei the full
implications of iapid change foi human capital investment decisions.
Befoie we do, howevei, we should take note of the iole of human
capital in the economy as a whole.
Human Capital and the Economy
When we shif oui view fiom the individual to the economy, we must
take account of the way in which the knowledge possessed by dieient
individuals is combined in joint and ielated piojects. One is diawn
natuially to the concept of the division of laboi.
Recognition of the phenomenon of human capital and its iole in
the economy is cleai in Adam Smiths tieatment of the division of
laboi in the Wealth of Nations. He gives the following as (two out
of the thiee) ieasons that the division of laboi leads to an inciease
in output (incieasing ietuins) that the specialized individual woikei
both impioves in dexteiity ovei time and may be expected ofen to dis-
covei impioved methods of pioduction (Smith 1vcz11c). We have
alieady seen an example of this in oui discussion of the im and of
the connection between the division of laboi and the acquisition of
knowledge (human capital) by the woikei and also in oui discussion of
Lachmanns capital theoiy and his ieinteipietation of Bhm-Baweiks
notion of incieasing ioundaboutness. Te division of laboi appeais to
be involved, implicitly oi explicitly, in many aspects of capital theoiy.
ln addition, as Cail Mengei has pointed out, Adam Smith has made
the piogiessive division of laboi the cential factoi in the economic
piogiess of mankind (Mengei 1vez).
Mengei goes on, howevei, to ciiticize Smith. He points out that
even in piimitive societies laboi is eciently specialized, yet the im-
piovement in pioduction is not such as is typical of technologically
1
Te woik of Gaiy Beckei and his collaboiatois has extended this appioach to the
seaich foi explanations of obseived outcomes ielating to inteigeneiational individual
and family mobility and aspects of family economics in geneial. We shall have an
oppoitunity to visit some of this below.
z1. CAPlTAL lN DlSEQUlLlBRlUM
piogiessive societies.
1c
Pioduction may be ecient within the given
state of the aits, piogiess consists in bieaking out of the existing fiame-
woik, in visualizing and implementing newmethods of pioduction. To
be faii, it seems to me that Smith does indeed imply this in his thiid
ieason foi the impoitance of the division of laboi (the inventions of
common woikmen, etc. (Smith 1vcz1vzz)). Be that as it may, the
point is that the division of laboi occuis within a given, known way
of doing things and it is piimaiily thiough changes in the lauei that
piogiess occuis.
Te quantities of consumption goods at human disposal aie lim-
ited only by the extent of human knowledge of the causal con-
nections between things, and by the extent of human contiol
ovei these things. lncieasing undeistanding of the causal con-
nections between things and human welfaie, and incieasing
contiol of the less pioximate conditions iesponsible foi human
welfaie, have led mankind, theiefoie, fiom a state of baibaiism
and the deepest miseiy to its piesent stage of civilization and
wellbeing, and have changed vast iegions inhabited by a few
miseiable, excessively pooi, men into densely populated civi-
lized countiies. Nothing is more certain than that, the degree
of economic progress of mankind will still, in future epos, be
commensurate with the degree of progress of human knowledge.
(Mengei 1ve., italics added)
What, piesumably, Smith would aigue is that advances in knowledge
(human capital accumulation) and the division of laboi aie intiicately
connected.
Tis is the theme of some iecent woik (Beckei and Muiphey,
iepiinted in Beckei 1vv!) integiating human capital, cooidination of
team pioduction, and economic piogiess. Beckei and Muiphey aigue
that the degiee of the division of laboi is goveined not only by the
1c
We may assume that the tasks in the collecting economy of an Austialian tiibe
aie, foi the most pait, divided in the most ecient way among the vaiious membeis of
the tiibe. Some aie hunteis, otheis aie sheimen, and still otheis aie occupied exclu-
sively with collecting wild vegetable foods. . . . We may imagine the division of laboi
of the tiibe to be caiiied still fuithei, so that each distinct task comes to be peifoimed
by a paiticulai specialized membei of the tiibe. [Te impiovement in allocation and
the inciease in pioduction that iesults fiom this] is veiy dieient fiom that which we
can obseive in actual cases of economically piogiessive peoples (Mengei 1vez!).
Essentially the same point was made at length by T. W. Schultz (1ve.).
HUMAN CAPlTAL z1
extent of the maiket, as Smith would have it, but also by the costs of
combining specialized woikeis. We have alieady discussed pioblems
of team pioduction that manifest in piincipal-agent diculties, fiee
iiding, communication diculties, and the like. Beckei and Muiphey
suggest that these consideiations imply that the costs of cooidinating
a gioup of complementaiy specialized woikeis giows as the numbei
of specialists incieases (ibid.!uu). Moie specically
Te pioductivity of specialists at paiticulai tasks depends on
how much knowledge they have. Te dependence of special-
ization on knowledge available ties the division of laboi to eco-
nomic piogiess since economic piogiess depends on giowth in
human capital and technologies. (ibid.!uu)
As societies piogiess, they become moie complex in the sense that
tasks become moie specialized. Tis echoes the views of Lachmann
and Bhm-Baweik. lt is in this sense that piogiess implies a gieatei
degiee of ioundaboutness. We see this in the specialization of the
piofessions (foi example, in physicians with theii specializations and
subspecializations) and in the way in which new industiies develop.
Much of this incieased specialization has been due to an extiaoidi-
naiy giowth in knowledge (ibid.!u). Tis knowledge embodied in
the human capital of specialized woikeis not only iaises the aveiage
pioduct of each woikei, but also iaises the maiginal pioduct of the
laigei team. Teams may be within oi between ims. Specialized mem-
beis of a team who aie employed by the same im get cooidinated by
the iules and ioutines of the im. Specialists who aie employed by
dieient ims have theii activities cooidinated by contiacts and othei
agieements acioss ims.
Te modein maiket economy, as Hayek (1v.) has pointed out,
facilitates the cooidination of laigei, moie complex teams than would
be possible in othei types of economy. And laigei and moie complex
teams facilitate economic piogiess.
1v
So teams get laigei and woikeis
become moie specialized and expeit ovei a smallei iange of skills as
1v
lt is the extensive coopeiation among highly specialized woikeis that enables
advanced economies to utilize a vast amount of knowledge. Tis is why Hayeks
emphasis on the iole of piices and maikets in combining eciently the specialized
knowledge of dieient woikeis is so impoitant in appieciating the peifoimance of
iich and complex economies (Beckei and Muiphey 1vv!!uc).
z1e CAPlTAL lN DlSEQUlLlBRlUM
human capital and technology giow. While, in Smith, causation goes
fiom the division of laboi to gieatei knowledge, in Beckei and Mui-
phey it also goes fiom gieatei geneial knowledge to a moie extensive
division of laboi and gieatei task-specic knowledge.
Teie aie impoitant complementaiities between dieient types of
human capital.
zu
ln paiticulai, geneial knowledge is usually comple-
mentaiy with investments in task-specic knowledge (adding anothei
dimension to the distinction between specic and geneial human cap-
ital discussed eailiei). Tus, incieasing geneial knowledge incieases
the demand foi specic knowledge. By the same token, incieases in
geneial scientic and othei knowledge, togethei with the decline in
cooidination costs that a matuie maiket system biings, iaise the bene-
ts fiomgieatei specialization. Declining tianspoitation costs, iaising
the eective size of the maiket, aie seen by Beckei and Muiphey as an
alteinative and additional explanation, but this may be equally seen
zu
Although he ofen does not seem to see the signicance of this and, indeed, some-
times claims to assume exactly the opposite, Beckei (and his collaboiatois in this woik)
cleaily see human capital as a heterogeneous stiuctuie, much in the same way as Lach-
mann thinks of physical capital stiuctuies, that is in which the elements aie ciucially
complementaiy. Anothei example An impoitant function of entiepieneuiship is
to cooidinate dierent types of laboi and capital (ibid.!u, italics added). Peihaps
suipiisingly, this is cleaily iecognized by the foundei of the concept of human capital,
T. W. Schultz, who states
l have aigued . . . that while a stiong case can be made foi using a iigoi-
ous denition of human capital, it will be subject to the same ambigui-
ties that continue to plague capital theoiy in geneial, and the concept
of economic giowth models in paiticulai. [Paiticulaily pioblematic]
is the assumption, undeilying capital theoiy and the aggiegation of
capital in giowth models, that capital is homogeneous. Each foim of
capital has specic piopeities a building, a tiactoi, a specic type of
feitilizei, a tube well, and many othei foims not only in agiicultuie
but also in all othei pioduction activities. As Hicks has taught us, this
capital homogeneity assumption is the disastei of capital theoiy. lt
is demonstiably inappiopiiate in analyzing the dynamics of economic
giowth . . . whethei capital aggiegation is in teims of factoi costs oi
in teims of the discounted value of the lifetime seivices of its many
paits. . . . One of the essential paits of economic giowth is thus con-
cealed by such capital aggiegation. (Schultz 1vc11u11)
lt does not seem as though this insight has peimeated the human capital liteiatuie in
geneial.
HUMAN CAPlTAL z1
as a paiticulai aspect of the giowth of knowledge and a deciease in
cooidination (communication) costs.
lt is impoitant to emphasize that the incentive to invest in knowl-
edge depends paitly on the degiee of specialization. ln this way the es-
sential and vital complementaiities between dieient types of knowl-
edge is biought out. At the economy level, investments in knowledge
aie not subject to diminishing ietuins in the usual way that invest-
ments in physical capital aie thought to be (but iemembei oui dis-
cussion on giowth theoiy above in Chaptei ). Gieatei knowledge
iaises the pioductivity of fuithei investment in knowledge (ibid.!1z).
Gieatei specialization enables woikeis to absoib knowledge moie eas-
ily, which tends to oset the tendency towaid diminishing ietuins.
Tus, complementaiities obviously exist within as well as between
individual woikeis. One has to leain howto leain and, having done so,
can leain moie easily and pioductively (we will ietuin to this below).
Accoiding to Beckei and Muiphey, the incieasing ietuins associ-
ated with the division of laboi and the accompanying accumulation of
knowledge aie gaineied by incieasingly moie ioundabout pioduc-
tion of human capital. All people who help pioduce human capital
aie called teacheis. Te human capital of the economy is pioduced
ovei many succeeding geneiations. Te human capital of woikeis in
latei peiiods is pioduced with moie ioundabout methods, and hence
longei lineages, than the human capital of woikeis in eailiei peiiods
(ibid.!1e). So the eects of human capital accumulation on the degiee
of specialization implies that membeis of moie ioundabout sectois
tend to specialize in a naiiowei iange of tasks. Tis piovides some
insight into the evolution of human capital. All suiviving human
capital is of ielatively old vintage-lineage.
Beckei and Muipheys vision complements the endogenous giowth
liteiatuie (see Chaptei ) in explaining the absence of any tendency
towaid diminishing ietuins in expanding economies and in explaining
why human capital tends to migiate towaid them iathei that towaid
less developed and moie slowly expanding economies. Rates of ietuin
on investment in knowledge depend on the costs of cooidinating spe-
cialized woikeis.
Countiies with lowei cooidination costs due to stablei and
moie ecient laws, oi othei ieasons, not only have laigei
z1c CAPlTAL lN DlSEQUlLlBRlUM
outputs, but they also tend to giow fastei because lowei costs
stimulate investments in knowledge by iaising the advantages
of a moie extensive division of laboi. (ibid.!1.)
ln sum, An analysis of the foices deteimining the division of laboi
piovides ciucial insights not only into the giowth of nations, but also
into the oiganization of pioduct and laboi maikets, industiies and
ims (ibid.!1c).
Human Capital and the Family
Introduction
Among the changes that have occuiied in the twentieth centuiy, pei-
haps none is moie piofound than the changes that have occuiied in the
natuie and iole of the family in the economy and in society as a whole.
Te family in the Westein woild has been iadically alteied
some claim almost destioyedby events of the last thiee
decades. Te iapid giowth in divoice iates has gieatly incieased
the numbei of households headed by women and the numbei of
childien giowing up in households with only one paient. Te
laige inciease in laboi foice paiticipation of maiiied women
has ieduced the contact between childien and theii motheis and
contiibuted to the conict between the sexes in employment as
well as in maiiiage. Te iapid decline in biith iates has ieduced
family size and helped cause the incieased iates of divoice
and laboi foice paiticipation of maiiied women. Conveisely,
expanded divoice and laboi foice paiticipation have ieduced
the desiie to have laige families. (Beckei 1vv11)
Among those women who weie maiiied foi the ist time in the 1vus,
less than 1 peicent have been divoiced, wheieas the compaiable num-
bei foi those ist maiiied in the 1vcus is aiound eu peicent. Te avei-
age household size has declined by one-thiid since the end of the nine-
teenth centuiy. lemale-headed households incieased fiom1 to !1 pei-
cent of all households (in the United States) between 1vu and 1vc.
Laboi foice paiticipation iates of women, especially maiiied women,
iose piecipitously in all of the advanced economies of the woild in the
postwai peiiod (see Beckei 1vv1 and the iefeiences theiein).
HUMAN CAPlTAL z1v
Economists have geneially not shown much inteiest in the family,
and wheie they have it has been piimaiily fiom the point of view of
population giowth. Changes in feitility aie a majoi deteiminant of
changes in population giowth and these aect not only the size of the
population at any given point in time but also the age composition
of the population thiough time. ln this iegaid the most famous con-
tiibution is that of Malthus. Even heie, howevei, subsequent to the
disciediting of the diie piedictions of Malthusian theoiy, economists
paid veiy liule auention to the deteiminants of population giowth and
simply took it to be exogenously given, as, foi example, in giowth eco-
nomics. Te human capital ievolution intioduced a new and iichei
peispective on population questions. Te human capital appioach in
fact began with this new look at population. ln a veiy inuential
aiticle Jacob Mincei (1vez) aigued peisuasively that the laboi foice
paiticipation of maiiied women was deteimined not only by theii
eainings but also by the eainings of theii husbands, the numbei of
childien they have, and othei aspects of the family. ln this way it
was seen that population inuences the economy not only by its size
and composition but in a moie detailed way by the degiee and type
of paiticipation of the elements of the population in woik and othei
activities. And these, in tuin, aie the iesults of endogenous foices
basic economic decisions involving inteitempoial planning.
While economists aie used to analyzing the decisions of economic
agents with iegaid to theii consumption paueins, houis of woik, in-
vestment piospects, and the like, they have tended to ignoie those
decisions ielating to maiiiage, childien, health, and othei peisonal
maueis. But this dichotomy between peisonal and economic mat-
teis is suiely an aiticial one that can be maintained only at the iisk
of ignoiing impoitant aspects of both. People, afei all, do not make
such decisions in isolation one fiom the othei. Rathei, they make
and change lifetime plans involving jointly woik, maiiiage, leisuie,
childien, and ietiiement. Each of these decisions inuences and is
inuenced by the otheis in ways on which economic ieasoning can
thiow consideiable light. Tis is the pioject of the family economics
that Gaiy Beckei deals with in much of his woik and most paiticulaily
in his A Treatise on the Family (1vv1, second enlaiged edition).
zzu CAPlTAL lN DlSEQUlLlBRlUM
Children
Te unpiecedented iise in laboi maiket oppoitunities available foi
women in this centuiy (as caused, foi example, the iapid expansion
of the seivice sectoi), manifesting in an inciease in the ielative wage
iate eained, has changed the value of time spent in the home by both
husband and wife. Tis is the majoi cause of the incieased paitici-
pation of maiiied women in the laboi foice. Te tiaditional division
of laboi between husband and wife has become less advantageous oi
moie expensive. Moie families have decided that they cannot aoid
foi the wife not to woik and foigo the second souice of income. Tis
inciease in the oppoitunity cost of the wifes time has meant that all
those things that aie pioduced in the household that intensively use
hei time have become moie expensive. Tis includes childien.
Childcaie is a veiy time-intensive activity, especially involving
the time of the mothei when the child is still young. Tus the de-
cline in feitility, accoiding to this peispective, is simply a ieection
of a decline in the demand foi childien. lt is a ieection also of a
shif, with uibanization, of the changing iole of childien in the family.
Wheieas in tiaditional societies childien aie an impoitant souice of
wealth, both in the foim of laboi and as a foim of social secuiity, in
modein uibanized societies this is no longei tiue. Childien aie desiied
moie exclusively as ends in themselves and can no longei be ielied on
as souices of wealth. Tis ieinfoices the eect of an incieasing cost of
time in making them moie expensive.
z1
Te decline in the aveiage size of the family has been accompanied
by an inciease (both absolutely and ielatively) in the amount spent on
(invested in) the smallei numbei of childien. Teie has been a shif
away fiom quantity to quality (Beckei 1vv1ch. ). ln impoitant
iespects this development stands the Malthusian model on its head.
lt is tiue that, othei things constant, an inciease in incomes leads
geneially to an inciease in the demand foi childien and theiefoie to
an inciease in family size, which ieduces income pei capita. What
Malthus neglects aie the implications of an inciease in the value of
z1
An explanation in teims of the advances in the technology of biith contiol has
been investigated and found wanting. Teie is histoiical evidence to suggest that
eective foims of biith contiol have always been ieadily (cheaply) available (Beckei
1vv1).
HUMAN CAPlTAL zz1
time. Othei things aie not constant when incomes iise as a iesult of
an inciease in eainings fiom woik (as contiasted, foi example, with
an inciease in piopeity oi inheiited income). A iise in the eainings
iate of a family membei incieases the cost of using that membeis
time in household activities, and when this applies to women, the
implication is a substitution eect away fiom childien towaid othei
types of expendituie that (if it is stiong enough) will outweigh the
Malthusian income eect. ln addition, with iising incomes and the
changing iole of childien, theie is a tendency to want moie foi ones
childien, that is, an inciease in the demand foi child quality.
We saw eailiei that dieiences in eainings among people could
be explained by the inteiaction of abilities and oppoitunities. We
can see now that these abilities aie most likely laigely deteimined
by the kinds of family decisions that we aie discussing. Te quality
and quantity of human capital invested in childien is piofoundly in-
uenced by paients lifetime decisions conceining family size, laboi
foice paiticipation and the division of laboi in the home, investments
in physical and nancial assets, and the success oi failuie of maiiiages.
e Family and the Division of Labor
Consideiing the family as a pioductive unit, one gains insights into the
type and extent of the division of laboi within it. As expected, at any
point of time, the division of household tasks foi the accomplishment
of mutually benecial outputs is deteimined by the peiceived compaia-
tive advantages of the vaiious family membeis. We abstiact heie fiom
the question of how, and by whom, decisions within the family aie
made, although cleaily this is a ielevant deteiminant of the allocation
of tasks. Given a paiticulai decision-making iegime, the peiception of
compaiative advantages will be impoitant. Te same piinciples that
govein the identication of the gains fiom tiade in an inteinational
tiade context (oi in any maiket context) opeiate as well within oigani-
zations in geneial and within the family in paiticulai. And just as has
been iecently emphasized in the inteinational tiade liteiatuie (Kiug-
man 1vv1), so with the family, the degiee and type of specialization is,
at least in pait, endogenously deteimined ovei time by the investment
decisions of the tiadeis. Resouices aie not simply given.
Te iising wage iates of maiiied women has meant an inciease in
zzz CAPlTAL lN DlSEQUlLlBRlUM
the cost of theii home time and an economizing of it within the family.
Tis has implied a reduced division of laboi within the household, a
gieatei shaiing of tiaditionally specialized tasks. Tis has, as we have
seen, also implied a decline in the size of families, a ieduction in the
numbei of childien pei family. Tese developments have, in eect,
ieduced the gain fiommaiiiage and incieased the likelihood of divoice.
And an inciease in the likelihood of divoice has, in tuin, ieduced the
advantages of specialization within the family.
Te incentive to invest in human capital specic to a paiticulai
activity is positively ielated to the time that one anticipates will be
spent on that activity. Te tiaditional division of laboi between men
and women, with men specializing in the accomplishment of maiket-
oiiented tasks and women specializing in the accomplishment of house-
hold-oiiented tasks, is piedicated on the assumption that men would
spend a sizeable piopoition of theii time in the laboi maiket and, moie
impoitantly, that women would spend the bulk of theii time in the
home. As a iesult, men tended to invest piimaiily in maiket-specic
human capital and women in household-specic human capital. Tus
the tiaditional division of laboi may not be the iesult of (laige) intiinsic
dieiences between people in geneial, oi between the sexes in paiticu-
lai, but, iathei, aie the path-dependent iesult of decisions to specialize.
Because of complementaiities in leaining and between dieient types
of specic human capital, investments in specialized human capital
pioduce incieasing ietuins and theieby piovide a stiong incentive foi
the division of laboi even among basically identical people. lnitially
small dieiences between people become, ovei time, tiansfoimed into
laige obseived ones (Beckei 1vv1.).
Divorce
As the amount of time that women anticipate spending in the home
has gone down, theii incentive to invest in household-specic human
capital has diminished and this has ieinfoiced the move away fiomthe
tiaditional division of laboi. ln addition, as the piobability of divoice
has iisen, the incentive of women to invest in maiiiage-specic hu-
man capital has likewise diminished. To some extent the acquisition
of maiket skills by women is a type of divoice insuiance, as it is they
HUMAN CAPlTAL zz!
who aie most likely to obtain custody of any childien and to have to
piovide foi them(the degiee of contiibutions by divoiced fatheis being
notoiiously low). Expectations of divoice aie, in this way, paitly self-
fulllingthe peiception of ieduced gains fiom maiiiage has led to a
ieduced commitment to maiiiage.
Teie is an element of paiadox in this. lt is almost as if, to some
extent, people maiiy in the expectation of geuing divoiced. Yet, funda-
mentally, divoice is a iesult of plan failuie, it is an indication that the
maiiiage has failed. lt is, in this sense, an indicatoi of disequilibiium
in the maiiiage maiket. Anothei way of looking at it is to see the
gains fiom maiiiage as having become moie unceitain, inviting the
piovision of moie contingency planning. Just as iapidly changing tech-
nologies have implied the expectation of a ieduced tenuie within ims,
the disappeaiance of the caieei tiack, so these same changes have im-
plied a ieduced tenuie of maiiiage. Women aie moie economically
mobile, moie commiued to maiket pioduction, and less able to iely
on the contiibutions of theii potential spouses. Tey theiefoie invest
less in maiiiage and get divoiced much moie ofen. And, while it is
tiue that men aie investing moie in household- and maiiiage-specic
human capital than they used to, this is much too weak to oset the
much laigei change in the status and iole of women. (See Hoiwitz and
Lewin (zuuc) foi a moie extensive discussion.)
Conclusion: e Evolution of the Family
Te momentous changes in the familyin feitility, divoice, and the
division of laboican thus be seen as a iesponse (to some extent an
unconscious one) to the iapid changes of oui technologically advanced
society and the unceitainty that it implies.
Tiaditional societies have enoimous pioblems coping with uncei-
tainty and changes in knowledge (Beckei 1vv1ch. 11). Societies ex-
emplied by tiaditional faiming and hunting (shing) economies do
not expeiience iapid and cumulative changes in techniques. ln such
societies, the family, oi moie accuiately the kinship gioup oi extended
family, is veiy impoitant in piotecting membeis against unceitainty.
Te family seives as both a social and a pioductive unit. Te chaiactei-
istics of the membeis of the gioup aie well known and theii behavioi
zz. CAPlTAL lN DlSEQUlLlBRlUM
is easily (inexpensively) monitoied since they live togethei oi close
by. Eldeis aie veneiated because of theii knowledge, the value of theii
specic human capital. Tis knowledge is paiticulaily valuable in sta-
tionaiy societies wheie it can be passed down to youngei geneiations
thiough the family, mainly via the cultuial inheiitance of childien,
nephews, and othei young ielatives. ln such societies occupational
tiacks acioss geneiations coincide with families. lamilies can be con-
sideied as small, specialized schools that tiain giaduates foi paiticulai
occupations and accept iesponsibilities foi auesting to qualications
and suitability foi ceitain tasks, especially wheie such is not easily
asceitained (ibid.!..).
ln dynamic economic enviionments, wheie technologies, incomes,
and oppoitunities change iapidly, the knowledge accumulated by oldei
membeis of society is much less useful, especially to youngei membeis.
Te young face a dieient and continually changing enviionment.
Geneial human capital (acquiied in laige schools) becomes much moie
valuable. Te ability to adapt becomes ciucial. Te impoitance of
kinship thus declines. Maiket insuiance ieplaces ieliance on the family.
Maiket contiacts ieplace infoimal family contiacts. Membeis of the
kin scauei. lndividualism ieplaces gioup identity.
Teie is some indication that the above tiends in feitility, divoice,
and the division of laboi may be slowing down and even paitially
ieveising, peihaps with a ienewed appieciation oi ieappiaisal of the
costs they have entailed. ln paiticulai, as Beckei has aigued, families
tend to be held togethei by altiuism, by shaiing of conceins acioss
family membeis, and those families that behave moie altiuistically
tend to be moie socially and economically successful. Altiuism is in
this way selected.
[A]ltiuistic paients tend both to have laigei families and to
spend moie on each child than selsh paients with equal ie-
souices. . . . lf childien inheiit cultuially oi biologically a ten-
dency to be like theii paients, families with gieatei altiuism
would become ielatively moie numeious ovei time.
(Beckei 1vv1cv)
lt iemains to be seen what this implies foi the natuie of the family in
the futuie.
CHAPTER 1z
Human Capital, the Natuie of Knowledge,
and the Value of Knowledge
Introduction: e Implicit Tension
To cieate knowledge is not to fathom oi command it oi own
it. All knowledge is boin, and foievei dwells, behind a veil that
is nevei shed. Afei theii biith, bodies of knowledge iemain
foievei unfathomed and unfathomable. Tey iemain foievei
piegnant with consequences that aie unintended and cannot
be anticipated. (Baitley 1vvu!z)
Having ieviewed some of the implications of the human capital ap-
pioach, we may now ietuin to an unnished theme staited in the
intioduction to the pievious chaptei. Human capital iefeis to the pei-
ceived value of accumulated knowledge in vaiious contexts. Yet, as
has been noted at vaiious points in this woik, knowledge is a veiy
dicult phenomenon to analyze. Te teim knowledge encompasses
an enoimous amount. lt undeilies eveiy action, eveiy thought. lt
is iiddled with paiadoxes and self-iefeiences. On the one hand, it
is ceitainly cleai, as suggested above, that an essential aspect of eco-
nomic development and piogiess lies in the existence and giowth of
vast bodies of knowledge. On the othei hand, although knowledge is
ofen consciously and puiposefully acquiied (pioduced), in iecogni-
tion of its necessaiy iole as a facilitatoi of giowth and development,
theie aie aspects of knowledge that cannot be puiposefully acquiied
because they cannot be peiceived ahead of time. Teie is a ieal sense
in which knowledge of knowledge is an impossibility. ln this section
we auempt a iesolution of this implicit tension. How can knowledge
at once be consciously pioduced and an unfathomable phenomenon`
zz
zze CAPlTAL lN DlSEQUlLlBRlUM
Pait of the iesolution lies in iecognizing that the phenomenon we
iefei to as knowledge is jam-packed with many diveise subphenom-
ena. Teie aie many dieient dimensions that emeige when knowl-
edge is unpacked. Along some of these dimensions knowledge can
be shown to be fallible, unfathomable, inexpiessible, and tacit.
Knowledge is Fallible
One dimension along which one can think about knowledge is its tiuth-
fulness, its fallibility. lollowing the woik of Kail Poppei, it is widely
(though peihaps not univeisally) held that knowledge is and must al-
ways be fallible. Todays valid theoiies may be iefuted tomoiiow.
Although he was talking piimaiily about scientic knowledge, Pop-
peis woik can be (and has been) applied to knowledge in geneial with
science seen as a metaphoi foi all knowledge.
My inteiest is not meiely in the theoiy of scientic knowledge,
but iathei in the theoiy of knowledge in geneial. Yet the study
of the giowth of scientic knowledge is, l believe, the most
fiuitful way of studying the giowth of knowledge in geneial.
loi the giowth of scientic knowledge may be said to be the
giowth of oidinaiy human knowledge writ large.
(Poppei 1vcvz1e)
All knowledge, accoiding to Poppei, is accumulated by tiial-and-eiioi
elimination of eiioi. ln scientic endeavois the elimination of eiioi is
moie conscious than in eveiyday life, but the piocess is essentially the
same. An implication is that all bits of knowledge, all theoiies, aie at
base conjectuies held with a gieatei oi lessei degiee of condence.
And conjectuies can nevei be positively justied oi veiied, although
they can (ideally) be iefuted. All knowledge is thus tentative to some
degiee. Teie can be no ultimate and absolute knowledge. Knowledge
is always fallible.
1
A model in which human capital is puiposefully accumulated in
iesponse to the accuiate peiception of its benets is thus, if we follow
Poppei, an inadequate depiction of the tiuth. Moie impoitantly, it
1
loi an inteiesting application of Poppeis ideas to the undeistanding of entiepie-
neuiship see Haipei (1vve).
HUMAN CAPlTAL & THE NATURE & VALUE Ol KNOWLEDGE zz
would seem to be inappiopiiate as an aid to undeistanding how and
why knowledge is accumulated. loi such a model piesupposes that a
paiticulai and ceitain (infallible) stock of knowledge exists (oi could
be pioduced) and is available to be ieplicated and distiibuted. Yet if,
on the contiaiy, all knowledge is tentative, how is it that people aie
able to make decisions iegaiding the acquisition of something whose
piopeities aie inheiently and iadically (as opposed to piobabilistically)
unceitain`
Knowledge is Unfathomable
A ielated but distinct and moie subtle dimension that can be used to
think about knowledge is its undeistandability, its fathomability. Te
unfathomability of knowledge tianscends its fallibility. Undeistand-
ing is ielated to but is dieient fiom knowledge. lt is not easy to
explain what undeistanding is (one suspects, to anticipate, that theie is
an element of tacitness to it). Vaiious aspects of cognition defy veibal
expiession. Baitley hazaids
To undeistand what a theoiy asseits will iequiie, among othei
things, undeistanding its logical implications, its content and its
context, what histoiical pioblem situations it addiesses, what
pioblems it can solve, and how it inteiconnects logically with
othei theoiies. Among these pieconditions foi undeistanding,
the haidest to undeistand (sic), and to chaiacteiize and convey
adequately, is the idea of content, even though, oi peihaps be-
cause, we all have an intuitive idea of what must be involved.
(Baitley 1vvu!.)
ln exploiing ways to chaiacteiize content, Baitley denes two ielated
concepts, logical content and informative content. Togethei they make
up the objective content of a theoiy oi body of knowledge.
1. Te logical content of a theoiy (oi a body of knowledge) is all
the non-tautological consequences that can be logically deiived
fiom it. All statements that follow logically fiom it as well as
fuithei implications that iesult fiom combining this theoiy with
othei theoiies pioposed oi assumed aie pait of its logical con-
tent. lt is well known that the logical content of any theoiy
must be innite (ibid.!).
zzc CAPlTAL lN DlSEQUlLlBRlUM
z. Te informative content of a theoiy is the set of statements that
aie incompatible with it. lt is also innite. Te moie a theoiy
foibids the moie it says. To say that it will eithei iain today oi it
will not is not veiy infoimative and does not exclude veiy much
of inteiest.
Te logical and infoimative contents aie distinct but ielated. Te el-
ements of the infoimative content of a theoiy stand in a one-to-one
coiiespondence to the elements of the logical content of a theoiy. Tis
can be seen by iealizing that foi eveiy element in eithei set theie is, in
the othei set, its negation. Hence the logical and infoimative content
of a theoiy inciease and deciease togethei (ibid.!e). To explain the
innite size of the infoimative content of any theoietical system, and
theiefoie of its logical content, Baitley uses the well-known example
of the ielationship between Newtons and Einsteins theoiies of giavi-
tation.
Call Newtons theoiy and Einsteins . Any statement oi
theoiy that is incompatible with will belong to the infoima-
tive content of , and similaily, any statement oi theoiy that is
incompatible with will belong to the infoimative content of .
Since Newtons and Einsteins theoiies aie mutually incompati-
ble, each belongs to the infoimative content of the othei. [But]
Einsteins theoiy is not simply incompatible with Newtons, it is
histoiically connected with it in the impoitant sense of having
supeiseded it. lt has supeiseded it in the sense that Newtons
theoiy is inadequate to the facts, and that Einsteins theoiy
appeais to come closei to the tiuth. Tis illustiates that any
new theoiy that supeisedes a ieigning theoiy . . . has to belong
to the infoimative content of the supeiseded theoiy. [Tus we
may say] any existing theoiy includes in its infoimative content
any theoiy that will eventually supeisede it, and in its logical
content the denial of any theoiy that will eventually supeisede
it. (ibid.!e!)
Tis should be sucient to illustiate the sense in which it can be
claimed that knowledge is a pioduct not fully known (oi knowable)
to its cieatoi. Teoietical systems have objective content beyond the
accessibility of any individual mind. Te full extent of a theoiy can
nevei be fathomed. Te content of Newtons theoiy is not identical
with Newtons thoughts oi opinions about it.
HUMAN CAPlTAL & THE NATURE & VALUE Ol KNOWLEDGE zzv
Baitley points out that the meaning and ielevance of any theoiet-
ical system, in the sense of the common undeistanding of it at any
paiticulai time, is in an impoitant way a histoiical mauei, as well as
paitly a mauei of logic. Te signicance of a theoiy depends on what
has been discoveied, at a certain time, in the light of the pievailing
situation, about the theoiys content, it is, as it weie, a piojection of
this histoiical pioblemsituation upon the logical content of the theoiy
(Poppei 1vezc). Baitley calls this piojection the accessed slice of the
objective content of a theoiy.
Te histoiical ielevance of a theoiy suggests that its meaning has
liule to do with the paiticulai woids and teims used in it. Almost
any statement may be iendeied in dieient teims without change in
meaning. ln fact, meaning and objective content aie not identical. Te
meaning, ielevance, and common undeistanding, and thus also the
economic value, of a theoiy (oi a body of knowledge) shifs as we
uncovei moie of, oi gain access to a laigei slice of, its objective logical
and infoimative content (Baitley 1vvu!c).
Knowledge existing at any point in time is ieected in the knowl-
edge objects to which it gives iise. Books, tapes, and computei pio-
giams aie obvious examples. But in an impoitant sense, a phaimaceu-
tical diug, a machine, oi a bunch of keys aie also knowledge objects.
What is ciucial [in oui piesent context] about an item of objec-
tive knowledgea book, oi a pill, foi instanceis its potential
foi being undeistood, oi being utilized in some way that has
not yet been imagined, a potential that may exist without evei
being iealized. (ibid...)
Baitley is heie (unconsciously) pointing towaid the essential and se-
quential complementaiity of knowledge elements and an impoitant
and unnoted implication of this. Te value of any itemof knowledge de-
pends ciucially on what is alieady known. Expectations of the piospec-
tive value of any knowledge object depend on what has alieady been
leaint about it in existing applications. So, foi example, the valuable
use of many medical diugs aiises out of imaginative conjectuies and
seiendipitous extensions to applications othei than those foi which
they weie cieated (like the use of blood piessuie medicine to aid in
the giowth of haii). So the cieation of the objects oi, indeed, the
teaching of any theoiy, could not have been completely connected
z!u CAPlTAL lN DlSEQUlLlBRlUM
to and could not have taken full account of theii piospective uses
(because of the impossibility of acquiiing the knowledge on which
those uses will depend), although ietiospectively one can (in piinciple)
tiace out the changing inuences on theii values. Since knowledge as a
pioduct is sequentially complementaiy, and since futuie knowledge is
unavailable, the pioductivity of knowledge can nevei ieally be known
ahead of time. One may again question the sense in which individual
motivations can be captuied in obseived (calculated) iates of ietuin to
the accumulation of human capital.
Te fact that knowledge is unfathomable, that its objective con-
tent is beyond the ieach of any human mind, is anothei aspect of the
dieience between infoimation and knowledge. As we have noted,
infoimation may be tiaded although knowledge may not. We see now
that infoimation is piegnant with meaning but that meaning may not
always be, and fiequently will not be, available to any individual, be-
cause its objective content is innite. lt is the content of knowledge
that, in a sense, extends beyond the individual knowei, not the knowl-
edge itself, which is subjective and contextual. What is valued in the
maiketplace is the accessed slice of any paiticulai body of knowledge.
Demand foi an item of knowledge, to the extent that it is avail-
able in the maiketplace, will be based on dispeised subjective
undeistandings oi estimates of, oi piefeiences foi, its accessed
slice, and on speculations about its potentialities. lt will not,
and cannot be based on its objectiveunfathomable and au-
tonomouslogical and infoimative content. Tis is not avail-
able oi ieadily accessible foi anyone to value.
(Baitley 1vvu.c)
Knowledge is Tacit
Knowledge can also be thought about in teims of its explicitness. lt
has been iecently acknowledged in a numbei of dieient contextsin
the philosophy of science (Polanyi 1vc),
z
economics and political econ-
z
Polanyi (1vc) (and ielated woik) is the best known, but the woik of many di-
veise and ofen seemingly inconsistent philosopheis of science like Poppei, Kuhn,
and Lakatos all aiguably imply a similai conclusion with iegaid to the question of
tacit knowledge. loi a iemaikablethough necessaiily incompletesuivey that mo-
tivates this position, see Lavoie (1vcbappendix).
HUMAN CAPlTAL & THE NATURE & VALUE Ol KNOWLEDGE z!1
omy (Hayek 1vv), and even iecently in the theoiy of business manage-
ment and oiganization (Nonaka and Takeuchi 1vv) that knowledge
is, at least in laige pait, tacit in natuie. Tis distinction between tacit
and explicit knowledge is ielated to the dimensions of fallibility and
fathomability. Oui acceptance of and oui undeistanding of bodies
of knowledge iest necessaiily on tacit (unaiticulated and fiequently
inaiticulable) iules, conventions, and inclinations. Te question iaised
heie is, if tacit knowledge is, as it must be, pait of human capital, how
is it valued and how is it pioduced` lf we do not even know what it
ieally is, how is it that we aie able to teach it` lf it cannot be taught,
how is it tiansmiued and acquiied`
A paiticulaily ielevant and well-known application of the impoi-
tance of tacit knowledge emeiged fiom the second iound of the so-
cialist calculation debate, paiticulaily in the woik of Hayek (and the
seminal aiticle that followed it, suiely one of the most widely quoted
aiticles in economics (Hayek 1v.)). lt has since peimeated (as we saw
above) into the theoiy of the business oiganization, paiticulaily in the
piolic woik of Heibeit Simon and of Olivei Williamson.
Hayek aigues that the economic pioblemdoes not consist in achiev-
ing the best allocation of iesouices among the vaiious means available,
as though the means and ends weie somehow given and known.
Te economic pioblem of society is . . . not meiely a pioblem of
how to allocate given iesouicesif given is taken to mean
given to a single mind which delibeiately solves the pioblem
set by these data. lt is iathei a pioblem of how to secuie the
best use of iesouices known to any of the membeis of society,
foi ends whose ielative impoitance only these individuals know.
Oi to put it biiey, it is a pioblem of the utilization of knowledge
which is not given to anyone in its totality.
(Hayek 1v., italics added)
Knowledge is dispeised and it is specialized. lndividuals have special
knowledge of time and place and they aie ofen not even awaie of
the knowledge that they have. Te implications of this foi the impos-
sibility of cential planning have been well coveied (see, foi example,
Lavoie 1vca,b, Kiiznei 1vvzch. e). Te fact that much of oui knowl-
edge is tacit and inaiticulate and unconscious, places insuimountable
baiiieis in the way of would-be cential planneis tiying to duplicate
z!z CAPlTAL lN DlSEQUlLlBRlUM
the achievements of decentialized maiket systems. lt is not simply a
pioblem of the technical diculty of collecting and piocessing all of
the ielevant infoimation. lt is, fuitheimoie, the impossibility of being
able to
1. extiact fiom this infoimation the necessaiy knowledge,
z. know what needs to be known when the individuals in posses-
sion of the necessaiy knowledge might not even be awaie that
they have it,
!. gathei the necessaiy infoimation when much of it has yet to be
geneiated by the maiket piocess.
Te maiket, indeed, is a piocess that cooidinates inaiticulate knowl-
edge by continual, and implicit, tiial and eiioi. Te knowledge pos-
sessed by dieient individuals is ofen inconsistent. How, then, could
it possibily be centialized`
Te tacitness of knowledge is thus of singulai impoitance in un-
deistanding the maiket piocess. lts impoitance is fuithei enhanced
by a iealization that all articulated knowledge rests on unarticulated
foundations. Te component paits of any statement accepted as tiue
(one plus one equals two) include undened woids which cannot be
completely dened. Requiiing a complete aiticulation of all teims
pushes us into eithei an innite iegiess oi into ciiculai ieasoning.
!
And, moieovei, the veiy act of foimulating any geneial statement
necessaiily iequiies using iules of piopei statement foimulation which
aie themselves inaiticulate. loi example, in desciibing ieal situations
we must always select ceitain abstiact qualities to which we wish to
diaw auention. Tis implies that nothing can be completely aiticu-
lated, since the veiy piocess of aiticulation involves abstiacting fiom
ieal featuies of the phenomenon being desciibed (Lavoie 1vcbeu, also
Hayek 1ve and 1v!). Peihaps the most giaphic illustiation of the
necessity of tacit knowledge is the way that childien leain language.
Achild, who usually does not leain the iules of giammai eaily in life, if
evei, can neveitheless constiuct giammatically coiiect sentences. Tis
is evidence of the kind of tacit knowledge that undeilies all aiticulated
!
lt was . . . Alfied Noith Whitehead (1vecv) who so concisely pointed out . . .
theie is not a sentence which adequately states its own meaning. Teie is always
a backgiound of piesupposition which dees analysis by ieason of its innitude
(Lavoie 1vcbeu).
HUMAN CAPlTAL & THE NATURE & VALUE Ol KNOWLEDGE z!!
knowledge. lt is only because oui minds aie capable of opeiating
accoiding to eective iules of which we aie unawaie that we aie able
to leain to speak a language (Lavoie 1vcbe1). Anothei example is the
act of iiding a bicycle and othei acquiied skills. Aiticulation, then, is
just one kind of skill that we leain without knowing piecisely how we
accomplish it (ibid.ez).
Te fact that all knowledge is in pait tacit and that all explicit
knowledge iests on tacit foundations, implying that knowledge can
nevei be made fully explicit, iaises inteiesting questions foi the eco-
nomics of infoimation in geneial and human capital in paiticulai.
Equilibrium and the Nature of Knowledge
Many aspects of the human capital model suggest the assumption that
agents opeiate in a context of equilibiium. ln paiticulai, theie is the
suggestion that the data histoiically obseived in the laboi maiket on
eainings in ielation to education and tiaining aie to be thought of as
valid and accuiate guides to the decisions that biought the data about
(and, foi that mauei, to decisions ielating to the cuiient futuie). Tis
implies that the piojections that motivated the decisions aie boine out
by the outcomes that iesulted and that theie aie no inconsistencies in
the peiceptions and plans of the vaiious decision-makeis. lt implies,
in shoit, a Hayekian equilibiium (see Chaptei !).
lf this weie tiue, we would have to conclude that the human capital
appioach not only abstiacts fiom impoitant aspects of time and change,
it also begs ceitain impoitant questions iaised by the natuie of knowl-
edge discussed above. lf knowledge is fallible, unfathomable, and tacit,
it must be a pioduct whose value cannot be fully known ahead of time
and whose value is continually changing. Te analogizing of knowledge
to a consciously pioduced pioduct is fiaught with pitfalls and paiadoxes
aiising out of the fact that it is a pioduct of unknown quality and foim.
So we must ask, how do the seemingly valuable insights of the human
capital appioach apply in a disequilibiium woild`
Te woild as we know it is, and must be, in disequilibiium, in the
sense that individuals at any given moment aie opeiating undei dif-
feient and ofen inconsistent expectations and theoiies. Te outcomes
that we obseive, in the laboi maiket and elsewheie, aie the iesults of
individual decisions that have been, and aie bound to be, to a gieatei
z!. CAPlTAL lN DlSEQUlLlBRlUM
oi lessei extent, mistaken. Just as obseived nancial poitfolios do not
iepiesent, except in a tiivial sense, optimal poitfolios (i.e., those that
would have been chosen if all the knowledge now available weie avail-
able at the time of decision), so poitfolios of human capital cannot be
optimal. Capital gains and losses aie, and must be, expeiienced as pait
of the maiket piocess. Te maiket value of accumulated knowledge is
an outcome that is (with iaie exceptions) dieient fiom its anticipated
value, to the extent that it can be anticipated.
l would suggest, howevei, that in oidei to make sense of oui (tacit`)
undeistanding of the maiket piocess, of oui veiy ieal conviction that
people do accumulate education and tiaining in the ieasonable expec-
tation of economic (and othei) gain, we ie-examine oui undeistanding
of equilibiiumand the natuie of knowledge. As was suggested in Chap-
tei !, iathei than seeing equilibiium as an all-oi-nothing pioposition,
we should iealize that we aie, in ielation to the vaiious aspects of oui
lives and the decisions we take, simultaneously in both equilibiiumand
disequilibiium. lt will be iecalled that l suggested a simple tiipaitite
taxonomy of knowledge. Knowledge type 1 (K1) is knowledge of the
laws of natuie, knowledge type z (Kz) is knowledge of social laws,
of conventions, ioutines, customs, etc., and knowledge type ! (K!) is
knowledge of specic and unique events that have occuiied (histoiy)
oi will occui. Knowledge types 1 and z aie knowledge of an abstiact
kind, knowledge of geneial piinciples (ielated to the natuial woild
apples fall fiom tiees to the giound, oi ielated to the social woild
people stop at ied lights, dollai notes aie a geneially accepted means
of payment), wheieas knowledge type !histoiical knowledge and
expectations oi anticipationsis knowledge of specic unique events.
lt should be cleai that K1 and Kz aie necessaiily fallible, unfath-
omable, and involve tacit elements, many of which aie the evolved
iesult of spontaneous social inteiaction. Even knowledge of the natu-
ial woild is fallible, as we have seen following Poppei. At any point
of time theie will, howevei, be a (moie oi less widely) shaied undei-
standing of how the woild woiks, in Baitleys teims the accessed
slices of the vaiious bodies of knowledge, and this will infoim and
help cooidinate individual actions in impoitant ways. Similaily, with
social laws of behavioi, many of which will be tacit, to the extent that
they aie widely undeistood they will seive to haimonize impoitant
HUMAN CAPlTAL & THE NATURE & VALUE Ol KNOWLEDGE z!
aspects of individual plans. With iegaid to K! we expect theie to be
inconstancy and disequilibiium. Since individuals plans aie multilay-
eied they could be, and, we contend, aie, in equilibiium with iespect
to some aspects (like what they will do oi not do if piots aie not
eainedthey will not go to wai, oi iesoit to thef) while they aie
in disequilibiium with iegaid to othei aspects (like being unable to
anticipate accuiately the level of piots, oi, indeed, the ietuins to
investment in education). As we have seen, howevei, the disequi-
libiium aspects do not incapacitate the decision-making abilities of
economic agents piecisely because such decisions aie taken within an
institutional enviionment that piovides K1 and Kz with meaningful
content.
Calculated iates of ietuin on investments in human capital iep-
iesent histoiical outcomes, but these histoiical outcomes will infoim
individual decisions to the extent that such outcomes aie iegaided as
ieliable guides to the futuie. A piioii, theie is veiy liule that one can
say in geneial about how likely this is. lt is cleai that individuals
do look at educational oppoitunities as oppoitunities foi economic
advancement. Some of these oppoitunities will be iegaided as moie
speculative than otheis. loi example, investments in geneial human
capital geneialized tiaining that is not specic to any im oi indus-
tiy, oi geneialized education (such as high school) will geneially be
iegaided as being moie secuie than an investment in moie specialized,
specic tiaining. lnvestments in geneial tiaining may be iegaided
as investments in K1 and Kz (theii accessed slices), as may some in-
vestments in ceitain types of specic tiaining. Te unceitainty that
auaches to the value of acquiiing dieient types of knowledge is a func-
tion not only of the changing foitunes of dieient pioducts, seivices,
and the technologies associated with them, but also to the shifing
sands of the validity of dieient piinciples and theoiies as new slices
aie accessed. Te above discussion ielating to geneial and specic
tiaining ceitainly continues to apply. One should emphasize, how-
evei, that cost and benet calculations should be inteipieted fiom a
piospective peispective in so fai as they aie motivatois of decisions.
Eveiy such decision is an entiepieneuiial decision, with a gieatei oi
lessei degiee of speculation involved. ln this iegaid, human capital is
no dieient fiom physical capital.
z!e CAPlTAL lN DlSEQUlLlBRlUM
Teie iemains the question of how tacit knowledge may be pui-
posefully acquiied. Cleaily not all such knowledge can be. To the
extent that we have knowledge of which we aie not awaie, we cannot
have been awaie of acquiiing it. But theie aie types of tacit knowledge
of which we aie awaie. Although we may not know exactly (fiom
the point of view of physics) how it is that we leain to iide a bicycle,
we do know what we have to do in oidei to leain. Te connection
between piactice (expeiience) and peifoimance piovides a piagmatic
oi piactical guide foi veiy accuiate decision-making, even though we
may not know why. Tiough tiial and eiioi we discovei beuei oi
woise ways of teaching language. Appienticeships and inteinships of
a veiy infoimal natuie aie ofen eective even if they mean simply
pioviding the iight enviionment foi the spontaneous emeigence of
ceitain skills.
Conclusion
Summary
A woild in which all individual plans, in eveiy ielevant detail, aie
mutually consistent, is a woild in which economic analysis is gieatly
simplied. lt is a woild devoid of essential change. All economic
values have univeisal and unambiguous meaning. Te capital stock,
that set of pioductive instiuments in combinations that give eect
to univeisally peiceived pioductive techniques, has an unambiguous
value. Each pioductive instiument can be unambiguously valued in
teims of its cleaily identied contiibution to the valued pioduction of
which it is a pait. And any contemplated dieience (one hesitates to
call it a change) in any of the paiameteis of the system, like the height
of any inteiest iate, will have piedictable and denite eects on the
value of the capital stock and the othei values in the system.
Such a woild, although it stiains the imagination and iendeis non-
sensensical the meaning to be auached to the passage of time, is, nev-
eitheless, illuminating as a contiast. And although it is seldom postu-
lated so giaphically, it does foimthe basis of much theoiizing in capital
theoiy and in economic theoiy geneially. lt is the implicit basis foi a
conception of capital as a substance, analogous to a physical substance,
whethei valued in teims of time, laboi houis, oi any othei metiic.
And it is the basis foi the woild of peifect competition so populai
in contempoiaiy theoiizing, in which no competition actually occuis
and in which no innovation is possible, no mistakes made.
An equilibiiumwoild, in the above sense, makes the connection be-
tween capital and time manifest in such a way that capital can actually
(and somewhat misleadingly) be expiessed in teims of time. ln such a
woild one can chaiacteiize eveiy pioductive piocess as a piocess that
culminates in the pioduction of a paiticulai output at a paiticulai time.
lt is thus possible to connect eveiy input to a specic pait of eveiy
z!
z!c CAPlTAL lN DlSEQUlLlBRlUM
output, and since each output has an unambiguous value, it is possible
to impute exhaustively and accuiately that value to the specic inputs,
and it is thus possible to calculate foi how long on aveiage each input
iemains in the pioductive pipeline.
ln this book l have tiied to suggest that such a tieatment of cap-
ital is inadequate and that to the extent that it has encouiaged us to
think in teims of capital stocks as longei oi shoitei it has been
unfoitunately misleading. Outside of equilibiium such notions have
no ieady application. luitheimoie, to think of capital in these teims,
that is in teims of equilibiium, encouiages thinking of capital accu-
mulation as an automatic piocess of value accietion. lt encouiages a
kind of capital illusion, an implicit conviction that by pioviding the
necessaiy nancial capital, oi even the specic tangible instiuments
foi vaiious capital combinations, one automatically can achieve the
kind of value cieation that chaiacteiizes the capitalistic economies
of oui ieal woild.
l have suggested a viewof capital that is imly iooted in individual
planning in a disequilibiium woild. Such a view sees value cieation as
the iesult of individual decisions and suggests that to undeistand how
such value is cieated, one cannot avoid looking at the decision-making
enviionment. Te decision-making enviionment necessaiily includes
the institutions of the economy and the knowledge of the decision-
makeis. Both of these aie pait of the capital of the economy. l have
suggested a viewof capital as a stiuctuie iathei than a stock. ln the ist
instance, the capital of an economy is embodied in the laigely unde-
signed netwoik of capital combinations of individual capital goods and
human iesouices. Tis stiuctuie opeiates within a supeistiuctuie of
(many undesigned) institutions like the institution of money, of piivate
piopeity, commeicial law, and, ciucially, the piivate im. Within
the piivate pioductive oiganization that we iefei to geneiically as the
im, capital combinations get made and changed against a backdiop
of shaied ways of doing things that seive to cooidinate individual
actions by haimonizing theii expectations. Ceitainly such institutions
as ims and the law aie not iigid, unchanging iestiaining devices.
Tey do change. But they change slowly enough to piovide a ieli-
able backdiop foi eective decision-making. So the capital stiuctuie
opeiates within an institutional stiuctuie. Tis institutional stiuctuie
CONCLUSlON z!v
encompasses and gives meaning to the nancial stiuctuie, the set of
nancial instiuments and piactices that facilitate the foimation and
mutation of the capital stiuctuie. Te nancial stiuctuie is volatile
and cannot be designed, but in its absence the capital stiuctuie has no
meaning and no value.
linally, the pioductive stiuctuie as a whole, encompassing the cap-
ital stiuctuie (naiiowly undeistood) and the institutional stiuctuie (in-
cluding the nancial stiuctuie), must also be seen to include the value
of human capital. ln fact the human capital stiuctuie is aiguably the
most essential (and the most dicult to ieplicate) ingiedient of the
entiie pioductive stiuctuie. Human knowledge has value. lt is an
asset. Te human capital stiuctuie is, howevei, indesciibably complex
and unfathomable. While it is possible to undeistand how individual
decision-makeis invest piotably in ceitain types of knowledge acqui-
sition, human capital as a whole iemains an unpiedictable amalgam
of diveise incommensuiate elements, many of which aie unknown,
unaiticulated, and unpiedictable. lt is one of the stiengths of a maiket
system that it is able (and has been seen empiiically to be able) to
evolve the kind of human capital stiuctuies necessaiy to foim the
capital stiuctuies that have biought the kind of cieation of value that
many have chaiacteiized as nothing shoit of miiaculous.
.
Implications for Policy
lf the above vision is coiiect, then the accumulation of capital is moie
than a quantitative phenomenon. Adding to the capital of an econ-
omy is a complex multidimensional piocess. lt involves not only, oi
piimaiily, the addition of existing capital equipment but iathei the in-
tioduction of piogiessively moie technically advanced equipment, the
pioduction of which is made possible by an institutional enviionment
in which the discoveiy of such technical advances is encouiaged. One
.
ln this book l have also suggested that the above conception of equilibiium is, in
a sense, too bioad. Tat is, it encompasses too much by iequiiing that all expectations
of everyone be consistent. l have suggested that moie iestiicted view in which some
expectations must be, and otheis must not be, mutually consistent. ln shoit, l have
suggested that the ieal woild of capital accumulation is one that is simultaneously
both in and out of equilibiium.
z.u CAPlTAL lN DlSEQUlLlBRlUM
must be cleai that what is involved is indeed discoveiy iathei than
the implementation of alieady known techniques. l amsuggesting that
the piocess involves a ieal Poppeiian giowth of knowledge.
Capital accumulation thus necessaiily involves knowledge accu-
mulation. lt is tiue that capital accumulation involves the intioduction
of moie ioundabout oi moie complex methods of pioduction, as
Bhm-Baweik and Lachmann have suggested. Te ieal question, how-
evei, is how do we come to know about these new and impioved
methods` lf the chaiacteiization of knowledge as fallible, tacit, and
unfathomable is coiiect, then knowledge in geneial is not something
that can be planned foi in a conciete way. lt is a pioduct whose value
and chaiactei cannot be fully known to its ownei. Tis has piofound
implications.
Te supeiioi peifoimance of capitalistic economies thus cannot be
logically pioved. Te iesoit to the eciency piopeities of peifectly
competitive economies is not only iiielevant and misleading, it is actu-
ally counteipioductive. loi the peifectly competitive model suggests
that knowledge is a standaidized pioduct equally available to eveiy-
one, including would-be cential planneis (as was quickly iecognized
by the socialist piotagonists in the socialist calculation debate). Te
supeiioi peifoimance of capitalist economies iests, iathei, on the fact
that they do not iely on cential planneis (policy-makeis) knowing
veiy much at all. lt is, as Hayek iealized (1v.), iathei that capitalist
economies aie able to eect a division of knowledge that facilitates the
accumulation and division of capital. Knowledge is, in eect, econo-
mized on. But it is also tiue that capitalist economies know moie.
Te most signicant aspect of accumulation is in fact the (laigely un-
designed and unplanned) accumulation of knowledge.
Tis has ielevance to the ecacy of piecemeal economic plan-
ning, whethei it be inteiest iate engineeiing, antitiust iegulation,
antipoveity planning, oi enviionmental husbanding. To be eective,
policy-makeis must have oi must be able to acquiie knowledge of
the ielevant economic futuie, of techniques, of piefeiences, of val-
ues. ln addition, since goveinment action iequiies iesouices that
would otheiwise be available to piivate individuals who would be, im-
plicitly thiough the competitive piocess, expeiimenting with vaiious
techniques and theoiies, the extent of discoveiy displaced by such
CONCLUSlON z.1
goveinment action is inestimable. Teie is liteially no way to estimate
the cost of goveinment, since a ciucial pait of that cost is the loss of
valuable knowledge. Knowledge lost cannot be known about.
Tis is ielevant also to the pioblem of economic development. Te
tiansition to capitalism cannot be simply bought. Capital equipment
can be bought. Buildings can be built. Expeits can be hiied. But
iespect foi piivate piopeity cannot be pioduced. A system of laws
that inteipiets and innovates piopeity iights cannot be easily acquiied.
A functional monetaiy system cannot be centially designed and im-
plementedthe money has ist to be accepted. And the necessaiy
human capital stiuctuie in all its subtleties and depths cannot simply
be ieplicated. Some tiansfeis can be simply taught, otheis can be
painfully acquiiedleaining by doing oi by immeision in othei
cultuiesothei aspects aie moie elusive. Piospeiity is a miiaculous
and impiobable evolutionaiy outcome. lf it can be tiansfeiied at all, it
will be by allowing and encouiaging the local population to evolve its
own paiticulai biand piivately.
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Competitive Economy. Oxfoid Claiendon Piess. [1veu].
Rizzo, M. J. 1vv. Time Uncertainty and Equilibrium: Exploration of Austrian
emes. Lexington D. C. Heath.
. 1vvu. Hayeks foui tendencies towaid equilibiium. Cultural Dy-
namics ! 1z!1.
. 1vvz. Equilibiium visions. South African Journal of Economics eu
no. 1 111!u.
. 1vv.. Time in Economics in P. J. Boeuke, ed. e Edward Elgar
Companion to Austrian Economics. Biookeld, VT Edwaid Elgai, 1vv..
. 1vve. lntioduction in ODiiscoll and Rizzo (1vve). [1vc].
Robinson, J. 1ve. e Accumulation of Capital. London Macmillan.
Romei, P. M. 1vvu. Aie nonconvexities impoitant foi undeistanding giowth`
American Economic Review cu no. z v1u!.
. 1vv.. Te oiigins of endogenous giowth. Journal of Economic
Perspectives c no. 1 !zz.
Rosen, S. 1vv1. Tiansactions Costs and lnteinal Laboi Maikets in
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Rothbaid, M. N. 1vu. Man, Economy and State: A Treatise on Economic Prin-
ciples. Los Angeles Nash.
. 1v. Americas Great Depression, thiid edition. Kansas City Sheed
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. 1v. lntioduction in leuei (1v).
. 1vc. Time Piefeience, in e New Palgrave: A Dictionary of
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(1vv1) Austiian Economics A Readei. Hillsdale Hillsdale College Piess.
Samuelson, P. A. 1vez. Paiable and iealism in capital theoiy Te suiiogate
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Schultz, T. W. 1ve.. Transforming Traditional Agriculture. New Haven Con-
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Scully, G. W. 1vvz. Constitutional Environments and Economic Growth. Piince-
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Selgin, G. A. 1vcc. e eory of Free Banking: Money Supply Under Competi-
tive Note Issue. Totowa, NJ Rowman and Liuleeld.
Shmanske, S. 1vv.. On the ielevance of policy to Kiizneiian entiepieneui-
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Smith, A. 1vcz. An Inquiry into the Nature and Causes of the Wealth of Nations.
lndianapolis, lN Libeity Classics. [1e].
Solow, R. 1ve. A contiibution to the theoiy of economic giowth. arterly
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. 1vv.. Peispectives on giowth theoiy. Journal of Economic Perspec-
tives c no. 1 ...
Soiokin, P. A. 1ve.. Sociocultural Causality, Space, Time: AStudy of Referential
Principles of Sociology and Social Science. New Yoik Russel and Russel.
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Stiglitz, J. E. 1vc. Te causes and consequences of the dependence of quality
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Teece, D. 1vcz. Towaids an economic theoiy of the multi-pioduct im.
Journal of Economic Behavior and Organization ! !ve!.
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Vanbeig, V. 1vcv. Cail Mengeis evolutionaiy and John R. Commonss col-
lective action appioach to institutions. Review of Political Economy 1.
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. 1vvz. Oiganizations as constitutional systems. Constitutional Polit-
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. 1vv.. Rules and Choice in Economics. London Routledge.
Vaughn, K. l. 1vvz. Te pioblem of oidei in Austiian economics Kiiznei vs.
Lachmann. Review of Political Economy . z1z..
. 1vv.. Austrian Economics in America: e Migration of a Tradition.
Cambiidge Cambiidge Univeisity Piess.
Vioman, J. J. 1vv. Economic Evolution: An Enquiry into the Foundations of New
Institutional Economics. London Routledge.
Whitehead, A. N. 1vec. Essays in Science and Philosophy. New Yoik Gieen-
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Williamson, O. E. 1vc. e Economic Institutions of Capitalism. New Yoik
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Williamson, O. E. and S. G. Wintei, eds. 1vv1. e Nature of the Firm: Origins,
Evolution, and Development. Oxfoid Oxfoid Univeisity Piess.
Yeagei, L. B. 1ve. Towaid undeistanding some paiadoxes in capital theoiy.
Economic Inquiry 1. !1!!.e.
. 1vv. Capital Paiadoxes and the Concept of Waiting in Rizzo (1vv).
lndex
A
action, !1!z
competitive vs. complementaiy, !z
dependence on iules, .z.!
piedictability, !c!v, .z, .
Ahiakpoi, James W. C., e, z.!
Alchian, Aimen, 1c, 1v, z.!
Aithui, W. Biian, .u, 1.., z.!
asset specicity, 1c1v
Austiian School, z!, .v, e., vc
Austiian theoiy of the business cycle,
1ze
aveiage peiiod of pioduction, e!c
B
Baetjei, Howaid, xii, 1, 1v., 1v, z.!,
zz
Baitley, William Waiien, lll, zz,
zzz!u, z!., z.!
Baizel, Yoiam, 1v, z.!
Beckei, Gaiy, vii, 1z, 1, 1v!, 1ve, 1v,
zu1zu!, zuzu, zuv, z1u,
z1zz1c, zzu, zzzzz., z.!
Beigson, Henii, !e, z..
Bieiman, Leonaid, 1., z..
Blaug, Maik, cc, z..
Bluedoin, Allan C., 1., z..
Boeuke, Petei, viii, 1ez, z..
Bhm-Baweik, Eugen von, , v, 11, .v, ,
e1, e!1, !c, v, cu, cc, cv, vz,
v!, v, ve, v, 11u, 11z11., 1ze,
1z, 1.11.!, 1., 1cv, z1!, z1,
z.u, z.., z., z.c
Buchanan, James M., 1.., z..
budget, .e., 1cc1vz
C
capital
capital accumulation, 1., ., , e, v,
e, ., , ce, 11, 1z!, 1!c1!v,
1.z1., 1.v, zu, z1., z1, z!u,
z!v, z.u, z
capital goods, !, .c, z, !, eue, z,
e, 1uz, 1u., 1u, 11!, 1111v,
1z1, 1zv, 1!11!., 1!e, 1!c, 1.!,
1ev, 1, 1c1, 1c, 1v!, z!c
capitalist economy, xi, , , 1, c, v,
e., z, 1zz, 1.c, 1, 1ce, z!c
capital stock, , e, .c, e., e, z.,
e, v1, v, 1u!, 1u., 1ze, 1zc, 1zv,
1!1, 1!z, 1.z, 1, 1ev, 1cv, z!,
z!c
capital stiuctuie, xi, !, 11, eu, ez, 1,
z, !, 1ze1zc, 1!u, 1!1, 1!.1.z,
1..1.e, 1., 11, 1e, 1ee, 1ev,
1z1!, 1cc, 1cv, 1vu, 1v!, z1e,
z!c, z!v, z.1, zu
capital theoiy, vii, xi, xii, ., 1u, 11,
1v, .v, 1, !, ., e!e., ev, c, v,
cc, v1, v!, v, ve, 11u, 11!, 1zu,
1z1, 1z!, 1z, 1ze, 1z, 1zc, 1!u,
1!v, 1.., 1.c, 1e!, 1cv, zuu, zuv,
z1!, z1e, z!, z.!, zu, z1, zz,
z, z
human capital, vii, !, 11, 1z, !!, c, ce,
1, 1ev, 1, 1cz, 1vz, 1v!zuu,
zu1zz., zzzze, z!u, z!1,
z!!z!, z!v, z.1, z.!, z.c
Chandlei, Alfied, 11, 1ee, 1z, z..
Chen, Ping, 1.., z.
childien, zzuzz1
Chiles, Todd H., 1., z..
Claik, John Bates, , u, 1!, z..
zv
zeu CAPlTAL lN DlSEQUlLlBRlUM
Coase, Ronald, 1.c, 1c, z..
Cockshou, W. Paul, 1ce, z.
Collis, David S., 1.c, z..
constant ietuins to scale (CRS), 1u,
c1c., 1z, 1u
constiained maximum, 1, 1
conveigence to equilibiium, zz, z.,
ze!u, .u, .z, ce
Couiell, Allin, 1ce
Cuiiie, Maitin, !1, !, !!c, z.
D
Dahlman, Cail, 1c, z.
Day, Richaid H., 1.., z.
Demsetz, Haiold, 1.c, 1v, 1e!, z.!, z.
discounted maiginal value pioduct
(DMVP), 11c
disequilibiium, xii, c, 11, 1!, z., z, zc, zv,
!1, !., ., .e, .c, u, 1, 1u., 1zu,
1zv, 1!1, 1!z, 1!!, 1!, 1!c, 1!v,
1v., zz!, z!!, z!., z!, z!c, zz
division of laboi, v, 11, , e, e, 1.1, 1.z,
1., 1ec11, 1c, 1cz, 1c1c,
z11, z1!z1c, zzuzz.
divoice, zzzzz!
Dolan, Edwin G., z!, z., z.v, zu
Doifman, Robeit, !, z.
Douglas, Cobb, cu
Diuckei, Petei l., 1, z.
E
Ebeling, Richaid M., viii, !v, v, z., z
endogenous change, 1u, zzv, 1., z1,
z1v, zz1, z.e
Endogenous Giowth Teoiy, c1c.
equilibiating tendencies, , 1!, z
and Austiian economics,
long-iun stationaiy state, v, v
equilibiium, c
absence of, 1.
as a balance of foices, 1e, 1
as a iesult of plans, !z
denition, 1!, 11c
eect of time, z1, ze
empiiical natuie, z!
geneial equilibiium, 1
equilibiium (cont.)
implications of, 1vz1
individual vs. system, zu
inteitempoial equilibiium, 1e, z1
micio and macio, zu
momentaiy equilibiium, 1
paitial equilibiium, 1
static equilibiium, 1
supply and demand, 1e
tempoiaiy equilibiium, 1e
tendency towaid, 1., z, !e
volitional aspect, 1c
equilibiium piice, zc!u
maiket-cleaiing piice, z.
piice disciepancies, zc, .
supply and demand, zv
Evans-Piitchaid, Edwaid E., .., z.
evenly iotating economy (ERE), 1111v
exogenous change, zc!u, cu, c, cv, zue,
z1v
F
labei, Malte, u, v., 11u, 11!, z., z.
leuei, liank A., c, 11z11., 11
im, vii, z, 11, ce, vv, 1uu, 1zu, 1z!, 1ze,
1!, 1!, 1.1, 1., 1.c, 1.v,
111, 11c, 1cv, 1vz, 1ve,
1v, zuuzue, z1!, z1, z1c, zz!,
z!, z!c, z.!, z.., z., z.e, z1,
zz, z!, z., ze, z
loss, Nicholai J., 1ze, z.e
G
Gaiiison, Rogei W., viii, ez, !, 11u, 11z,
z.e
Goleman, Daniel, z1u, z.e
Gieening, Daniel W., 1., z..
giowth theoiy, 11, !, ., c, cu, c1, cc,
cv, v!, z1, z.e, ze
Gupta, Vishal K., 1., z..
H
Hahn, liank H., 1v, z.e
Haicouit, Geoiey C., cc, z.e
Haipei, David A., viii, zze, z.e
Hausman, Daniel, e, z.
lNDEX ze1
Hayek, liiediich A., xii, c, 11, 1!, 1.,
1cz., ze, z, !1, !., .z, .., ., .c,
u, 1, !, ., c, cc, v, ve, vc,
1u, 11v, 1z!, 1ze1!1, 1!v, 1.,
1., 1.v, 1eu, 1e., 1e, 1, 1c,
1cv, 1v!, 1v, z1, z!1z!!, z.u,
z., zu, zz, z!, z, ze
denition of equilibiium, c, 1!, 1., 1c,
z
eect of time on equilibiium, z1
Monetary eory and the Trade Cycle,
1ze
Prices and Production, 1ze
e Pure eory of Capital, 1ze
equilibiium tendencies, zz
existence of equilibiium, zz
individual and system equilibiium, zu
Hennings, Klaus H., e!e, ., z.
Hicks, John R., 1u, z1, .v, !, ., , vu, vz,
v!1u, 1e, 1cu, 1c., 1cc, 1vu,
z1e, z.c, zu, zz
Capital and Growth, v!
Capital and Time, v!, v, ve
Pure eory of Capital, 11
Value and Capital, v!
lundamental Teoiem, 1uu1u1, 1ue
inteitempoial equilibiium, z1
neo-Austiian appioach, 1u
Hodgson, Geoiey M., 1.., z.c
Ho, Tigie J., 1, z.c
Hoiwitz, Steven, viii, z, .u, .1, 1, 1c,
1c, 1cc, zz!, z.., z.c
human capital, see capital
Hume, David, z11
I
inteiest, 1uv1zu
inteinal iate of ietuin (lRR), vv, 1u1, 1uz,
1ue1u, 1v
J
Jevons, William Stanley, , 1z
joint pioduction, 1e
K
Keynes, John Maynaid, ., , v., 1ze, 1zv,
1!, z!
Kiiznei, lsiael, M., viii, xii, c, 1!, 1,
z!zc, .u, c, cc, v1, 1u, 11u, 11z,
11!, 11, 11e, 1ze, 1zv, 1!v, 1.,
z!1, z., z.v, ze, z
denition of disequilibiium, z.
Klein, Petei, 1v, z.v
Knight, liank H., , u!, z.v
Knowledge capital, !, zzz!e
infoimative content, zz, zzc
logical content, zz, zzc
objective content, zz
Kiegel, Jan A., !, v, e., z.v
Kiesge, Stephen, 1!1, zu
Kiugman, Paul, .u, zz1, zu
Kuhn, Tomas S., z!u
L
Lachmann, Ludwig M., vii, xi, xii, 11, 1!,
1e, z!zc, !, !, .u, .1, .!, !, .,
v, !, c, v., v, vv, 1u, 11e, 1z!,
1ze, 1z, 1zc, 1!u1.e, 1., 1.v,
1u, 11, 1e, 1v, 1ez, 1ee, 1u,
11, 1!, 1v., zuu, z1!, z1, z1e,
z.u, zu, z1, zz, z
Capital and its Structure, 1!11.e
Lachmanns axiom, ze, z, !, .!, 1ez
Laing, N. l., cc, z.e
Lakatos, lmie, z!u
Langlois, Richaid, 1z!, 1., 1!, 1c, 1eu,
1e1, 1e!, 1e., 1e, 1ee, 1e, 11,
1z, z1
Lavoie, Donald C., viii, 1, 1cv, 1v.,
z!uz!!, zu, z1
Leijonhufvud, Axel, 1e11, 1!, z1
Lewin, Petei, xii, !, 1!, z!, ze, !z, !, v,
v!, 11u, 11., 1z, 1!u, 1!1, 1,
1, 1v., zz!, z.c, z1, zz
Liebowitz, Stan J., .u, zz
Lindahl, Eiik, !, zz
Loasby, Biian, .z, 1z!, 1, 1e, 1., z.e,
zz
Lucas, Robeit E., cu, c, zz
Lutz, liiediich A., ., e, v, zz
zez CAPlTAL lN DlSEQUlLlBRlUM
M
Machlup, liitz, 1, 1v, zu, zz
Maclachlan, liona C., 11!, z!
Malthus, Tomas, v, z1v, zzu, zz1
Maigolis, Stephen E., .u, zz
maiket-cleaiing piice, z.
maiiiage, zzzzz!
Maishall, Alfied, z., 1z!, 1ze, 1!, 1.c,
zuz, zuv, z.e, z!
Maix, Kail, 11, z.
Masten, Scou E., 1c, z!
McMullen, Jeiey, 1., z..
measuiement cost appioach, 1v
Mengei, Cail, v11, .u, .v, eue, 1, !,
vz, vv, 1z!, 1z1z, 1zv, 1.,
1e., 1c1c, z1!, z1., z.c, z!,
z
Time Stiuctuie of Pioduction, eue!
Mincei, Jacob, 1z, zue, z1v, z!
Minklei, Alanson P., 1., z!
Mises, Ludwig von, 11, !z, !., .e, ., c,
11u, 11z11., 11, 1ze, 1zv, 1,
1, 1c, 1v, 1c1cv, zu, z.e,
z.c, z.v, zu, zz, z!, z.
modein giowth theoiy, ., cu
Montgomeiy, Cynthia A., 1.c, z..
multiple specicity, 1!., 1., 1v, 1ez, zuz
Muiphey, Kevin, 1v!, z1.z1, z.!
N
Nelson, Robeit R., 1e., z!
neo-Austiian, 1u, v!, z.c, zu
neo-Ricaidian, v, 1u, 1v, .v, v, e, c, v,
ccv1, vz, 1u1, 1uz, 1.
net piesent value (NPV), vcvv
Nonaka, lkujiio, 1, z!1, z!
O
ODiiscoll, Geiald P., zu, z, zc, !., z.e,
z., z
Oi, Waltei, zu!, z.
On the Principles of Political Economy
and Taxation, v
Oiosel, Geihaid O., u, z.
P
Pellengahi, lngo, 11u, 11.
Peniose, Edith T., 11, 1z!, 1., 1.v,
1.1e, 1ez, 1u, 1z, z.
Polanyi, Michael, 1eu, 1v, z!u, z.
Poppei, Kail, 1v, zze, zzv, z!u, z!., z.u,
z.
piice
as a measuie of woith, .e
as a mode of calculation, .e
as a social institution, .e
changes in, .
disciepancies, zc, .
eects within disequilibiium, .e
piocesses of conveigence, .u.!
pioduction function appioach to
capital, v, vvz
capital intensity, cv, 1u1
capital ieveising, cv
challenge to, ccv1
complete pioduction function, cz
constant ietuins, 1u
diminishing ietuins, 1u, e, cv
endogenous change, 1u, z, zc
Endogenous Giowth Teoiy, c1c.
limitations, cecc
paitial pioduction function, c!
technological change, 1u
piot, 1u, u, 111zu
piospective piots, 1c!1c.
ietiospective piots, 1cu1c!
Pure eory of Capital, 11, 1ze
Puie Time Piefeience Teoiy (PTPT), 1u,
1uv11
R
Ramsay-Steele, David, 1, z.
Ricaido, David, , v, .v, ., eu, eze.,
!, , vz, v!, ve, 1z!, 1., z.
Richaidson, Geoige B., 11, 1z!, 1.v1.,
1, 1e, 1ez, 1z, z.e, z.
Rizzo, Maiio J., viii, zu, z!, zezc, !., !e,
z.e, z., z, z
Robeitson, Paul L., 1!, 1c, 1eu, 1e1, 1e!,
1ee, 1e, z1
Robinson, Joan, v, z
lNDEX ze!
Romei, Paul M., cu, c1, c!, c, z
Rosen, Sheiwin, zu., z
Rothbaid, Muiiay, c, 11u, 11z11., 11,
11c11v, 1ze, 1v, z., z.e, zz,
z
ioundabout methods of pioduction, v, 11,
z, e1, ez, eec, u, ., c, v,
11!, 1ze, 1.z1.., 1., 1cv, z1!,
z1, z1, z.u, z.c
S
Saleino, Joseph, viii, 1
Samuelson, Paul A., vu, z
Schultz, Teodoie W., 1z, 1ve, z1., z1e
Schumpetei, Joseph Alois, xii, 1zc, 1!.,
1., ze
Scully, Geiald W., cc, ze
Selgin, Geoige A., .u, ze
Shackle, Geoige L. S., z, zu
Shmanske, Steven, 1, 1c, ze
Simon, Heibeit, z!1
Smith, Adam, c, v, 11, .v, 1, !c, ., ,
v1, v!, 1z!, 1.u, 1.z, 1., 1e1ev,
11, 1v, z11, z1!, z1.z1e, ze
coin economy, !, ., 1.u, 1.
Solow, Robeit, cu, c!, c., c, ze
Soiokin, Pitiiim A., !, !c, ze
specic human capital, 1v
Siaa, Pieiio, , v, ze
steady-state economics, v, 1u!1u., 11
Steedman, lan, !1, !, !!c, z.
Steele, Geihaid R., 1.!, 1, z., ze
Stiglitz, Joseph E., 1v, ze
T
Takeuchi, Hiiotaka, 1, z!1, z!
technical infoimation, 1u
Teece, David, 1z!, 1.c, 1ee, ze
theoiy of the im, see im
time, eue!, ee, u, 1, !, , v1, v.ve
Treatise on the Family, A, z1v
Tuggle, Chiistophei, 1., z..
U
Unifoim Rate of Piot, eu
V
Vanbeig, Victoi, 1e., z
Vaughn, Kaien, viii, ze, z
Vioman, Jack J., 1c., z
W
Wealth of Nations, c, z1!
Wenai, Leif, 1!1, zu
Whitehead, Alfied Noith, z!z, z
Wicksell, Knut, v, ve, 1z
Wiesei, liiediich von, 1zv
Williamson, Olivei E., 1z!, 1.c, 1eu, 1.,
z!1, z.!, z., z!, z, z
Wintei, Sidney G., 1.c, 1eu, 1e., z., z!,
z, z
women in the woikfoice, z1czzz
Woodwaid, Susan, 1c, z.!
Wyotinsky Lectuies, z1u
Y
Yeagei, Leland B., cc, vu, 11u, z
Yoon, Yong J., 1.., z..