Production & Wealth creation

Basic concepts en common misunderstandingsThomas Vergote

WealthWhat is it and how does it come about?

Introduction to Wealth Creation

It is: the greatest number of possibilities for the greatest number of people in the face of scarcity

Possibilities are:• Subjective• Materialistic and non-materialistic• Not measurable

The best thinkable means are used to attain certain ends by mixing natural resources and human effort

Some questions Can wealth be created centrally? Who should be rewarded and why? Are capitalists stealing a part of the

productive efforts of labourers for their own gain?

Does consumption add anything to our wealth? What is its role in the production process?

Can we increase wealth creation by some (smart) government spending?

Building blocks for wealth creation

The division of labour (Adam Smith)• Self-interest benefits for society

• Specialisation Comparative advantages (David Ricardo)• Everybody has a role to play in the creation of wealth

Capital accumulation• Machines and tools make the unthinkable possible

(Technological improvements)

Content

1.The Structure of Production

2.Capital and Interest

3.Pricing of factors

Structure of Production

Structure of Production

Creation of wealth in a world of scarcity:Not more than the reorganisation of existing elements, mixed with human action

labour + land + capital consumptionOriginal

factors of

production

Structure of Production

The structure of production: Higher order goods vs. Lower order production goods

Imputation theory (Carl Menger):

All factors of production are valued, based on the valuation of consumption goods that they realize

Truck

Chainsaw

Structure of Production

PRODUC

TION VALUAT ION

Capital and Interest

Capital and Interest The production process takes

time All factors (land, labor and

capital) have to be paid in advance

Capitalists provide resources that only create returns much later

Eugen Böhm-Bawerk

= postponement of consumption

= saving

Time-preference advancing resources is not free;

Capitalists are paid interest = price for time

Capital and Interest Savings used for

• Maintenance of capital & production process

• Increasing capital structure Increased saving = shift from present

consumption to future consumption

Capital and Interest Secret formula of wealth:

More savings less present consumption, more investments

more “roundabout” processes (more stages)

higher efficiency of the production process more future consumption goods and higher real wages

This contradicts Keynes’ Paradox of Thrift: Saving ratio ↑ Aggr. demand ↓ Income ↓

Tot. Savings ↓Possible if capital structure stays fixed and C/I = constant

Capital and Interest

• Capitalists-entrepreneurs have a real role in society as they give two services to the other economic players with:

Time & Uncertainty• Consumption is a prerequisite for any production BUT does not add anything to the production process• Capital production and maintenance is a choice and function of the time preferences• Interest is an important price:

interest distortions intertemporal discoordination

Implications of the importance of time

Pricing of factors

Revenue of economic roles Each factor has a Discounted Marginal Value

Product (DMVP)

In a free market: Pricing serves a allocative function; every

factor is employed at its best use

The distribution and production of wealth are not independent!

Adjustment for time↓

Capitalists

Imputed added value of every

factor

• Land• Labour• Capital

Revenue of economic roles

Labour Wages (DMVP)Land owners Rent land & natural

resources (DMVP)Time services InterestMarket insights Profits & Losses (= 0 in

ERE)

Accounting profit = Total Revenue – Total (accounting) Costs

= Enterpreneurial Profit + Interest for investors + Implicit wage of owner (- sunk costs)

Enterpreneurial profit = Total Revenue – Total Opportunity Costs

Revenue of economic roles - capital

Capital generates a DMVP which goes to returns for• Labour• Land• Interest Interest is not the price for “capital”,

but for the provision of resources to cover time from conception to result

Remark: Interest is not specific for capital, all factors are discounted for interest which goes to capitalists

Revenue of economic roles - labour

Wages in an uncertain world are• ≤DMVP (to be sustainable) productivity

thanks to capital• Adjusted for uncertainty• Adjusted for working conditions

Forcing wages > DMVP Unemployment Forcing employers to accept wages > DMVP

complete discoordination due to the Misesian calculation problem

Conclusion Prices matter

• Allocation of factors according to productive value

• Distortion leads to discoordination Time matters

• Coordination between present and future consumption

All economic functions (labourers, land owners, capitalists and enterpreneurs) matter

If we respect these facts, wealth can be created effectively

Suggested readings Murray Rothbard, Man, Economy and State, 1993,

Chapter 5 – 9 Friedrich A. Hayek, Prices and Production,

1935 Roger Garrison, Time and Money, 2001

Questions?

thomas.vergote@rothbard.bewww.rothbard.be