Capital and Its Structure

Lachmann, Ludwig M.
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First Pub. Date
Kansas City: Sheed Andrews and McMeel, Inc.
Pub. Date
2nd edition.

Chapter I


The realm of economics consists of many provinces between which, in the course of time, a fairly high degree of interregional division of labour has evolved. Naturally, development in some of these regions has been faster than in others. There are some 'backward areas', and a few of them actually appear to merit description as 'distressed areas'. None seems to have a better claim to this unenviable status than the Theory of Capital. In fact it would hardly be an exaggeration to say that at the present time a systematic theory of capital scarcely exists.


Considering the degree of division of labour just mentioned this surely is an astonishing state of affairs. There can hardly be a field of economic thought, pure or applied, in which the word 'capital' is not more or less constantly employed. We hear of a world-wide capital shortage. In discussions on the convertibility of currencies we are asked to distinguish between 'current' and capital transactions. And it is clear that the 'economic integration of Western Europe' requires that some at least of the industrial resources of these countries be regrouped and change their form; in other words, that it entails a modification of Europe's capital structure.


Yet, in the Theory of Capital the present state of affairs is as we have described it. The product imported and used by the other economic disciplines is not a standardized product. The word 'capital', as used by economists, has no clear and unambiguous meaning. Sometimes the word denotes the material resources of production, sometimes their money value. Sometimes it means money sums available for loan or the purchase of assets. While to some economists 'capital' has come to mean nothing but the present value of future income streams. The conclusion suggests itself that no progress made in the theory of capital could fail to pay handsome dividends in the form of 'external economics' to be reaped by all those who have to work with the notion of capital.


The root of the trouble is well known: capital resources are heterogeneous. Capital, as distinct from labour and land, lacks a 'natural' unit of measurement. While we may add head to head (even woman's head to man's head) and acre to acre (possibly weighted by an index of fertility) we cannot add beer barrels to blast furnaces nor trucks to yards of telephone wire. Yet, the economist cannot do his work properly without a generic concept of capital. Where he has to deal with quantitative change he needs a common denominator. Almost inevitably he follows the business man in adopting money value as his standard of measurement of capital change. This means that whenever relative money values change, we lose our common denominator.


In equilibrium, where, by definition, all values are consistent with each other, the use of money value as a unit of measurement is not necessarily an illegitimate procedure.*4 But in disequilibrium where no such consistency exists, it cannot be applied. The dilemma has been known ever since Wicksell drew attention to it.*5 But in most current discussions on capital the whole problem with its manifold implications, which go far beyond the confines of the theory of capital, is, as a rule, allowed to be ignored.


In confronting this dilemma it seems best to start by setting forth a few fundamental facts about capital.


All capital resources are heterogeneous. The heterogeneity which matters is here, of course, not physical heterogeneity, but heterogeneity in use. Even if, at some future date, some miraculous substance were invented, a very light metal perhaps, which it was found profitable to substitute for all steel, wood, copper, etc., so that all capital equipment were to be made from it, this would in no way affect our problem. The real economic significance of the heterogeneity of capital lies in the fact that each capital good can only be used for a limited number of purposes. We shall speak of the multiple specificity of capital goods.


Each capital good is, at every moment, devoted to what in the circumstances appears to its owner to be its 'best', i.e. its most profitable use. The word 'best' indicates a position on a scale of alternative possibilities. Changing circumstances will change that position. Unexpected change may open up new possibilities of use, and make possible a switch from yesterday's 'best' to an even better use. Or, it may compel a switch from 'present best' to 'second best' use. Hence, we cannot be surprised to find that at each moment some durable capital goods are not being used for the purposes for which they were originally designed. These new uses may, from the point of view of the owners of the capital goods, be 'better' or 'worse', more or less profitable than the original ones. In each case the change in use means that the original plan in which the capital good was meant to play its part has gone astray. In most of the arguments about capital encountered today these facts and their implications, many of them crucial to a clear understanding of the nature of economic progress, are almost completely ignored.


It is hard to imagine any capital resource which by itself, operated by human labour but without the use of other capital resources, could turn out any output at all. For most purposes capital goods have to be used jointly. Complementarity is of the essence of capital use. But the heterogeneous capital resources do not lend themselves to combination in any arbitrary fashion. For any given number of them only certain modes of complementarity are technically possible, and only a few of these are economically significant. It is among the latter that the entrepreneur has to find the 'optimum combination'. The 'best' mode of complementarity is thus not a 'datum'. It is in no way 'given' to the entrepreneur who, on the contrary, as a rule has to spend a good deal of time and effort in finding out what it is. Even where he succeeds quickly he will not enjoy his achievement for long, as sooner or later circumstances will begin to change again.


Unexpected change, whenever it occurs, will make possible, or compel, changes in the use of capital goods. It will thus cause the disintegration of existing capital combinations. Even where it opens up new and promising possibilities for some resources it will open them up for some, not for all. The rest will have to be turned to second-best uses. It is because of these facts that it is impossible to measure capital. Capital has no 'natural' measure, and value will be affected by every unexpected change.


Yet, we need a generic concept. We want to be able to speak of 'Capital'. Logically, we can establish no systematic generalization without a generic concept. But we need more than that. Unable as we are to measure capital resources, we must at least make an attempt to classify them. If there can be no common denominator there should at least be a criterium ordinis. The stock of capital does not present a picture of chaos; its arrangement is not arbitrary; there is some order in it. As we saw, capital resources cannot be combined in an arbitrary fashion. Only some modes of complementarity are economically significant. These form the basis of the capital order.


If our classification of capital resources is to be realistic, the criterion of order we employ must correspond to the order in which these resources are in reality arranged. As all capital resources exist for the sake of the uses to which they are, or may be, put, this means that we must make our conceptual order reflect the actual pattern of capital use. The elements of this pattern are the capital combinations of the various enterprises, and they in their totality form the capital structure of society. Entrepreneurial decisions on capital combinations are the immediate determinants of the Order of Capital, though, on a wider view, these decisions reflect, of course, the complex interaction of economic forces from which the entrepreneur takes his orientation. It will be our main task in this book to study the changes which this network of capital relationships, within firms and between firms, undergoes as the result of unexpected change. To this end we must regard the 'stock of capital' not as a homogeneous aggregate but as a structural pattern. The Theory of Capital is, in the last resort, the morphology of the forms which this pattern assumes in a changing world.


We may turn aside for a moment to consider how economists in the past have coped with the problem of the capital order.


The classical economists, when they spoke of the 'stock of capital', conceived of it as homogeneous and measurable, like any other stock. From Ricardo onwards, of course, their main interest was in the distribution of incomes. Capital was of importance mainly as the 'source' of profit in the same way as labour was the source of wages and land the source of rent. And as the rate of profit was regarded as tending towards equality in all uses of capital, the problem was really posed only under equilibrium conditions. For only here is there a determinate and homogeneous quantity which we may call 'output', and as profit is conceived as part of homogeneous output, so its 'source' would appear to be equally homogeneous.


The notion of a homogeneous capital stock no doubt was borrowed, as are so many of our concepts, from accounting practice which makes a (homogeneous) money sum appear in the capital account. Now, the classical economists were certainly not unaware of some of the dangers of describing economic magnitudes in money terms. But in this case the danger seemed to be avoided, and the notion of a 'real stock' gained a certain plausibility from the employment of two devices which played a prominent part in the classical doctrine. On the one hand, the labour theory of value made it possible and necessary to reduce capital values to labour values, i.e. to homogeneous labour units. On the other hand, there was the concept of the Wages Fund which not merely served to render the stock of capital homogeneous but also reduced all capital goods to consumption goods measurable in labour units.


In the neo-classical schools which rose in the last three decades of the last century the focus of interest is still distribution, explained now by the marginal productivity principle. Here factors of production of various classes between which there is no longer over-all homogeneity, though the members of each class are still regarded as homogeneous, produce a homogeneous product. The Wages Fund is abandoned, but the new problem which emerges now that capital goods can no longer be regarded as consumption goods in statu nascendi, viz. the effect of capital change on capital values in terms of consumable output, is ignored.


The analysis is still couched in equilibrium terms. But capital is no longer measured in labour, or any other cost, units, and 'no one ever makes it clear how capital is to be measured'.*6 Reasoning based on the marginal productivity principle can no longer be applied to capital even where the change is, within the framework of 'comparative statics', from one equilibrium to another. A fortiori it is impossible to speak of capital in quantitative terms in conditions of disequilibrium.


More recently the focus of interest in discussions on capital has shifted to Investment, defined as the 'net addition to the capital stock'. Now, it is possible to define the economic forces engendering investment in terms which avoid the quantification of capital, or even the very concept of capital. Professor Lerner, for instance, has defined his 'marginal efficiency of investment' exclusively in terms of present output forgone and future output obtained.*7 But in any realistic discussion of the 'inducement to invest' it is clearly impossible to ignore existing capital resources, on the use and profitability of which the new capital cannot but have some effect.


A theory of investment based on the assumption of a homogeneous and quantifiable capital stock is bound to ignore important features of reality. Owing to its very character it can only deal with quantitative capital change, investment and disinvestment. It cannot deal with changes in the composition of the stock. Yet there can be little doubt that such changes in the composition of the stock are of fundamental importance in many respects, but in particular with regard to the causes and effects of investment. As long as we cling to the view that all capital is homogeneous, we shall only see, as Keynes did, the unfavourable effects of investment on the earning capacity and value of existing capital goods, since all the elements of a homogeneous aggregate are necessarily perfect substitutes for each other. The new capital competes with the old and reduces the profitability of the latter. Once we allow for heterogeneity we must also allow for complementarity between old and new capital. The effect of investment on the profitability of old capital is now seen to depend on which of the various forms of old capital are complementary to, or substitutes for, the new capital. The effect on the complements will be favourable, on the substitutes unfavourable. The 'inducement to invest' will therefore often depend on the effect the new capital is expected to have on the earning capacity of old capital complementary to it. In other words, investment decisions, as to their magnitude, and even more as to the concrete form they are likely to take, depend at each moment on the prevailing composition of the existing capital stock. In general, investments will tend to take such concrete forms as are complementary to the capital already in existence. A real understanding of the investment pattern is therefore impossible as long as we cling to the homogeneity hypothesis. Investment is thus seen to be ultimately a problem of the capital order. At each moment it reflects, both as regards its quantitative volume and its concrete form, the possibilities left open by the existing capital order.


We must now return to our main task in this chapter. We shall attempt to present very briefly a preliminary view of the chief problems with which we shall be concerned in this book. The problem of capital as a 'source' of profit is not among them. In Chapter V, to be sure, we shall have occasion to examine certain aspects of the theory of interest, but in the context of this book this will be to us a mere side-line. The main subject-matter of this book is the Capital Structure. When we turn our attention to the relationship between capital and interest we do it for the light that interest sheds on capital, not vice versa. Those economists to whom the concept of capital was in the main an instrument in their search for the explanation of the interest phenomenon naturally conceived of it as a homogeneous aggregate consisting of value units. By contrast, our conception of capital is that of a complex structure which is functionally differentiated in that the various capital resources of which it is composed have different functions. The allocation of these functions, and the changes which its mode undergoes in a world of change, is one of our main problems.


In this book we shall endeavour to outline an approach to capital problems which is both realistic and directly based on the definition of economic action: realistic in that we deal with the world of unexpected change; directly based on the definition of economic action in that we start from the fact that capital resources are scarce resources with alternative uses.*8 To us the chief problem of the theory of capital is to explain why capital resources are used in the way they are; why in a given situation some alternatives are rejected, others selected; what governs the choice or rejection of alternative uses when unexpected change compels a revision of plan. There are two broad answers to these questions, the first of which is perhaps rather trite, but the second of which has not as yet been given the prominent place it deserves in economic thought. The first answer is that, of course, capital goods must be used in such a way as to produce, directly or indirectly, the goods and services consumers want at prices they are prepared to pay. This is a familiar theme. The urge to maximize profits warrants the belief that after some trial and error capital goods will in reality be used in such a fashion. But there is a second answer. Capital uses must 'fit into each other'. Each capital good has a function which forms part of a plan. Capital goods with no such function will not be maintained. The fact that capital goods which do not 'earn their keep' will be discarded warrants the belief that a tendency towards the integration of the capital structure really exists. But while, on the one hand, the scope of this phenomenon is wider than is commonly recognized, the tendency does not operate unimpeded.


It is obvious that capital equipment for which no labour can be found to work it, is useless and will be scrapped. Once we abandon the assumption that all capital is homogeneous the scope of this phenomenon is seen to extend beyond that of the complementarity between labour and capital. Capital equipment may have to be scrapped because no capital combination can be found into which it would fit.


On the other hand, the scrapping of surplus capital, and consequently the integration of the capital structure, may in reality be delayed for a number of reasons. For one thing, expectations of a future different from the present may spoil the simplicity of our theorem. If capital owners think that complementary factors will be available in the future, they will prefer to wait. Moreover, for heavy durable equipment the annual cost of maintenance is probably relatively small. This means that even a small profit may suffice to keep capital goods in existence. Owners of displaced capital goods will then try to find complementary resources by offering their owners co-operation on favourable terms. This, of course, is what we meant by 'switching capital goods to second-best use'. Before displaced capital goods are scrapped attempts will thus be made to lure other capital goods, potentially complements to them, out of the combinations of which they happen to form part. To some extent these attempts will be successful. This is important as it gives rise to certain dynamic processes we shall study in Chapter III. As we shall see, equilibrium analysis cannot be applied to them.


For the present we may conclude that a tendency towards the integration of the capital structure exists, but that it may encounter resistance from optimistic expectations and the possibility of multiple use. While the former will lead to 'surplus stocks' and the maintenance of other forms of visible excess capacity which have of late attracted the attention of economists, the latter will give rise to a kind of invisible excess capacity, a counterpart to 'disguised unemployment'. Capital resources will be used in ways for which they were not planned, but these uses will be discontinued the moment complementary resources make their appearance.


It is evident that only a morphological theory can be expected to cope with such problems. Whether in reality an integrated capital structure, in the sense that every capital good has a function, can exist in a world of unexpected change remains to be seen. But we may say that the desire to maximize profits on existing capital goods and the obvious futility of maintaining those that cannot, either now or in the foreseeable future, be fitted into the existing structure, warrant the belief that economic action will at each moment tend in the direction of such an integrated structure, even though this may never be completed.


All this has implications for the theory of investment. We cannot explain how either existing resources are being replaced, whether by their replicas or otherwise, or what kind of new capital goods is being created, without having first of all learnt how existing capital is being used. The shape in which new capital goods make their appearance is determined largely by the existing pattern, in the sense that 'investment opportunities' really mean 'holes in the pattern'.


In the traditional view, maintained by Keynes and his followers, new investment follows the success of similar existing capital combinations. If shipping lines have been profitable more ships will be built. While, to be sure, the marginal efficiency of capital is defined as an expectational magnitude, we are always given to understand that high profits on existing capital offer a strong incentive to invest while low profits do not. As we shall see, this is another illegitimate generalization based on the homogeneity hypothesis. A number of investment opportunities actually owe their existence to the failure of past capital combinations to achieve the purposes for which they were designed. This problem will be discussed also in Chapter III.


All capital goods have to fit into a pattern or structure. What determines the structure? In the first place, there are the various production plans, which determine the use to which each capital good will be put. But if we are to speak of a structure, these plans must be consistent with each other. What makes them so? The market compels the readjustment of those production plans which are inconsistent with either consumers' plans or other production plans. From the push and pull of market forces there emerges finally a network of plans which determines the pattern of capital use.


But the economic forces which integrate the capital structure via the network of plans should not be confused with the force, discussed above, which causes the re-integration of the structure by discarding surplus equipment. The former serve to minimize, though they cannot altogether eliminate, the impact of unexpected change by removing inconsistency of plans. The latter only comes into operation after unexpected change has happened and caused some capital to be displaced. The former will be discussed at some length in Chapter IV.


We hope to have persuaded the reader that once we abandon the homogeneity hypothesis we are compelled to adopt a morphological approach to the problems of capital, which must supersede purely quantitative reasoning. For the quantitative concept of a homogeneous stock we have to substitute the concept of a functionally differentiated Capital Structure.*9


As yet we have left the concept of Capital undefined. We now define it as the (heterogeneous) stock of material resources. In thus defining it we follow Walras in stressing heterogeneity ('les capitaux proprement dits') and Irving Fisher in refusing to draw the traditional distinction between land and capital. In fact, all the three possible criteria of distinction between land and other material resources are readily seen to be irrelevant to our purpose.


When capital is defined, with Boehm-Bawerk, as the 'produced means of production' land is, of course, excluded. But to us the question which matters is not which resources are man-made but which are man-used. Historical origin is no concern of ours. Our interest lies in the uses to which a resource is put. In this respect land is no different from other resources. Every capital combination is in fact a combination of land and other resources. Changes in the composition of such combinations are of just as much interest to us where land is, as where it is not affected.


A second criterion of distinction between land and other capital resources is based on the contrast between the 'fixed' nature of the supply of land and the variable character of the supply of other material resources. The criterion is quantitative in a purely physical sense which is not necessarily economically relevant. There are even today large tracts of undeveloped land in the world which could be brought into productive use by combining them with capital resources. In other words, there is 'physical' land which is not a source of economic services. The conditions in which such economic transformation will take place are precisely a problem in the theory of capital. To ignore them is to ignore one of the most significant dynamic aspects of capital.


Professor Hayek has defined capital as 'those non-permanent resources which can be used contribute to the permanent maintenance of the income at a particular level'.*10 Permanent resources thus fall outside the scope of this definition and outside the scope of the theory of capital. But we cannot adopt this definition as we cannot ignore the uses to which permanent resources are put. There is no reason to believe that in their case the pattern of resource use is fundamentally different from that of non-permanent resources. In fact, as we said above, the two are almost invariably used together. This does not mean that the replacement, the recurrent need for which is the distinguishing characteristic of non-permanent resources, is of no interest to us. In so far as replacement does not take the form of the production of mere replicas it is of interest to us as it changes the composition of the capital stock. But what distinguishes our approach from Professor Hayek's is that we are not concerned with the maintenance of income at a particular level. We are not interested in that long period which must elapse before the income-stream from non-permanent resources dries up, but in the series of short periods during which resources are shifted from one use to another, and in the repercussions of such shifts. The causes and repercussions of these shifts are more or less the same, whether the resources shifted are permanent or not (except for very short-lived resources). As long as the period during which income-streams from non-permanent resources might be exhausted remains beyond our horizon, there is no reason why we should distinguish between permanent and non-permanent resources. The growing predominance of very durable capital equipment in modern industrial society appears to underline the pointlessness of the distinction and justify our neglect of it.


We shall now briefly set out the logical structure of the argument thus far presented in this chapter.

Heterogeneity of Capital means heterogeneity in use;
  Heterogeneity in use implies Multiple Specificity;
    Multiple Specificity implies Complementarity;
      Complementarity implies Capital Combinations;
        Capital Combinations form the elements of the Capital Structure.


We are living in a world of unexpected change; hence capital combinations, and with them the capital structure, will be ever changing, will be dissolved and re-formed. In this activity we find the real function of the entrepreneur.


We must now give some consideration to the method of analysis which we shall employ in this book. Multiple Specificity, as we saw, is a characteristic of the capital resources which form the subject-matter of this book. Their mode of use changes as circumstances change. Their life-story thus falls naturally into a sequence of periods during each of which we note their use for a specific purpose in conjunction with labour services and other capital goods. This fact already points to the need for Period Analysis in studying the pattern of capital use. It is not, however, a mere matter of time, but of human action in time.


The employment of a number of capital goods in a capital combination during a given period is embodied in a production plan made at the beginning of the period. The plan thus provides a scheme of orientation, a frame of reference for subsequent action. This pattern of resource use will be continued as long as the plan succeeds in the sense that a 'target' envisaged in it is attained. The method to be employed in describing such events might thus be strictly called 'Plan-Period-Analysis'. And inasmuch as we have to go beyond the 'unit period', and consider what happens in the next period as a result of what happened in this, we shall speak of Process Analysis. In the context which alone interests us this means that if the plan fails the capital combination will be dissolved and its constituent elements turned to other uses, each within the range permitted by its multiple specificity.


The method of Process Analysis has been described by Professor Lindahl in a famous passage:

Starting from the plans and the external conditions valid at the initial point of time, we have first to deduce the development that will be the result of these data for a certain period forward during which no relevant changes in the plans are assumed to occur. Next we have to investigate how far the development during this first period—involving as it must various surprises for the economic subjects—will force them to revise their plans of action for the future, the principles for such a revision being assumed to be included in the data of the problem. And since on this basis the development during the second period is determined in the same manner as before, fresh deductions must be made concerning the plans for the third period, and so on.*11


In this book we shall thus employ the method of process analysis based on plans and those entrepreneurial decisions which accompany their success and failure. But we shall not indulge in building 'dynamic models' based on 'behaviour functions' expressed in terms of 'difference equations'. Our reason for this refusal is that to assume that entrepreneurial conduct in revising plans at the end of successive periods is, in any objective sense, determined by past experience and thus predictable, would mean falling into a rigid determinism which is quite contrary to everyday experience.


Men in society come to learn about each other's needs and resources and modify their conduct in accordance with such knowledge. But the acquisition of this knowledge follows no definite pattern, certainly no time-pattern. Knowledge is not acquired merely as time goes by.


All human conduct is, of course, moulded by experience, but there is a subjective element in the interpretation of experience to ignore which would be a retrograde step. Different men react to the same experience in different ways. Were we con-concerned with 'Macro-dynamics' all this might not matter very much. Probability might provide a convenient way out. But we are concerned with the conduct of the individual entrepreneur. A rigid determinism in these matters would appear to reflect an outmoded, pre-Knightian approach. The econometricians have thus far failed to explain why in an uncertain world the meaning of past events should be the only certain thing, and why its 'correct' interpretation by entrepreneurs can always be taken for granted.


To assume 'given behaviour functions' or 'entrepreneurial reaction equations' is simply to deny that entrepreneurs are capable of interpreting historical experience, i.e. experience which does not repeat itself. In other words, to make these assumptions is to say that entrepreneurs are automata and have no minds. Observation, however, bears out the contention that entrepreneurial minds exist and function.


The entrepreneurial interpretation of past experience finds its most interesting manifestation in the formation of expectations. Expectations, i.e. those acts of the entrepreneurial mind which constitute his 'world', diagnose 'the situation' in which action has to be taken, and logically precede the making of plans, are of crucial importance for process analysis. A method of dynamic analysis which fails to allow for variable expectations due to subjective interpretation seems bound to degenerate into a series of economically irrelevant mathematical exercises.


It thus seems clear that a study of capital problems in a world of unexpected change has to be conducted by means of process analysis, and that the application of this method presupposes a study of entrepreneurial expectations.


The plan of this book is conceived in the following manner: In Chapter II we start by establishing a few systematic generalizations about expectations. In doing so we shall have to delve much more deeply into the subject than has been the case in recent discussions. Arguments about how people bring the various possible outcomes of actions they envisage into consistency with each other will be seen to be quite inadequate for our purpose. The formation of expectations is a moment in the process of the acquisition of knowledge and has to be studied as such. In Chapter III we shall show how process analysis can be applied to capital problems; how entrepreneurs react to unexpected change by forming and dissolving capital combinations in the light of experience gained from working with them. In Chapter IV we ask how a capital structure can come to exist in a world of unexpected change. We shall see that, though in the real world a capital structure integrating all existing capital resources, even if it ever came into existence, could not exist for any length of time, integrating as well as disintegrating forces are always in operation, and much can be learned from a study of their modus operandi.


The Chapters II to IV constitute the theoretical nucleus of the book. In the following three chapters the ideas set forth in the earlier part will be applied to a variety of capital problems. In Chapter V we attempt to show that, in so far as the accumulation of capital can be said to prompt economic progress, it does so by prompting certain typical changes in the composition of the capital stock. In Chapter VI we raise the question whether structural relationships exist in the sphere of property rights and claims as well as in that of physical capital resources, and if so, how the two spheres are interrelated. In Chapter VII we hope to show that if capital accumulation entails changes in the composition of the capital stock, it also entails certain consequences for the course of the Trade Cycle; that industrial fluctuations are frequently due to intersectional maladjustment, and that in the circumstances which usually accompany economic progress this is often almost inevitable. Finally, some attention will be given to the question of how such maladjustments can be, and are in reality, overcome.


The argument so far set forth in this chapter, derived as it is from heterogeneity and multiple specificity of capital, has a number of implications which will come up for fuller discussion at various points in the book. But a few of them which, in a sense, underlie all that follows should be noted already now.


What we have so far said in this chapter serves to sharpen our understanding of the function of the entrepreneur. We usually say that the entrepreneur 'combines factor services'. So he does, but the statement is too wide and not precise enough since it suggests that the relationship between the entrepreneur and the owners of resources, human and material, is symmetrical in all cases. Labour, of course, is hired and dismissed. But the entrepreneur's function as regards capital is not exhausted by the hire of services. Here his function is to specify and make decisions on the concrete form the capital resources shall have. He specifies and modifies the shape and layout of his plant, which is something he cannot do to his typists, desirable though that may seem to him. As long as we disregard the heterogeneity of capital, the true function of the entrepreneur must also remain hidden. In a homogeneous world there is no scope for the activity of specifying.


This fact is of some practical importance. For it follows that the entrepreneur carries, and must carry, a much heavier responsibility towards the owners of his capital than towards his workers, since as regards the resources of the former he enjoys a much wider range of discretion than as regards those of the latter. It means not merely that 'workers' control of industry' is impossible. It also means that capital owners, having delegated the power of specification to the entrepreneur, are 'uncertainty-bearers' in a sense in which workers are not. They are in fact themselves entrepreneurs of a special kind. The whole relationship between manager-entrepreneurs and capitalist-entrepreneurs will be taken up for discussion towards the end of Chapter VI.


From time to time, in particular in the last three chapters of this book, we shall employ the notion of 'economic progress'. By this we mean an increase in real income per head. We must note that to assume progress is not necessarily the same thing as to assume the 'dynamic' conditions of a world of unexpected change. On the one hand, of course, dynamic conditions may lead not to progress but to disaster. On the other hand, most recent discussions of progress have been couched in terms not of a dynamic world, but of the model of an 'expanding economy', of Cassel's 'uniformly progressive economy' slightly modified by Messrs. Harrod and Hicks. This model embodies the notion of 'growth', of progress at a known and expected rate. Its significance for the real world, however, is doubtful. Already the metaphor 'growth' is singularly inappropriate to the real world as it suggests a process during which the harmony of proportions remains undisturbed. Nor can we, after what has been said, any longer believe that progress will manifest itself in the capital sphere merely in the form of capital accumulation, i.e. purely quantitative growth. In what follows we shall always assume that progress takes place in conditions of unexpected change.


Inevitably unexpected change entails some capital gains and losses. Hence we cannot say that progress is either accompanied or caused by the accumulation of capital. But the malinvestment of capital may, in some cases, by providing external economies, become the starting-point of a process of development. A railway line built for the exploitation of some mineral resource may be a failure, but may nevertheless give rise to more intensive forms of agriculture on land adjacent to it by providing dairy farmers with transport for their produce. Such instances play a more important part in economic progress than is commonly realized. The ability to turn failure into success and to benefit from the discomfiture of others is the crucial test of true entrepreneurship. A progressive economy is not an economy in which no capital is ever lost, but an economy which can afford to lose capital because the productive opportunities revealed by the loss are vigorously exploited. Each investment is planned for a given environment, but as a cumulative result of sustained investment activity the environment changes. These changes in environment did not appear on the horizon of any of the entrepreneurial planners at the time when the plan was conceived. All that matters is that new plans which take account of the change in environment should be made forthwith and old plans adjusted accordingly. If this is done as fast as the new knowledge becomes available there will be no hitch in the concatenation of processes, of plan and action, which we call progress.


What we have just said has some relevance to the problems of the 'economic development of underdeveloped areas' which have in recent years been so extensively discussed by economists and others.*12 Economic progress, we saw, is a process which involves trial and error. In its course new knowledge is acquired gradually, often painfully, and always at some cost to somebody.*13 In other words, some capital gains and losses are inevitable as durable capital goods, in the course of their long lives, have to be used for purposes other than those for which they were originally designed. Such capital losses have been frequent concomitants of economic progress in the history of almost all industrial countries, and have on the whole done much good and little harm.


But a question arises in this connection which has, to our knowledge, rarely been adequately discussed: who will bear the risk? Where economic development is financed by risk capital, capital owners, of course, bear the risk of loss. But risk capital is now rapidly becoming very scarce everywhere in the world, even in those countries in which it is not actually being taxed out of existence. On the other hand, the political myths of the twentieth century being what they are, politicians in most underdeveloped countries abhor the very thought of foreign risk-bearing capitalists, or, if they do not, at least have to pretend before the electorate that they harbour such feelings. The reason is not far to seek: He who bears the risk must also appoint the managers. In the prevailing climate of opinion the economic development of such countries will therefore largely have to be promoted with the help of loan capital. This means that the capital losses will have to be borne by those who are probably least able to bear them, viz. the inhabitants of these areas themselves, whose rescue from poverty has been, after all, the ostensible purpose of the whole operation!

Notes for this chapter

'But although, even in the analysis of a stationary equilibrium, the inclusion of the "quantity of capital" among the determinants of that equilibrium means that something which is the result of the equilibrating process, is treated as if it were a datum, this confusion was made relatively innocuous by the essential limitations of the static method, which while it describes the conditions of a state of equilibrium, does not explain how such a state is brought about.' F.A. von Hayek: Profits, Interest and Investment, pp. 83-4.
Lectures on Political Economy, Vol. I, p. 202.
Joan Robinson: The Rate of Interest, and other Essays, p. 54.
A. P. Lerner: 'On the Marginal Product of Capital and the Marginal Efficiency of Investment', Journal of Political Economy, February 1953, see especially pp. 6-9.
We do not wish to imply, of course, that other capital theories are not based on, or do not conform to, the definition of economic action and the praxeological axioms it entails. But all too often the link is rather tenuous.

There is a 'missing link' in most equilibrium theories; they all have to assume that, once the data are given, the problem of how equilibrium is reached has been solved. By contrast we shall concern ourselves with the 'path' which men have to follow in building up capital combinations and using them.

Professor S. Herbert Frankel has for some time expounded a similar view. ', apart from the symbolism of accounting, always "concrete" in the sense that it is embedded in, and attuned to, the particular purposes and state of knowledge which led to its "creation". It is but temporarily incorporated in ever changing forms and patterns suited to the evanescent ends for which it is designed' (The Economic Impact on Under-developed Societies, 1953, p. 69).
The Pure Theory of Capital, p. 54.
Erik Lindahl: Studies in the Theory of Money and Capital (George Allen & Unwin Ltd.), pp. 38-9.
In these discussions Professor Frankel has shown himself an undaunted critic of the quantitative notion of capital which most other writers on the subject accepted without question. In particular, he frequently warned his fellow-economists 'not to regard the calculations of the private entrepreneur in terms of established accounting symbolisms as in any sense an automatic or mechanical process' (S. H. Frankel, op. cit., p. 66).
For examples see S. H. Frankel, op. cit., pp. 101-2.


End of Notes

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