Tuesday, April 10, 2012

The Function of the Capitalist

In the Introduction to the Second edition of Murray N. Rothbard's Man, Economy, and State with Power and Market, a brief description is given of the vital role played by the capitalist in overcoming the temporal [time] issue raised by having a multi-state production process.

Let's begin with the quotation (all emphasis is mine):

The function of the capitalist is to relieve the factor owners [i.e., the land owners and the labor owners] of the burden of waiting for income, as he advances them present money payments from his accumulated savings for the joint product of their labor and land services.  In exchange for the present wages and rents, the capitalist receives an interest return on his invested funds, which is based on time preference and reflects the value discount of the anticipated future monetary revenues he will be receiving relative to the present money payments he expends on the factor services.
Conversely, the factor owners [the land owners and the labor owners] agree to this deduction from the full-sale proceeds of their product that is embodied in their discounted wage and rent payments from the capitalist, because the present payments unshackle them from the temporal dimension of the production process.  
When I first read this yesterday, it reminded me of a typical time-value of money problem that would be taught to undergraduates in an introductory-level finance course.  So let me first interpret the quotation above in light of elementary undergraduate business finance.  Then I will try to answer the "so what does all of this mean" question, i.e., what is the importance or relevance of having capitalists in an economy.

Basically, in the first part I will provide a mathematical or technical explanation of what I think is going on here.  Then, I will give a verbal or qualitative explanation of what I think is going on in the quotation above.  I think that the latter explanation will be more meaningful to most of my readers.

Let us pretend that we are analyzing this problem from the point of view of the capitalist.  Normally, in finance we use positive numbers in order to denote the receipt of cash.  Conversely, we use negative numbers in order to denote the payment of cash.  Let us further assume that the production process begins today, at time 0, and that the production process ends at time 1, i.e., with the sale of the final end product to the consumer.  Let's assume that the gap of time between 0 and 1 conveniently works out to 1 year in time.

What this problem seems to boil down to is a situation in which the net present value of the "project" equals 0.  I suppose we could conclude, from a technical perspective, that the function of the capitalist is to set up and see through to completion this zero net present value project.

The production process begins today, at time 0.  Let's say that the capitalist pays the land owners $50, and let's say that the capitalist pays the laborers $40.  In other words, the capitalist pays out $90 today in order to buy these productive services.  This would be, for the capitalist, viewed as -$90 since it is a cash outflow today, at time 0.  Obviously, I am oversimplifying here.  Normally, labor would be paid weekly or bi-weekly, not in one big gigantic lump sum at the beginning of the project, i.e., one big annual payment at the start of the year.  I do this in order to simplify the mathematics.  One could, of course, set this up with weekly cash payments to the labor and land owners if one wanted to.  Then there would be 52 payments that would have to be discounted.  Moreover, there is a formulaic way of solving this problem; however, I am trying to avoid this computational issue.

Now, one year later, at time 1, the production process is finished.  What this means is that we have transformed the labor and land factors into a final consumer good.  So for example, we have transformed the labor services of authors and the land services of tree harvesters and paper producers into a book.  The book is sold, and the capitalist receives the cash inflow of +$100.

To summarize, the capitalist (the saver really) advanced $90 to the labor and land owners today, at time 0.  The capitalist then receives $100 one year from now, when the book is sold to the final consumer, at time 1.

Such an arrangement seems to imply that the interest rate is 11.11%.  I solved for the implicit interest rate by setting up the following equation:

90*(1 + i) = 100
And I solved for i, the interest rate.

The cash flows then are as follows (again, from the point of view of the capitalist):

Time 0:  -$90 to the land and labor owners
Time 1:  +$100 from the consumer who purchased the book (the final consumer good)

However, if we take the +$100 at time 1 and discount it back to time 0, it will become, because the rate of interest is 11.11%, +$90.

So, we now have, at time 0, -$90 (the payment to the land and labor owners) and a +$90 from the discounted value of the book sale (the actual book sale happens one year from now but I have discounted that cash flow back to time 0).  The -$90 and +$90 at time 0 obviously "wash out" to zero (i.e., cash inflow of $90 and cash outflow of $90 leaves one with $0).  This would imply a net present value of zero for this project.

This is how I have interpreted this introductory explanation from Rothbard's Second Edition of Man, Economy, and State with Power and Market.  As I read more of the book, I will be able to see if I have interpreted the introduction correctly or incorrectly.  Maybe I have missed something, which would allow for a more nuanced explanation in the future.  Regardless of what happens, I have tried to be faithful in my presentation of Rothbard's work (technically this introduction was written by Joseph T. Salerno).

This leads us to the ultimate question:  what then is the function of the capitalist?  From the above, we could answer using very textbook like language:  the capitalist's function is to initiate a zero net present value project.  The capitalist is just breaking even on his investment project, in this case, his book producing and selling business venture.  By advancing his savings today to the land and labor owners, the capitalist is effectively initiating the entire production process.  Now the labor and land owners can buy food and shelter (and other things) in order to stay alive!  This is obviously advantageous for the labor and land owners because now they don't have to sit around for one year slowly starving to death while waiting for the book to be produced and sold one year from now, at time 1.  Instead, they can eat tonight, at time 0.  This benefits the land and labor owners.  The capitalist's function is to first save money and then to advance those savings to the labor and land owners in order to launch a time consuming production process, in this case a one year long process.  The time consuming production process that the capitalist launches has broader implications for the welfare of society (thinking in terms of the standard of living for the masses of people).  To see this linking of the capitalist/saver, the longer-production process, and the higher standards of living for the masses, a look at the ideas of Eugen von Böhm-Bawerk is in order.

Commenting on the ideas of Eugen von Böhm-Bawerk in 1963 was Ludwig von Mises, in an article entitled The Economic Role of Saving and Capital Goods.  In this paper, Mises stresses that without this "capitalistic" method to production, civilization as we know it would simply not exist.

All material civilization is based upon this "capitalistic" approach to the problems of production.
Mises then stresses why these longer and more complex production processes are so vitally important to the welfare of the average man.  He mentions a term called "roundabout methods of production," which just means the capitalistic means of production, i.e., first we produce capital goods, then with the help of these capital goods, we produce the final consumer goods.  But where do the capital goods come from, the capital goods that get the ball rolling so to speak in our production process?  They capital goods come from saving and the saving comes from the capitalist.  And so, we see again that the capitalist plays an integral role in launching the entire production process.  To elaborate on these observations, Mises writes (all emphasis is mine):

Capital goods come into existence by saving...."Roundabout methods of production," as Böhm-Bawerk called them, are chosen because they generate a higher output per unit of input.  Early man lived from hand to mouth.  Civilized man produces tools and intermediary products [these are more specific examples of capital goods] in the pursuit of long-range designs that finally bring forth results which direct, less time-consuming methods could never have attained, or could have attained only with an incomparably higher expenditure of labor and material factors.

Finally, these longer, more complex production processes brought about initially by the capitalist/saver force the capitalists into the role of servants to the consumers.  The capitalists do NOT control the production process; the final consumer does. This makes sense.  For example, take our mathematical example above.  Suppose the capitalist ignores the consumers.  The consumers want condoms but our capitalist produces books.  What is going to happen?  The capitalist advances $90 to the land and labor owners today, at time 0.  Then, the capitalist brings the books to market one year later, in time 1.  But the consumers don't want these books; the consumers want condoms.  So the price of the books will be very low, let's say +$2 at time 1.  The capitalist then has to discount the +$2 that he receives at time 1 back to time 0 in order to compute the net present value on this project.  Using the 11.11% interest rate, the +$2 becomes +$.1.80 at time 0.  So the net present value at time 0 is -$90 (the land and labor cash outflow) +$1.80 (the discounted revenue from the sale of the unwanted books), which works out to -$88.20.  The capitalist has a negative net present value, which means that he should not be engaged in this project.  He has wasted his savings on this project.  He should have listened to his customers and produced what they wanted--and the consumers signal their desires by offering higher prices for the things they want more urgently.

Continuing with the same paper from Mises (emphasis mine):

In order to attend to the orders received from the consumers, their real bosses, the capitalists must either themselves proceed to investment and the conduct of business or, if they are not prepared for such entrepreneurial activity or distrust their own abilities, hand over their funds to men who they consider as better fitted for such a function.  Whatever alternative they may choose, the supremacy of the consumers remains intact.  
In conclusion, we see that a wealthy civilization with a relatively high standard of living depends upon the existence of long and complex production processes, not simple and direct ones.   To get these longer and more complex production processes, we need capitalists/savers because the savings can then be turned into capital goods, and the capital goods eventually are turned into consumer goods.  The savers/capitalists launch this entire process, which enriches society by producing more consumer goods than could be produced without this process, by advancing funds to the owners of land and to the owners of labor.  These land and labor factors can then be transformed into capital goods and eventually into consumer goods.  The land and labor owners don't have to wait for this entire process to be completed in order to get paid--the capitalist advances them the money before the final consumer good is sold.  The difference between the wages and rent paid today and the future sales price of the final good is the interest return earned by the capitalist.  The most important point here is that more consumer goods are being produced.  This means that overall, the standard of living is rising--and this is a very good thing indeed.

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