Complications in the Bohm-Bawerkian Concept of Average Periods of Production

The importance of the marginal revolution is one that can not be side-stepped when speaking of serious contributions to economic analysis. William Stanely Jevons and Carl Menger are two of the greatest marginal economists, the latter being the father of the Austrian school of economics. Carl Menger in his epic Principles of Economics explained the origin of value, namely its subjectivity with respect to the differing valuations of individuals, and the importance of marginality when dealing with economic phenomenon. Though the marginal revolution may have altered much of economic theory and analysis for the better, there still have been less than optimal adherences to the importance of the marginal economics by both old and new economists. Many economists disregard what they have learned from the marginal revolution and think in terms of aggregates or averages; this is true when dealing with Keynesian and neoclassical economics. It is the marginal value of a good, not its average value, that determines its use and importance in production or consumption. When an individual consumes a product they are using it to fulfill their marginal desires, not their aggregate or average desire. This is something that is taught in many microeconomic classrooms and is adhered to by the Austrian school of economics. Though this may seem elementary, certain economists overlook the simplicity of this theory and consequently deal in averages. It is only by understanding marginal values can economist begin to understand the concepts associated with trade cycle theory and the impacts of marginal cost, marginal product, and marginal profit with respect to changes in the market rate of interest. Problems in dealing with averages is applicable even to the most productive follower of Carl Menger, Eugen von Bohm-Bawerk author of Capital and Interest.

The theory of capital and rent is one that is largely debated throughout the field of economics and is one of the more complex subjects in the study. It is by understanding capital and interest theory that economists can truly comprehend the workings of the business cycle and those functions which regulate the market from a macroeconomic perspective. Austrian capital theory was developed by Eugen von Bohm-Bawerk in his opus magnum, Capital and Interest. With Capital and Interest, Bohm-Bawerk set out to uncover the main element that decides the rent of capital or interest. The natural rate of interest, that rate of interest which is not altered by inflationary policy, must be determined by an endogenous factor that encompasses the market. Bohm-Bawerk isolated time-preference as the factor that determines the existence and extent of the natural rate of interest and is, therefore, a determinant of capital value. In addition, Bohm-Bawerk understood that there is a virtual lengthening of capital or the roundabout methods of production as there is a decrease in the real rate of interest and vice-versa with respect to an increase in the real rate of interest. By changing the real rate of interest there could be this shift in the length of capitalist production processes. Though Bohm-Bawerk solved one of the most important problems in economic theory, there were many detrimental strains of the productivity theory of capital valuation still found in his explanation of interest. Bohm-Bawerk, in Capital and Interest, did not completely divorce time-preference from the then outstanding explanation of capital valuations and this way weakened his theory in specific areas.

John R. Hicks, Nobel Laureate in Economics, has an argument worth elaborating on in his volume Value and Capital in which he criticizes the Bohm-Bawerkian concept of the “average period of production.” The average period of production is summed up correctly by the American economist, Frank Fetter, as being "not an average time in one industry, but an average period during which the value of the total productive force of the community is supposed to be embodied in the total existing body of capital" and "as that period which elapses between the application of productive agents and their reward in the form of satisfaction." This idea is used by Bohm-Bawerk as a way of explaining improvements in the overall productive possibilities of an economy by means of an average. That by taking an average of the length of time of all the productive capacities of industries, the movement or height of an economy's productive yield can be understood. Hicks has a somewhat different opinion with respect to the Bohm-Bawerkian analysis of the average period of production and views this failure by Bohm-Bawerk as the necessary downfall of his theory. Before moving into the discussions by Hicks on this concept, it must be noted that he does not disagree with Bohm-Bawerk on his time-preference analysis and believes that this is a vital contribution by the Austrian school. That said, Hicks does hold that the failure of Bohm-Bawerk's theory lies in the misuse of the concept of the average period of production.

John Hicks writes in Value and Capital that "[Bohm-Bawerk] was quite right to conceive of the process of capitalistic production as being essentially a process in time...there is no objection to this." To Hicks, the Bohm-Bawerkian theory of time-preference as a main determinant of capital value "does not generalize in the sort of way in which it might have been expected to be generalized." By this he means that the theory found in Capital and Interest can only go so far in its use and that the theory is only fully applicable to severely rare and limited situations. Hicks clarifies that there is nothing wrong with Bohm-Bawerk's theory when illustrating the fact that a change in the rate of interest either way may induce the entrepreneur to accelerate or postpone production. Yet, when addressing the issue beyond elementary examples, Hicks believes that the theory present in Capital and Interest stresses too much the average period of production as a unit of time and not enough on the average period of production as an abstract measurement of capital growth or decay. To Hicks, the "absolute length of the true average period has no significance whatsoever" but instead it is only a change in the average period due to an alteration in the rate of interest that is of importance. Where Hicks believes Bohm-Bawerk fails is in his adherence to the average period of production as being a length of time when in actuality it is the measurement of a crescendo, as Hicks puts it, of the production process; a difference in the "height" of the production process. In summation, what Hicks seems to be saying is that the actual length in time of the average period of production is not crucial to understanding the extent of overall "social" yield but instead what is important is a change in this average period of production via an alteration in the rate of interest. Here Hicks does not seem to realize the problems associated when dealing with averages in economic analysis. Average value does not illustrate the importance of an additional good to a production process and in fact misleads individuals into thinking in terms of averages.

This is a problem caught early on, circa 1904, and solved by the Austrian economist Frank Fetter. In analyzing Capital and Interest Fetter was taken by Bohm-Bawerk's explanation of capital valuation in terms of time-preference but soon found quarrel with the latter's attachment to strains of the productivity theory. Fetter, along with Wicksell and Fisher, excelled Bohm-Bawerk's theory of interest and produced strains of their own. Fetter went on to explain the totality of capital valuation and rent in terms of time-preference. By use of different essays mostly published in the Quarterly Journal of Economics and accumulated by Rothbard in Capital, Interest, and Rent, Fetter finally divorced the Bohm-Bawerkian theory of time-preference from any hint of the productivity theory. Frank Fetter's objections to the use of the "average production period" by Bohm-Bawerk lies in the fallacy that the average length of time of the totality of production processes found in an economy has any tie to the productivity of capital and the height of economic yields. Different industries have differing maturities with respect to their production inputs. Some industries may benefit greatly from a marginal increase in capital and some may not. The problem found in Capital and Interest is not that Bohm-Bawerk is not using the term "average" properly or is not identifying it with the correct economic elements. The issue lies fundamentally with the use of averages as a sampling of productivity or of real and current economic factors. What is important in the discussion of capital theory is an emphasis on the marginal yield of capital or as Fetter states "the marginal application" of capital and not on the average length of time of the totality of roundabout processes. Capital could be shifted from one industry to another to result in a higher yield but in effect lower the average period of production. By shortening the length of one production processes and moving the capital to other processes without an equal increase in the length of roundaboutness will, in turn, result in a decrease in the average production period.

Bohm-Bawerk also seems to use in Capital and Interest the term "average period of production" as a historical analysis of the structure of production. In this way, productive capabilities have been stacked, if you will, upon one another since the beginning of time. Capital and Interest suggests that improvements have bee made upon the capital of previous generations. Rothbard had problems with this aspect of the "average period of production" stating that "Bohm-Bawerk sowed confusion by giving an historical interpretation to the structure of production" and that this interpretation is "one of the weakest parts of [Bohm-Bawerk's] theory." In Man, Economy, and State, Rothbard tackles this aspect of the "average period of production" by expressing the Misesian critique that certain technological advancements, like those since the beginning of time, have been embodied into common knowledge or infused into land. Mises states that the "acting man does not look at his condition with the eyes of an historian" and thus "the length of time expended in the past for the production of capital goods available today does not count at all." Rothbard writes in Man, Economy, and State that land may include any alterations that are labeled as permanent or "not [having] to be reproduced or replaced." Under this category, economists can place land that has been altered by adding irrigation canals or trees that have been permanently cut down. These are all alterations to land that are permanent. Human action, as Mises writes, is concerned not with the past but the present and future in order to achieve the highest degree of satisfaction. Therefore, any permanent additions or subtractions from land before the individual has received the factor can be put under the heading of land and not capital. Capital does not socially appreciate over time for the use of later generations. Its value does not appreciate nor does it maintain its value. Capital depreciates as it is being used in production and therefore if an input to the production process does not exhibit this trait, one must be weary in calling it capital or that it necessarily has a rent.

This concept of land and capital can be traced back to one of the greatest followers of Eugen Bohm-Bawerk, Knut Wicksell. Wicksell wrote heavily on this topic in his book Value, Capital and Rent and expressed his differences with the Bohm-Bawerkian analysis of land and capital. In Value, Capital and Rent, Wicksell states that it is land that is permanent and does not need to be invested into in order to offset its depreciation. Land, as opposed to capital, is a natural resource that must be used properly in the process of production and does not require investment to replace its faculties. It is capital that requires investment due to its continuous depreciation and use during the production of given outputs. Wicksell believes that under the category of land falls structures that do not depreciate quickly overtime and need very little to no investment within the lifetime of a production process. Such structures can include fortified buildings, railroads, automobile roads, alterations to land such as irrigation, and so on. Wicksell states that in these cases "the original cost of construction no longer has any influence on the present-day level of rent of these buildings or on the freight charges of the railways in question" and that the returns of these seemingly permanent structures have "just as little significance for its present capital-value or profitableness." In Wicksell's opinion "it is precisely because of this that goods of greater durability (such as streets, railways, buildings, etc.) cannot be regarded or treated as capital in the narrower sense, but, once they are there must be placed, economically speaking, in the same category as land property itself." The value of these factors, to Wicksell, must be thought of as the value of the land itself and as a secondary phenomenon with respect to any rent earned on capital in a production process or in wage determination. Therefore, to conceive of the permanence of certain efforts expended by previous generations on land can not be categorized as capital or that its value can be averaged over centuries but instead must be associated with land value. These seemingly permanent structures do not have a rent nor do they lend to the determination of wages but instead are simply another factor and must therefore be added to the totality of costs in the process of production.

In sum, the Hicksian analysis of Bohm-Bawerk is incorrect and embraces the misconception associated with the use of averages. It is not through averages but marginal usage, as Fetter explains, that value can be understood. The average of any process, or any change therein, is useless as a measure of economic growth or capital accumulation. As Fetter shows, it is only through looking at present and future yields that an outward growth of production possibilities can be brought to light. The best illustration of this incorrect Bohm-Bawerkian concept can be found in both Human Action and Fetter's Capital, Interest, and Rent. These are two great analyzes that have been shared in this paper and argue against this mishap in Bohm-Bawerk's theory.

The history of economic thought teaches us much about the importance of those theorists who came before. It is with the help of their originality and genius that we are able to engage in the intellectual discussion of complex economic factors. Bohm-Bawerk paved the way for an abundant amount of research, including many theories of the trade cycle, by successfully deducing the main determinant of rent and the discounted nature of capital valuation. It is time-preference that gives us the discounted value of capital and which is the origin of the natural rate of interest. Though Bohm-Bawerk contributed immensely to capital theory, there were still a few minor flaws in his analysis. These flaws may be associated with lessons learned from the marginal revolution and the need to stay away from averages as a means of understanding value. What must be understood from this paper, if nothing else, is that we must celebrate the discoveries of prior theorists and understand, not ridicule, their failures. Only by the comprehension of the flaws of prior economists can modern economists alter theory so as to make it applicable to the present market. Knowledge is only perfected over time with the help of honest and diligent thinkers. Only through reverence for those who paved the way and an understanding of their flaws can we begin to improve upon our present conditions.

Sources:

1. von Bohm-Bawerk, Eugen. Capital and Interest. Libertarian Press, 1959.
2. Fetter, Frank A. Capital, Interest and Rent. Sheed Andrews and McMeel, Inc., 1977.
3. von Mises, Ludwig. Human Action. Contemporary Books, Inc., 1949.
4. Rothbard, Murray N. Man, Economy, and State. Ludwig von Mises Institute, 2004.
5. Wicksell, Knut. Value, Capital and Rent. Rinehart & Co. Inc., 1954.