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1. Peter G. Klein | Mises Academy 20121 | Production and the Firm
Peter G. Klein
University of Missouri
August 9, 2012
Austrian Microeconomics
Production and the
Firm

2. 2 | Production and the Firm Peter G. Klein | Mises Academy 2012
Definitions
► Production: “the use by man of available elements of his
environment as indirect means — as co-operating factors — to arrive
eventually at a consumers’ good that he can use directly to arrive at
his end” (Rothbard, Man, Economy, and State, p. 9).
 Central idea: transformation
 Focus on purposeful human action — doesn’t
happen automatically!
 Implications
► Passage of time
► Original versus produced factors of production
 Importance: five chapters of MES
► Firm: locus of productive activity
 Entrepreneurs
 Factors of production

3. 3 | Production and the Firm Peter G. Klein | Mises Academy 2012
Basic principles of factor pricing
► Rental prices of factor services that are rented, and purchase
prices of factors, are determined by demand and supply in
factor markets.
► What determines the demand for factors?
► Austrian theory of imputation
 Rental prices of nonspecific, isolable factors used in variable
proportions tend to equal their discounted marginal revenue products.
 Rental prices of other factors set by bargaining between resource
owners and entrepreneurs.

4. 4 | Production and the Firm Peter G. Klein | Mises Academy 2012
Marginal products and the law of returns
► Law of returns: holding constant the quantities of
complementary factors, there always exists an optimum amount
of a variable factor.
 Marginal physical product of a factor: addition to total product from
adding an additional unit of the factor, holding other factors fixed
 Diminishing marginal returns: as units of a factor are increased, its
marginal product eventually falls.
 Marginal revenue product (MRP) of a factor: marginal product of the
factor × the price of the final good
 Discounted marginal revenue product (DVRP): MRP discounted by the
rate of interest

5. 5 | Production and the Firm Peter G. Klein | Mises Academy 2012
MRP examples
► Variable proportions 4A + 10B + 2C → $100
(isolable factors): 3A + 10B + 2C → $80
MRP(A) = $20
► Fixed proportions 4A + 10B + 2C → $100
(non-isolable factors): 3A + 7.5B + 1.5C → $75
MRP(A) = $25
► Specific, non-isolable, 1A + 2B + 3C → $200
and indispensable 0A + 2B + 3C → $0
factors: MRP(A) = $200

6. 6 | Production and the Firm Peter G. Klein | Mises Academy 2012
DMRP for an isolable factor
► Entrepreneurs demand factors based on DMRP; factor
owners have reservation demands
Factors
1st
2nd
3rd
4th
5th
DMRP
$30
$27
$25
$22
$20
Pmin
$ 9
$11
$13
$15
$17
Factor
owners
O1
O2
O3
O4
O5

7. 7 | Production and the Firm Peter G. Klein | Mises Academy 2012
DMRP for an isolable factor
1 2 3 4 5
1st
2nd
3rd
5th
4th
O4
O5
$30
$27
$25
$22
$20
$17
$15
stock of
the factor
DMRP of
the factor
reservation
demand for the
factor
Q* = 5, P* = $20

8. 8 | Production and the Firm Peter G. Klein | Mises Academy 2012
► Classical view: costs determine prices
► Austrian view: prices determine costs
 All costs are opportunity costs.
 Factor prices tend to equal their DMRPs
(marginal productivity theory).
 Factors tend to be allocated to their highest-
valued uses in production.
 The purchase price of a capital asset tends to
equal the sum of its future DMRPs.
► Common fallacies
More on imputation

9. 9 | Production and the Firm Peter G. Klein | Mises Academy 2012
Changes in factor prices
► Changes in supply (stock) of factor
► Changes in demand for factor (DMRP)
 Changes in time preferences (rate of interest)
 Changes in productivity of the factor (marginal physical product)

10. 10 | Production and the Firm Peter G. Klein | Mises Academy 2012
Change in supply (stock)
P
Q
S
D = DMRP
P1
P2
S′ Example: increase in
supply (stock)

11. 11 | Production and the Firm Peter G. Klein | Mises Academy 2012
Change in demand
P
Q
S
P2
P1
D′ = DMRP′
D = DMRP
Example 1: increase in
interest rate
MRP

12. 12 | Production and the Firm Peter G. Klein | Mises Academy 2012
Change in demand
P
Q
S
P1
P2
D = DMRP
D′ = DMRP′
Example 2: increase in
marginal physical
product
MRP′
MRP

13. 13 | Production and the Firm Peter G. Klein | Mises Academy 2012
The labor market
► More on the demand for labor
 Prices of final goods and services
 Quantity and quality of complementary capital goods
► Note on the secular increase in wage rates – increases in capital per worker,
not unions, government…
 Employer tastes for discrimination
► More on the supply of labor
 Worker tastes for occupations
► Compensating differentials

14. 14 | Production and the Firm Peter G. Klein | Mises Academy 2012
Changes in reservation wages
1 2 3 4 5
1st
2nd
3rd
5th
4th
O4
O5
$30
$27
$25
$22
$20
$17
$15
stock
DMRP
original reservation
demand
Q1 = 5, P1 = $20
Q2 = 4, P2 = $22
O4
O5
O3
O2
O1
new reservation
demand

15. 15 | Production and the Firm Peter G. Klein | Mises Academy 2012
The labor market
► More on the demand for labor
 Prices of final goods and services
 Quantity and quality of complementary capital goods
► Note on the secular increase in wage rates – increases in capital per worker,
not unions, government…
 Employer tastes for discrimination
► More on the supply of labor
 Worker tastes for occupations
► Compensating differentials
 Wages in alternative occupations
 Costs of entry (e.g., licensing)

16. 16 | Production and the Firm Peter G. Klein | Mises Academy 2012
Occupational licensing
P
Q
S
D = DMRP
P2
P1
S
Example: market for
lawyers
supply curve
with Bar Exam
supply curve
without Bar Exam

17. 17 | Production and the Firm Peter G. Klein | Mises Academy 2012
More on compensation
► Non-monetary compensation
 Compensating differentials
 The quality of the work environment
 Salaries versus fringe benefits
► Note on minimum-wage laws
► Careers and lifetime pay
► The entrepreneur’s implicit wage

18. 18 | Production and the Firm Peter G. Klein | Mises Academy 2012
Applications and extensions
► No distinction between production and “distribution”
► In the absence of uncertainty, only land, labor, and the “time
factor” earn net incomes.
 Gross income of capital goods is imputed back to the “original” factors
that produced it, less interest.
► Land consists of two components.
 Economic land: part that’s inexhaustible (“original,” “basic,” “ground
land”) – earns its DMRP.
 Geographic land: part that embodies capital improvements – earns
interest.

19. 19 | Production and the Firm Peter G. Klein | Mises Academy 2012
Applications and extensions II
► Rent = unit price of services of any good (Fetter)
 Ricardian rent: payment to a factor beyond that necessary to attract the
factor into production
 Marshallian “quasi-rent”: payment to a factor beyond that necessary to
retain a factor in production
► Prices of durable goods (i.e., their capital values) determined by
capitalizing the stream of expected future rents.
► Note on positive time preference

20. 20 | Production and the Firm Peter G. Klein | Mises Academy 2012
Entrepreneurship, profit, and loss
► In the evenly rotating economy (ERE)
 Factors (including management) earn their
DMRPs.
 Capitalists earn interest (reward for forgoing
current consumption).
 No profits and losses!
► Outside the ERE
 Entrepreneurs earn profits and losses based on anticipations of
future prices (Frank Knight calls “judgment”)

21. 21 | Production and the Firm Peter G. Klein | Mises Academy 2012
The firm as an organization
► Neoclassical view: firm as production function
► Austrian view: firm as ownership of assets
 The firm is the capitalist-entrepreneur (or a group of capitalist-
entrepreneurs) plus the alienable assets he owns.
 Ownership conveys authority
 Firms can own many, or no, production processes (functions).

22. 22 | Production and the Firm Peter G. Klein | Mises Academy 2012
The theory of the firm
► Why do firms exist?
 Transaction costs of market exchange (Coase 1937)
 Entrepreneurial judgment is non-contractible (Knight, 1921)
► What determines the boundary of the firm?
 Internal and external transaction costs
 Entrepreneurial talent
 Need for economic calculation (Rothbard)
► How should the firm be organized?
 Costs and benefits of delegation (Foss, Foss, and Klein, 2007)

23. 23 | Production and the Firm Peter G. Klein | Mises Academy 2012
The limits to the firm
► Incremental limits: indivisibility in the entrepreneurial judgment
► Ultimate limit: need for external markets for all internally
transferred factors
 The vertical stages of production
 Divisional profit and loss
 Need for market-based transfer prices
► Calculational chaos
 As external markets disappear, “islands of noncalculable chaos swell to
the proportions of masses and continents. As the area of incalculability
increases, the degrees of irrationality, misallocation, loss,
impoverishment, etc., become greater” (p. 548).
► Relationship to socialist calculation debate

24. 24 | Production and the Firm Peter G. Klein | Mises Academy 2012
Takeaways
► Austrian economics offers a unique theory of production, not
merely a verbal rendition of neoclassical production theory.
 Causal, realistic analysis of factor pricing and use
 Grounded in marginal utility theory
 Emphasis on economic, not technological, aspects of
production
 Focus on the entrepreneur
► More work remains to be done in this area.
 Rent theory, internal organization of the firm, microeconomics
of business cycles, critique of neoclassical cost-curve analysis,
more. . . .