The long and short of factor prices

Economists make a distinction between the short-run and the long-run. Generally, the long-run is when “everything settles”–when frictions and unexpected changes disappear. So you see this distinction made in the mechanical, smooth models of mainstream economics because they can add time periods and stochasticity (randomness) to see where the endogenous variables in their model settle after enough time periods.

Rothbard and other Austrians lamented the popular conceptions of these sorts of long-run equilibria. The criticism wasn’t just over the implausibility and (if I can make up a word) unachievability of a long-run state, but over the way such a state is heralded as superior or desirable to the gritty, unpredictable short-run.

The short-run is the ugly caterpillar. The long run is the beautiful butterfly.

Böhm-Bawerk addressed frictions and unexpected changes, and instead of lamenting their existence, he embraced them as critical elements of the market process. They shouldn’t be wished away, but acknowledged and integrated into economic theory:*

The steadiness of supply is continually disturbed even when economic decisions are made correctly. Be it that in spite of the correct use of resources their expected returns are unbalanced by unforeseeable external circumstances such as unequal harvests in different crops; be it that changes in wants, e.g. in consequence of an illness, unbalances the harmony of supplies geared to the old state of affairs; be it finally because generally the supply of commodities is subject to continuous change … because [final products as well as intermediate ones] are subject to replacement, and the quantitative and temporal coincidence of them being used up and being replaced is a technical impossibility…

Not only does production take time (a hallmark of Böhm-Bawerk’s writing), but adjustments to changes in expectations, replacing capital, and (I would add) the implementation of new technological ideas take time. These events are not somehow outside of economics, but important decisions that economics can and should address.

Actual factor prices depend on the valuations of the entrepreneurs who want to use it and the current owner of the factor. Their valuations depend, in the end, on the consumer valuations of the output they help produce.

Even factors employed in early stages of production, far removed from the consumable output, are valued based on the valuations of their immediate output of factors to be employed in the next stage of production, and so on until you get to the consumption good. This phenomenon (factors valued based on value of the consumable output) is called imputation theory and can be traced back to Menger.

So the factor owners and entrepreneurs who want them meet and bargain over the price of the factor. The owners of the factors will prefer higher prices, but will sell at prices higher than some reservation price based on alternative uses of the factor. On the demand side, the entrepreneurs who wish to use the factors in production will prefer lower prices, but will buy at prices below some reservation price based on the expected revenues from selling the consumable output, which is based on consumer demand and the physical output of the entrepreneurs’ chosen line of production.

Böhm-Bawerk emphasizes that every part of the determination of factor prices is up in the air. “Unforeseeable external circumstances” can enter at any part of the logical steps just outlined.

Consumer valuations of the output could change. Harvests can be larger or smaller than expected. Illnesses, technological ideas, tools breaking and all other sorts of events that many economists would chalk up as “friction” happen and influence the supply and demand for factors of production and therefore their prices.

There is another level of “friction”, too. There is an indeterminate delay between these unforeseeable events actually happening and a change in the various market participants’ preferences and then the realized effect on the actual prices.

All of this affects the actual prices of factors via the preferences of the market participants formed via real-world happenings and expectations, which in turn are affected by decisions and happenings in the past. It’s a causal mess, but it’s causal. We can’t assume away and ignore the real world in an attempt to explain the real world. We can’t explain where butterflies come from without caterpillars.

*This quote from Böhm-Bawerk came from Klaus Henning’s book, The Austrian Theory of Value and Capital.


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