The basic premise of various economic theories is derived as ‘scarcity’. In fact the study of economics is limited towards ‘economic goods’, that is, goods that carry use value to people but are scarce compared to peoples’ infinite desires. Prices for these scarce ‘economic goods’ arise out of an implicit process of bidding.
In short, the market allocates resources among the several bidders who can outbid their counterparts.

While conventional mainstream economists do not falter till now, they’ve seldom recognized the scarcity of another important factor in human action–time. It should be obvious to anybody that time is not an abundant source available to human beings. Human beings contemplate the fact that time is scarce, and conform all their actions to harmonize with the limited time available. Thus arises the concept of ‘time preference’.

The ‘price’ of time

The thought of tagging a ‘price’ for time can sound weird first, but an example can make things clear. Lets take the case of a prosperous farmer wanting to acquire new land to increase production. How much would the farmer be willing to pay for the new land? According to mainstream productivity theory, the farmer will be happy to pay the amount of value that he expects the new land to add to his returns in the future. Suppose the farmer anticipates the land to boost his returns by $1000 per year, he would be ready to pay any price below $1000 for the first year(Let us, for a moment, assume that there is no well-developed financial system established which could offer interest returns on deposits).

So, if $1000 is the return from the new piece of land for a single year, and further since land is productive for centuries together, should the land be priced at infinity? It would have to be, if the world works merely as what the productivity theory claims. Unlike mainstream economists, the Austrian school recognizes the importance of time as an economic factor. The most important idea to keep in mind, with respect to our farmer example, is the fact that the farmer doesn’t live forever; or that he wouldn’t value returns from his land when he is bound to his bed in his twilight days(assuming the farmer has no heir). This solves the problem of the valuation of land. Land, like all other economic goods, has a finite price.

The valuation of land being one important lesson this example teaches us, that’s not all about it. The example also shows us how the infinite value of land is ‘discounted’ to a finite value(price) based on the amount of time elapsed. So how does the price of time express itself in the market place? The most basic expression of time discounting being expressed in the valuation of durable economic goods land, the other important market for time is, the loanable funds market.

The loanable funds market

The loanable funds market or the financial market is the most explicit expression of the time market in the economic world. This market witnesses suppliers and borrowers of present capital carrying out the same bidding procedure that is characteristic of any free market. Like the market for other commodities, the borrowers of capital in the loan market bid for present goods, and suppliers of present capital supply their capital to those borrowers who promise the highest amount of future goods. The interest rate thus expresses the premium or discount that is placed on present and future goods respectively.

Ill-effects of the lack of time accounting

While almost all mainstream economists consider land, labor and capital as the factors of production, Austrian economists have for long contended the possibility of the other factor of production–time. Over here looms a wide scope of disastrous implications that could be framed against various mainstream theories, that is, based on their failure to account for time as a factor of human action.

The major effect could be seen in policy recommendations of mainstream economists vying for the government to possess a monetary policy–that is, a set of guidelines to tamper with the time(loanable funds) market. The advent of fiat currency has helped governments to ‘fine-tune’ the economy with monetary tinkering of the time market.

Any sound theorist of the Austrian should feel aghast at the kind of ignorance that conventional economists lie under when they recommend tampering with key signals(i.e. interest rates) of the time market as one of the ways to ‘stabilize’ the economy. Inflation, currency debasement, business cycles, the doomsday event that follows any policy based on debasing the currency–hyperinflation, and many other side effects of intervention in the time market, are taken to be normal policy prescriptions in today’s economics mainstream–all because of the failure to recognize the role time plays in human action.

I have always been empathetic to the cause of the poor, and had a special liking for charity. A huge influence in this regard comes from within my family and other close quarters. It wasn’t too long before I got enmeshed into the popular trap of associating charity with socialism, and ‘exploitation’ with the free market; goodness with the working class, and evil with the rich. Much of this distorted view of reality could be associated with interpreting economic issues based on what, taking some help from Bastiat, is seen prima facie and missing out on what goes unseen.

It all started sometime in 2006 during my high school days. I had opted for science stream, only to find out that I had made yet another bad choice in my career. My academic graph was plunging quite rapidly, while my affair with political and economic systems, which sprouted when I was in middle school, grew manifold. Meanwhile I persuaded my dad to get me internet at home, and well, I tried out different things online before making it into orkut(the craze then was multifold when everybody had open scrapbooks, zero privacy. Those were great days, duh!). Like few other teenagers, I was a member of the bandwagon of nationalistic fervor and pride, wanting a violent revolution to weed out ‘evil’ capitalists who were, I believed, the reason for all our economic and social problems. Adolf Hitler was so attractive a figure to me, only to be taken over shortly by my romance(which still persists in a somewhat diminished flavor though) for Russia and the “Iron man” Stalin.

During one such endeavors to pick up some fight over orkut, I happened to step into the scrapbook of RFL’s one of the writer. If I’m right, I begun the conversation with him by pasting some old Russian joke(which I don’t remember anymore) deriding Capitalism. Notably he was the first person who took real interest, while others responded to derision with hard words I wanted, in pointing out to the flaws in my thinking process, and my misplaced priorities (Perhaps it’s not really a bad idea, I think now, to take interest in rehabilitating numbskulls on networking sites who are taken over by emotions featuring real world economic problems? After all I was one such…). Our discussions(I like euphemisms) lead us into starting a community on orkut(which now has hundreds of dead members but which still the best place to educate yourself on the subject).

The virtual community was the best thing could have happened to me at that point of time. It served as a graveyard for all my misconceptions about the market. It was a truly nice experience, where I was exposed to the works of Austrian economists, which I nevertheless ignored for more than a year. I knew I had to read them at least to know what the people at the other end were saying. I couldn’t be dishonest.

One of the other important things that happened at the community was the contacts I got with many socialists, who were radicals(except a very few may be). It was spine-thrilling to be a part of a virtual Red army on a battle against the capitalist ‘exploiters’. But things weren’t quite smooth inside the camp. My personal interactions with these socialists gave me an idea of their cause. But I found out that I wasn’t in complete agreement with what they purported. They were more concerned with economic inequality than in the welfare of the poor. ‘Equality’ was their cause, welfare for the poor was to be paid lip service alone. While I had some inclination to gather some logical defense which I could use in support of socialism, I could sense something. Socialism(and most importantly Marxism) doesn’t have any solid logical backing. Marxism is dogma, a pile of completely wrong propositions. Jargon is the best veil Marxist ‘intellectuals’ use to feign their errors. The most outright questions would give me unconvincing answers.

Getting to know the stupidity, and hypocrisy of socialists was never going to change me, for I was sure to stick on to socialism if I could find a logical basis in which I could defend socialism as the system that works for the interests of the majority. But things definitely started to drift. I had to read what my opponents really said. I made repeated attempts to go through previous discussions, many of which I didn’t understand. This was when I was in college. I was least interested in the course I had opted for a course(from which I eventually dropped out), and all that I did in the latter part of the year was to bunk classes and start reading my first economics textbook(which wasn’t actually Austrian). But it got me thinking. My mind gained clarity on how the market works, and why it works to the best interests of the workers.

There was no looking back. I could see that my socialist comrades were wrong many times. I would point them their errors, but they’d be least bothered to think on an unbiased plank. I got branded as a deserter when I decided to count my days in the Left. The recent year has been a very fruitful phase in my intellectual development. My episode must help drive home the point on what actually can change a emotionally handicapped person into a person who can find the right ways to the goal, which is the welfare of the collective(Yeah, and I am indeed aware RFL’s core philosophy). Noble intentions alone do not suffice to provide the desired results. I have no doubt now that the interests of the masses can be served only by the free market. Any other solution proposed is pure hogwash to divert attention.

While socialists would call for the abolition of market anarchy, Austrians would tell me the efficiency of the ‘invisible hand’. While socialism would demonize profits as ‘exploited surplus labor’, Austrian economics would teach me that labor without present goods through capitalist savings would lead us nowhere. While socialism would characterize the stock market as a casino, Austrians would teach me the resource allocative function of the stock markets. While speculation would be derided by socialists as greed, Austrians showed me how speculators shielded the poor from price shocks. While socialists called for a society of abundance, Austrians recognized the importance of calculation under scarcity. While mainstream economists would term interest as usury, Austrian greats would point towards the importance of time as an economic factor. I could just go on!

The only way to diagnose the real economic disease is to learn the science of cure. The cure is here, and it’s definitely Austrian economics—the only easy and fun-filled way to see beyond what’s seen prima facie and explain that what’s unseen.

People get enmeshed into a trap when they try thinking about the value of money¹. That is, why is a paper bill worth so many(tens, hundreds etc.) rupees, dollars or any other monetary unit. How exactly does the mint get about printing these numbers?

Was paper so acceptable?

To start off, lets ask ourselves some questions. Why did the vendor accept a 50 rupees note from me, in exchange for a kilo of sugar? The obvious answer many people give is, money(paper money to be precise) is a commonly accepted medium of exchange in today’s economies.

But lets board the time plank, to regress back in time. How did the first issuer of paper money(lets say he was Mr. Spaulding) ascertain any monetary value(like 10 rupees, 100 rupees etc.) to the paper money that he made?

Did he print just arbitrary numbers on the green papers that he printed? If so, what made our predecessors to accept paper pieces with arbitrary numbers(we will later see they weren’t really arbitrary numbers printed on the green paper bits) printed on them in exchange for real goods and services?

Lets trust the intellect of our ancestors for a moment(and for lack of real evidence to support that Mr. Spaulding actually got his way through with the trick), to assume that the first men who started using money did not exchange real, valuable goods and services for mere paper pieces printed with numbers.

Evolution of Commodity money²

The first money(ies) used by mankind were real commodities, and not paper pieces, which had specific use value attached to them. To get the crux of the idea, lets take a seemingly simple economy of three people.

Lets say Jon has a couple of apples, Jim a couple of oranges and Jame has an ounce of gold. All three guys don’t actually make it to the place of transaction at the same time. Lets say Jon and James meet each other, with their goods(apples and an ounce of gold) in hand. But now, it turns out to that James wants apples(from Jon), but Jon isn’t actually interested in the ounce of gold James has.

Now this sounds like a trade exchange between Jon and James ain’t gonna happen, no?

Surprisingly, the exchange does happen with James exchanging an ounce of gold for apples from Jon. What possibly made Jon to accept the ounce of gold from James in exchange for the apples although he had no real personal use to satisfy with the ounce of gold? The answer is, although Jon does not value the ounce of gold for the personal use-value that it could provide him with, it does help him as a ‘marketable’ medium of exchange. Jon accepts an ounce of gold from James only because he believes that it can be exchanged with Jim for the oranges.

In short, gold is accepted as a common medium of exchange because it is easily marketable, or in other words, it can be exchanged readily for real goods and services. The principle is quite the same even in complex economies; people trade with a common media of exchange because it is easily marketable(that is everybody accepts it in exchange for real goods and services).

What is money?

We can, by now, actually figure out a few crucial points.

1) Money is just another commodity, but readily marketable than other commodities for certain reasons.

2) Money was a product of the free market, with people engaging in voluntary trading. There is no evidence of people accepting paper money as a valuable common medium of exchange which they could trade for real goods and services.

The bastardized history of paper currency

While this sounds to be a sound case for the evolution of commodity money(like gold, silver, sugar etc.), it does not satisfactorily answer the evolution of paper money. Rightly so, paper money has had a kind of bastardized birth history to it.

What made(or tricked) men of the past to accept paper pieces(of no real worth) as money?

The answer lies partially in the fact that paper money was introduced as a veiled representative of real commodity money. That is, paper money initially only served as a money instrument(representing money) backed by real commodity money(most often gold and silver).

The warehouses in which men deposited commodity money were the first to introduce paper money. Capitalizing on the trust that the depositors thrust on the money instruments of these warehouses, these warehouses started to create fake money instruments which were not backed by real commodity money. But the trust that the customers of the warehouses had on these warehouses prevented them from asking for redeeming their money instruments for the real commodity money that backed them. This made it easy for these warehouses(predecessors of banks) to expand credit, and increase the supply of money.

Imagining today’s paper money as the remnants of these warehouse receipts, which were not backed by real commodity money helps us deal with our initial question of the value of money; that is about how Spaulding actually managed to print numbers to green papers he printed. All that he could have done was printing warehouse receipts which bore claims to definite weights of the commodity money which supposedly backed the receipt. This is further confirmed by the fact that today’s monetary units like the dollars, francs, pounds etc. were units of weight measurement of commodities like gold and silver of the previous centuries.

Conclusion

Paper money can have a fixed face value only when looked at as a measure of unit weight of commodity money backing the paper money. and not if it were to denote it’s purchasing power.

The fixed face value of paper money can only represent claims to real commodity money backing it. But, whether, warehouses(or today’s banks) can actually in real redeem commodity money for today’s paper money is another question to explore.

1. Mystery of money [↩]
2. Story of Money: An alternate story of evolution of money [↩]

I have dealt with this question already in one of my previous posts.¹ But judging by the comments I got for that particular article, I found myself guilty of being too complicated. So, I decided to write a detailed article which can explain profits and losses to the layman. A few basic economic concepts to start with.

Scarcity

Human beings essentially live in a world of scarcity. All of us cannot have everything we want indefinitely. Whatever be the sophistication of human civilization, the scarcity of goods refuses to disappear. Hence, goods which are not available in abundance and need to be rationed among different uses of men can be called ‘economic goods’.

Goods which are abundant and virtually inexhaustible, like air, are ‘free goods’, and they do not make a part of economic study.

The Role of prices

As we live in a world of scarcity, and not everybody can have everything they want at any point of time, the available amounts of economic goods must be rationed towards the various uses of men.

A centrally planned socialist economy which does not use the price system employs bureaucrats to carry out the rationing of goods. For various reasons such an allocation process tends to be inefficient. We need not bother about it at this point of time.

The market economy on the other hand uses the ingenuous price system to ration goods. Prices, as most of us know, arise out of competitive bidding by buyers for economic goods. At the end of the auction, a single price is arrived at, which clears all goods from the market(unless the sellers decide to hoard for future).

The Market as a Democracy

The essential character of the market is the price system, with voluntary buyers and sellers engaging in the trading process. Money plays an important role in the market process. It plays the same role in the market, what ‘votes’ play in democratic elections. Money notes(to keep the example really simple we assume the buyers have ready cash in hand) are ‘votes’ which various buyers cast in favor of different goods. The highest bidder usually gets the goods on payment of the bid price.

The difference between a market and real democracy is that the market allows the casting of multiple votes by a single buyer. Many skeptics have complaints against this, but, they hardly recognize the fact it gives a chance for the various buyers to express the intensity of their wants through money ‘votes’. Under a single vote system it would be an impossible task to figure out whose needs are the most urgent. The market process is the best tool available to mankind.

People make choices!

You might have seen your parents deciding on the month’s budget, on what to buy and what to cut, probably so that your family can spend the saved money on something else. You might have also heard of people in the ice-clad polar regions deciding on the amount of wood they might need during the worst times. You might have heard of increasing number of people opting for fuel-efficient cars.

What these decisions have in common is that all involve allocation of various resources(like time, energy etc.) towards various means to attain particular goals which they value at different degrees.

A Robinson Crusoe who lives in an isolated island too would have had to make these decisions, probably on how many logs of wood to cut, how many fishes to catch etc. He would have had to allocate his time, energy and other resources towards these ends he aims to achieve.

What the pricing system does?

What differentiates a complex economy from the simple Crusoe economy is not the decisions we make (after all decisions are always to be made in a world of scarcity). The vital difference is that modern economy conducts this process of allocation of resources towards various ends through the price system, like how Robinson Crusoe allocates his time, tools and energy towards particular ends. But, unlike the simple Crusoe economy where a single individual makes all decisions to himself (since he is both the producer and the consumer of the goods), the complex economy with sophisticated division of labor, involves millions of consumers convey their plans to the producers through the price system.

Hence, basically, what the market does is, it allocates resources in the economy according to the most urgent demands of the consumers.

‘Static’ vs. ‘Dynamic’ conditions

The condition of ‘Static equilibrium’ is an imaginary construct which can help us in economic study. It hypothesizes a world where the goods of the economy have been perfectly allocated in such a way that the most urgent bidders have got what they wanted. This ‘static equilibrium’ is what mainstream economics texts are usually obsessed with, and as a result mainstream models of the market miss one important element, namely the entrepreneur.

Since Jon expresses his urgency with a higher bid, he gets the apple while Kate does not. This is just one of the many decisions happening in the market, where goods are allocated to the most urgent needs through the price system. If the world were to freeze after this simple allocation in a two-member economy, we would have a ‘static equilibrium’ condition.

Now, lets assume that the world is in a state of ‘static equilibrium’ with the best possible allocation of resources (that is resources are allocated to the most urgent uses they are required for). There is the first-ever Christmas season coming up, in just a couple of weeks, and there happens to be great demand for cakes. The flour that was, until then, used to make bread (which was indeed the most urgent use of flour until Christmas came by), has new competition from cakes. Hence, here happens to be a ‘disequilibrium’ in the allocation of resources, since bread is not the most urgent use of the consumers coming out of the use of flour. Change in consumer taste has caused a ‘disequilibrium’ in the allocation of the resources.

From this state of ‘disequilibrium’, the market tends to move towards the static state as cakes start being made and sold to the consumers.

Role of the Entrepreneur

This movement towards the equilibrium state, which envisions the best allocation of available resources for the most urgent uses, does not happen automatically. The driving force behind the market which actually makes it happen is the spirit of entrepreneurship. The entrepreneur who sense this ‘disequilibrium’ in the allocation of the available resources can buy these resources at cheaper rates from places where it has not been put to the most urgent use to places in the economy where they can offer more urgent uses.

I am reminded of a famous retail chain in my city which transported laborers from villages where these workers were paid very low wages, and got them to work in the chain’s stores in the city where their work was much more valuable. The workers got increased wages since they were serving the most urgent needs of the market unlike when they were working for low wages in the villages. The middle-men who made this transfer of labor possible were able to gain profits, not because they exploited workers, but because they put them to the most valuable use. Anybody who thinks otherwise should understand the role of entrepreneurship in the market economy better!

1. On Overproduction [↩]

One of the most important theories to make the rounds in 20th century world politics was the ‘exploitation theory’ proposed by the German Political theorist Karl Marx. Leftists all over the world have found it to their political convenience to blindly accept this theory, and to convince themselves of the morality of the workers’ hours of toil.

Karl Marx shouted that the source of the profits gained by the Capitalists is the exploitation of labor’s productive effort. He accused scornfully, the capitalists of looting the workers of their rightful share of the returns of their productive labor. So according to Marx, profits are nothing but the ‘surplus value’ that the capitalist with-holds from the laborer.

Much of this proposition could be dismissed as emotional outburst of an unstable individual, unless there was a ‘scientific’ discourse from the man himself, in his famous work ‘Das Kapital’ published in 1867.

Marx’s theory of value

Marx, like other Classical economists, recognized the two kinds of values of any commodity: use value and exchange value. Use value being the personal utility that the commodity used as a consumer good yields to the consumer; while exchange value being the value that the commodity commands in a trade exchange in the market.

Marx in his preconceived mindset to arrive at an ‘objective’ theory of value, tried to find similarities in the properties of commodities that traded at the same exchange value at some particular point of time. He finally concluded that commodities with the same exchange value had the same amount(hours) of labor involved in producing them, and hence exchanged on equal terms. Thus was born Marx’s version of the Labor Theory of Value.

The fallacy in Marx’s theory of value

Marx believed that if two commodities were exchanged for each other, they had something in common and Marx propounded that to be the amount of labor hours required to produce the commodities. Thus Marx proposed that people exchange commodities which had equal number of labor hours spent in producing them.

The basic fallacy here with Marx’s perception of trade relations lies with the conditions of trade, and the source of value of any commodity. The question to be considered with respect to trade is: why would people exchange commodities of equal value?

If Alice and Bob have eggs and apples respectively, and both value the commodity that the other person has the same as the commodity he/she has, why would either of the two want to trade with each other? The only way trade could happen in this case is only when Alice values apples more than eggs; and Bob values eggs more than apples. Marx’s theory falls into a pit!

The other even more basic question on which Marx’s theory turns out to be nothing short of absurdity is: why would people consider the amount of labor hours involved in producing a commodity while valuing it? The only consideration of a buyer is to consider the commodity’s personal use value to him, which is based purely on his subjective preference scale.

In addition to that there are many questions which Marx’s ideology does not want to answer. For example if there are only 10 eggs in the market, and there are 15 buyers(they all want 15 eggs in total) then which 10 buyers will have their demand fulfilled. In the market the prices of the eggs will go up, which will result in the top most 10 buyers who value the eggs highest will get the eggs. But under Marx’s theory of value since the eggs had some specific hours of labor involved in it, therefore they cannot have some arbitrary higher values. Marxians do not bother themselves with the fact that there are not sufficient eggs to fulfill the needs of every individual.

What Austrian economics offers?

Austrian economic theory, unlike Marxism, offers two important points for anybody to remember:

1) People exchange commodities with each other because they expect to benefit from the exchange. The only condition is that, the parties involved must value the commodity that they buy from the other person more than the commodity that they give up(or sell).

2) The value of commodity is based on the subjective valuation of the buyer. Commodities have no ‘objective’ value.

In our previous example where there aren’t enough eggs in the market, the prices of eggs will go up and only the 10 most highest payers of eggs will get those eggs. This helps in the production of more eggs. Because the prices of eggs went up, there is no more profit incentive to the egg producer to produce eggs, and next time bring 15 eggs in the market. But under Marxian theory of exploitation since only rich people are able to buy the eggs for higher prices, the whole economy looks like a conspiracy against the poor people.

It’s not been tough for me to get to hear of derogatory comments against ‘greedy’ capitalists; about how those selfish pests suck all wealth unto themselves, by selling their products to consumers at prices above production costs to earn ‘undeserved’ profits. Going even further, some distressed souls even expect Capitalists to sell the products they produce at prices below production costs, and suffer outright losses.

I strongly believe most people with an anti-Capitalistic-mentality, are so, only because they don’t understand how the economy actually works. For instance, they don’t really understand why entrepreneurs don’t produce unless they gain profits. Otherwise, I believe, many people are usually sympathetic towards the efforts of the entrepreneurs in growing sustainable business models.

First up, lets analyze how economic calculation originated. We have usually heard of the merits of money, as a media of exchange which solves the trouble of ‘double coincidence of wants’, a store of value, divisibility, etc. But one more very important economic tool money has equipped us with has been the tool of economic calculation. Times of barter witnessed people exchanging goods and services through direct exchange without any common medium exchange called money.

Lets, for instance, take a person named Bob who lived in a barter economy. Bob produces wheat, corn and paper and he exchanges them for wine and squash. So, how would Bob’s book to keep track of his business accounts look like? As you must be able to guess, it would just have an array of goods bought and sold without any monetary values to any of the goods, whether bought or sold. Hence, Bob has no way to economically calculate whether he is economically better-off in an objective manner.

(Notice that Profit and Loss helps in objective measurement of economic value of goods. The subjective satisfaction that people gain when they exchange goods can’t be measured by any means, for obvious reasons)

The evolution of money necessarily revolutionized the way economic transactions happened on earth. There was now a common medium available towards the service of everybody, including Bob, to help them reduce details of their economic exchanges to a common denominator. That is Bob could now ascertain price figures to objects he bought and sold, and thereby enabling him to make economic calculations of profit and loss, and know if he is economically better-off or not. That is if he is richer or poorer at the end of an exchange.

Much has economic calculation helped people to have a hold of their economic situation, thereby directing their efforts towards production of goods that are economically valuable. For instance, Bob could now understand if his net personal wealth has increased or decreased. He now has a objective scale which could guide his production activities towards production of economically valuable goods which he could exchange with others.

Not to be ignored, the advent of the division-of-labor society where people are no longer self-sufficient, but specialize in specific production activities, has further directed our activities towards the production of goods for satisfaction of others.

An important contribution of economic calculation has been the Price system. Money is similar to ‘votes’ that you cast at the ballot every election, only that different people have different number of votes. Consumers vote everyday for products which they want, and refuse to vote for products they don’t like, giving rise to prices. Thus, the market reflects a democracy in action where voting takes place every day.

Prices can also tell us the relative scarcity of different goods in an economy. For instance, if the market is flooded with huge amounts of wheat which out-weighs consumers’ needs, consumers will instantaneously decide to use less of their votes to spend on wheat, giving wheat producers the signal to cut production. The exact opposite happens when a product is not produced in sufficient amounts.

So how, and where, does contempt and disdain against profits figure out in what we’ve been talking about till now?

What we notice until now, in our discussion about economic calculation and the Price system, has been the way the market directed by the spending patterns of the consumers guides producers to produce certain products and stop producing certain other goods. Even in the previous example, in which we talked about the movement of prices according to the preferences of the consumers what we see is it is the consumers who decide how much to pay, or in other words, how many votes to cast in favor of a product.

Another aspect of the problem can also be explained with a critical example. Lets take the case of distilled water. As one must be knowing, distilled water is used for various purposes. For the purpose of convenience, lets assume distilled water of limited stock in a particular town, can be used for two purposes: for filling car radiators, and to treat patients at a local hospital. Lets also assume, the people of the city decide to coerce the supplier of distilled water not to raise his prices, and sell at prices that cover just his cost of production alone. Lets also assume all car owners in the city are getting ready to make their holiday travel, so their demand for distilled water will increase. There is one critical thing that will certainly happen, which is, too many distilled water bottles would get diverted towards usage for cooling car radiators. People who have their dear ones at the hospital will run out off distilled water, unless they were the first in the queue to get distilled water. The problem here is, people who want distilled water for their medical requirements have to lose out, because they were disallowed to bid up prices and compete with car owners for the limited stock of distilled water. This is just a very simple example of how rational allocation is impossible without the price system in place. Now suppose the city managers get to know of the situation and they remove the price controls on the supplier of distilled water, and as expected, people who need the supplies for their medical needs bid higher prices for the distilled water, and the supplier will make huge profits.

Another entrepreneur comes into the city at the same time, and he buys some of the distilled water at those currently prevailing high prices, and mixes some gelatin powder into them and makes nice tasting jellies. He goes to the market place and tries selling those jellies. Nobody in the city wants to buy them at above his cost of production, and his venture goes broke with losses within weeks. The reason obviously is that the entrepreneur had a very bad taste of anticipation.

The entrepreneur failed to understand that distilled water was already selling at very high prices. That is, it was already very scarce. People had no intention to buy jellies from him because their more important needs, like to fill their car radiators, were yet to be realized. The entrepreneur made a very bad mistake which wasted the already scarce supplies. So, he was punished for causing loss to the society.

So, profit or loss of a particular venture is not determined by the entrepreneur who runs the business. It is the market, where consumers vote everyday welcoming and rejecting products, that determines if an entrepreneur makes profits or goes broke. The entrepreneur makes profits, only because he is able to satisfy the most urgent needs of the consumers. He neither plunders nor coerces consumers. It is the consumers who order all actions of the producers.

One of the theories which tries to explain the cause of capitalist depressions is the under-consumption theory. This forms the thesis of writers like Prabhat Patnaik who often calls Capitalism a ‘demand-constrained system’; and also lingers around in the writings of John Maynard Keynes as the ‘lack of aggregate demand’. The under consumption doctrine goes as something like this: due to excessive business savings and reinvestment, production of goods and services increases, and leads to fall in prices. But the consumers cannot buy out this increased production because of the lack of purchasing power. That is, in simple words, people can’t buy the goods produced at prices above the cost of production of these goods. Hence, the State has to step in by releasing new money into the economy, either through loose monetary policies or huge fiscal spending, to supply consumers with the ‘missing’ purchasing power.

The fallacious argument of these economists can be busted by looking into a basic fact of production in a capitalist economy. And that is, the cost of production of goods and services can never be more than the purchasing power of the workers (who are also the consumers).

Lets assume a very simple economy of 100 persons all involved in cultivating apples, and consumers (who are also the workers) are content eating apples that they don’t try producing any other good. All that the consumers want is 100 apples, nothing more and nothing less. As a note of caution: do not be concerned about the unrealistic example, this will help us catch the crux of the issue. So, for instance, the land-owner produces 100 apples at labor cost of $100, and hence he wouldn’t be happy with a price below $1 dollar per apple. Note that the farmers have $1 dollar each as wage. So, the farmers now are in a state of affairs in which they are capable of spending at least $1 for an apple, which will certainly cover the production costs of the land-owner. So, there is no question of a lack of purchasing power as such.

The cost of any product is embedded in the wages paid to the laborers, either in a single stage of production or spread through a chain of round-about production stages. So, this automatically implies that wages in the economy will equal (or cover) the production costs in the economy, and hence no question of lack of purchasing power. It’s a self-evident proposition.

One could argue against the example I have provided as non-expressive of various market phenomenon. The most probable opposition to the example I have proposed would be the absence of profits and losses in this hypothetical economy. That’s actually not a problem. The hypothetical economy I have used is an economy in equilibrium with perfectly satisfied consumers. Profits and losses occur whenever this equilibrium is disturbed, that is, when a ‘disequilibrium’ sets in.

Say the consumers (who are also workers in the apple farm) decide to cut down their purchase of apples by half. So every consumer now buys only half an apple at 50 cents. This will lead to losses for the land-owner who is unable to sell his apples. So he lays off exactly half of his work-force anticipating the same pattern of demand next season too. Now an entrepreneur enters into the economy and makes a crude market survey and finds out that people’s obsession with apples is over at least by half, and they are now ready to pay for oranges. So this new entrepreneur immediately absorbs the laid-off workers at cheap wages and employs them in growing oranges in a new piece of land. The harvest season arrives, and true to his expectations oranges have a great demand in the market. He is able to receive profits.

The money that was unspent on any further puchase of apples was rather spent on oranges, and the efficient entrepreneur who was able to anticipate future demands in the best way was able to rake in profits. The change in consumer preference lead to a ‘disequilibrium’ phenomena which leads to losses to those who stick to production of goods which have lost consumer preference; and high profits to those entrepreneurs who forecasted consumer demand in the best possible way. These initial profits of course cease to exist as new producers enter the market sensing high profits and profits are brought down by the bidding up of wages, and increased production which leads to lowering of prices.

The study of a more realistic ‘disequilibrium’ market does not change the basic fact that cost of production of goods and services can never be more than the purchasing power of the workers. The losses that happen in particular sectors, for various reasons, is not because workers (or consumers) lack the monetary purchasing power to buy the products at above production costs, but because they don’t prefer any more of that particular product.

So, although production costs equal the purchasing power of the consumers profits and losses are made possible (and thus not causing a contradiction with real life market happenings) whenever there is a ‘disequilibrium’ in the market caused mostly by change in consumer preference, or even entrepreneurial errors in properly judging consumer demand could lead to relative overproduction of particular goods at the cost of relative underproduction of other goods.

One should be careful here not to assume that profits in an economy will always equal losses. This is possible only in a stationary economy where no improvement in capital occurs. In such an economy the profits of a particular entrepreneur occur causing equal losses to other entrepreneurs. If the capital per head in an economy increases, profits (owing to lowered production costs) will be more than losses. The exact opposite happens in a retrogressing economy with a diminshing capital per head.