5. Allocating Factors of Production

Factors of production are priced according to their discounted marginal value product (DMVP).  The marginal value product (MVP) is the additional revenue that can be generated by the marginal unit of a product.  Hence, the DMVP is simply the present market value of the future MVP.  For example, if an additional hour of labor will generate $110 of additional revenue in one year’s time (MVP=$110), and the interest rate is 10%, then a prospective employer will pay no more than $100 today to hire the worker (DMVP=$100).

In the ERE, the marginal value product is known because there is no uncertainty.  In the real world however, the MVP must be estimated by entrepreneurs.  If an entrepreneur believes that a factor is being undervalued, he will invest in that factor and (hopefully) make a profit.  This means that in seeking profits, entrepreneurs look to put productive factors to better use than what they are currently being used for. 

Entrepreneurs tend to eliminate profit and loss opportunities.  By investing in those lines offering higher rates of return, they bid up the factor prices and force down the product prices, thus shrinking the rate of return.  Successful entrepreneurial actions light the way for other investors to switch productive resources to those lines of production.  On the other hand, investment is pulled away from unprofitable lines of production, so the supply of the final product is reduced, raising its price and returning that line to profitability.  As discussed above, accounting profits in all businesses the economy will tend towards the interest rate; in other words, economic profits will tend to 0.

Through the actions of individuals seeking profits, resources in society are automatically allocated to their most productive use.  While the (temporary) profits go to the capitalists, as the economy adjusts, the profit rate in that line tends to 0, and ultimately all increases in productivity will be passed back to the original factors, land and labor (raising rents and wages).  All individuals benefit from the improved structure of production, through an increase in consumer goods. 

We say that an economy is progressing (or growing) if there are net aggregate profits, and an economy is retrogressing if there are net aggregate losses (the ERE, where there are neither, is a stationary economy).  Net aggregate profits occur whenever there is net saving and investment, i.e. whenever gross investment exceeds the amount necessary to maintain the existing structure of production.  Capital accumulation (net investment) alone then, even without scientific discoveries or technological advances, can allow for a continuing increase in living standards.  Time preferences thus serve as a limit to how quickly an economy can grow. 

In summary, consumer valuations determine the marginal utility of consumer goods, which ultimately determine the prices of these goods. The rental prices of land, labor, and capital factors are then determined on the basis of these prices, and the technological recipes of production, by estimating the MVP of a productive factor. The pure rate of interest is determined by the time preferences of individuals, and this rate is used to compute the DMVP, or asset price, of durable goods, based on their known future rental prices.  Outside the ERE, actual market prices will tend toward these final values. Uncertainty due to changing conditions will always leave open the possibility for forecasting errors. Profits will accrue to those entrepreneurs who best deploy scarce resources for the satisfaction of consumer desires.

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