. 3
( 10)


exchange and will be accepted as payment in almost all
transactions. This is the origin of money, the missing ingredi-
ent that we mentioned in the previous chapter.
Historically, a great variety of goods has been used as a
medium of exchange: cows, salt, cowry shells, large stones,
exotic feathers, cocoa beans, tobacco, iron, copper, silver,
gold, and more. Economist Milton Friedman notes that ciga-
rettes were used as money in post-World War II Europe.
However, not every good is equally suitable as money.
There are certain characteristics that favor the use of a good
for indirect exchange:

The good is widely marketable.
This is the chief prerequisite for a good to become
money. There is no point in trading a good you want to
sell for one less marketable, unless you have a specific
use for the less-marketable good. The rest of these fac-
tors are important in that they contribute to a good
being widely marketable.

The good transports easily.
If someone wants to trade using a commodity, it helps
to be able to get the commodity to the trading site. Early
instances of indirect exchange often employed livestock,
especially cattle. That was money that not only talked
but walked as well. Land is a poor medium of exchange
because you can™t ever bring it anywhere.

The good is relatively scarce.
This criterion is closely tied to the one above. If the
good used as money is plentiful, you™ll tend to need a
lot of it to make your purchases, making it hard to move

around. For instance, if we used topsoil as money, we
would all need a dump truck to go grocery shopping.
The good is relatively imperishable.
You don™t want your money “going bad” a couple of
hours or days after you get it. The longer you can hold
your money, the more opportunity you have to wait for
a good deal to come around. This is why items like milk,
eggs, meat, and so on are not suitable as money. Live-
stock can, of course, die, but you can check when
you™re trading to ensure that you™re not being given
money that™s on its last legs. The precious metals and
gems clearly stand out in this regard.
The good is easy to store.
Not only should your money last, you don™t want to
have to go through a lot of rigmarole to get it to last. A
chemical compound that is only stable below -300
degrees Fahrenheit will not come to be used as money.
Carl Menger mentions that cattle were a popular
medium of exchange among people in societies that
were primarily agricultural and had plenty of open land
nearby. The rise of cities made cattle much less useful
as money. Most co-ops have strict rules against keeping
livestock in an apartment, and the practice makes it very
hard to keep the shag carpet clean. The precious metals
and gems are again winners here.
The good is easily divisible.
Not every exchange ratio will result in whole numbers
of each good being exchanged. If your money is easily
divisible, you can make change. Livestock clearly falls
short in this regard, as once you divide it up, it™s not
going to walk anywhere for you, and it becomes much

more perishable. Gems are weak here also, given the
difficulty in dividing them without destroying much of
their value.
Each unit of the good is very similar to every other unit.
You don™t want to keep fussing around checking out the
quality of your money and adjusting the exchange ratio
based on this quality. For one thing, someone else might
judge this quality differently than you do. Diamonds,
while in many ways suitable as money, are problematic
in this regard”it takes an expert to judge the value of
any particular diamond. The divisibility problem with
diamonds is related to this. You can™t get the price of a
whole diamond by adding up the prices of its pieces
once it is cut.

The only goods that stand out in all of the above criteria
are the precious metals, and most societies eventually came to
use silver and/or gold as money. As international trade
increased, gold gradually displaced silver in most places. (The
amount of gold that needs to be shipped for any particular
payment is only a small fraction of the amount of silver
needed for the same payment.) This process finally led to the
international gold standard of the nineteenth century.
There is nothing mystical about the choice of gold as
money. It is merely the commodity that best fit the above cri-
teria. Another commodity, such as platinum, could easily
prove superior at some point in the future.
The value of a good used as money originates from its
value as a good employed in direct exchange. However, in the
process of becoming money, the good gains additional value as
a medium of exchange. Still, the value of money is determined
in the same way as that of any other good”by the subjective

evaluations of those trading it. We could substitute “ounces of
gold” for “goats” in our analysis in the previous chapter, and
it would proceed in the same fashion. We would find that
Kyle would pay two ounces of gold for six bushels of corn
and so forth. We would say that the gold price of corn is one-
third of an ounce per bushel.
All of the above discussion of gold and other commodities
may seem puzzling, as today we employ pieces of paper as
money. The value of this paper clearly does not arise from its
value as pieces of paper. The government has decreed that it is
money. The fact that the government can demand that taxes be
paid in “its” money helps to give its decree force. Such a cur-
rency is called fiat money. The original value of fiat money
comes from an earlier time when it was a commodity money
(e.g., the U.S. dollar once represented a claim on a fixed amount
of gold). When the government removes the link between the
commodity and the paper currency, people understand how to
value the paper because of its former tie to the commodity. We
will look at fiat money in more depth in Chapter 9.


B of trade, there is another major difference
between a barter economy and an economy employing
money: the use of money enables economic calculation.
Money provides us with a common unit in which to express
different quantities of different goods. Since, in a well-devel-
oped system of indirect exchange, all economic goods will
trade against money, we can express any amount of any good
in terms of the amount of money necessary to acquire it, or,
alternately, the amount of money for which it will sell.

If we place Marco in a money-based economy we can
appreciate this difference better. He is now able to set up his
ledger with a definite numerical value assigned to each item”
let™s say, the amount of gold for which the item would sell. Let™s
look at two consecutive months™ balance sheets. In the liability
column, there is both gold that Marco has borrowed to set up
shop, as well as some items he has sold forward”when, for
example, he accepted payment today for an order to be deliv-
ered next month.

Assets Liabilities
1 hammer @ .25 oz. gold = .25 80 fishhooks @ .01 oz. gold = .80
2 chairs @ 1 oz. gold = 2.00 9 oz. gold = 9.00
20 cords wood @ .5 oz. gold = 10.00 1 net @ 1 oz. gold = 1.00
10 pounds iron @ .1 oz. gold = 1.00 3 poles @ .25 oz. gold = .75
100 fishhooks @ .01 oz. gold = 1.00
1 pole @ .25 oz. gold = .25
Total: 14.50 oz. gold Total: 11.55 oz. gold

One month later, we find:

Assets Liabilities
2 hammers @ .25 oz. gold = .50 120 fishhooks @ .01 oz. gold = 1.20
3 chairs @ 1 oz. gold = 3.00 7 oz. gold = 7.00
18 cords wood @ .5 oz. gold = 9.00 5 poles @ .30 oz. gold = 1.50
8 pounds iron @ .05 oz. gold = .40
1 net @ 1.2 oz. gold = 1.20
200 fishhooks @ .01 oz. gold = 2.00
Total: 16.10 oz. gold Total: 9.70 oz. gold

Marco™s assets over the month have increased by 1.6
ounces of gold, while his liabilities have diminished by 1.85
ounces. Adding these changes together, we see that he
increased his capital during the month by 3.45 ounces of gold.
The fact that his capital increased shows Marco that he has not
withdrawn so much from his business, for current consump-
tion, that he will not be able to continue operations. In fact,
he has a margin within which he could have withdrawn more.
Marco has been engaged in capital accumulation. If we had
totaled up Marco™s books and found a negative number,
Marco would have been engaged in capital consumption. It is
crucial for a business to be able to determine whether it is
accumulating or consuming capital, as one that is consuming
capital is not viable in the long run.
Without money prices, Marco could not have arrived at
these figures. His books would have consisted of columns of
goods, with no way of summing them. Beyond being able to
gauge the overall state of his business, the existence of money
prices aids Marco in evaluating individual decisions as well.
The price of iron fell during the month in question. If Marco
expects the trend to continue, he might be better off keeping
less iron in stock, perhaps finding a way to purchase it just
before he needs it. And since iron is less expensive, Marco
might alter some production process to use more iron and less
wood. Meanwhile, the price of poles has risen. If Marco thinks
that trend will continue, he will not want to sell forward as
many poles. Instead, he will wait to sell them until they are
made, in anticipation of a higher price.
The ability to calculate in terms of money prices opens a
tremendous new vista to human planning, extending the
capabilities of human thought. As Mises says in Human
Action, “Goethe was right in calling bookkeeping by double
entry ˜one of the finest inventions of the human mind.™ ” The

enormous significance of this advance will be examined fur-
ther in Chapters 8, 10, and 11.


I to realize that money is like all other goods
in that its value is determined subjectively, and in that it,
too, is subject to the law of supply and demand. The key
difference between money and other goods is that money is
acquired neither for direct consumption nor for use in manu-
facturing goods for direct consumption. Money is acquired to
trade later for consumer or producer goods. Its value consists
in being available for such use.
The demand for money is the demand for cash holdings.
All human action takes place in the face of an uncertain
future. Because of that uncertainty, people desire a cushion
against shocks, “something for a rainy day.” In the market
economy, this desire expresses itself first and foremost in the
desire to keep a supply of cash around. Although a reserve of
other items can help as well”grains, canned goods, fuel, and
so on”it is the tremendous flexibility of money in meeting
our needs that makes it the most desirable good to have in
reserve. The very nature of any event that is a shock is that
we don™t now know exactly what we™ll need when the sur-
prise arrives. The baby may get sick and we™ll need medicine.
The car breaks down, or the roof springs a leak, and we need
some repairs done. Or perhaps a great job opportunity comes
up, but we need to make a long, expensive flight to look into
it. A cash reserve can help in any of those situations, while a
big bag of rice in the basement is very difficult to use for
booking a cross-country flight.

People™s demand for cash holdings fluctuates. In times of
crisis, it may rise dramatically. Often, this leads to government
propaganda and perhaps even laws against “hoarding.” But
this so-called hoarding is only an expression of individuals™
desire for a sense of security. There is no economic basis for
deciding what is a reasonable level of cash holdings and what
constitutes hoarding. Government attacks on hoarding are
especially ironic in that the state often created the very crisis
that led to the increased demand for cash, often through war.
Once we understand the subjective nature of the demand
for cash balances, we can see through another common eco-
nomic fallacy”the idea that we should have stable money. By
the very nature of being an economic good, subject to human
valuation, money cannot be stable, as valuation implies the
possibility of change. In an economy where nothing changes,
there would be no valuation, as there is nothing to choose.
Goods would circulate in a purely mechanical fashion, driven
by who knows what impetus.
The idea of a stable money has spawned the idea of price
indices, designed to measure the value of money. We will
examine the changing valuation of money as well as price
indices in Chapter 9, where we take up the topics of inflation
and deflation.


T ENGLISH economist Alfred Marshall criticized
Carl Menger™s concept of consumer utility as the sole
source of value. Surely, he claimed, market prices are
determined by both the utility of the good in question to

consumers and the objective, monetary cost of producing it.
His famous metaphor was that utility and cost were like the
blades of scissors, and that it was foolish to debate which
blade did the cutting.
But we must conclude that Marshall hadn™t understood or
fully grasped Menger™s vision. As Israel Kirzner emphasizes,
Menger was after the essential cause of economic phenom-
ena, not incidental factors determining their magnitude. A
price is paid for a good because someone values it. The price
will not exceed that value, whatever the cost of producing it
may have been.
Perhaps I want to sell illuminated manuscripts of The Life
and Times of Gene Callahan. I contract with a monk in the
Carpathian Mountains to produce the book, at $10,000 per
copy. After the first copy is made, I start trying to sell it. Due
to consumers™ lack of interest in the finer things in life, I find
that I am unable to sell even my sole copy at that price. Since
I™ve already paid for the darned thing, I finally sell it for $9.95
and cut my losses. Even though my costs were over $10,000
per copy, I was not able to sell this book at a price anywhere
near that.
It would have been useless for me to attempt to drive up
the price by adding more cost. If no one was willing to pay
more than $9.95 for such a book, doubling the amount of time
the monk spent producing it, and therefore doubling my cost,
wouldn™t have budged the price a penny.
It is true, as Austrian economist F.A. Hayek pointed out,
that in the long run the sale price of a good will tend toward
the cost of producing it. But this is not because costs cause
prices to be paid. Rather, if the price fetched for the good is
below the cost, the good won™t be produced anymore! After
suffering a $9,990.05 loss on the first sale of my book, I™ll be

very unlikely to want to continue production. And if the price
fetched is above the cost, the market will attract other sellers
who hope to take advantage of this profit opportunity, driv-
ing the price down toward the cost of production. In the
meantime, valuations will change, new data will appear, and
new profit opportunities, where prices paid will exceed costs,
will emerge. Although in the long run, prices will equal costs,
we will never arrive at that long run. The notion that prices
equal costs must be taken as the expression of a tendency in
the market, not as a description of a state that the market ever
Taking this long-run view, we might say Marshall was right
after all. Don™t “objective costs” eventually help determine
price? However, Menger™s deeper point is that the costs of pro-
ducing a good are simply what the producer estimates the
demand for the necessary factors of production would be in
an alternate use. The cost of the monk™s time for me arises
from the subjective demand of others for alternate uses of his
time. Costs are not objective. Both blades of Marshall™s scis-
sors are honed by subjective valuation.
Menger™s insight is relevant to some policy debates, where
we might see critics of an industry contending that its prices
are “too high” and are not justified by the industry™s costs.
Whether or not they realize it, such critics are using a Mar-
shallian notion of objective costs to make their case. The fact
that costs are subjective derails such arguments.
How could we quantify the costs that equal Michael Jor-
dan™s salary when he played for the Bulls? Did it “cost” him
$34 million a year to produce his basketball output, justifying
his salary? For some economists, the answer is “yes””his costs
justify his salary, once we realize that Jordan™s cost in playing

for the Bulls is what he could make instead of playing for the
Lakers (or some other team).
To answer that question, we must look at Jordan™s oppor-
tunity costs. That concept was introduced by Friedrich von
Wieser, who was a follower of Menger and teacher of Hayek.
We touched on opportunity costs, without naming them, in
Chapter 2, when we saw that the cost to Rich of continuing
work was the value to him of the relaxation he was giving up.
The cost to me of marrying Sue is that I can™t marry Betty. To
be more precise, the cost of End A is the cost of the most valu-
able, alternate end given up in order to achieve End A. My
cost in marrying Sue is how much I value the next-best mar-
riage prospect (or, perhaps, remaining a bachelor).
Let™s look at opportunity costs more closely. Unless we can
arrive at an objective statement of what someone™s opportu-
nity costs are, we cannot judge that a market price is “too
high” relative to costs. If we try to arrive at an objective
accounting of Michael Jordan™s opportunity costs in playing
for the Bulls, we encounter the following difficulties:
(1) Jordan may never have received any offers from any
other team (a quite realistic scenario) before signing his
contract. In that case, no one has any idea what the Lak-
ers would pay him. And opportunity costs are never
realized: Even if he had received an offer, the alternate
deal might have fallen through, if he had chosen to act
on it.
(2) Jordan may love living in a cold, windy city, in the
proximity of meat-packing plants, near a large Polish
population. While each of these could come into play in
his decision, raising his opportunity cost for moving, even
Jordan himself could not quantify them. His preferences
represent an ordering, but they cannot be measured. As

Mises says: “Profit and loss in this original sense are psy-
chic phenomena and as such not open to measurement
and a mode of expression which could convey to other
people precise information regarding their intensity.”
(3) He might also be considering an acting career, in
which he thinks he might be able to make $40 million a
year, without sweating as much. Then again, he might
fail miserably. That is often the real situation of entre-
preneurs considering a speculative venture, for instance,
of a bank considering placing an automatic teller
machine (ATM) at an area hotel. How will the profits
from the ATM compare to those the bank might garner
from a new advertising campaign? At best, the bank™s
managers have an educated guess as to the answer. Far
from being amenable to objective calculation, real busi-
ness estimates of opportunity costs are often based on
vaguely sensed premonitions of future market states.
(For example, “Joe, I think we™re gonna sell a lot of this
(4) Even if we knew precisely what someone™s oppor-
tunity costs were, pricing based on such figures does
not account for the possibility of entrepreneurial profit.
By correctly adjusting the factors of production to antic-
ipate consumers™ future desires, the entrepreneur hopes
to achieve returns well beyond what he might have
made in some other venture. (We will discuss entrepre-
neurial profits further in Chapter 7.)
Formal models that attempt to quantify entrepreneurship
are sterile. They are akin to predicting the future batting aver-
age of major league ballplayers with a model that abstracts out
the human batter and formulates its equations with the bat
and the ball as the only variables.

A Place Where Nothing Ever Happens


W consider several situations in which the
market has, in some sense, “come to rest.” While
some of the market states we will examine are not
possible states of the real world, they are nevertheless impor-
tant to our understanding of economics. In order to conceive
of the impact of changes in the economy, we must first imag-
ine an economy where change has stopped. We can then
introduce a single change and ponder what its impact will be.
Gradually introducing change into our mental models, we
build up an inkling of the market process in its full complex-
The first of these states is the plain state of rest. The plain
state of rest is not an imaginary state, but actually occurs in
the market. It comes about whenever all buyers and sellers
who wish to exchange at the market price, and who know
that the option is available to them, have been able to do so.
We saw the plain state of rest in Chapter 4, where our goat
and corn traders made all of the trades from which they
expected to profit, then stopped trading.


In the real market economy, this state occurs again and
again. Anyone who watches a stock market ticker can observe
the plain state of rest many times a day. Sometimes for sec-
onds, sometimes for minutes, sometimes, with lightly traded
securities, for hours, no market activity will take place. All
buyers who wish to buy at the current price and all sellers
who wish to sell at the current price have done so.
The plain state of rest never lasts. A change in the market
data prompts market participants into activity. In our example
of the goat-corn market, we imagined that Kyle and Stephen
grew tired of eating corn and found a source of squash down
the road. That change starts the market process anew, as the
buyers and sellers search for a new price, which will again
result in the plain state of rest.
Similarly, in the securities market, a given price lasts as
long as there is no change in data that are seen as relating to
that price. Even an investor™s view of the prospects of a com-
pany could be an item of market data. A price may last only
while some investor is recalculating a spreadsheet evaluating
the stock at the current price. If the investor decides to buy as
the result of that evaluation, that increases the quantity
demanded, introducing new data into the market.
The plain state of rest may not take into account future
plans of market participants. Perhaps Emma has planted a
new strain of corn that she will have on the market next sea-
son. Today™s goat-corn market may have reached the plain
state of rest, but looking ahead we can see that there is new
data coming that will alter this state. However, we can imag-
ine a situation where all changes in the data relevant to this
market have stopped. Such a market will approach the final
price, or the final state of rest. It is an imaginary state, which
can never come about in the real economy. The essence of

human action is the attempt to replace what is with what
ought to be, in the eyes of the actor. As long as humans and
not robots populate the economy, we will never see the final
state of rest emerge.
Now, we can take our imaginings one step further, and pic-
ture an economy where for all goods, the final state of rest has
been reached. Such an “economy” is an endless cycle of the
same events being repeated. The same number of babies is
born each year, and that number exactly equals the number
of people dying. The same goods are manufactured each year
and demanded in the exact same quantities. No harvest ever
fails, no business ever goes bankrupt, no new products are
ever introduced, and no person™s tastes ever change.
If you have seen the movie Groundhog Day, you can begin
to envision what such a world would be like. The star of that
film, Bill Murray, awakens each morning to find that it is the
same day as the previous one, with all of the same events
occurring again and again. The difference between the movie
and our imaginary world is that, in the movie, Bill Murray™s
character continues to learn and change. If we eliminate that
difference, Groundhog Day is a perfect image of the world we
are envisioning.1
Such an economy is sometimes described as being in equi-
librium. However, because it does not lack economic activity,
but rather consists of a situation where every economic activ-
ity is repeated at the same time interval, over and over, Lud-
wig von Mises christened it the evenly rotating economy.

Thanks to Sanford Ikeda of SUNY Purchase for pointing out this

Such a world could not possibly exist, but it is helpful for
us to create the image of such a world for use as a mental
tool. By introducing a single change into our mental con-
struction, we can isolate what the effects of that particular
change would be, apart from the welter of complicating data
that exists in our real world. We will see applications of the
evenly rotating economy in chapters to come.
Regarding such a mental construct, we face danger from
two sides. As Mises commented in Human Action:
The method of imaginary constructions is indispen-
sable for praxeology; it is the only method of prax-
eological and economic inquiry. It is, to be sure, a
method difficult to handle because it can easily
result in fallacious syllogisms. It leads along a sharp
edge; on both sides yawns the chasm of absurdity
and nonsense. Only merciless self-criticism can pre-
vent a man from falling headlong into these abysmal

On one side of the razor™s edge is the danger of failing to
employ imaginary constructions at all, because they are not
realistic. However, we employ such mental tools precisely
because they are not realistic”they allow us to abstract from
reality just those factors relevant to any given analysis. We
should not for a moment mistake our models for images of the
real world, nor should we judge the real world by how closely
it approximates the models.
On the other side of the blade lies the danger of taking our
fancies too seriously, as in too much of modern economics.
Reams of paper have been filled with mathematical equations
describing “equilibrium conditions,” as if the real economy
were being discussed. But equilibrium is a mental tool for
studying human action isolated from all changes but one, and

not a potential state of the economy. As Mises says, “What
they are doing is vain playing with mathematical symbols, a
pastime not suited to convey any knowledge.”

Butcher, Baker, Candlestick Maker


The entrepreneurs, capitalists, landowners, workers, and
consumers of economic theory are not living men as one
meets them in the reality of life and history. They are the
embodiment of distinct functions in the market operations.

W up an economy with a capital structure,
interpersonal exchange, and money, and have
examined the states of rest that are the still points
toward which human action gravitates. Now, we are ready to
ask what is perhaps the most common economic question:
“Who gets the money?” (Or perhaps the second most com-
mon, behind, “How do I get more of it?”) When a good is sold,
to whom do the proceeds flow? And how can we account for
the fact that they got to put their hand in the till? What is the
distribution of the wealth produced in an economy?
Karl Marx offered an explanation for distribution: He con-
tended that all of the value of a good comes from the labor
that went into it. The fact that the workers do not get all of
the proceeds from a sale is due to exploitation, according to
Marx. The capitalists and landowners, having control of the


political system, are able to siphon off a portion of the wealth
that should flow to the workers.
However, we previously saw that Helena would not pay
Rich to grind up traps, even though he might have to work
just as hard at doing that as he did at making them. We can-
not account for the value of goods through “totaling” the labor
that went into them. People do not value labor per se; they
value things that they think will improve their life. Even Marx
recognized that totaling hours worked or calories expended
would not give any sort of account of value: Consumers are
unlikely to value the large number of calories I would burn if
I spent my days doing jumping jacks in my living room. Marx
attempted to dodge the problem by basing value on “socially
useful” labor. But we can only gauge what labor people con-
sider useful by seeing what they are willing to pay for that
labor! We call that amount a wage. Marx unwittingly had made
the case for the market economy.
Marx™s theory further leaves unexplained all of the
machines the workers are using. Forget how they were cre-
ated and who owns them in the market before socialism is
adopted”how will they be maintained? It takes resources to
do that. In a market economy, capitalists supply those
resources. Far from being able to return the wages that were
being “stolen” from the workers by the capitalists, communist
governments simply had to steal that portion themselves. In
fact, they had to “steal” more than the capitalists did, due to
the inefficiency of resource use under socialism.
Besides the “normal” returns to capital, we also should
explain from whence enormous “windfall” profits arise. Even
for many people who believe that capitalists deserve a “decent
return” on their investment in machines, buildings, research,
and so on, the sight of someone earning several billion dollars
, , 103

in a few years is disturbing. What did that person do to
“deserve” so much money?
Economics cannot tell us which people deserve which
earthly goods. But it can explain how consumers™ valuation of
first-order goods flows back to the various factors that helped
to produce them. To understand that flow, we abstract out
several distinct economic functions from the totality of human
action: entrepreneurs, capitalists/landowners, workers, and
The market is a process of bewildering complexity, where
all economic events are intertwined with all others. It is
beyond human capability to grasp the web of relationships
that makes up the market in its entirety. We comprehend the
market by isolating key abstractions, such as the productive
functions we study in this chapter. In essence, such a proce-
dure is not different than the use by physics of terms like mat-
ter and energy, two abstractions that aid in the comprehension
of the stunning multiplicity of forms of physical existence. The
basic difference between the two sciences is that physics
searches for the abstractions that help explain the world of
“stuff out there,” while economics searches for the abstrac-
tions that will help explain the world of human plans and
Each of the functions that Mises mentions in the quote at
the start of the chapter”entrepreneurs, capitalists/landown-
ers, workers, and consumers”besides being an economic
function, is also used as the name for a historical type. When
history speaks of “the plight of the workers in nineteenth-cen-
tury factories,” it is using the term “workers” to designate a cat-
egory of people in the real world. Depending on the context,
workers in this sense means something like “manual laborers”
or “wage earners.” But economics uses the terms to designate,

not categories of people, but functional roles. When it speaks
of the role worker, it means that aspect of action that involves
employing human labor. From the economic point of view, all
people who are not purely supported by others (e.g., infants)
take on the role of worker. When the wealthy landowner
opens the mail containing his rent checks, he is, at that
moment, acting as a worker. Even during consumption, the
role of worker is present”you must expend some labor to flip
the pop-top on your beer.
As a historical type, entrepreneur means the class of men
who start great enterprises and take bold risks in the financial
markets. History may discuss, for instance, “the entrepreneur
as social icon in the 1990s,” meaning Bill Gates (Microsoft),
Larry Ellison (Oracle), Steve Case (America Online), Jeff Bezos
(Amazon.com), Jim Clark (Netscape), and so on. But when
economics uses entrepreneur as a category of action, it means
that aspect of action that attempts to cope with uncertain
future conditions. Entrepreneurship as a function is something
that everyone employs: We all must risk acting in the face of
an uncertain future.
Mises defines our functions as follows:
In the context of economic theory the meaning of
the terms concerned is this: Entrepreneur means
acting man in regard to the changes occurring in the
data of the market. Capitalist and landowner mean
acting man in regard to the changes in value and
price which, even with all the market data remain-
ing equal, are brought about by the mere passing of
time as a consequence of the different valuation of
present goods and of future goods. Worker means
man in regard to the employment of the factor of
production human labor. (Human Action)
, , 105

Each category earns a different type of return in the mar-
ket: entrepreneurs, through creative judgment, earn profits;
capitalists, by planning for the future, earn interest; and work-
ers, through their labor, earn wages.
We will now examine each of Mises™s definitions in more


T “ENTREPRENEUR” as an economic category,
we will look at the role of the entrepreneur in the evenly
rotating economy, or rather, the complete lack of role!
The main characteristic of the evenly rotating economy is that
there is no uncertainty as to the future. Under that special con-
dition, the function of the entrepreneur does not exist”there
is no uncertain future with which to cope.
We comprehend the effect of a change in the market by
imagining a situation where no change is occurring, then
introducing the change in question. Let us say that we have
an evenly rotating economy “up and running” in a land we
will call Nirvana. (Remember, though, that the evenly rotating
economy is an imaginary construction. Thought of as a pos-
sible state of the real world, it is nonsensical.) From some-
where, a change comes in and disturbs the unreal smoothness
of the operation of that economy. Let us say that the current
generation of Nirvanians has a few more babies than the pre-
vious generation did. Suddenly, the perfect adjustment of all
elements of their economy is out of whack. There will be a lit-
tle more food demanded in the current year than was
demanded in the previous one. Nirvana will need more baby
clothes and cribs. In many other ways, the structure of the

economy will no longer correspond to the needs of the citi-
zens of Nirvana.
It is entrepreneurs who make the necessary adjustments.
Some factory owner must judge that he can bid more for the
items that go into baby carriages than the prevailing price. He
will bid them away from other uses. If his judgment is correct
he will profit because of the new demand for carriages. But
suppose Nirvanians decide to just plop two kids in some car-
riages, so that demand remains unchanged? Then the factory
owner will suffer a loss. Loss by those who misjudge the
changing desires of the consumers is as much a part of the
market process as is profit by those who judge correctly. The
factory owner must risk acting on his personal interpretation
of events even though that interpretation is necessarily con-
trary to the prevailing market interpretation. (If “Mr. Market”
has already adjusted his bids and asks based on the entrepre-
neur™s interpretation, then there is no more profit to be had.)
Similarly, some landowners must see that it now will be to
their advantage to shift some land to raising crops from some
other use. Some workers must perceive that they will be bet-
ter off becoming nannies than continuing at whatever they
were doing before. In making those adjustments, all of those
people are acting in the role of entrepreneur. As Mises says in
“Profit and Loss”:
The activities of the entrepreneur consist in making
decisions. He determines for what purpose the fac-
tors of production should be employed. Any other
acts which an entrepreneur may perform are merely
accidental to his entrepreneurial function. (Plan-
ning for Freedom)

It is the correct perception of the possibility for improve-
ment, for turning what is into what ought to be, that creates
, , 107

profits in the economy, and the incorrect perception that creates
losses. We can see that in the evenly rotating economy there is
no profit or loss in the economic sense. (The capitalists will earn
the market rate of interest on their investments. Accountants and
tax collectors may consider such returns profit, but economics
considers profits to be returns above that rate.) All elements of
the evenly rotating economy are perfectly adjusted to meet the
unchanging demands of the consumers. For the opportunity for
profit to arise, there must be a change in the data of the market.
Furthermore, the change must be one that introduces an ele-
ment of uncertainty into the future plans of acting humans.
It is risk and uncertainty that create the need for the entre-
preneurial role. If Nirvanians have more children, will they
consume proportionally more food? Will the new rate of child-
birth continue, or is it an isolated event, or even the first in a
series of increases in the birthrate?
Human choice both presupposes and creates uncertainty.
Choice is absent in the evenly rotating economy, since all rel-
evant data is already known. Such perfect knowledge is
incompatible with true choice. Real choice implies that the
person who is choosing might pick a steak or might pick a
lobster. Until the choice is made, even he doesn™t know which
he will select”if he already knows, there is nothing to weigh
and no decision to make. If he chooses a steak instead of a
lobster, there is no guarantee that he will not choose a lobster
tomorrow. If he picks a steak over a lobster, that does not
mean he would pick two steaks over two lobsters. (The mar-
ginal utility of steak might decline faster than that of lobster.)
If he picks a steak over a lobster today, and a lobster over a
pheasant tomorrow, that does not mean that the next day he
might not choose a pheasant over a steak. Mises described the
importance of true human choice in differentiating economics
from the physical sciences as follows:

As there exist constant relations between various
mechanical elements and as these relations can be
ascertained by experiments, it becomes possible to
use equations for the solution of definite technolog-
ical problems. Our modern industrial civilization is
mainly an accomplishment of this utilization of the
differential equations of physics. No such constant
relations exist, however, between economic ele-
ments. (Mises, Human Action)

We cope with the uncertain future of human action by
using our understanding. To employ human understanding is
to “walk a mile in the other fellow™s shoes.” We try to place
ourselves in another person™s mind, to imagine how they are
evaluating a situation, to guess their desires and plans. When
a waiter walks up to us at our restaurant table, we don™t need
to gather reams of information on the entirety of his physical
existence to surmise that he wants to take our order and not
to assault us. Now, at times human understanding goes astray:
People have been attacked by waiters! But the plain fact is
that in the vast majority of cases it works pretty well. We do
treat other people as acting, thinking beings, like ourselves,
and attempt to grasp the purpose of their actions. (Kurt Von-
negut wrote a novel, Breakfast of Champions, in which one of
the protagonists, Dwayne Hoover, abandons that view and
begins to treat others like automatons in a play that God is
putting on for him. The results are not pretty.)
The entrepreneur relies on his understanding of humans,
his “gut feeling” about what choices other people will make
in response to change, in order to comprehend the effects of
that change. That skill, like all others, appears to be unevenly
distributed among humans. Those who are good at it are able
to gain entrepreneurial profit. Using their superior under-
standing, they adjust production to meet new needs faster
, , 109

than their competitors can. They recognize that a change will
eventually be reflected in market prices, but that it will take
time for all actors in the market to fully digest the meaning of
the change. Until that happens, prices are out of alignment.
There are some factors of production”workers, land, raw
materials, machines, and so on”that best can be used to meet
new needs. At the moment of the change, however, they are
in less important uses. Eventually, the prices of those items
will be bid up so that their usefulness in meeting the new
needs is fully reflected in their price, but at the moment the
change occurs, their prices are too low, while the relative
prices of some other factors are too high.
Let™s imagine that word reaches the evenly rotating econ-
omy of Nirvana that a new animal has been discovered in
Freedonia: the Freedonian foozle. The foozle is sort of a com-
bined kitten, teddy bear, and monkey, and Nirvanians are
smitten with it. It is the job of the entrepreneur to understand
what adjustments in the market that new infatuation may call
for. Perhaps consumers will want a line of foozle dolls avail-
able by Christmas. But the available resources in the economy
are employed making other things. In order to rush out a line
of foozle dolls, an entrepreneur will have to bid some of those
resources away from their previous employment. That will
raise the price of those factors”but by how much? Will it be
worthwhile to manufacture foozles at that cost? How many
dolls will consumers demand? How much will they pay for
All human actions have an entrepreneurial aspect to them,
not just those of the people who run businesses. Workers who
make teddy bears will have to decide whether the higher
wage offered at the foozle factory makes it worthwhile to
switch jobs. Landowners have to decide how the location of the
new foozle store will affect their property values. Capitalists

must decide whether to lend the foozle entrepreneur the
money to start his company. Austrian School economist W.H.
Hutt pointed out that entrepreneurship is present even in acts
of consumption. Personal-computer buyers speculate on how
large the Christmas price cuts will be”should they buy a
computer now, or wait until after Christmas for the drop in
price? Entrepreneurship is the attempt to deal with the uncer-
tainty of the future when planning one™s actions.
Let™s say that the foozle entrepreneur judged the situation
correctly, went ahead with his project, and made a bundle.
Those profits will attract the attention of other businessmen,
who will enter the business as well. But they must bid for the
same scarce resources as the first foozle maker. Let us further
imagine that the event was an isolated occurrence in Nirvana,
and that the evenly rotating economy is gradually being re-
established there by the market process. In that case, com-
peting businessmen will bid up the cost of foozle-making
resources until profits in the foozle-doll business disappear
completely, and the evenly rotating economy comes back into
existence. The entrepreneurial profits available as a result of
any change are always temporary, as are the entrepreneurial
Of course, in the real world, new changes in the market
data will occur. Uncertainty, in our world, is always present.
No entrepreneur can rest on his laurels. Since the profits avail-
able from any single change will disappear over time, the
entrepreneur, if he wants to continue profiting, must continue
to search for the significance of further changes. Those who
continue at that task with the most skill and energy, over time,
will accumulate more and more capital. Those who are the
very best at it become the “titans of industry,” the “superrich.”
Their wealth is mostly in the means of production. In the
, , 111

unhampered market, if they want to remain wealthy, they
must never stop evaluating how to best use their resources in
order to satisfy the demands of the consumers.
We must also realize that it is only entrepreneurial effort to
profit from price discrepancies that eliminates those discrep-
ancies. A major focus of the work of Mises™s student Israel
Kirzner has been to demonstrate that the idea of equilibrium
prices without the entrepreneurial process is nonsensical.
When mechanistic economists draw supply and demand
curves and write equations describing the equilibrium state
(the evenly rotating economy), they offer no explanation of
how the economy arrives at that state. It is as though a mysti-
cal power (Federal Reserve Chairman Alan Greenspan?) simply
transmits the equilibrium price into the minds of buyers and
sellers. But our economics is the economics of real people.
We recognize that it is the desire to profit, to improve one™s
condition, that is the driving force of the market. It is that
force that alters prices to bring supply and demand into bal-


T landowners are the suppliers of the
nonhuman factors of production. The classical econo-
mists, having failed to arrive at the subjective theory of
value, had to develop specialized theories of land and capital
to account for the value of each. But the subjective theory of
value unites those elements under the category of factors of
production, or higher-order goods. The factors of production
are valued by estimating their contribution to the value of

the consumer goods they can produce: All economic value
originates with someone™s judgment as to the role a good or
service can play in improving his or her life.
However, we have a puzzle to solve. In the evenly rotating
economy, if we total up the price of all of the factors of pro-
duction that help create a consumer good, we would find that
total was somewhat less than the price the manufacturer
received for the good itself. What is the source of that “sur-
plus value”?
Let™s consider, in the evenly rotating economy, a machine
that we know will be rented for $1,000 for the next ten years
and then break down, having produced a $10,000 return. (By
definition, we have absolute certainty as to future prices in the
evenly rotating economy”they will be the same as today™s
prices.) The price paid for such a machine will be less than
$10,000. How do we know that? No one will give up a good
today in order to receive the same good back in the future, all
other things being equal. (And in the evenly rotating econ-
omy, all other things are, of course, equal!) So no one will pay
$10,000 today for a machine that will give him $10,000 over
the next ten years.
Let's say the machine sells for roughly $6,144. The capital-
ist who buys it can rent it out for $1,000 per year, so he earns
a 10 percent annual return. Where does that 10 percent return
come from?
The answer is apparent from our discussion above: it is a
return for the capitalist™s time, for the patience to forgo cur-
rent consumption and allow one™s resources to be devoted to
future production. If the return on capital is 10 percent in the
evenly rotating economy, that means that 10 percent is the
marginal time preference of the buyers and sellers of future
goods against present goods.
, , 113

The concept we are discussing is sometimes called the nor-
mal rate of profit. In the evenly rotating economy there are no
entrepreneurial profits, as they arise through adjusting pro-
duction to changing conditions, but there will still be “normal
profits.” Since the source of the return to capital is significantly
different than the source of entrepreneurial profits, it is better
to use a different term for it. We will call that return interest.
The capitalists and landowners refrain from the current
consumption of part of the goods available to them and per-
mit those goods to be used in order to satisfy future needs.
(They may either use those goods for production themselves,
or rent, lease, or lend them to others to use.) The return they
receive for the use of their goods is interest. The magnitude
of the return (the interest rate) is determined by the marginal
time preferences of all actors in the economy in the same way
that all other prices are determined: Buyers and sellers of
future versus present goods attempt to discover all possible
trades where they can exchange a good they value less for
one they value more.
Recall Rich, alone on his island: The degree to which he
preferred current consumption over future consumption
determined how much effort he would devote to accumulat-
ing capital goods. We generally think of interest as the rate of
payment for money loans, which is true, as far as it goes. But,
more fundamentally, interest is the market™s discount of future
goods to present goods, an expression of the time preference
of market participants. Let us say that an entrepreneur buys
the rights to next year™s grape harvest from some vineyard for
$1,000. If the risk-free rate of interest is 5 percent, the entre-
preneur will not consider that he has made a profit unless he
can sell the grapes for more than $1,050. This is because he
could, with less effort and risk, simply lend the money out at 5
percent and have $1,050 at the end of the year. The distinction

between interest and true entrepreneurial profit is well estab-
lished in modern finance. No investor is happy with an invest-
ment in a risky high-tech venture that yields him 2 percent a
year when U.S. Treasury bonds (which are generally consid-
ered the least risky investment) are yielding 5 percent. He
realizes that the high-tech firm is suffering entrepreneurial
losses. If it cannot turn things around, both the investors and
the economy as a whole would be better off if the funds tied
up in it are freed to be invested elsewhere.
The return to the capitalist arises because he exchanges a
present good for a future good, and therefore earns the price
differential between them. The capitalist always has the option
of consuming his capital now. The landowner who rents to a
farmer could instead throw lavish hunting parties on his land.
The person who lends out money at interest could have used
it for a world tour. Someone who buys a cattle futures con-
tract on an exchange could instead have bought a new Lam-
Arbitrage”simultaneously buying and selling goods to
take advantage of price discrepancies between different mar-
kets”will tend to establish a single interest rate for the econ-
omy as a whole. Let™s say that the interest rate on money loans
is currently 5 percent per year. Meanwhile, cattle futures
maturing in one year are selling at a discount to spot (current)
prices, so that for $90.90, an investor can contract for the
delivery of $100 of cattle a year from now. For simplicity™s
sake, we will assume there are no transaction costs, no carry-
ing costs for the cattle, and no possibility of demand or sup-
ply changes in the spot cattle market. Given those assump-
tions, there is a pure arbitrage opportunity available. Investors
can borrow money at 5 percent. They can buy cattle futures
that will return 10 percent. (We have taken as a given that spot
cattle will still be $100 next year, and the $9.10 they will earn
, , 115

is 10 percent of $90.90.) Investors net the 5-percent difference.
Since they are borrowing the money and making no capital
investment themselves, such arbitrageurs are essentially pick-
ing up money that has been left on the sidewalk. Once that
opportunity has been noticed, investors will rush to take
advantage of it.
The effect of their actions will be twofold. Their demand to
borrow money now to buy the cattle futures will drive the
price of present money higher against future money: the
money interest rate will rise. Conversely, their demand for
future cattle will drive the price of future cattle up against that
of present cattle. Soon enough, the money interest rate will
rise to, say, 6 percent, and the price of the cattle futures to
$94.34. ($94.34 + $5.66 [6 percent of $94.34] = $100.) The arbi-
trage opportunity will vanish.
A similar story will be played out in any market with a
unique interest rate, so that all rates will tend to be arbitraged
toward a single rate. Of course, we are not in the evenly rotat-
ing economy, so there will be changes in supply and demand.
The opportunity for arbitrage arises again and again in the
market, but entrepreneurial judgment is necessary to recog-
nize it. Is it really an arbitrage opportunity? Or is the cattle
future priced below the money interest rate because traders
suspect an increase in the number of cattle coming to market
next year?


H own labor to achieve their ends
are acting in the role of worker. All people labor
except those completely supported by others, such as

infants and invalids. As Hans Sennholz says in The Politics of
To sustain his life, man must labor. No abilities,
however great, can command success without labor.
To improve his condition, man must expend vital
effort in some form.

The return to workers is in the form of wages. Now these
wages may be explicit, as when someone takes on a job for
$50,000 a year or for $12.00 an hour. On the other hand, one™s
wages may be mixed in with other returns, and take some
effort to separate out for the purposes of gauging the result of
one™s efforts. That is often the case with the proprietor of a
small business. His books may show he made a profit of
$40,000 last year. But usually such a figure represents a mix of
interest on his capital invested, wages for his otherwise
unpaid labor, and true profit. In fact, many small business
owners, if they fully accounted for their own efforts at a wage
they could draw working for someone else, would find that
their business loses money every year, and they are only able
to stay open because they don™t pay themselves the higher
wage rate they could earn working for someone else. (Having
made that discovery, it is quite possible they would still keep
the business running for nonpecuniary reasons, perhaps
because they like being their own boss. Still, it is worthwhile
for them to have an idea of how much money they are giving
up for that benefit.)
A feature of work is what Mises called the disutility of
labor. The phrase signifies the fact that, in our world, people
prefer leisure to work. As Mises says: “The spontaneous and
carefree discharge of one™s own energies and vital functions
in aimless freedom suits everybody better than the stern
restraint of purposive effort” (Human Action).
, , 117

The disutility of labor does not come about from some
aspect of “the system.” No changes in social structure”com-
munal living, the dictatorship of the proletariat, or a return to
guild labor”can do away with that fact. A CEO making $5
million a year is as much subject to the disutility of labor as a
“burger flipper” making $10,000 a year.
The price of labor is an outcome of the same process as all
other prices. The buyer (an employer) and the seller (an
employee) must try to agree on a price for the labor offered.
The wage will fall within a range. The endpoints of the range
are determined by the value judgments of the employer and
the employee. At one end of the range is the lowest wage rate
that will interest the potential employee. He may have another
employer offering to pay $11.95 an hour. This might mean
that the lowest bid he will take is $12.00 per hour. Or, if he
has some other means of support, he might consider that, for
any rate under $12.00 per hour, it is not worth leaving home.
At the other end of the range the employer has a certain
amount of revenue he expects to gain from adding one more
employee, let™s say, $13.00 per hour. He may not be willing to
bid above $12.95 for the employee™s services. If they agree on
a wage, it will be between $12.00 and $12.95 per hour.
As we mentally approach the condition of the evenly rotat-
ing economy, the range will narrow until the difference
between what the marginal employee receives and what the
marginal employer pays becomes vanishingly small. Competi-
tion among employers for labor will tend to move the level of
wages toward the marginal productivity of labor. An
employer will attempt to hire workers until the revenue he
expects from the last worker hired”the marginal unit”just
exceeds the wage he must pay to attract the worker. The rev-
enue he would expect from the next worker he might hire will
fall below the wage he would have to pay. The bidding

among employers for labor constantly reshuffles the labor
supply, aligning worker and job with the entrepreneurs™ best
estimates of the wishes of the consumers.
If an employer and employee reach a deal, it should be
recognized that both of them feel they are better off than if
they hadn™t done so. The employer has not done the
employee a favor by hiring him. He has hired him because he
expects to profit by doing so. It is only because of the
expected difference between wages and revenues that any-
body hires anyone else at all! At the same time, the employee
is not being exploited by the wage he agrees to”if he knew
of any better opportunities, he surely would have taken
advantage of one of them.
The capitalist does add something to the production of con-
sumer goods”he adds his capital. Without the capital goods
he makes available, the workers would be far less productive.
A Marxist would counter by saying that it is only due to
exploitation that the capitalist owns capital. But such a con-
tention is unfounded. Capital arises from acts of saving and
investment. Without the efforts of a farsighted few, the bulk of
humanity would still be struggling for survival with rudimen-
tary tools.
Now it is true, of course, that there are many people in the
world today who possess capital as the result of some past act
of theft. How we could sort through history and set all wrongs
aright is a bit of a puzzle, since there have been so many of
them. Nevertheless, for our purposes it is enough to under-
stand that the ultimate source of capital is saving. Theft is a
violation of, not a part of, the market economy, and capital
does not rely on theft for its existence.
, , 119


O the consumer, also involves all
human actors. Whenever we stop to enjoy the fruits of
our labor, when we rest, when we vacation, when we
eat, we are consumers. In the popular press this term is some-
times used in a limited and derogatory sense to refer to those
obsessed with acquiring material things for their pleasure. But
from the economic point of view, someone enjoying a sym-
phony or taking a year off of work to meditate in a monastery
is no more or less a consumer than someone shopping at
That does not mean that economics considers a religious
retreat to be no better than a shopping spree. As we™ve seen,
economics does not attempt to intrude into the ethical sphere
of value judgments. All we mean is that such activities play the
same part in the economic system”consumption. None of
them produce (as their goal, anyway) consumer goods, and
all of them require the use of such goods to achieve their
ends. Even the ascetic retreating to the forest requires his
bowl of rice and loin cloth.
The first three functions we examined”the entrepreneurs,
the capitalists/landowners, and the workers”make up the
productive forces of the economy. The goal of all production
is ultimately consumption. It makes no sense to condemn
consumption while praising production. All production repre-
sents a demand for consumption, either now or in the future.
Insofar as any of the producers wish to maximize their
return, they must ultimately fulfill the desires of the con-
sumers. Aside from fraud, theft, and the granting of special
favors by the government, there are no other means to wealth
than to produce some good or service. The production of a

good or service yields a return because someone wants to
consume it, or because it can be used to produce another
good that someone wants to consume. (In fact, an artifact that
ultimately cannot be used to produce a valued consumer
good is not a good at all, and the manufacture of it was not
production in the economic sense.)
We have seen that, with the exception of those completely
dependent on others for their sustenance, all people are both
producers and consumers. That casts a curious light on gov-
ernment efforts to aid consumers”for instance, price ceilings
and mandatory safety features”and similar efforts to aid pro-
ducers”for instance, production subsidies and tariffs. Any
measure that favors consumers at the expense of producers
helps a person in his role as a consumer and hurts him in his
role as a producer. The reverse is true of measures to help
producers. People advocating such measures are, to borrow a
phrase from P.J. O™Rourke, having a leg-wrestling contest with

Make a New Plan, Stan


T an astounding variety of definitions of cap-
ital advanced in the history of economics. Capital has


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