Let’s not forget: http://mises.org/rothbard/mes/chap5b.asp#9._Pricing_Theory_Bargaining
The whole paradox of ‘the back and front wheel of the bike’ can be helped by combaining this with the DMVP analysis. Never forget this. 
You can only discover factor prices if they are non-specific or the only specific factor. You’re implicitly assuming that both the cycle - 1 wheel and the wheel are specific factors.
See Rothbard here:
That makes much better sense. Thanks Stephen!
And that gives even more reason to stop using the term ‘Marginal Value Product’ to denote the value contribution of a particular factor to a product. What I can see is, the pricing of various factors that go into making a product is determined by the relative scarcity that exists between the various factors involved in making the product, not based on any vague stuff like MVP.
It’s ultimately based on the contribution it makes to a final consumer good valued by consumers. I think DMVP is perfect. Most factors in the real world are non-specific.
Yes, but not on the marginal value that it makes. It’s only based on the relative scarcity that exists in the supply of various factors that make the final product. If the supply of labor is scarce compared with that of capital, laborers will attain a much larger share of the returns. The vice versa would be true when capital is scarce compared to the supply of labor. But in this case, competition between capital owners will start to diminish the share on returns of capital. Finally it’s only the primary factors, land and labor, that earn their discounted values.
Prashanth, I believe your process analysis is a bit off. You have to consider each valuation one at a time.
I have a bike. Let’s say the wheels of the bike are only useful to ME as components of the bike. The bike is appraised at $200. I am offered the chance to sell the bike’s front wheel. If I did so, I would forego the chance to exchange the bike for $200. So I would not accept any less than $200 for it. I then have a one-wheeled bicycle. THEN, I am offered the chance to sell the bike’s back wheel. If I did so, I would forego the chance to exchange the bike for… $0, because I can’t sell a one-wheel bike anyway. So, assuming away transaction costs, I might sell the wheel for any amount of money, even if it’s less than $200. The marginal value product of the back wheel without the front wheel is $0.
Liburne, I don’t think you actually get what I mean.
Take a bicycle valued at $200. Speaking simply, the sum of the value of individual parts of the bicycle would not be more than $200. You can see why: because these components derive their value from the cycle’s utility. So there is no way for the sum of the value of the individual components of the bicycle to be greater than $200(the value of the entire bicycle).
But the problem with marginal productivity theory is that, when you add the marginal productivity of each component of the bicycle the total sum surpasses the value of the entire bicycle.
If your wanna counter my case, and you tell me that the bicycle minus front wheel is valued at zero and hence the total sum of the marginal productivity of each component of the bicycle now does not surpass the value of the entire bicycle(that is $200), then my question would be: why then would other components of the bicycle be paid anything at all? The front wheel would be the only component which gets any pay.
My solution is clear: factors of production are not paid based on their marginal productivity. The share of the total returns of each factor of production depends on the relative scarcity that exists in the supply of these various factors. The scarcer factor gets greater part of the returns.
Which only proves the folly of adding up the potential MVPs of all the components. It does not prove that “factors of production are not paid based on their marginal productivity.”
- A. (Given) What would the bike owner get for his bike? $200.
- B. What would the bike owner give up were he without any given collection of essential bike components? (In other words, what is the marginal value product of any given collection of essential bike components?) $200.
- C. What would the bike owner accept for any given collection of essential bike components? No less than $200, otherwise the exchange would not be beneficial.
C is true because of B. B is true because of A. Therefore the minimum price IS determined by the bike’s marginal value product.
Tell me, which letter is not apodictically implied by the previous letter and why?
If a purely logical derivation doesn’t fit some contrived test, then it is the test that is faulty.
The MVP sets the minimum selling price, not necessarily the actual price. The back wheel, without the front wheel, does not have any MVP as a factor of production for the bike. But that has no bearing on its usefulness to the buyer.
Of course greater scarcity will increase the price of any given factor. But scarcity is no original source of value, or else Lou Gehrig’s disease would be in hot demand. Things are valued because they are directly useful, they can be used toward the production of something directly useful, or they can be used in a chain of exchanges, the last of which is for something directly useful. You seem to be trying to take the “utility” out of the subjective marginal utility theory of value.
There is nothing foolish about it. If the idea is that the price of a factor in real is set or tends towards it’s marginal productivity, it provides even more reason to add up marginal values. The fact simply is, factors aren’t priced on their marginal value.
We’re talking of the pricing of each single factor that goes into making the bicycle.
It actually has to according to theory, as the real economy is always in a drive to move towards an evenly rotating economy.
I didn’t say anything like that. I was only telling about the relative scarcity that exists between the various factors.
That’s the whole point. Perhaps I find the idea that marginal prodcutivity of a factor determines it’s price to be quite weird because of this fact.
Prashanth you’re trying to graft a material, cardinal notion of measurement onto a psychic, ordinal phenomenon. There is simply nothing damning for MVP as a determinant of value in the fact that you can’t add up factor MVPs to get the value of the good which the factors produce. You’ve made up an arbitrary rule that they must do so, but have offered no logical deduction as to why that is the case. Just because there are numbers which can be added doesn’t mean adding them tells you anything meaningful.
In fact, there isn’t even a single coherent meaning of “sum of factor MVP’s”. Let’s say there’s a man with a well. He could sell the water in the well for $200. But he only has only one rope to lower and raise a pale to get the water. The rope is therefore a necessary factor of production for the water. And therefore its MVP is $200. Also, the 20 foot rope is just BARELY enough to reach the water. Giving up ANY length of rope would completely prevent him from getting ANY of the water. A neighbor comes by and offers to buy 10 feet of rope (half the length). The well-owner, as an acting man, considers 10 feet of rope as a factor of production for water. What is the MVP of this factor? Giving up either half of his rope means giving up $200. So the MVP for each half would be $200. So then the “sum of MVPs” you’re so concerned about is $400. But then another neighbor comes over and offers to buy 5 feet of rope. Giving up even a quarter of his rope (a factor of production) would STILL mean giving up $200. So the MVP for each 5-foot length of rope would be $200. In light of that, the “sum of MVPs” would be $800 ($200 for each of the four 5-foot lengths). Well which is it? What is the “sum of MVPs” for the 20 foot length of rope? $400 or $800? And if a third neighbor offered to buy 1 inch of rope, would the “sum of MVPs” be $48,000 ($200 for each of the 240 inches of rope)?!
It should be obvious from this example that “sum of MVPs” is a meaningless concept and certainly does not imply a need to divorce factors of production from Austrian marginal utility-based value theory.
You are almost there. But then I don’t understand how you still could maintain that factors are priced based on their marginal value(MVP). Economic theory says that factors are priced based on their MVP(or discounted MVP). You’ve clearly pointed out the problem with the theory(the same which I pointed out with the bicycle and nuts and bolts in the aircraft engine example), but you still maintain that MVP is what determines the price of a factor. I find it quite hard to digest that you point out the flaw in the MVP theory of determination of factor prices and in the very same post you actually say MVP is what determines factor prices.
Warning; what follows is a personal musing and a call to discussion, it is not a settled or final opinion, but one offered in admittedly relative ignorance
the ERE is tricky to use, for example, in the ERE there is no money
(in the previous paragraph to this Rothbard proves that in an ERE, supposing there would be money then there would not be money, im confused why he qualifies ‘nearly so’, which strikes me as wrong)
so, what justifies saying that anything would cost any amount of dollars in an ERE? perhaps nothing could justify it; since there are no units of money (gold dollars or silver coin or whatever used for the purpose of money) and no things priced in money in the ERE. there are units of gold in the ERE, but they are not money, they are just goods like any others
if we do ERE analysis and say that assuming the market price for a bicycle is $200 (plus all our other asumptions) , what are the market prices of the factors?.. are we even justified to ask the question given the (non)-role of money in the ERE.?
the ERE is an economy thats not an economy. I find it difficult to use. i’m sure it must be used with great care.
I’m not the sharpest crayon in the box but it seems to me that MVP originates in consumer preference and works it’s way back through production.
We see this happen all the time in the tractor and equipment industry.
Certain models or designs become outdated or too expensive from the perspective of the end-user. This often results in over-valued equipment inventory wthich must be liquidated. If the technology is still viable then a less expensive means of production must occur in order for those models to be moved in the future.
The old (slow-cutting) sickle-type hay mower is nearly outdated by new (faster-cutting) rotary-type hay cutters because the costs of production are much closer than they used to be.
eg. When a sicklebar mower was $4000.00 and a disc mower was $6000.00 a hay-cutter could opt to spend $2000.00 less on equipment and sacrifice a little more time in the field.
Later, when factors of productions indicated that a sicklebar mower had to sell for $7000.00 to be profitable (for the retailer) and the faster-cutting disc mower was $8000.00 well, then the old hay cutter decided that for only $1000.00 more he could spend less time in the field and that would be worth it to him.
Ultimately, the old sicklebar mower retail market is religated to cutting ditch banks and new ones are rarely every ordered or offered for sale.
What HAS occurred is that a much more cheaply made version of sicklebar mowers arose in the production process to meet the lower price preference of part-time ditch bank mowers and the hay cutters ‘all’ buy disc cutting technology.
Hope I didn’t screw up thewhole idea of this topic…
Because of the following deduction…
By showing that it is meaningless to add up MVPs, I’m not pointing out a flaw in the MVP theory of the determination of factor prices, because that theory doesn’t say anything about adding MVPs. Rather, I’m pointing out the flaw in YOUR theory that adding MVPs is a meaningful test for the validity of MVP/factor price theory.
Don’t use the ERE use equilibrium theory realistically based. See Hulsmann’s article here.
There is some confusion here as to whether MVP refers to individual monetary valuation of a good, or the market monetary valuation of a good. When one uses the evenly rotating economy construction to the justify the statement, “factors are paid their discounted marginal value product”, I am pretty sure one has in mind market monetary valuation, not individual valuation. If the statement were to refer to individual valuation, it would be utter nonsense, as the sine qua non of exchange is that there is a divergence of individual valuation, and in that case “marginal value product” could not be a definite magnitude.
If one has in mind an evenly rotating economy, however, the market’s (as an aside, when I say “the market”, I mean the market process) valuation of various goods (i.e. the money prices that those various goods command) is, once a plain state of rest has been established, definite (we now have “given” prices to work with). Now, if we assume that there is market for “incomplete bicycles” in this economy, then bicycles of various degrees of completion will command various market prices. Presumably, we could then compare the price of a bicycle without a front wheel to that of a complete bicycle (i am assuming for simplicity that there is only one type of bicycle).
Now, note that in the evenly rotating economy, a single rate of profit prevails (which corresponds to the rate of originary interest, or the intertemporal price of goods, See Chapter 14 of Human Action): let’s call this rate of profit “r” (Incidentally, this rate of profit is an accounting profit, not a pure economic profit, since in a plain state of rest, by definition all opportunities for entrepeneurial profit have been reaped). A bicycle seller, then, must by definition earn a profit of “r” if he of she purchases a bicycle missing a front wheel (let’s say its price is pib), a front wheel (price = pfw), and labour services to attach the front wheel to the bicycle (price = w), and then sells the completed bike (for price pb). With this is mind, the price of a front wheel will be (actually it will have to be due to the very nature of our hypothetical construction) equal its discounted marginal value product. Algebraically,
r = pb -pib -pfw - w
-Solve for pfw:
pfw = (pb- pib - w)/r
Note what the above expression tells us. pb- pib - w is an expression that simply nets away the “value added” due to labour and the other complementary capital good, the incomplete bike, leaving one with the “marginal value product” of the front wheel. This marginal value product is then discounted since the final price of the bicycle includes a profit component (which is due to time preference), that must be accounted for.
The reason that the expression “factors are paid their discounted marginal value product” is true in an evenly rotating economy, is simply because it is assumed that there is a *single level of accounting profit that prevails in the economy (*which is equal to the rate of originary interest), which means that there can be no entrepeneurial profit (profits greater than the “given” rate of profit"), and as such, the sum of all the factor prices multiplied by the respective quantity of those factors that go into the production of a good, must be equal to the price of that good multipled by the given level of profit.
Now, if we move out of this hypothetical construction and back into the real world, there will basicallyalways be opportunities to reap entrepeneurial profits at given price levels, and thus the statement that “factors are paid their discounted marginal value product” cannot hold true. Entrepeneurial profits are reaped by taking advantage of the fact that the discounted marginal value products of various factors are less then the price for which the fruits of their labour can be sold for in the future. However, entrepeneurial competition has a tendency to push prices towards the the state they would be if we were in an evenly rotating economy.
Oh come on, it is a valid test. When a theory says that the price of a factor is equal to it’s MVP, then the sum of the MVP(which equals price of the product according to theory) of all the factors that goes into making the whole product must equal the total value of the product.
Yeast and Flour(ignore factors, like labor, entrepreneurial risks etc.) is combined to make Bread worth $20. According to the MVP theory, the price that yeast and flour command would be equal to their MVP. So it must be: MVP of Yeast + MVP of Flour = Price of Bread.
And you’ve already accepted that adding MVPs of the factors would give us a value that’s huge, and surpasses the real price of the whole product. So it automatically goes against the MVP theory of pricing of factors. Saying MVP is what determines the pricing of a factor is just preposterous. If bread is worth $20, how this $20 gets diverted towards various factors depends on the bargaining power each factor holds, which is purely based on the relative scarcity that exists in the supply of these factors.
PS: Just to clarify a bit, MVP of a factor refers to the monetary value that the factor adds to the value of the final whole product.
Oops. Mises defines originary interest in Chapter 19 of Human Action, not 14. My bad. Chapter 14 defines the evenly rotating economy though, which should also be of interest (ha!) to the current discussion.
- Have any Austrian economists said as much?
- Why does it logically follow?
You’re assuming that MVP is like weight, volume, or some other physical phenomenon.
Only according to your misconstruction of the theory it would.
No, I’m saying that there is no single, coherent way of adding factor MVPs in the first place. I’m saying the very notion of “sum of factor MVPs” is fallacious.
Pranash, in my rope/well example (quoted below for your convenience), let’s say it’s completely uncertain what lengths of the well-owner’s rope customers want to buy. We don’t know if people want to buy 10 feet, 9 feet, 2 feet, 1 inch, 20 centimeters… we have no idea, and neither does the well-owner. Now the market for a factor has NO bearing on it’s marginal value product. The ONLY thing that matters for the MVP is the additional revenue its produced good (water) garners. Please, you tell me, what is the “SUM of factor MVPs” for the length of rope? PLEASE try to answer this question, because it really gets to the crux of the matter.
I know that. Do you think I would enter this discussion without knowing that?