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Leonard Read’s classic essay, “I, Pencil,” is justly celebrated as the best short introduction to the division of labor and undesigned order ever written. But it holds another, largely overlooked lesson as well: “I, Pencil” is an excellent primer in the Austrian approach to capital theory.

Read’s pencil describes its family tree, beginning with the cedars grown in northern California and Oregon that provide the wooden slats. But he doesn’t really start with the trees. He notes that turning trees into pencils requires “saws and trucks and rope and the countless other gear used in harvesting and carting the cedar logs to the railroad siding,” and those things have to be produced before a pencil can be produced.

This is what Austrian economists call a structure of production. This structure is characterized by two closely related elements: multiple stages (distinguished by their “distance” from the consumer) and time. The pencil that eventually emerges at the end of the process must first proceed, in various states of incompleteness, through a series of stations at which components are transformed in ways consistent with making pencils. The stations themselves have to be prepared through earlier stages of production. Thus before trees can be cut down and turned into wooden slats, saws, trucks, rope, railroad cars, and other things must be produced first. Before steel can be used to make saws, trucks, and railroad cars, iron ore must be mined and processed. And so on. The same kind of description can be provided for each component of the pencil: the paint, the graphite, the compound that comprises the eraser, the brass ferrule that holds it.

Tracing the pencil’s genealogy back—to iron, zinc, copper, and graphite mines; hemp plants; rubber trees; castor beans; and much more—demonstrates the “roundaboutness” of production, the term of the early Austrian economist Eugen von Böhm-Bawerk. Much time and effort are spent not on making pencils but rather things that will—sooner or later—help to make pencils. Without central direction, entrepreneurs set up production this way because it produces more, better, and cheaper pencils more profitably than some more direct process.

Prices—particularly interest rates—coordinate all this production through time. A quantity of a resource cannot be used both at an early stage of production and a later stage simultaneously. A unit of iron could be devoted to making a ferrule machine or a machine for mining more iron—or many other things in between. Tradeoff is the rule, and consumer welfare depends on having things arranged appropriately. Time preference and the market for loanable funds—that is, interest rates—govern coordination to maximize consumer satisfaction.

Capital equipment wears out. Replacing machines, engines, vehicles, saw blades, and ropes requires money, which requires saving—that is, deferred consumption. Saving is also necessary to finance research and development so that better and cheaper machines, tools, and writing implements might be created. Remember this when Keynesian politicians and economists deride saving.

The stages of the capital structure consist in discrete, specific, scarce, and complementary things—buildings, machines, tools, materials—in particular places at particular times, all of which derive their value from the final goods they help produce. They were put in place as part of entrepreneurs’ plans, and in keeping with Austrian subjectivism, the plans give them meaning. A change in a plan might convert equipment that was once complementary to an operation into something of little or no value.

This description of the structure of production should raise no eyebrows. We see it all around. But anyone who has taken a standard economics course will know that capital is usually discussed as though it were a lump of colorless, timeless Play Doh. That conception of capital is amenable to mathematics, but that’s a case of the tail wagging the dog. Economics should be a way of thinking about the world we actually confront.

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When people are nervous about the banking system, the time may not be propitious to ask if we’d be better off without government deposit insurance. But that doesn’t keep Jeffrey Miron from asking—and answering—the question. (read it now)

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Our columnists have burning issues on their minds. Lawrence Reed wants to know what we owe each other. Thomas Szasz tells the tragic story of scientific genius Alan Turning. Robert Higgs discusses World War II price controls. John Stossel says protectionism made the so-called stimulus bill even worse. Charles Baird documents union abuse of workers who don’t want representation. And Chidem Kurdas, confronting those who say the Bernard Madoff Ponzi scheme justifies more government regulation, replies, “It Just Ain’t So!”

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Sheldon Richman
srichman@fee.org
Sheldon Richman

Sheldon Richman is the former editor of The Freeman and TheFreemanOnline.org, and a contributor to The Concise Encyclopedia of Economics. He is the author of Separating School and State: How to Liberate America's Families.