Capital Is in the Eye of the Beholder

Mr. Summers is a member of the staff of the Foundation for Economic Education.

When I was a boy my older brother’s slide rule was a marvelous toy. When I went to college that slide rule became a useful tool. Today, with the advent of pocket calculators, I view that very same slide rule as a relic.

Clearly, the slide rule has remained the same; it is I who have changed. When I thought of the slide rule as a toy, it was a toy. When I thought of it as a tool, it was a tool. Now that I think of it as a relic, it is a relic. At least, to me it is.

My estimate of the slide rule’s value has also changed. When I was preparing to go to college, its value to me increased. As my college days were coming to a close, and I saw little further use for the slide rule, the value I placed on it declined.

Why this variation in the slide rule’s value to me? Obviously, the slide rule didn’t change. Neither did the price paid for it nor the work that went into producing it. The only thing that changed was my evaluation of the slide rule’s future usefulness to me. The slide rule’s future usefulness is what determined its value to me.

What is true for a slide rule is true for any material object—its usefulness, and hence its value, is in the eye of the beholder. In particular, an object is a tool—a capital good—only to someone who perceives it as a tool. The value an individual places on a capital good is determined by his estimate of its future usefulness to him.

This simple observation—capital is in the eye of the beholder—has profound consequences because it helps one choose between free enterprise, in which capital goods are controlled by individuals, and socialism, in which capital goods are controlled by the government.

In a free enterprise economy, businessmen seek profits. Thus, an object is a useful capital good only to those businessmen who believe it can help them earn profits. This is true for large corporations as well as small businesses. The division manager of a large corporation has a single mandate: Earn profits. His job depends on how well he fulfills this mandate from the corporation’s stockholders. Hence, he evaluates factors of production—land, labor, and capital goods—according to his estimate of their future usefulness in earning profits.

But what is the nature of profits? Are they something plundered from consumers? Or are they the rewards of efficient production?

A businessman’s profits or losses are the difference between his costs of production and the selling price of his products. Let us look at each in turn.

When a businessman is planning a project, he hopes to keep his production costs at a minimum by making efficient use of his factors of production. This involves much foresight and careful prior arrangement. When the businessman implements his plan and engages land, buildings, machines, and labor, he tallies up his production costs as the bills come in. By the time his product is finished, the production costs are already paid or contracted to be paid. They are "water under the bridge.’

When the businessman tries to sell his product, he hopes that the price will be high—at least as high as his costs of production. But there isn’t much the businessman can do about the price except try to live with it. He would like to sell for more, but he would lose customers to his competitors, leaving some of his products unsold. There is little he can do at this stage of his operation except advertise his wares and hope that consumers will buy.

Thus, a businessman has little influence over his profits or losses once he has committed his resources to a course of production. If his production process is efficient, he will keep his production costs low and, hopefully, earn a profit when the time comes for him to sell his wares.

In the final analysis, it is foresight and planning that earn profits. For hundreds of years people were aware of the existence of crude oil, but saw limited applications. It was only when men of vision perceived new uses for oil and carefully planned its extraction and refinement that the public enjoyed those uses, and the most efficient oil companies earned profits.

What about socialism?

Under socialism, capital is still in the eye of the beholder. The manager of a nationalized enterprise still evaluates a capital good according to its future usefulness to him. But, usefulness for what’? In free enterprise a capital good is useful because it helps earn profits by making production more efficient. However, a nationalized industry is a monopoly. There is little incentive to cut costs of production because the nationalized industry can pay its bills simply by raising its prices (there are no competitors to whom consumers can turn) or obtaining a subsidy from the government. Witness the Post Office.

Moreover, under complete socialism, in which the government controls all factors of production, costs of production lose all meaning. In free enterprise, the prices of factors of production are determined by the bids of competing businessmen who hope to use these factors to make products that consumers will reward with selling prices that exceed costs of production. If the businessman bids correctly, customers reward him with profits; if he bids incorrectly—wastes scarce resources—he loses money. Hence, in free enterprise the prices of factors of production are ultimately determined by the buying public, with businessmen acting as intermediaries. But under socialism there is no competitive bidding for factors of production so prices must be set arbitrarily by the government.

How then does the manager of a nationalized enterprise evaluate the usefulness of a capital good? He evaluates it according to its usefulness in helping him carry out production orders issued by his superiors. For instance, in the Soviet Union , when the manager of a nail factory was ordered to produce a certain number of nails, he made small nails. When he was told to produce nails by the ton, he made large nails. At no time did he consider consumers’ preferences for large or small nails because his job was not to earn profits. His job was to fill production quotas.

To summarize, in free enterprise capital is used by businessmen to earn profits by efficiently producing goods and services of use to consumers. If a businessman is not efficient, the selling price of his product probably will not cover its cost of production. In contrast, in a nationalized industry capital is used by production managers to carry out orders from their bureaucratic superiors. Whether or not this makes for efficient production is largely incidental because the difference can always be made up at the Federal Treasury or with a higher monopoly price. Finally, under complete socialism it becomes impossible to measure efficiency because, with the market in chains, the government must arbitrarily decide what to produce, how much to produce, as well as guess the costs of production. Instead of responding to the ever-changing evaluations of consumers, production is set according to the eye of the official in power.