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Friday, January 16, 2009

“I, Pencil” Revisited

Leonard Read’s classic essay, “I, Pencil,” which is now 50 years old, is justly celebrated as the best short introduction to the division of labor and undesigned order ever written. Read saw an “extraordinary miracle … [in the] the configuration of creative human energies—millions of tiny know-hows configurating naturally and spontaneously in response to human necessity and desire and in the absence of any human master-minding!

His subject and its relation to freedom and prosperity were certainly worth capturing in such a clever, pleasing, and illuminating essay, which is why it is one of the best-known works in the popular free-market literature.

But there’s another lesson in “I, Pencil” that has been largely overlooked, perhaps by Read himself. “I, Pencil” is also an excellent primer in the Austrian approach to capital theory. It’s worth looking at Read’s essay in that light.

Early on, Read’s pencil describes his 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. “Think of all the persons and the numberless skills that went into their fabrication: the mining of ore, the making of steel and its refinement into saws, axes, motors; the growing of hemp and bringing it through all the stages to heavy and strong rope; the logging camps with their beds and mess halls, the cookery and the raising of all the foods. Why, untold thousands of persons had a hand in every cup of coffee the loggers drink!”

What emerges here 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 the eraser.

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 more, better, and cheaper pencils can be made more profitably than by some more direct process.

Price Communication

Several things are worth pointing out about the structure of production. First, while no central planner is responsible for pencil production overall, entrepreneurs and workers at each stage do have plans and expectations, which they strive to coordinate with one another across stages and time periods. The key to coordination is the price system. If there’s a brass shortage, rising prices will communicate that information to the ferrule and pencil makers. The downstream entrepreneurs will have to adjust their plans in response to the new conditions–say, by finding a substitute material. The demand for a substitute material will in turn set appropriate processes in motion as entrepreneurs react. In the real world of disequilibrium, change is the rule, so plans are always undergoing revision.

Moreover, 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 ferrule machines or it could be used to make 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 across time and maximize consumer satisfaction. It all works marvelously well when government stays out of the way, but alas there are many opportunities for mischief by the central bank and the Treasury. For example, artificially depressing interest rates can shift resources from later to earlier stages in defiance of consumer preferences and resource scarcity.

Second, capital equipment wears out. Machines, engines, vehicles, saw blades, ropes and the rest need to be replaced. That 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, materials, and writing implements might be created. Remember this when Keynesian politicians and economists who aspire to stimulate the economy deride saving as inimical to economic growth and increased consumption. Such derision invariably ignores the need for capital at stages of production remote from the final consumer level. That’s what inappropriate aggregation gets you.

Third, the stages of the capital structure consist in discrete, specific, scarce, and complementary things–buildings, machines, tools, materials, and more–in particular places at particular times. They were put in place, as part of an entrepreneur’s plan, to work together with labor to produce other specific things. In keeping with Austrian subjectivism, the plan gives meaning to the capital goods. A change in plan, for example, might convert equipment that was once complementary to the rest of the equipment into something of little or no value (besides scrap).

Menger and Value

This leads to the final point. Carl Menger, founder of the Austrian school, taught that capital goods get their value ultimately from the final consumer goods they help to produce. If there were a machine that could only make pencils and if people stopped wanting pencils, the value of the machine would drop to its scrap value. Capital goods are not a lump of Play-Doh. They are specific things, which means they cannot be adapted to any use whatever. Even when they can be adapted, the conversion will likely not be costless and certainly not instantaneous. Moreover the goods are in particular places. Equipment in the wrong place is not as valuable as equipment in the right place.

These facts have implications for booms and busts, which are much on people’s minds today. If government policy (monetary or other) artificially induces investment in unsustainable projects that are out of alignment with true consumer preferences, the realignment that will have to be undertaken later can be neither instantaneous nor costless. Equipment that was suitable for the now-liquidated projects may not work as well–or at all–in other endeavors. Much “investment” will be seen now as waste, and time and money will have to be spent putting things right. That’s the recession.

This description of the structure of production should raise no eyebrows. We see such things 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 malleable and homogenous Play-Doh (“K”). If you assume this about capital and think in terms of aggregates and averages, you may underrate the need for the market process, which has no rival in its ability to coordinate the plans of strangers in order to raise living standards. The Play-Doh conception of capital may fit in mathematical equations, but that’s a case of the tail wagging the dog. Economics should be a way of thinking about the world we actually confront.

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