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decisions performed under the guiding pressure of market forces. And we
shall find that the more detailed analysis of production for the market covers
the activities of the autarkic producer as well.

It is possible to imagine a society where all production would be carried
on without a market. Such would be a society of self-sufficient farmers each
growing his own food, making his own clothes, and providing for all his
other wants to the best of his own unaided ability. Resources would be
neither bought nor sold; each autarkic producer would use only his own
resources. Products would be neither bought nor sold; each household
would enjoy only the fruits of its own productive efforts. For the purposes
of economic analysis, such a society would be simply a congregation of
isolated islanders.
Our analysis of demand has already shown that a society without ex-
change is extremely unlikely. The discrepancies between the scales of
value of the different householders are likely to generate situations where
exchange of consumer goods between numerous pairs of householders are
mutually profitable. Where the individuals are engaged in production,
the scope for such profitable exchanges becomes greatly widened. This
occurs because the resources at the command of different individuals are
likely to be different. In the first place, this will generate exchange of
resources to some extent; and in the second place (especially where pro-
nounced differences in resources cannot be diminished through direct ex-
change”for example, special labor skills), this will generate a continual
recurrence of situations where the products of different individuals, each
produced with resources relatively unavailable to the other producers, can
be profitably exchanged against one another.
This fosters the further development of the phenomenon of division
of labor”a social process that takes advantage of the intransferable special
resources at the disposal of individual members of society and forges out
of them the social organization of production through exchanges in the
market place. It is unnecessary to expand here on the advantages of divi-
sion of labor.1 It is sufficient to notice that the process of division of labor
feeds on itself, continually making possible further gains for individuals
by progressvely wider and more intricate division of labor. The economic
history of modern society consists chiefly in such a progressive widening of
the range of specialization and exchange.
Production in a society based on division of labor, specialization, and
exchange, is carried on with almost complete responsiveness to the pressure
of market forces. Individuals produce primarily for sale on the market;
they produce largely with resources bought in the market. The production
decisions are thus made on the basis of alternatives and opportunities rigidly
l The classic statement of the advantages of division of labor is Smith, Adam, The
Wealth of Nations, Bk. 1, Ch. 1; see also Miscs, L.v., Human Action, Yale University
Press, New Haven, Connecticut, 1949, pp. 157-164.

determined by market prices, in addition to the framework of purely physi-
cal laws production is carried on within. This chapter is principally con-
cerned with production as it is carried on within the market economy, to
which we now turn.

Production decisions in a market economy are made by entrepreneurs.
Entrepreneurs take the initiative in undertaking productive activity in con-
junction with the market, buying and combining the productive resources
to obtain the product, and selling the product on the market. The essen-
tial element in the entrepreneurial role is, for the economist, that the
entrepreneur undertakes ventures whose outcome is uncertain. This specu-
lative element is present, to be sure, in all human action, since action being
necessarily involved in the flow of time is always directed at some moment
in the future”and hence is always undertaken in the face of uncertainty.
Nevertheless, in economic analysis we distinguish, in every act of buying or
selling, between this "entrepreneurial" element on the one hand, and the
act of buying or selling seen as if it could be carried on with uncertainty
absent. In production within the framework of a market society, the de-
cisions to produce are essentially entrepreneurial. All the resources re-
quired for the emergence of the product can be bought in the market; the
entrepreneur in actually buying them”and thus allowing the product to
emerge”has made his decisions to pay prices for the resources completely
on the basis of his appraisal of the future value of the product to him in
the market. In this sense decisions to produce are purely speculative: they
involve the present purchase of resources (that is, the purchase of the
"product" in the form necessary to physically produce it) in the hope of
being able to resell them (that is, to sell the "resources" in the form of the
finished product) at a higher price in the future.
The direct motive for production in the market economy is thus the
profit motive in its simplest sense. Under the impulse of this motive the
entrepreneur makes his choices among the alternatives the market offers
to him. The range of these alternatives depends on the extent of the
market and on the degree of specialization already attained. In a highly
developed market economy an entrepreneur must choose from innumerable
possibilities; he can choose to produce any of innumerable kinds of goods
and services”the necessary resources can be obtained somewhere at a price;
and he can choose to produce any one particular good by any one of the
possibly numerous methods technologically conceivable for the purpose.
Very few of these alternatives, however, promise to be profitable. An
entrepreneur might produce air in a laboratory”but this product would
fetch nothing in the market. He might produce shoes by hiring labor to

make them by hand and be able to sell them for a price,”but would prob-
ably be unable to recoup his costs. To win profits the entrepreneur must
seek to produce a good, the resources for whose production can be bought
for a sum less than the sum likely to be obtainable from the product's sale.
The entrepreneur scans the available alternatives in order to seek those
offering the greatest difference between these two sums.
Specifically, the entrepreneur must decide (a) what good to produce;
(b) what quantity, per unit of time, to produce of this product; and (c) what
method of production to employ. Included in these basic decisions, of
course, are decisions where to buy resources, where to sell the product, what
quality of resources to use, and so on. The market presents the possibilities;
quantities of given resources can be bought for given prices and quantities
of given product can be expected to be sold for given prices. Technical
facts determine the quantities of product obtainable from given resource
combinations. The entrepreneur, at any given moment, seeks the one
opportunity he believes to be most profitable.
Once an entrepreneur has embarked upon a productive venture, he
frequently finds that his choices as to production in later periods of time
are to a considerable extent decisively influenced by his past activities. A
man who has been a shoe producer for some years may have gained so
thorough a knowledge of this line that continuation in it seems for this
reason alone the most profitable available productive enterprise. A man
may have in the past purchased equipment for the production of a certain
commodity, and the continued availability to him of this equipment makes
the production of this commodity the most profitable available undertaking
in subsequent periods. This frequently tends to make individual entre-
preneurs identify themselves with the production of definite commodities or
services. Thus, the decision an entrepreneur must make as to what to pro-
duce frequently does not have to be explicitly made at all; it is only at fairly
wide intervals that this question demands even casual attention.
This is the reason why a good deal of the analysis of production in the
market economy centers around the theory of the firm. The firm is an
entrepreneurial unit committed to some degree to the production of a
specific output. The theory of the firm involves principally its decisions
as to the level of its output and the particular resource combination to em-
ploy. It must never be forgotten, however, that entrepreneurs are as com-
pletely under the discipline of the market with respect to the product that
they produce as with all aspects of their productive activities. Entrepre-
neurs constantly experiment with new products, diversify their output, close
down plants, and switch to other products under the pressure of market
prices. The decision of a firm to continue with an established line of prod-
ucts means that this line promises greater profits than other lines of product.
It is of the essence of the market process that the pattern of production

changes in response to changes in the basic data, namely, the resources availa-
ble to the economy and the wishes of the consumer. Both kinds of change
will exert a decisive influence on the type of product that an entrepreneur
will be producing at different periods of time.

In order to produce products the entrepreneur must buy resources.
Resources sufficient for the production of a given product are known as the
factors of production. A factor of production (also termed an input) may
be a commodity, such as a raw material; or a service, such as a type of skilled
or unskilled labor; or a piece of information, such as the knowledge of a
technical formula. It is obvious that there are innumerable such factors,
different kinds of raw materials, different kinds of tools and equipment,
different kinds of labor services, and so on. At one time economists con-
sidered it expedient to group factors into three broad classes: land, labor,
and capital. Capital was the produced "factor," the class of resources that
had been produced, in turn, through the combination of other resources.
Land and labor were the "original" factors, "labor" including all services
provided directly by human beings and "land" covering all other nature-
given objects and services that could be used for production.
This classification was adopted on the belief that different economic
laws governed the returns earned in the market by each of these classes.
This belief is no longer held by modern economists so that this classifica-
tion, while it provides a grouping useful enough for a number of purposes,
is no longer considered as expressing a distinction of any fundamental eco-
nomic significance. The laws governing the prices of productive factors
are common to them all.
Nevertheless, it is economically significant to distinguish some impor-
tant characteristics attached to some groups of factors that play a role in
the determination of the actions of producers, with respect to both these
and other factors. Such characteristics, for example, are the substitutability
and complementarity of factors. We have already met these categories in
the theory of demand. The fact that a productive process, unlike an act
of consumer choice, yields a measurable result makes it possible to formulate
the categories, in the case of productive factors, in a somewhat different
way. A given quantity of factor A is a substitute for a given quantity of a
factor B when, in a process of production that utilizes factor B, the outcome
expected of the process is unchanged with the replacement of the given
quantity of factor B by the given quantity of factor A. If the conditions
under which the quantities of the two factors could be obtained were com-
pletely similar, then an entrepreneur would have no reason to prefer the
one quantity of factor over the other. It may be immaterial, for example,

to the owner of a factory whether its walls are painted grey or green. Grey
and green paint are to this extent substitutes.
Perfect substitutability would mean that under all circumstances a
given quantity of factor B is a substitute for a given quantity of factor A.
No matter what the purpose is, no matter how much of factor A or factor
B is already being used, a replacement of the quantity of the one factor by
that of the other leaves the expected outcome unchanged. It is noticed
that if two goods or services were discovered to be perfect substitutes for
one another in production in this way, then we would consider them, from
the economic point of view, as constituting a single factor of production.
Economic goods, whether those of lowest order (consumer goods) or of
higher order (factors of production) are considered as units of the same good
not on the basis of physical homogeneity but on the basis of economic
homogeneity. Units of a physically homogeneous group are considered
the "same good" because there is no reason to prefer one unit over any other.
If there is no reason to prefer, for any purpose, a unit of one good over a
fixed number of units of a physically different good, then, economically
speaking, a unit of the first good, and the fixed number of units of the second
good, are both units of the same good, even though there may be physical
differences between them.
The concept of substitutability thus provides the basis for distinguish-
ing between factors. A single factor consists of all goods or services that are
perfect substitutes for one another. A factor A is not the same as a different
factor B, if the two are not perfect substitutes for one another. Thus, while
for some purposes grey and green paint are substitutes for one another,
nevertheless they are two distinct factors of production since there are
numerous purposes for which only the one or the other will do. Substi-
tution between different factors, we will discover, plays an important role in
the decisions made by the entrepreneur.
Complementarity in the case of factors of production is very similar to
complementarity in the case of consumer goods. Factor B is complementary
to factor A if a given increase in the employment of A (other things remain-
ing unchanged) yields an increment of output that is greater when a larger
quantity of factor B cooperates in the process than when a smaller quantity
of B is in use. Production invariably requires the cooperation of a num-
ber of factors. Raw material without labor can yield no product. Labor
without materials and equipment yields no product. Even a singer requires
a hall or a stage to produce his product. One factor by itself cannot pro-
duce. It requires the cooperation of complementary factors of production.
A given factor for the production of a certain product may require the co-
operation of a complementary factor which has no close substitutes. In
order to produce a typed letter a secretary can do nothing without a type-
writer. Or merely the cooperation is required of any one of a group of

factors that are to some extent substitutes for each other. In either case,
as we will see, the quantity of a factor an entrepreneur will buy depends
in part on the price and availability of the factors complementary to it. The
typical situation with a productive process is that a group of complementary
factors is required between which, however, a degree of substitutability
exists. This will be discussed later in this chapter.
Another category relating to factors that must be discussed is specific-
ity. A resource is a factor specific to the production of a certain product
when there is no other product it can be a factor for. The resource is
either employed in the production of one particular product, or it must
remain unemployed. A spare part designed to fit a machine of a particu-
lar make might be mentioned as a possible example of a specific factor; it
is likely to be useless for any other purpose. It is extremely difficult, how-
ever, to give a good example of a completely specific factor. Specificity must
be considered as the limiting case in a spectrum that ranks factors accord-
ing to their versatility. A factor that is non-specific is to some degree versa-
tile”it is useful for more than one productive purpose. Although it is
difficult to locate examples of perfectly specific factors, it is not at all a
difficult task to find factors with extremely low versatility. Such factors
are considered as specialized for the production of one or more products.
From the point of view of the entrepreneur, it is far more productive in
these productive processes than in any others. An intricate machine may
be "specialized" because its use as scrap is far less productive than the use
it was designed for.
The specific or specialized character of a factor plays an important
part in decisions concerning the disposition of resources in production.
In the case of the isolated individual as a producer, use of a factor in a
production process for which it is specific involves no opportunity cost.
The product that he obtains by the use of the factor in its particular use
is not offset by the loss of any product that he could have obtained by em-
ploying it in any other way. He will tend to use this factor rather than its
substitutes, wherever these substitutes have alternative uses. In a market
economy the entrepreneur of a firm in an industry where a factor is specific,
however, cannot expect to obtain the factor without cost. Although the
factor will not be sought by any other industry, nevertheless, other firms
in the same industry will be competing for it thus forcing up its price.
The factor specific to a certain industry will hardly be specific to a partic-
ular firm within the industry. From the point of view of the owner of
the resource, however, the price he receives for its allocation to any one
firm in the industry is greater than the minimum necessary to persuade
him to allow it to be used in the industry. This is so since he can obtain
nothing by selling it to a firm in any other industry. It follows that any-
thing causing the income to the owner of a specific factor to fall (for

example, a special tax on the income from this resource) will have no effect
(at any rate in the short run) on production.
Entrepreneurial decision making concerning the purchase of factors
will be influenced considerably by the institutional circumstances defining
the length of time the commitment is to be made for. A man buying a
machine makes a decision relevant not only to the immediate production
period but to periods in the future as well. On the other hand, when
a firm rents a machine (on a short-term lease), the decision to purchase
the machine's services may be reviewed at fairly frequent intervals. Labor
services are usually bought on a short-term basis, but if labor could be
bought only through long-term contracts (or if one could buy labor only
through buying a slave) then here too the decision would have overriding
influence on future production periods. When making a long-term factor
purchase of this kind, the entrepreneur, besides engaging in current pro-
duction, is investing resources for the sake of future production and profits.
While it is true that some element of investment is present in all produc-
tive activities, nevertheless, in a first analysis of production theory the
complications introduced by these investment components are often con-
veniently ignored. There is considerable justification for initially ab-
stracting from the existence of time differences between the purchase of
factors of production and the sale of the product. For most of the re-
mainder of this chapter we will consider production from the point of
view of this simplification We must of course not allow this simplification
to obscure the essentially speculative character of production. But it
will enable us to abstract provisionally from the complications introduced
by the once-for-all purchase of factors that will yield productive services
over a period of time. These are principally (a) the complication that
current decision making is powerfully influenced by past decisions on such
purchases, and (b) the complications introduced into an entrepreneur's
decision making for current production, by the fact that a part of the
price he pays for factors needed for such current production may only be
recouped by the production yielded by these factors in future periods of ;
time.- /

Much of what has been discussed thus far in this chapter can be sum-
marized and formalized with the aid of the concept of the production
function. In mathematics a function is the expression of the precise re-
lationship existing between a number of variables, where the value of one
of the variables depends on the value of the others. The production
-' In the Appendix on multi-period planning (see pp. 316 f®) some explicit attention is
paid to the time-consuming aspect of all production.

function formalizes the relationship between the quantity of output yielded
by a productive process, and the quantities of the various inputs used in
that process. Thus a single typed letter is produced by combining some
minutes of secretarial services, a sheet of paper, the use of a typewriter
for some minutes, and so on. Algebraically a production function may
be written x ” ’ (ait a2, a?>, . . . an). The equation reports that the quantity
x, of the product X, that is produced, depends on the quantities alf a2, a·¿
. . . an (of the inputs Ax, A2, Az . . . An, respectively) employed in the pro-
ductive process. The factors, for which the quantities are not zero, are
the complementary factors for the production of X. If the quantity of
any of the a's in the production function has a constant value, for a given
value of x, in all possible methods of production, then the factor con-
cerned has no substitutes. As a rule, however, it will be the case that
for a given quantity x, the a quantities are variables, denoting a degree
of substitutability between the ^4's.
For the analysis of production it is frequently convenient to visualize
the available alternatives with the aid of graphical methods. In this
regard the production function is of particular use. The limitations of
three-dimensional space make it necessary to limit the exposition to a pro-
duction function involving only two variable productive factors, but the
insights thus obtained can be intuitively extended to more complex proc-

Input of


In the diagram [Figure 8-1 (a)] the two horizontal axes refer respectively
to the quantities used (per unit of time) of two factors, Alf A2, and the verti-
cal axis refers to the quantity of output of the product X that is produced
by the factors (during the given time period). A point in the space (such
as the point C) relates a quantity of the factor A1 (such as the quantity

OD) and a quantity of the factor A2 (such as the quantity OE), with a quan-
tity (CN) of the product X. If the relationship associated with such a point
is technically feasible, then the point is said to be on the production surface.
The production surface (of which ODCE in the diagram is an arbitrarily cut
portion) represents the outputs possible with all conceivable combinations
of the two factors.3 The line KL is drawn on the production surface so that
all points on the line are the same vertical distance from the horizontal plane
passing through the origin. The line KL thus indicates all the different
ways of combining factors Alf A2, that will produce a given quantity of out-
put. Thus, for example, in the diagram the output LH can be produced
either by using the quantity OD of Ax together with the quantity OG of A2,
or by using the quantity OF of Ax together with OE of A2, or by using any of
the other combinations corresponding to points on the line KL.
The situation set forth in Figure 8-1 (a) can be conveniently further
analyzed by means of a number of separate two-dimensional diagrams.
Thus Figure 8-l(b) shows a projection of the production surface onto the
horizontal plane passing through the origin”a "map" of the surface. The
line KL appears here as a "contour line" on the production surface, repre-
senting points of equal "altitude." Such a line is termed an isoquant. For
any production surface there will be any number of such isoquants, one for
each possible output level. The coordinates of any point on this line
represent for the entrepreneur one of the alternative "packages" of inputs
that he may be able to buy in order to produce a given output.


H N Input of Az

Figure 8-2

In Figure 8-2 the diagram shows a vertical section of the production
surface parallel to the XA2 plane through the point C (or better, it can
be considered as the projection of this section onto the XA2 plane so that
O is at the origin). The curve thus represents the quantities of product
3 The notion of a surface presupposes continuity in the production function. This
implies divisibility of the inputs and outputs. Production theory, while simplified by
such assumptions, does not depend on them for the validity of its general theorems.

that can be obtained by employing alternative quantities of one factor, A2,
in combination with a fixed quantity (OD) of the other factor Ax. Thus
(always keeping this quantity of Ax unchanged), the employment of OH
of factor A2 yields HL of output, and the employment of the quantity ON

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