The previous post, Meaning of Capital and its Implications for Entrepreneurial Risks, described the risks entrepreneurs face when market-data (consumer desires, technology) changes and the impact it has on investment in capital goods.

The problem of convertibility of capital goods

Plans (production processes) are guided by goals (meeting consumer wants); when consumer goals change unexpectedly, in the course of production, the future viability of capital goods is brought into question. The capital goods, for it to be saved, must be converted into its next best alternative use. Convertibility is a function of the specificity of the item; the nearer the good is at the end of the production chain and as a result closer to the consumer, the harder it is to convert. Goods that are far removed from the consumer and form part of the early-stages of production processes are generally non-specific and easier to adapt to new goals; that is, convertibility is easy.

The higher the intensity of capital goods used in production processes the more the risks it carries. On the other hand, the simple hand-driven methods of production in use the lower are the risks. In the latter, the risks are lower because a change in goals will only mean writing off some simple tools. Therefore, one what would be led to think that capitalistic societies have more at stake due to likely changes in market-data compared to one at a primitive stage of development.

To examine this further, the important questions before us are;

  • Would changes in technology cause abrupt changes to a capital intensive society?
  • Would the high accumulation of capital act as a burden causing huge losses to producers from changes in market-data /goals (changes in consumer desires, technology etc)

Innovations tend to propel new methods by abandoning old ones. Complacency is an expensive trait and people are constantly urged to improve their methods. However, the long evolution of capitalistic society has certain inertia built-in; as well as the quality of innate individualistic momentum. Instant, overnight and stroke-of-the-pen changes are unusual.

Factors of production are bound by the past and hasty course corrections are generally avoided. It appears that while goals guide plans in the early stages of capitalism, once a certain level of capitalization is achieved, production plans also influence the goals. People arrange their affairs around the capitalistic setup that they grow up with. This means past behaviour of generations guides future conduct as well.

In a philosophical sense, capital goods stores the memory of historic methods of production and consumption; and these facts are hard to change.

Utopian fallacies

The production facilities and consumption patterns are an outgrowth of historic modes of production and consumption. Given today's ideas, technology and values, it might appear (of course, on hindsight) that the current capitalist systems are inefficient and that better arrangements of society can be easily attained. This has also been the claim by socialists who wishfully think-away today's imperfections by super-imposing their ideal methods of production and consumption.

Little do the dissatisfied souls realize that production/consumption patterns of today are an outcome of millennia of human ideas, saving, production and consumption actions. The 'imperfect' systems seen today are an accumulation and not installed from above just at the moment such an assessment is made.

Even if we take such Utopian fallacies forward, one would still grapple with the convertibility problem of existing capital goods. Is a new pattern of society (production and consumption) worth the cost of abruptly abandoning large parts of existing capital goods which have been accumulated over thousands of years? More important than how-much is who gets to decide this forced evolution?

In a market economy, it is the consumers who decide the structure of production and consumption patterns. Albeit, any change that one wishes to see happens slower than what the planners wish to see.

The slow pace of technology absorption

The changes in the market are not as rapid as desired because as we discussed above, plans influence goals, rather than the unidirectional goals influencing plans assumed previously. This bi-direction doesn't mean that plans can remain insulated and descend into an archaic culture. The role of entrepreneurs in the economy is significant - both in executing the plans that serve goals - as well as derive profits from such action.

To enhance profits, entrepreneurs are always looking at technology as a means of reducing manufacturing cost and/or increasing output. The question then becomes how fast can technology alter production processes and influence the nature of capital goods in use.

The naive question is: if the technology is good, shouldn't more of it, simply be, more good?

We have seen in an earlier post, Saving, Production and Economic Calculations in an Economy, the importance of economic-calculations. An entrepreneur is keenly interested in measuring costs, prices and profits. A restraining factor of any innovation is the costs associated with its adoption. This restraint applies to consumers too.

Do we change our television sets just as a new model arrives on the shelves of a supermarket? Do we sell our car every time an improvement is added and a new model is launched? Answers to these simple questions reveal the adopt-ability of innovations.

Our economic system runs on economic-calculations using money as a common denominator. An innovation or technology improvement must fit the economic-calculation model. Factories apply marginal-costing principle when deciding about replacing an old piece of machinery with a new one. A new machine may be, no doubt, more efficient one. But the tipping point in its favour would be the degree of superiority it offers. If there is sufficient reason evidenced through economic-calculation, only then it makes sense to scrap the old machine.

The marginal-costing principle

The calculations involved are as follows;

  • Price of the new machine: p
  • Scrap value of the old machine: q
  • manufacturing cost of the product using the new machine: b
  • manufacturing cost of the product using the old machine: a

Assume the yield z is constant in both cases and that the efficiency is reflected wholly in manufacturing cost. It makes sense to replace the old machinery with the new machinery if savings (a-b) over the yield z is large enough to compensate for (p-q) expenditure.

The illustration shows that mere superiority of technology doesn't suffice in a market economy. Technology inferiority of a production process may also be compensated by other factors (such as favourable location) rendering overall economic superiority to the project.

The illustration also helps understand that capitalism is not an unstoppable force that absorbs all technological contrivances in its path thereby upending all previous methods of production and consumption. The scarcity of overall resources, which is a fundamental truth, reflects itself via economic-calculation. Using economic calculations, the cautious businessman contemplates whether it's worthwhile improving production processes by acquiring innovations.

In contrast, in a fully socialistic system where prices are non-existent, economic-calculation is a mirage. Here, scarcity doesn't get adequately priced in each economic decision rendering big scarcity events one too often. In a capitalistic society economic-calculations help transmit the truth of scarcity and it gets factored in micro-decisions of individuals. Hence, lumpy scarcity events are rare.

Everybody economizes

The fact that technology and new products have to meet the calculation test is not limited to businesses alone. A family, too, chooses whether to continue living in a small two-bedroom apartment or move into a bigger house. Despite an increase in income, it might choose to continue living in a smaller dwelling and instead use the additional income to fund the higher education of a child.

Similarly, a businessman finds it more economical to repair an old piece of machinery that is still usable than simply go by the recommendation of his technician who prefers newer, superior machinery. It is also the reason why households economize by hanging on to existing washing machine, car, television, furniture etc.

It is amply evident that capitalism is not as insipid as having to routinely replace old machinery as newer ones arrive. Yet, there is always a tendency to overestimate the potentialities of some new technology apparatus and a constant fear-of-missing-out exists among practitioners of old methods. Such misleading apparatus appear under the cloak of patenting. Patents provide the veneer of technological superiority.

The fallacy of some technologies

In socialistic economies there is extreme behaviour on display: either blindly accept some new technology or flimsily reject it without due consideration. These extremes exist because of the bureaucratic nature of decision making.  Bureaucrats are biased towards patented technologies. They simply reflect the attitude of their counterparts in the patents office.

Patent registration, many a time, is merely based on improvements in one or more esoteric feature of a contrivance regardless of its economic significance. Technological novelty is the only consideration. Even among technologies, no discretion is attached to real technological significance. A minor improvement of one and a major discovery of another elicit the same dispassionate study from the approving patent registrar.

This kind of cognitive dissonance passes through to the socialist planners as well.
The test for economic usefulness appears only when the patents are introduced in the marketplace. The fact that the vast majority of patents have no economic value is evidenced by the low degree of real-world acceptance of it. It is clear that the production processes simply don't follow "certified technologies" but are guided by economic feasibility considerations.

The above are features rather than flaws of capitalistic systems. To recap and summarize, following are the characteristics of a capitalist system;

  • Capital goods are constrained by the convertibility factor.
  • The present arrangement of production and consumption pattern evolved over many years.
  • The evolution of today's system traces back to thousands of years and the ideas and technology at several points in time in the past helped shape the present system as we see it.
  • Superior ideas of today may look at the systems as they are and complain about the inappropriateness of the arrangement.
  • This is a Utopian fallacy. The present system and the changes that we need to see are best left to the decision of the consumers.
  • Technology is not adopted merely because it has an improvising feature. The decision to replace old machinery is driven by marginal-cost considerations.
  • Economic superiority of a business may arise from other considerations and could make up for technological archaicness.
  • The signals of scarcity is best conveyed through prices (economic-calculation) in a capitalistic system. This is conspicuously absent in socialistic systems leading to lumpy scarcity events.