[j.fournier]

In Chapter 5.8 of “Man, Economy & State” Rothbard states that in the evenly rotating economy “price will equal average money cost for every good”. However, he disagrees with people like Marshall who think that costs determine the price in the ERE. He says that the truth is the reverse: “price determines what the cost will be”. I am having trouble following his explanation for this. Can you explain this to me in the context of real property?

The factors of production are land, labor, materials, and entrepreneurial coordination. Let’s say that under current market conditions a shopping center t is worth $10,000,000 based on the rent that it is generating, and market capitalization rates. Let’s say that the replacement cost of the shopping center is $3,000,000 for the land, $1,500,000 for the labor, and $3,500,000 for the materials, leaving $2,000,000 in entrepreneurial profit. I have read that in the ERE entrepreneurial profit is $0. What is the explanation for how the price determines the cost? As we approach ERE, and profit goes to zero, should we expect that the land value will go to $5,000,000? Or, should we expect that the money costs of the labor and materials will share part of the increase? I’m trying to understand how this will happen, given that the land, labor, and materials could be used for different types of buildings, which may not be experiencing such high rates of profit right now.

I think a lot of real estate professionals who do care about replacement costs probably care because they think that prices will tend to move toward replacement costs. I would love to understand Rothbard’s argument better so that I can argue that the opposite is true.

[jmherbener]

Prices for the factors of production, labor, land, materials, etc. are determined by the demand entrepreneurs have to use them in their various production processes across the economy. The land has a price of $3 m because their are entrepreneurs who will pay that price to employ that land in their productive processes. The same is true of the price for labor and the price for materials. Prices for factors of production are determined by entrepreneur demands for them which in turn are determined by the revenues that consumers generate from the output produced and the productivity of the factor of production in producing those outputs.

The net income entrepreneurs earn in their production processes comes from the productive contributions made by the entrepreneurs: wages for their labor used; interest for their capital invested; and profit for their foresight. In the ERE, profit would be zero, but net income would remain because entrepreneurial labor and capital funding still has value in producing goods.

The spread between output prices and input prices in the ERE, then, reflects the interest return on investment. This must be uniform for a similar types of investments, because capitalist would invest more heavily in higher return areas than lower return areas. By expanding production in higher return areas, output prices decline and input prices rise, reducing the price spread and by contracting production in lower return areas, output prices rise and input prices fall, increasing the price spread.

As we approached the ERE, in your example, production of malls would increase because of the greater return. This would lower output prices and raise input prices. Which input prices rise by how much cannot be determined by theory alone. All we can say is that factors more specific to a production process would rise more and prices less specific to a production process would rise less. In your example, land prices probably would rise the most.

Prices of output do not move to conform to replacement costs. Prices of output fall because of the additional supply of entrepreneurs who are taking advantage of the profit opportunity. Prices of inputs rise for the same reason. Price spreads conform to the interest return.

[j.fournier]

Thanks for your very thorough response! I think I understand what you are saying. Would you say then that in the ERE the shopping center would be worth somewhere between $8 million and $10 million then?

[jmherbener]

It would be worth the present value of the future revenue stream generated by its contribution in satisfying consumers. In your example, that is currently $10 million (before reaching the ERE). In the ERE if the mall had a price of $10 million, then the factors of production used to build such a mall would have a value equal to $10 million discounted by the appropriate rate of interest.

[j.fournier]

OK, but but above you say “As we approached the ERE, in your example, production of malls would increase because of the greater return. This would lower output prices and raise input prices.” I interpreted this as saying that since more malls will be built, the price of malls will fall from $10 million (presumably the increased supply of malls would result in a decrease in rents and/or increase in their cap rates or discount rates), and the total money cost of factors of production of malls will increase from $8 million, and that in the ERE the money costs and price of the mall will equal each other somewhere between $8 million and $10 million because costs will go up and price of mall will go down. Did I interpret you incorrectly? Will the price of the mall stay at $10 million in the ERE?

Basically, I’m trying to figure out if economic theory can tell me whether the value of a shopping center will tend to go down if its replacement cost is lower than its current value. I thought Rothbard was saying that costs will go up to meet value, but I thought what you were saying implied that cost and value would meet somewhere in between because costs (inputs) will go up and value (output) will go down.

[jmherbener]

I think Rothbard was stipulating, as I also did in my previous post, that the value of the output was staying the same in the adjustment process.

In general, however, such a stipulation does not hold (which is what I implicitly assumed in my first post) and both output and input prices would adjust. In your example, then, the price of the mall would fall below $10 million when the economy reached the ERE and the reproduction costs would rise above $8 million.

[j.fournier]

Thank you.

[Author]

Posts