The Austrian School View of the Evenly Rotating Economy

The Austrian School of Economics analyzes four distinct economic functions: those of laborers, owners of "land" (productive natural resources), capitalists, and entrepreneurs. Though unrealistic and in part contradictory, the model of the evenly rotating economy (ERE) allows the Austrian economist to accurately analyze in isolation the sources of income derived from each economic function. Using the ERE, one can examine the root of wages for labor, rental payments to owners of factors of production, and interest payments to capitalists. One can also distinguish the nature of entrepreneurial profit from the three aforementioned types of income by understanding why the ERE lacks opportunities to earn said profit.

In the evenly rotating economy, income payments (wages) to laborers are determined by the discounted marginal revenue product (DMRP) of the service that the laborers provide. The DMRP of labor is the marginal utility of a given unit of the service in question. It equals the revenue which this specific unit of the service provides-i.e., the discounted value of the subjective satisfactions the worker creates via the unit of service.

The rental payments to machine owners in the ERE are determined by the productivity of their machines. That is, in the ERE, the rental payment gained by the machine owner in a given time period will precisely equal the value of the goods the machine produces during that period.

A capitalist in the ERE will earn interest on the basis of saving and accumulating capital goods that can produce consumer goods in the future. The capitalist will advance these capital goods to owners of land and labor-the other factors of production-in return for the future yield of those factors. Over time, the future consumer goods attainable via the capital goods are produced and turn into present goods. Because the capitalist postponed present consumption to purchase capital goods which eventually yielded more consumer goods than existed before, he earns interest equal to his rate of time preference: his willingness to delay present satisfactions in return for a greater number of future ones.

Two measurements of a capitalist's interest income are gross return and net return. The gross return equals the overall income from the capital good, including its interest income and revenue from productivity. The calculation of gross return does not take into account the expenses the capitalist accrued in making his investment. Net return, however, equals the gross return minus what is consumed in the process of creating the desired goods.

In the ERE, gross return will always be positive: in order to maintain the same structure of capital every time period, the same resources must be invested into it anew during every such period. Furthermore, the income to land, labor, and capital must equal gross investment each period in order to compensate for the resources invested by the capitalist and enable him to invest them again during the next period. However, the net return to a capitalist in the ERE will always equal zero. If net return were positive, the capitalist would have more funds during the next period to invest than he had previously. He would be able to not only maintain the existing capital structure, but also to expand it-an action contradicting the ERE's assumption of a final state of rest in all markets. If the capitalist's net return were less than zero, he would not have sufficient funds to maintain the existing capital structure during the next period. Hence, the only way for the structure of production to perfectly replicate itself repeatedly is if the capitalist always earns the same gross return from it.

However, the lack of net returns on investment in the ERE does not mean that the capitalists cannot earn interest income. Time continues to pass in the ERE, and all individuals exhibit positive rates of time preference. The capitalists earn an interest income corresponding to their time preference: their willingness to forego present goods in exchange for more future goods. Every period, the capitalists will personally consume the same portion of their income and reinvest the complement of what they consumed.

While capitalists earn interest in the ERE, entrepreneurs do not earn profit. The entrepreneur's function is made possible solely by uncertainty and imperfect information possessed by buyers and sellers on a given market. The entrepreneur discovers an arbitrage opportunity: a mistake in the price structure which gives him the ability to buy a good for a lower price than he can sell it. The entrepreneur's actions gradually come to eliminate the arbitrage opportunity and move the market toward a final state of rest-provided that no new economic disturbances occur. However, in the evenly rotating economy, all markets are already in final states of rest; hence, no arbitrage opportunities exist. All market participants already possess all the information relevant to their economic decisions, thereby rendering mistakes in the price structure impossible. Thus, pure entrepreneurial profit is absent from the ERE.

Note: This essay was approved as an accurate representation of Austrian School economic ideas by Dr. Robert P. Murphy, one of the leading contemporary scholars of Austrian Economics.