Ch. 3, Specialisation Deadlock

To illustrate the problem hinted at in the previous chapter, consider Adam Smith’s well-known example of the division of labour in pin production in the pin factory. Though, in accordance with our assumptions, we shall consider the production process per se and, at least for the present chapter, pay no attention to the fact that this process is, in Smith’s depiction, carried out specifically within a ‘manufactory’. Smith describes the production process as follows:

One man draws out the wire, another straights it, a third cuts, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.[1]

For the sake of simplicity, we assume with Smith that a total of ten people are involved in the production process and that each of them contribute with one or more specific tasks necessary to the process. For now, let us also assume that any and all inputs and tools used in pin-making are readily and freely available. It is easy to see that production in this market necessitates that each labourer aligns with the nine workers of other specialisations to form a production chain of ten workers, one of each specialisation. If all of the workers do this, which they of course have an incentive to do, the effect is that the market fully utilises its productive resources. This situation allows us to make several important observations about how this market for production functions.

Since there is no competition among workers, an obvious implication is that there is in each aligned production process no redundancy in the execution of individual production stages and consequently the production process is completely dependent on each task being carried out in a timely manner. All labour workers in the process depend on all other workers in that process to do their part; if anyone fails to do so, the whole process fails as it cannot complete production. If someone is sick for a day, workers ‘upstream’ from the sick worker’s specialisation can continue production of the intermediate products used as input for this stage. But the ‘downstream’ workers in this process will lack the inputs necessary for their stages since the outputs of the sick worker’s stage are not produced. This indicates that the ‘social cooperation’ through this division of labour also implies a rather severe vulnerability as each worker is fundamentally dependent on the workers carrying out the other stages.

Interdependence and Market Adjustment

Assume that we have a society consisting of 100 equally able workers, all of which are involved in pin-making, and that they are evenly distributed across tasks. We then have a market for pin production where the process is divided into ten separate production ‘stages’ and where there are a total of ten labourers specialised to carry out each these stages. In other words, production comprises ten fully carried out pin-making processes like the one discussed above. Using Smith’s estimate, we can then calculate that this market’s production output is upwards of 480,000 pins in a day.

Production in this market is now redundant since there are ten workers in each specialisation, which means the failure of any one worker may not turn out to be a problem – there are still nine able workers producing the same stage in the production process. However, since ten per cent of production of one stage is lost there will be excess supply of the produced inputs for this stage while, at the same time, the demand for the stage’s output exceeds the produced quantity. The effect is similar to that above, but it is – due to productive redundancy – partial rather than comprehensive. The effect is that those producing the ‘upstream’ stage will find it in their interests to compete with each other in order to sell their output to the remaining nine buyers (who, in line with our assumptions, will be able to use only 90 per cent of the inputs used by all ten workers in this stage the previous day), so the price of the nine’s input will fall. Correspondingly, there are ten workers in the ‘downstream’ stage competing for the output of the nine remaining workers, so the price of the nine’s output will go up.

To some extent, an immediate change in prices may lead to a slight reduction in the magnitude of the market shortage that we may expect as the remaining nine workers could choose to work overtime to exploit this opportunity for increased income. But how much lost work can the remaining workers replace through working overtime? If we allow workers to quickly change their specialisation, so that workers from other stages specialisations can ‘chip in’ when necessary, the market may become less vulnerable to loss of specific manpower (but the effect, of course, is that labour is no longer as specific). The same is true if we let the market keep a surplus of workers so that there are replacements standing by where needed. But such flexibility-increasing measures are costly since the unemployed are effectively unable to earn a living.

Another option to deal with such problems is if ten parallel production processes in effect constitute overcapacity in the market, and therefore that the market in the event of disturbance can choose to increase resource utilisation to counter the loss of a worker. This would be the case if, for example, there is market demand that is lower than the productive capacity so that all workers normally are able to sell products representing only, say, 90 per cent of full capacity. In this case, the loss of one worker in one particular stage means the remaining workers specialised in this specific stage would need to increase resource utilisation through increasing production and thereby keep overall production at a constant level. Producers of other stages would continue to produce at 90 per cent of capacity. But this too is costly since resources are kept unused, and is not really different from the example above. There is no economic difference between having every tenth worker be idle and all workers work at 90 per cent. Both amount to 10 per cent underutilisation of existing resources and therefore loss of potential output.

This, in effect, makes both ‘solutions’ unsustainable in a market setting. There is nothing stopping an unemployed worker to slightly underbid those already employed in producing a particular stage, just like there is nothing keeping underutilised but producing workers from increasing their output to capture a greater part of the market and therefore increase their revenue. In both cases, leisure is traded for labour and for this reason the market’s overall production is increased. This, in turn, forces unit prices down and, consequently, reduces the total income of those who choose not to increase their production; similarly, those who produce more get a larger share of total income. This is the same problem of instability that cartels face, since the interest of any individual member (to produce more) undermines their collective interest (to keep production low).[2]

Let us now consider the case where the labour workers in pin production have varying productive abilities (skills). While we have described the production dynamic in terms of cooperation, this is most obvious vertically (through the production chain) whereas the dynamic horizontally, within each production stage, is synonymous with competitive distribution of effort and income. Thinking of the latter in terms of competitive distribution may help in understanding the dynamic within a stage where workers are heterogeneous in their ability to produce. Instead of each worker choosing between labour and leisure on the basis of equal productive ability, we now have a situation where more able workers have greater latitude. The reason for this is that if production volume is equally distributed across workers within a stage, the more able workers get more leisure time than the less able at the same income level. If, instead, production time (invested productive effort) is equally distributed across workers, the more able workers will be able to produce more and thus earn a greater income while having the same leisure time as those less able.

In the former case (equal production volume), the more able workers may choose to increase production for greater income. Correspondingly, in the latter case (equal production effort), the more able workers may choose to increase leisure time while still earning at least as much as the lesser able workers. Both cases are economically equal since the more able workers make the choice between labour and leisure at comparatively lower cost than the less able. This is why, in the open market, we see a general tendency toward production being carried out by those better suited for a specific type of production – which increases overall production in the economy or, alternatively, increases the time available for other activities (whether leisure or labour) while production output is stable. In other words, this law of comparative advantage shows how society as a whole is better off by letting individuals specialise in producing what they are relatively better at producing, and the individuals are at the same time incentivised to make individual choices in accordance with this rule since it makes them better off. The social cooperation under the division of labour is ultimately strengthened by people’s differing abilities, since heterogeneity simplifies and improves our individual specialisation choices.

These adjustments across production processes can also be described in terms of competition between workers specialised to perform the same standard tasks in a particular production stage. These competing workers are the ones who, acting in their own interests and seeking to make themselves better off, assist in the market’s social cooperation by bringing about a resource allocation that better benefits society as a whole. The latter is an unintended result of their individual actions, but is brought about as were they led by an invisible hand.[3]

All production processes in this market are ‘spontaneously’ coordinated through exchange, so there is no issue of formal employment; the issue is only who buys/sells from/to whom. This is why the temporary loss of a sick worker in one of the production stages does not affect a particular production process (of the ten), but has a general effect – if any – across the market. As we started out describing the market in terms of standard tasks in standard production processes, competition is limited to the intra-stage allocation of resources through standard exchange across stages. Consequently, we have so far focused on the production process and the sequential nature of its standard stages, and the dynamic by which a particular production stage ‘deals with’ changes to keep production intact and avoid losses due to incompleteness (that is, by failing to carry out the whole process and thereby not delivering the end product). This is an important perspective, since it elucidates the productive interdependence and therefore vulnerability of highly specialised production processes under the division of labour. It is central to the argument in this book, and is an aspect of the market that is often overlooked – but has important implications for organisation.

Changing Production Stage Boundaries

The model has so far only focused on adjustments and, to use Kirzner’s term, ‘arbitrage’ across production processes within a particular production stage. We saw that our limited market of 100 people dynamically adjust to changing circumstances and, to some extent, make up for lost production through ‘overtime’ work. Prices change to reflect shortages and surpluses in such a way that the loss of one tenth of producers in one stage makes the price of inputs for this stage go down and the price of its outputs similarly goes up. The ‘automatic’ response by the market to the loss of one worker in a particular stage is to redistribute some of the profits from the ‘upstream’ and ‘downstream’ stages (by lowering the selling price and increasing the buying price, respectively) to the affected stage. In this sense, the price changes incentivise workers to give up their current position to take a place in this stage. It is easy to imagine that if such price changes are of sufficient magnitude, workers may consider retraining in order to earn profits by filling positions in stages that have suffered, say, a loss of two or three or more workers. And the greater the loss, the stronger the incentive. As long as prices are allowed to adjust freely throughout the complete production apparatus so that they reflect real market conditions, the overall allocation of resources will tend to properly adjust to ‘maximise’ the outcome.

Consequently, even though the discussion above concentrated on changes to and within a single production stage, other stages were affected and involved, so to speak, in bringing about a better allocation of productive resources (workers). There is in this sense effective competitive forces between production stages that help even out existing misallocations over time. But there is also competition between (and within) stages that is primarily vertical. This competition can take several typical forms, which have distinct theoretical implications. However, as we will see, the occurrence of one such form does not exclude other forms but can often instigate another; likewise, there is a compounding effect such that the impact of one form of vertical competition is reinforced by the occurrence of another.

The simplest type of vertical competition within a production process is the potential risk for a ‘tug of war’ between those performing the stages. In the discussion above, we initially assumed the workers are equally skilled (both in terms of performance of chosen tasks and ability scope) and that they engage in standard activities traded in the market. It is very possible that a world with heterogeneously skilled workers sees one or more comparatively very skilful workers who deal directly with workers of comparatively limited skill. To the extent that the skilful worker is more high-performing than other workers labouring with the same stage, the skilful worker may be able to take over part of the production volume and thereby free resources for alternative uses (as discussed above). To the extent that he or she has the ability to perform part of the task(s) in an adjacent stage with the same (or better) skill as those specialised thusly, the skilful worker can engage in productive ‘imperialism’ by e.g. continuing to produce beyond the boundary of the standard production stage and thus sell more finished intermediate products. The skilful worker can, if sufficiently able, choose to profitably do part of what in standard market production ‘should’ belong to another stage and thereby either buy inputs from the ‘upstream’ stage earlier (in a less developed form) or sell outputs to the ‘downstream’ stage later (more developed). In both cases, this worker would then ultimately relieve less skilful workers in adjacent stages of part of their standard market undertaking.

The effect of this is, on the one hand, that less skilful workers get a chance to specialise to more narrowly defined stages (since the more skilful worker is doing part of the task of ‘their’ stage) and therefore may be able to become more productive in the remaining tasks. But the effect is also that the standard division of labour adopted by the market toward the existent production stages is undermined by being heterogenised. This will ultimately increase the frictions in the market as workers focus their labour toward productive activities that deviate from the market standard. Let us assume that one of the workers specialised to producing the fifth stage in pin production is competitively skilful also in the finishing touches normally carried out as part of the ‘upstream’ fourth production stage. Since this worker can do this part of the fourth stage at least as well as some of the workers specialised to this stage, it is possible for workers to renegotiate the boundaries of the standard stages they carry out. There may therefore be an opportunity for the skilful worker to expand their vertical productive scope and for the less skilful worker to contract theirs in a similar manner.

Say worker E is the highly skilful worker in stage five, and that E is at least as able to efficiently produce the last part of the previous stage as two of the workers presently specialised to stage four. For the first eight in the order of skill or ability, let us refer to them as D1-8, E is no match – D1-8 are more skilful and thus more productive. But for the remaining two, D9 and D10, E is as good as or better than they are in terms of economic productivity. They may therefore consider selling the intermediate product at an earlier point in time (production-wise), for example when it is only finished to 85 per cent of the standard intermediate product traded, and it is possible that E may consider buying if the price is right. But establishing this type of exchange relationship effectively creates a situation that resembles a bilateral monopoly in our limited market. While this may not be much of a problem for E, who can still procure the standard intermediate product from other workers should this seem like a more economic play, it can possibly become a problem for D9 or D10, who may have already stocked up on their produced 85 per cent finished goods to deliver to E when requested. The market for almost finished goods is very limited – in this example it consists of only E – so the unfinished intermediate goods must, if E no longer chooses to buy them, be prepared for and reintroduced in D9 or D10’s productive activities, meanwhile generating costs of stocking and capital through delayed income. As the remaining 15 per cent of the stage’s productive tasks is likely what D9 or D10 are least productive in performing, which would be a reason to ‘outsource’ this part to E, resuming production may become a highly costly endeavour. If substantial time has passed since E started buying ‘earlier’, it is likely that the cost for D9 or D10 to resume this type of production has increased.

This illustrates a problem of deviating from the market standard, since whereas production in standard processes entails interdependence between stages any deviation therefrom will entail interdependence of a much narrower scope (possibly dependence on a single market participant, as in the example above). By deviating, D9 or D10 not only relinquished revenue by in effect ‘paying’[4] E to produce the remainder of the intermediate product offered in the market, but forced upon themselves a highly restricted density (only one possible purchaser of their output) and therefore a highly vulnerable market position. And, at the same time, they risked high cost of resuming production using skills potentially lost due to not carrying out certain parts of the standard task (since this was ‘sold’ to E) should the decision be reversed.

The situation above can also be caused by more effective use of productive capital, which can produce a slightly different dynamic as it may set in motion both horizontal and vertical adjustments. Instead of being naturally more skilful, let us assume that E is one of ten somewhat equally skilled workers producing stage five in the ten-stage pin production process, but that E finds a more productive way of utilising the tools and other capital readily available (and perhaps already in use in this particular production activity). This can be thought of as a limited form of innovation in which E reconfigures or adjusts the way in which these capital resources are used to perform the tasks in this standard production stage. The result is that E, thanks to the greater assistance of capital in production, emerges as more productive than previously. To the degree E used to be equally productive as other workers carrying out this production stage (for simplicity, we may assume that workers used capital in a standardised way), E’s increased productivity entails an ability to – at least partially – outcompete other performers of this production stages. The higher profitability incentivises these other workers to adopt E’s innovation, which will eventually even out productivity differences in the production stage.

But whereas E’s innovation in a sense brings about a ‘disruption’ within the production stage, whether or not this is a limited or strictly temporary effect, this also upsets the market balance between stages. The reason for this is that the market tends to balance returns between production stages such that they enjoy the same (or at least similar) profitability and return on capital. Where this is not the case, say if workers in the fourth stage earn overall double the rate of return as compared to those in other stages, we should expect at least some workers in other stages to abandon their current positions for production at the higher rate of return. In a sense, workers will flock to specialise in production of the stage with the relatively much higher yield. The resultant increased competition within the stage eventually diminishes profitability while the stages abandoned by these workers may see a concomitant rise. Overall, the tendency in the market is toward equal rates of return throughout the production process.

As E’s innovation is very simple (we assumed a discovered new configuration or use of existent and readily available capital), it can rather easily be emulated by other workers. In a real market, as opposed to our limited example of only pin production, this may not always be the case. Also, there may be competition from outside of the production process as workers migrate from other types of production – especially where similar skills are utilised and thus demanded in many situations. This makes the picture much more complex, especially if we also involve the uncertainty of selling the end product in the consumers market, but does not change the forces at play or the tendencies they engender. The market as a whole does not tend to even out the number of workers employed in each stage, but allocates resources according to the productivity of tasks carried out throughout the production process. It would therefore be inaccurate to assume a production process would utilise the same number of labour workers in each stage, though it can serve as a valid starting point for theorising on market dynamics. As shown above, changes in relative productivity (whether on the individual or stage levels) incentivise corresponding changes throughout the production process, and therefore brings about a more efficient resource allocation. This affects both the boundaries between standard market stages, the tasks carried out in each stage, and the number of workers contributing to a stage’s production.

Adjustments across Production Stages

In an extreme case of the previous example, in which E ‘innovated’ a new way of using existent capital, it is possible to imagine how the new use of capital increases productivity to such a degree that the production stage attracts and can provide for a very large number of workers. These entrant workers previously utilised their labour powers in other stages, but chose in great numbers (relatively speaking) to abandon their positions in order to capture some of the extraordinary returns enjoyed in stage five of the production process. Assume all workers in stage five have already adopted (or emulated) E’s particular capital use and that, as a result of their achieved profitability, one worker from each of the other stages is enticed to abandon their present position for a share of the profits in stage five. The number of workers in stage five is thereby approximately double to that of all other stages (19 as compared to 9).

Assume further that there is sufficient space so that these workers do not step on each other’s toes, and – as assumed above – that there is abundant supply of costless capital. This situation may alter the boundaries somewhat (as above), but the massive increase in production capacity primarily increases demand for input as well as, to the degree demand is satisfied, increases output to be sold to the subsequent stage. As stage five workers bid for inputs, the prices increase and the profitability therefore diminishes with the increased productivity as well as the inflow of workers. Meanwhile, the higher prices make profits in stage four increase. The extraordinary profits earned in stage five are thereby eventually evened out by in part being distributed onto other stages, which in turn experience similar dynamics (though of lesser intensity). One stage’s increased profitability, therefore, has ripple effects through the market and the increased wealth is in this sense ‘shared’ with all who contribute to the production. This is the case since these changes occur within a production process, which is aimed at producing a specific final good – and therefore the benefit of increased overall productivity is to some extent shared by all taking part in this effort in ‘social cooperation’.

Even though profits tend to ‘leak’ into other stages, the increased productivity of stage five will still make it relatively more productive and it can therefore ‘afford’ to employ more workers than other stages. But it will, due to its increased productivity, in fact ‘need’ fewer workers to produce a certain quantity. This brings about a reversal of the inflow of workers as their higher productivity will, despite the initial increase in productivity-based profitability, greatly increase competition between them. In the short term, the available quantity of inputs for this stage, as produced in stage four, is fixed (more cannot be produced instantaneously) as well as in shortage (lower quantity than demanded by the increased number of workers in stage five). Performers of stage five must thus outbid their competitors to secure necessary inputs to earn a profit, which suggests that they, to paraphrase Mises, appear as bidders at an auction in which the owners of stage four output put up for sale their intermediate goods.[5] As this increases prices and thus profitability of stage four, as we saw above, it will attract more workers and thereby increase the stage’s future output. Since stage five can produce more with less (due to their achieved higher productivity), the evening out of returns across production stages will continue past the previous scale – until profitability is approximately the same across the production process. The increased productivity in one stage in this sense first creates an inflow of workers (if profitability increases with sufficient magnitude) to then causes an outflow of potentially greater numbers and thus increases the worker population in all other stages to support an overall increase in production. The previous worker population of 19 in stage five is thereby likely to decrease to well below the original 10, while the worker populations of all other stages increase beyond the original in order to keep up with the absolute production capability of the more productive stage five.

The reason for this is the interdependency of stages within a production process. Each of the stages, and therefore the full ‘length’ of the production process, is dependent on inputs being carried through all stages. This is what effectively allocates resources to the less productive stages as productivity of some other stage is increased. Throughout the production process, the productive capability is evened out so that production can be carried on at the best possible overall volume. As a result, the returns to production within the process are rather uniformly increased alongside the increased production volume.

What is at play here is that, within a production process, the workers must act as capitalist-entrepreneurs and therefore bear the uncertainty of their actions and decisions. The workers will be able to sell their output only because a capitalist-entrepreneur-worker in the subsequent stage is willing to procure the unfinished good, and this worker in turn will carry out a number of tasks or operations to further add to its completion, and then sell to a worker specialised to producing the next stage, and so on. The whole chain of serially dependent stages is ultimately dependent on its eventual completion and the sale of the completed product; without a consumers market in which there is an anticipated demand for the completed product, the production chain fails and workers in all stages are ultimately affected by the losses. In fact, at the time of failure any worker who is not idle (which means he or she is in possession of intermediate products) loses all funds invested in intermediate goods that have yet to be transferred to the following stage. Each worker thereby bears the uncertainty inherent in the production process and risks losses.

The Issue of Incompleteness

Production is technically a serial process from the top to bottom, but the market valuation of the production stages as well as their financing runs in the opposite direction. It is an obvious point if we consider how goods, including intermediate goods, change hands for money, but it is a point with important implications for the working of the production apparatus and so the capital structure and divisions of labour and capital in an economy. Indeed, from a temporal perspective a new production process must be completed before the first payment can be received and then transferred step by step upstream through the stages. If we follow the process from start to finish, a worker producing in the first stage must bear the uncertainty until it is transferred to a worker producing the second stage, who then must invests it funds to gain ownership of the former’s output, and so on through the full length of the production process. And at each stage the assumed value of the unfinished or intermediate good increases, thereby increasing the burden of workers closer to the product’s completion.

The dynamic may become clear if we assume that each worker initially lacks funds to invest and so pays for its stage’s input with an IOU and sells the output for another IOU. For the sake of simplicity, let’s also assume that each stage in the ten-stage process adds an estimated tenth of the anticipated market value of the final good. The IOU that purchases the first stage’s output for the worker in the second stage is consequently worth one tenth of the final good; the IOU that purchases the second stage’s output for the worker in the third stage is worth two tenths; and so on. The completion of the first final good has therefore generated a situation where each worker owes the producer of the previous stage a sum corresponding to the estimated value of the inputs used. Each worker is then in net debt a total of one tenth of the final good price.[6] As the worker of the tenth step is finally paid in cash for the final product, the worker honours its issued IOU and consequently pays the worker in the ninth step a sum equal to 90 per cent of the price of the good (assuming the received price is equal to the anticipated price, which of course may not be the case). The worker of the ninth step, now with the 90 per cent cash on hand, can then honour its IOU issued to the worker in the eighth by paying a sum equal to 80 per cent. And so on backwards through the production chain until all IOUs are honoured and each worker has one full tenth of the price of the final good in cash.

Should the production process at any point fail, including if the final product turns out to be altogether unmarketable, all workers generate losses. As there is no ‘double coincidence’ for redeeming the issued IOUs, the workers end up debtors and creditors if there is no working money capital market. As none of the workers has earned an income from this particular production endeavour, they lack the funds to pay outstanding debt. Consequently, the worker specialised in producing the eighth stage will owe the worker in the seventh stage a sum equal to 70 per cent of the anticipated but unrealised market value of the final product while also having an irredeemable IOU from the ninth stage worker corresponding to 80 per cent of the value. The consequent situation is, financially speaking, highly problematic for the worker.

It is of course possible that workers are able to initially finance their production with savings instead of IOUs, but this is unlikely to lessen the risk involved for workers since our implicit assumption that only one product is produced is unrealistic and should appear overly cautious (and, to the extent the production process is successful, it is a very costly approach since it relies on all but one worker waiting for the end result). If the workers believe there is a market for the end product, which of course must be the case since they are investing in its production, there is no reason for the worker in the initial stage to be idle while awaiting the completion of the product. Rather, it may be reasonable to expect this worker to continue to produce the first stage and thereby supply the second stage worker with continuous inputs. But this greatly increases the risk involved. If we assume that each stage takes one standard time period to produce, which means the completed product will be available for the market ten full time periods after production in the first stage is initiated, the worker in the first stage will have completed inputs for the second stage at the end of each time period. The outstanding ‘value’ is therefore equal to ten times the first stage’s contribution to the complete product. Likewise, the producer of the second stage will have completed nine intermediate products to be used in the third stage (the first time period is spent waiting for the completion of the first inputs); the producer of the third stage will have completed eight intermediate products to be used in the fourth stage; and so on. We then see that each worker in this production process, at the time of completion of the first product, has invested much more substantial sums in the process. It should also be fairly clear that, to the degree workers invest their own funds (rather than IOUs), the money trickle up to pay for inputs. But it also means the risk of the endeavour is distributed and compounded downstream before it is known if there is a market for the final product.

As the production of intermediate goods in each of the stages of the process is well underway and a market for the final product has been found, the aforementioned problem shrinks to a much lesser magnitude. The reason for this is that payment has been received for the final product and therefore started flowing in the direction opposite to the production process; the workers are then relieved of the uncertainty borne through the debt incurred by investing in the process. Due to the division of labour in the specialised production process, all workers participating in and thus contributing to the process are ultimately dependent on the completion of the final product for payment as well as dependent on each other to bring the final product to the products market. The ‘social cooperation’ through the division of labour is therefore a necessity, since workers cannot afford not to cooperate – they are completely dependent on each stage being carried out at sufficient productivity and in a timely manner. Problems occurring somewhere in the process may affect all of them. This is due to the problem of incompleteness, which is a pervasive problem where there is not redundancy. As we saw in the discussion above, the market has ways of dealing with changes where there are redundant production processes and therefore market bidding within each production stage. But this really only mitigates the scope of the problem by increasing the number of individuals sharing the cost of incompleteness. Yet this is an important extension of production that lessens the effect of uncertainty and relieves producers of its cost. The market provides incentives to bring about redundancy where feasible.

As soon as one successful pin production process consisting of the previously discussed ten stages has been created, it is intuitive that other workers eager to increase the return on their labour may seek to compete for a share of the profits. Note that it is not necessary for new entrants to produce a whole new process to be able to compete; rather, they only need to specialise to providing the same production services as are already established in the complete ten-stage process. In other words, a worker who has identified the greater return to labour made possible through the new pin-making process can step in and compete head to head with any of the workers in the process. All that is necessary is that the entrant worker adopts the existing end points of an established stage so that, in the case of the sixth production stage, the outputs from stage five can be used and inputs for stage seven are produced. In other words, the services offered (sixth stage production) must be fundamentally compatible with the newly established division of labour. Where this is not the case, an entrant worker forces incompleteness, and the costs thereof, on their own production undertaking. These costs cannot in any important respect be distributed to (and will thus not be shared by) workers in the established production process, since the entrant worker has failed to competently compete with and therefore been unable to become part of the process.

To get a share of the proceeds of the established production process, the entrant worker aims to supplant the existing worker producing stage six. To successfully do this, the stage must be carried out at lower cost so that the entrant worker can offer a higher price for the stage’s inputs and offer its standard output at a lower price. In a situation where the pin production process is so recently established that production is carried out at a low volume, it may be necessary only to be able to do the former. But to remain competitive and take the incumbent worker’s place (at least in part), the new entrant should be able to match and outdo the prices relied on by the incumbent for both inputs and outputs.

The effect of the new entrant is the creation of a horizontal market within the production process for the specific stage (here, stage six). Entry thereby sets in motion the dynamics discussed above; it also undermines the monopoly-like situation of the incumbent worker and thereby relieves workers carrying out the adjacent stages five and seven of their interdependence on the single worker carrying out stage six. In other words, the worker producing stage five can, after the entrant worker’s entry, choose to whom to sell its outputs. Similarly, the worker producing stage seven can choose from whom to buy its inputs. This means the worker in stage five will have a chance to increase its revenue from sales while the worker in stage seven may be able to reduce costs of input, both thereby increasing their rates of return. All else equal, the increased rates of return increase the risk of attracting new entrants that specialise in producing stages five and seven. As the competitive forces play out, we may well end up with the market assumed at the beginning of the chapter with ten workers producing each of the ten stages.

As we saw above, the horizontal competition within any single stage moderates the productivity of workers, and the potential repositioning or movement of workers from one stage to another bring about an overall tendency to even out rates of return throughout the production apparatus. This does not mean that the number of workers must (or tend to) be evenly spread out across stages; the input and output markets for the stages may therefore differ. We can thus have a situation where workers have chosen positions such that the production process has the shape of an hourglass in terms of the allocation of workers. In our pin-producing market this may mean, for example, that stage five is carried out by only two workers whereas stages four and six are carried out by seven or eight workers, and other stages by even more. This suggests that the two workers in this stage are highly productive, since they are able to produce sufficiently to satisfyingly demand the supply of inputs and supply the demand of outputs from the seven or eight workers in each of the adjacent stages; they are able to keep up with the preferred production volume of the full production process. But it also means that they are in a comparatively better position in the event of a retracting market, since seven or eight workers in both adjacent stages will then compete for their business. It is therefore likely that, as the market fluctuates and under conditions where all resources are not fully employed, these two workers will be less adversely affected. This, in a sense, exemplifies the ‘pricing power’ enjoyed by highly capable producers within a specialised production process.

The Specialization Deadlock

So far in this discussion we have elaborated on the dynamic within the production process, as well as the supply-side pin-making market overall, and we have briefly touched on how competition can create markets across processes within production stages. However, an obvious omission so far is the initial creation of the specialised production process. The reason for keeping this discussion until now is that it is important to understand how the market’s production side dynamically responds to changes and adjusts to changes in incentives in order to produce the best possible outcome. The productive apparatus as a whole necessarily responds to and is subject to real consumer demand, which was implied in the discussion on the entrepreneurial problem of financing production that is yet to be completed. This problem is central to how the structure of the process can change.

Incompleteness emerges as a very real problem in our highly decentralised market model due to the interdependence of workers throughout the production process. Where there are existent markets within stages, and thus redundant (which does not imply underutilised) production capacity, the production apparatus is overall more resistant to abrupt or unanticipated changes such as the introduction of new production technology or declining demand. The creation of a new production process is different, however, since it breaks new ground and for this reason necessarily takes place outside of the established market. There can here be no redundancy or market dynamics to rely on, and therefore those involved – even if successful – are necessarily more vulnerable to changes. Even more so than in the discussion above, incompleteness is a necessary consequence of innovating in production, whether this relates to implementing a new and previously unseen process (either to replace previously established production processes or for the sake of introducing a new final good) or changing the structure of an existing production process (by dividing work differently, in different stages, even if this only affects a part of the existing process). The effect in both cases is the same, as we shall now see.

If we again assume the ten-stage pin-making production process with 100 workers evenly distributed across the production stages, we can trace the steps and forces involved in the creation of a limited new processes by (1) the creation of new capital and (2) dividing work in a new way, respectively. The creation of new capital that we are here interested in entails a much greater change than the case discussed above, in which E found a more productive way of utilising the tools and other capital readily available. Instead of reorganising the utilisation of existing capital and thereby simply changing the way in which it is used, the creation of capital entails thedesign of a new type of tool that could more effectively assist in the production of the stage. The implementation of this design is much more complex than simple reconfiguring or recombining existing components, and requires some type of production in order to make the tool available and usable. The innovator, E, is therefore presented with the choice of (at least temporarily) ceasing production in order to produce the tool, or give up the income of production in order to contract with someone else to produce the tool. Both alternatives entail a capitalistic investment in producing a new type of means of production. To the degree that this new tool is fully compatible with the existent production process and therefore can simply replace existing tools, which means it is similar to introducing a new and more efficient type of hammer to carpenters, this innovation may not change the existing production process in a significant way. However, the production of this capital itself would likely take place in a new production process, the implementation of should thereby take place outside the market, which only shifts the incompleteness logic one step out from the pin-making production process.[7] What matters here is therefore the creation of a new production structure.

Consider first the example of creating a complete alternative production structure to compete with and, if successful, supplant the existing ten-stage structure for pin production. As we have already seen, the status quo utilises an intensive division of labour through distinct yet interdependent specialisations in production, and includes a dynamic that adjusts to changing circumstances and adopts minor innovations to the degree they increase productivity and, consequently, the rate of return. In order to successfully compete with it, the new structure must then provide a better resource utilisation and so rely on comparatively more intensive specialisation. Minor reconfigurations or reorganisations, in other words, constitute no real challenge since such differences are easily adopted by workers in the existing structure. Competition therefore takes the form of a structure that is divided into a greater number of stages, either through establishing a greater division of labour through splitting existing stages into two or more separate stages or through extending the production structure through the production of new capital to assist in production.

Yet in order to establish the complete novel production structure, a total of at least eleven specialised workers need to be involved and sufficiently specialised toward carrying out all the new stages. Where this is not the case, the new structure is incomplete and will therefore not be able to compete with the existing ten-stage process of pin production. Even if this new division of production stages does not necessitate extensive and time-consuming re-training of workers to be able to assume the respective positions in the production structure and carry out the necessary tasks, the new process must be fully populated in order to be economically viable. For this reason, the creation of a new production process cannot be an individual endeavour (in contrast to the adjustment dynamics above), but suffers from being a collective endeavour that therefore necessitates coordination. At a minimum, the new production structure requires as many workers, appropriately specialised, as there are stages in order to be completed.

Add to this picture the fact that several if not most or all of the stages in the anticipated new structure do yet not exist, which suggests the workers who are to carry out those stages need first – at least partially – be educated and trained. While such an undertaking takes time and may necessitate the use of specific (and sometimes new) resources, it is likely that the required information is neither accessible nor even in existence. The reason for the latter is due to the novelty of the production process – as it has not yet been created, it is impossible to know whether there is sufficient knowledge of specifics available to realise the new structure or, if the knowledge indeed exists, whether this knowledge has been properly collected and understood. To some extent, the necessary knowledge is purely technological and in this respect the production stages could conceivably be calculated and specified in advance. However, even where this is the case there is still uncertainty in what routines and standards in production are technologically efficient and effective as well as unknowable specifics about deliverables of intermediate goods between stages. As is the case in the already established structure, the stages are necessarily interdependent and must consequently be fully compatible in order for the process not to suffer incompleteness.

Individual workers involved in specifying and implementing the new production process must not only rely on the information at hand, but must place their trust in the hands of all other involved workers without which the project fails. There must also be means to solve problems that may arise as well as for troubleshooting across stage boundaries and adapt designs. All of these tasks are theoretically possible under a decentralised structure where each worker acts in his or her own interest, but it is a costly process that may suffer from actors engaging in opportunistic or otherwise cost-avoiding behaviour. Even if workers are able to ‘spontaneously’ coordinate their endeavour, problems can arise due to decentralised financing and decision-making as well as conflicting interests: what is supposedly a low-cost or highly effective solution (assuming this can be known) in a particular production stage may turn out to be costly ‘downstream’ in the process. In many cases the specific knowledge necessary for proper decision-making for the overall process or at the stage level may not exist but will be generated through the implementation process. Even considering only the engineering aspects of putting together a novel production structure, the costs of coordination are significant.

These problems still fade in comparison with the economic calculation problem existent in the new structure. Even if we assume that the structure produces an already existing final good using already existing inputs, which means it consists solely of a new production structure and therefore a different division of labour and capital, it is impossible to calculate which of the many stages are efficient and which are not.[8] Should the structure as a whole generate a profit, the workers are still blind as to who of them are contributing to the profit by efficient production and who are, in contrast, consuming capital through inefficient resource utilisation. Since there are no markets available for the intermediate goods, and therefore no market valuation and no prices, the process as a whole suffers from the calculation problem and in effect produces an island of noncalculable chaos.[9] It cannot be optimised, and it will be very difficult to even improve it, without markets for the individual stages.

It should also be noted that in our assumed market, in which there is already full resource utilisation, all workers occupy a profitable space in the market’s production. It is conceivably easier to attract a number of unemployed workers to new specialisations (though they would likely lack the funds to make such an investment) than it is to lure already employed (and hence profitable) workers to the new structure with uncertain outcome. Financing therefore becomes an important aspect of as well as a quite significant problem for producing a new production structure, which we will discuss further in chapter 7.

But it is not necessary to establish a new process to completely supplant the existing ten-stage pin-production process. A much more limited example could entail the simple splitting of an existing production stage into two (or more) more intensively specialised production stages. Yet such comparatively limited innovation faces the same problems: any splitting of an existing stage suffers from costs of noncalculable chaos, coordination, uncertain outcome, and inexistent information. These costs can potentially be surmountable where the number of workers involved is very limited and there is a very high degree of trust between them – and the outcome of the innovation is relatively known. For instance, two innovative workers may figure out a novel way of collaborating in producing a standard stage traded in the market by splitting it into two distinct parts (thereby extending the division of labour and consequently the production process) – perhaps by having one of them produce a tool used by the other – and they may be successful in implementing it. While this scenario would be more costly and potentially involve slower full scale market adoption since it is not simply an adjustment but an effectual ‘splitting’ of a stage, it bears resemblance with the dynamic process discussed above. The major difference is how the innovation requires collaborative coordination, without which it suffers from incompleteness – all parts of a production process must be carried out for it to be viable.

The simple adoption of a more intensive division of labour and capital constitutes innovative low-hanging fruits, since they are comparatively easily implementable – and therefore also easily emulated. With a much more advanced splitting of tasks, whether or not it entails the production of supporting capital, it is a different story, and the lack of market here constitutes a real barrier to productive development as decentralised, sovereign workers suffer the immense coordination and discovery needed in order to escape incompleteness. The implication is that while the overall market aims for and engages in specialisation through the divisions of labour and capital to the extent possible, there is an upper limit to what is possible through the adoption of relatively simple innovation. The market, while unbeatable in efficient resource allocation, is unable to extend past its boundaries; the only development possible are adjustments and the adoption of simple innovations and task-splitting that do not require extensive coordination and information generation. This is a problem that is not simply of theoretical import, but that indicates a real limitation as specialisation makes possible increased productivity, but leads to a situation in which the production stages are highly interdependent. Whereas this order produces a relative abundance and therefore generates wealth, it also points to a vulnerability and a problem: decentralised and bottom-up efforts to specialise is a one-way street that increases productivity but that is limited to simple steps rather than collaborative leaps forward. The market faces a specialisation deadlock of sorts, in which the divisions of labour and capital engender a path dependent development that is limited to relatively incremental changes and responses to exogenous change. Yet this is neither what we have seen historically in terms of economic development nor what characterises the present market. Whereas the specialisation deadlock in an ‘atomistic market’ should be a real problem in terms of both development and vulnerability, the empirical market is differently organised. There is reason for this, and the next chapter elaborates on how the market deals with and overcomes its own limitations in this respect.



L. v. Mises, ‘Economic Calculation in the Socialist Commonwealth’, in F. A. v. Hayek (ed) Economic Calculation in the Socialist Commonwealth (London: George Routledge & Sons, 1935), pp. 87-130.

—–, Human Action: A Treatise on Economics. The Scholar’s Edition (1949) (Auburn, AL: Ludwig von Mises Institute, 1998).

M. N. Rothbard, Man, Economy, and State with Power and Market. Scholar’s Edition (1962) (Auburn, AL: Ludwig von Mises Institute, 2004).

J. T. Salerno, ‘Postscript: Why a Socialist Economy Is Impossible’, in L. v. Mises (ed) Postscript: Why a Socialist Economy Is Impossible (Auburn, Al: Ludwig von Mises Institute, 1990), pp. 51–71.

A. Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776) (Chicago, IL: University of Chicago Press, 1976).

—–, The Theory of Moral Sentiments (1759) (Oxford UK: Oxford University Press, 1976).

M. Thornton, ‘Cantillon and the Invisible Hand’, Quarterly Journal of Austrian Economics, 12:2 (2009), pp. 27-46.




[1]A. Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776) (Chicago, IL: University of Chicago Press, 1976), p. 8.

[2] See M. N. Rothbard, Man, Economy, and State with Power and Market. Scholar’s Edition (1962) (Auburn, AL: Ludwig von Mises Institute, 2004), pp. 651-653.

[3]Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, pp. 62-7, A. Smith, The Theory of Moral Sentiments (1759) (Oxford UK: Oxford University Press, 1976), pp. 179-187. See also M. Thornton, ‘Cantillon and the Invisible Hand’, Quarterly Journal of Austrian Economics, 12:2 (2009), pp. 27-46.

[4] In order to motivate E, the price reduction of the 85 per cent finished intermediate good would have to exceed E’s cost of production plus their expected rate of return on producing according to stage five standard. As D9 or D10 by assumption are less productive than E, the latter should have overall higher profitability and D9 or D10 will therefore need to, at least initially, use their profitability to incentivize E to produce the remaining 15 per cent of stage four. This does not, of course, mean that D9 or D10 are victimized, only that they must offer E sufficient remuneration to redirect part of their productive ability to the 15 per cent.

[5]L. v. Mises, Human Action: A Treatise on Economics. The Scholar’s Edition (1949) (Auburn, AL: Ludwig von Mises Institute, 1998), p. 335.

[6] Consider the worker producing stage four as example, who has issued an IOU to the producer of the third stage equal to three tenths of the completed product’s price and has received an IOU from the producer of the fifth stage equal to four tenths.

[7] It is possible, though should be very rare, that the production of new and specific tools can be carried out without innovation in processes used for their production. As such cases are uncommon and do not entail the type of problem here discussed, they are excluded from this analysis.

[8] The calculation problem is core in the Austrians’ (most notably Mises’s) critique of socialist economics, see L. v. Mises, ‘Economic Calculation In The Socialist Commonwealth’, in Hayek (ed) Economic Calculation In The Socialist Commonwealth (London: George Routledge & Sons, 1935), pp. 87-13, J. T. Salerno, ‘Postscript: Why a socialist economy is impossible’, in Mises (ed) Postscript: Why a socialist economy is impossible (Auburn, Al: Ludwig von Mises Institute, 1990), pp. 51–71.

[9] For comparison, see the discussion in Rothbard, Man, Economy, and State with Power and Market. Scholar’s Edition, pp. 613-615.