The Affordability Equation | Mises Institute

Lately, “affordability” has been the buzzword du jour driving political discourse. Essentials like food, housing, and healthcare cost more than most younger working people can afford to pay, leaving them to struggle without hope of being able to start their own families or purchase single-family homes in decent neighborhoods. In other words, for younger generations the American Dream is dying.

Even politicians and their lackeys—people who have no difficulties affording things at everyone else’s expense—have had to take notice of Gen Z’s discontents. They have responded with all sorts of crazy ideas about how government is supposed to fix this, including promises of free money and free stuff, imposition of price controls, and even a plan for fifty-year mortgages (default risks being subsidized by the government, of course). But what is the truth about affordability? What does economic theory have to say about how a worker can get the most stuff for each hour of his or her labor?

With respect to a given consumer good, its “affordability” is simply the ratio of the price of one’s labor to the price of the good. The more affordable it is, the less labor one has to expend to obtain it. But what is the relationship between labor prices and output prices? To answer that question, we can turn to chapter 7 of Man, Economy, and State, where Austrian School economist and Mises Institute stalwart Murray Rothbard presented the theory explaining the general pricing of factors of production like labor.

Whenever a business purchases an extra unit of labor, that will result in additional revenue (called the marginal value product [MVP]) equal to the price of the output times the extra quantity of outputs produced per extra unit of labor, a quantity which Rothbard called the marginal physical product (MPP). However, the business also needs time to transform labor and other inputs into outputs, so the maximum compensation that the business is willing to pay for an extra unit of labor must discount this extra revenue to reflect the prevailing rate of time preference. Thus, the discounted marginal value product (DMVP) represents the upper bound on the price of labor, with the capitalist investors earning the difference between the MVP and the DMVP as compensation for their willingness to have their purchasing power tied up over the time interval between when labor expenses are paid and when revenues are collected from consumers.

Rothbard went on to explain that, in a steady-state or “evenly rotating economy” (ERE), competition for labor among businesses will further constrain the price of labor:

It is clear that if the marginal value of a specific unit of a factor service can be isolated and determined, then the forces of competition on the market will result in making its price equal to its DMVP in the ERE. Any price higher than the discounted marginal value product of a factor service will not long be paid by a capitalist; any price lower will be raised by the competitive actions of entrepreneurs bidding away these factors through offers of higher prices. These actions will lead, in the former case to the disappearance of losses, in the latter, to the disappearance of pure profit, at which time the ERE is reached.

Thus, we can summarize Rothbard’s ERE analysis in the form of a simple equation:

Price of input = DMVP = Price of output x MPP of input x discount factor

While real-world economies are never stuck in the ERE, competition is always driving prices towards their ERE values, so as long as chasing profits and avoiding losses remains legal, dropping the ERE assumption only adds some unknown degree of price volatility without changing the underlying logic of what causal factors determine input-output price relationships. Given our notion of affordability above, we can divide both sides of our equation by the output price while taking labor to be the relevant input to restate Rothbard’s analysis in terms of affordability:

Affordability of a given output = MPP of labor x discount factor

Note that the discount factor has a value less than one, with decreases in time preferences or decreases in the amount of time required for producing the output bringing this discount factor closer to one. Thus, affordability is increased by a greater desire by savers to engage in thrift (i.e., greater restraint of their present consumption so that more inputs like labor can be diverted to more time-consuming lines of production, which lowers the pure rate of interest) or by new production technologies and skills which shorten the time needed for transforming the added labor into outputs.

There are three ways to increase labor’s MPP. New productivity-enhancing technologies and skills raise labor’s MPP and hence raise affordability. Another way is to make greater quantities of complementary natural resource inputs available—the exploitation of new mineral and fossil fuel resources, the conversion of wilderness into productive agricultural or timber lands, etc., will raise labor’s MPP and thus increase affordability. Finally, destruction or exclusion of a part of the labor force while the stocks of natural resources and capital goods remain unaffected (e.g., the Black Death killing half of Europe’s population in the mid-14th century) is a way to raise the MPP of the remaining workers. Many restrictive labor policies (e.g., deportation of illegal aliens) can be frustrated by the tendency of the unprivileged to resort to black markets, smuggling, and other inefficient workarounds, and might provoke political strife that everyone finds costly, so deadly plagues remain the most efficient method for increasing affordability via workforce reductions.

Since increased thrift-financed investments, improvements in technologies and skills, and increased quantities of natural resources relative to the number of workers make outputs more affordable, we can immediately infer from Rothbard’s analysis that to improve affordability, government needs to stop discouraging private thrift and investment, stop restricting the private use of technologies and skills that don’t violate the rights of others, and stop throttling private access to natural resources. Affordability could be improved with policies like getting rid of Social Security and Medicare benefits, putting the dollar and all dollar substitutes on a 100 percent gold basis, eliminating licensing and patent restrictions, revoking environmental restrictions unrelated to the enforcement of individual rights, and opening up wilderness lands (which, for the most part, have been arbitrarily claimed without actual physical possession by the government and its favorites and left undeveloped) to homesteading by private individuals.

Government taxes and spending also affect affordability. One has to read later chapters of Rothbard’s book for the full analysis, but we can touch on some of the highlights here. Transaction taxes on outputs (e.g., sales taxes, excise taxes) reduce the revenue received by businesses relative to output prices. This directly reduces affordability by the percentage of the tax. Likewise, transaction taxes on labor (e.g., Social Security and Medicare payroll taxes) and personal income taxes levied on wages also directly reduce affordability by the percentage of the tax.

The impact of the income taxes paid by businesses is a bit more complicated. The marginal income tax extorted from the business is calculated as a percentage of the difference between MVP and DMVP. Part of this burden results in a lower price being paid for labor, but another portion comes at the expense of investor incomes. The former represents a direct reduction of affordability. The latter acts as a deterrent to thrift (reducing rates of return) and diverts funds to the government that otherwise would have been reinvested, both of which make the structure of production less capital-intensive and consequently indirectly reduces affordability. The general conclusion is that increasing affordability requires tax cuts for both workers and businesses.

As for spending by government and its various minions and clients, it competes directly with spending by workers on consumer goods. Government spending bids up prices of consumer goods and thus directly reduces affordability, so spending cuts across the board will result in higher affordability. At the federal level, cuts to Social Security, Medicare, Medicaid, and Pentagon spending would be critical to achieving higher affordability.

But what about government stepping in to produce free stuff for workers? Socialist production features much smaller MPPs and smaller discount factors than competitive profit-and-loss production does, but this isn’t reflected in the prices charged to consumers (if any) by the socialist enterprise. Thus, any artificial affordability gain provided by a socialist enterprise must come at the expense of making everything else relatively less affordable due to tax subsidies of the socialist enterprise’s losses and to less productive uses of labor and other inputs. Socialist measures can only make the affordability crisis worse overall.

Paraphrasing Ronald Reagan, we must agree with him that government is not the solution to our affordability problem; government is the affordability problem.