“As long as it is kept within certain limits, inflation is an excellent psychological support of an economic policy which lives on the consumption of capital.” (Ludwig von Mises, Socialism, pp. 448-9)
What causes economic growth? Is it a reduction in tariffs? Is it a cut in tax rates? Is it cutting red tape and bureaucracy? While each might stimulate or encourage economic growth, none of these choices causes growth. Economic growth is the result of an entrepreneur employing a new method that reduces the cost of production. Costs can be reduced in several ways. Newly discovered resources will reduce costs. A new technique that saves time, labor, or resources also reduces costs. And, often overlooked, are the cost reductions, which come from resource allocation according to the law of comparative advantage.
To clarify, suppose that there is an entrepreneur who can make 1,000 units of cloth per day. If this entrepreneur spends $5,000 per day in wages and on maintenance of the capital equipment, then his average cost of production is $5 per unit of cloth. Further suppose that the market price for each unit is $6, leaving the entrepreneur a rate of return of 20% (setting aside other costs and taxes). Now suppose that an improvement in the capital equipment is developed. (The improvement could just as easily have been locating a new source of cotton, an increase in the workers’ skill sets, or an adjustment of production to account for the law of comparative advantage. The important point is that the cost of production falls.) As the cost of production falls, the entrepreneur has a decision to make. He could try to simply pocket the additional profit, but if he does, he is missing out on a much larger gain. If, instead, he lowers his asking price, he will attract customers away from his competitors. His sales will increase, and his revenues will also grow. (When “stealing” customers from other competitors, the demand is “elastic.” Therefore, as the price is lowered, the company’s revenues will increase.)