Fundamental to clear thinking and rigorous results in political economy is the separation of institutions from the underlying non-institutional realities.

John Stuart Mill used a version of the separation when he contrasted the non-institutional production of wealth with the institutional distribution of wealth.

Mill's treatment of the production of wealth should not leave the impression that the non-institutional realities could be adequately described using solely the concepts of engineering and the natural sciences. Notions like de facto individual welfare or preferences (described by economists' utility functions), de facto responsibility, de facto possession of goods, and de facto consent are all part of non-institutional (i.e., "de facto") realities that would not be captured using solely the concepts of engineering and the natural sciences.

A clearer differentiation has been developed in neo-classical economics. The basic notion of allocative efficiency (or Pareto optimality) is specified in non-institutional terms using goods, preferences, and technical possibilities but without mentioning property rights or prices: "A social state is allocative efficient if it is not technically possible to make someone better off in terms of their own preferences without making someone else worse off." This does not assume some state of Nature with no institutions such as property rights or market prices. "Efficiency" is simply specified without presupposing any particular institutional arrangement so that differing institutions can be evaluated according to their efficiency.

The neo-classical notion of a "competitive equilibrium" (CE) is a quintessentially institutional notion specified in terms of property rights, competitive markets for the transfer of property rights, and the (implicitly assumed) market mechanism of appropriation for the birth and death of property rights. The crown jewel of neo-classical microeconomics is the Fundamental Theorem of Normative Economics which shows that under certain assumptions (mainly that there are no externalities), a competitive equilibrium is allocative efficient. This theorem is a paradigm for clear thinking in political economy. It separates the institutional notion (CE) from the non-institutional notion (efficiency) and then relates them in the Fundamental Theorem.

Economic models tend to be rather abstract but that is not necessary for a clear separation of the institutional and non-institutional realities. Non-institutional descriptions can be quite specific. People can be specified by name, machines by serial numbers, and land by location without assuming any particular institutions of legal rights or property rights. This conceptual separation is necessary to understand the flaw in the Fundamental Myth.

Consider a productive operation being carried on currently under the auspices of an employment firm OldCo. What rights give the OldCo corporation the management rights over the workers and the ownership of the product? Develop a non-institutional description of the same productive operation by specifying the people by name, the machines by serial numbers, and so forth. That process could then be organized in a number of institutional frameworks; the workers could be slaves, private employees, state employees, or members of a democratic firm.

Consider now the original framework with the OldCo corporation owning the means of production, i.e., owning the machines with certain serial numbers and the specified buildings and land. However, suppose that those capital goods are leased out to another corporation NewCo, and that NewCo hires the named workers. Then the same non-institutionally specified production operation is being carried on, but OldCo does not have management rights over the production process and does not appropriate the whole product of the process. Yet OldCo still owns the means of production. Thus it was not OldCo's ownership of the means of production that gave it the management rights and product rights in the original arrangement. That is why the Fundamental Myth is indeed a myth.

The word "firm" was used as a technical term to specify the legal party which ended up legally appropriating the whole product of the non-institutionally specified production process:

"Firm" = Whole Product Appropriator.

In that sense of the word, we saw there was no such thing as the "ownership of the firm" in the capitalist property system even thought there is the ownership of corporations such as OldCo. The identity of the firm is contractually determined as the last legal owner of the inputs consumed in the production process. That legal party voluntarily appropriates the negative product (the liabilities for the used-up inputs) and thus has the legally defensible claim on the positive product (the produced outputs). That legal party also holds the management rights by virtue of its ownership of the input services employed in production, e.g., the employees' labor services.

The phrases "de facto" or "factual" are used as technical terms to describe the non-institutional realities as in the expression "de facto responsibility." The phrases "de jure" or "legal" are used as technical terms to describe the institutional realities as in "legal responsibility":

There is one more level of complication. In addition to the factual and legal concepts, there is the legal view as to what the facts are. For instance, a jury obviously does not determine the facts; a jury determines what the legal system will take to be the facts of the matter.

The imputation principle is to assign legal responsibility in accordance with de facto responsibility. However, the legal system can only assign legal responsibility in accordance with what the legal system takes to be the facts about de facto responsibility. There will be a miscarriage of justice when the facts turn out to differ from the "official" legal view of the facts, e.g., when the jury's decision was in error about the facts.

In a similar manner, the legal contract for the transfer of goods or services is to be fulfilled by the de facto transfer of the goods and services in question. However, the legal system will take the contract as being fulfilled upon completion of what it legally views as the de facto transfer of the goods or services. There is a similar miscarriage of justice when the facts of the transfer differ from the legal view of the facts. Such a miscarriage occurs on a system-wide institutional scale in the employment contract. The legal system legally views the de facto responsible cooperation of the employees with the employer as the de facto transfers fulfilling the legal contract for the sale of the (de facto nontransferable) labor services–unless that cooperation breaks the law–in which case the legal view of the "de facto transfers" is rather different.

The analysis uses a simple stylized description of a production operation that, suitably interpreted, is quite general. Consider a production process where the workers (all who work in the process) by performing the labor services L use up the capital services K and produce the product Q during a certain time period. Each of L, K, and Q could itself be a list or vector with a large number of components. For instance, K stands for all the non-labor inputs such as raw materials and semi-finished parts as well as the services of capital goods and land. The labor services L include the services of all workers including managers working the production process.

The simplest description will require consideration of two legal parties: Labor consisting of all the people (managers and other workers) who work in the firm performing the services L, and Capital consisting of the suppliers of K. It is not assumed that Labor is self-consciously organized as a legal party. In terms of people, Labor is the de facto firm. This is clear, for example, in the business literature describing the realities of a firm. Consider the following from standard managerial accounting textbook.

This description of the de facto firm could be contrasted with the de jure firm, the legal members of a company such as General Electric. In the conventional corporation, they are the shareholders abstractly represented here as Capital, the suppliers of the capital K. When one reads in the business pages about General Electric having its annual meeting, that is the meeting of the de jure members of GE, the shareholders. The de facto members of GE have a "meeting" every working day.

The same distinction between the de facto firm and the de jure firm was pointed out in 1944 by Lord Eustace Percy.

This contrast between the underlying facts and the superimposed institutions is fundamental to the analysis of production in the employment system.

To represent commodities, lists or vectors will be used with the three components in the following order:

(Outputs, Capital Services, Labor Services).

The production vector for the time period is the

Whole Product = (Q, –K, –L).

The employment-based organization of the production operation will be represented by Capital hiring the workers (including managers), i.e., buying the labor services L in the employment contract from Labor.

The property theoretic analysis of production compares what each party is de facto responsible for with what each party is legally responsible for, i.e., with what each party legally appropriates. In terms of de facto responsibility, only human actions, herein called "labor," can be de facto responsible for anything–regardless of the causally efficacy of the capital services K. The same people may perform labor services as a part of the party Labor and also be part of Capital owning the capital services K. Since only Labor can be de facto responsible, Labor produces what we have called

Labor's Product = (Q, –K, 0) = (Q, –K, –L) + (0, 0, L)

Whole Product + Labor

which is the sum of the whole product and the labor services L. Since any work performed by the capital owners would have been counted as a part of the labor L, the party Capital (as capital suppliers) is de facto responsible for neither producing outputs nor using up inputs. Capital (qua capital suppliers) is absentee with respect to production.

In terms of legal responsibility, Labor sells L but did not buy L from any other party so Labor was considered legally responsible for creating (0, 0, L), i.e., Labor legally appropriates (0, 0, L). Capital purchased or already owned K and purchased L but did not resell those inputs consumed in production, so Capital legally appropriated the liabilities –K and –L for those inputs. Moreover, Capital sold the outputs Q but did not buy those outputs from any other party, so Capital legally appropriated the outputs Q. Thus in total, Capital legally appropriated the whole product (Q, –K, –L).

The juridical principle of imputation (i.e., the labor theory of property in juridical garb) is that legal responsibility is to be assigned in accordance with de facto responsibility. When the two notions agree, that is a matching, in particular a responsibility-matching. It is a miscarriage of justice when the two notions diverge, i.e., when the legal responsibility is assigned to a non-responsible or innocent party, or when the legal responsibility is not assigned to the de facto responsible party. That is a responsibility-mismatch, or in the context of production, a production-mismatch. The following table calculates the de facto-minus-legal responsibility mismatch involved in the employment firm for both the parties of Labor and Capital.

The differences can be computed. Labor produced Labor's Product but only received the legal responsibility for the labor services L, so Labor produced but did not receive the whole product. Capital, on the other hand, was absentee with respect to production so it did not, qua Capital, produce anything but it legally appropriated the whole product. Thus Capital legally appropriated but did not produce precisely what Labor produced but did not legally appropriate–the whole product.

No prices were mentioned or used in the analysis. No assumptions were made about markets being competitive or non-competitive, or being in equilibrium or not.

The private property system, employment-based or not (i.e., with hired labor or not) is intimately tied together with the system of contracts. Indeed, it is best to think of it as a system of property-and-contract instead of just as a property system. Even the changes in property rights in production are geared to exchange (i.e., voluntary contracts) by the market mechanism of appropriation. The hiring party, the legal party who hires or already owns all the inputs used up in production, voluntarily appropriates the negative product and thus has the legally defensible claim on the positive product.

Production is also geared to exchange at the factual or de facto level. The people de facto responsible for using up the inputs in production will be the last people to have de facto possession of those inputs. Similarly, the people de facto responsible for producing the product will have the first people to have de facto possession of those outputs.

Production is geared to exchange at both the legal and factual levels. In this section, we analyze the legal and factual exchanges involved in the capitalist production. In the next section, we develop the Fundamental Theorem of Property Theory which states that if there is a legal/factual mismatch in production, then it must show up as a legal/factual mismatch in exchange.

Prices must now be mentioned since they are involved in the money part of market exchanges. Let w be the unit wage so the wages and salaries are wL. Let p be the unit price of output so the revenue is pQ. Let r be the price per unit of capital services (i.e., the unit rental rate) so the market value of the capital services is rK. The profit per period in the production operation at those prices is

p = pQ – rK – wL = Value of the Whole Product.

The legal transaction between Capital and Labor is assumed to be the employment contract. Labor voluntarily sells the labor services L to Capital in return for the wages wL.

It should be noted that legal transfers do not refer to transfers between points in physical space but between legal parties. It is not as obvious but the same is true of de facto transfers.

De facto or factual transfers of commodities refer to transfers in the de facto possession and direct control of the goods and services between people. For instance, the de facto transfer in the possession and control of ordinary commodities like food fulfills the contracts for the legal transfers of those commodities. The purchased food is transferred from seller to buyer, and the purchase price is transferred in the opposite direction.

It should be carefully noted that the commodity does not have to move in physical space to be de facto transferred. When a person buys a house and then takes factual possession of the house, the house is not moved in physical space. Changes in possession take place in "possession space." The "points" in possession space are people–often grouped together as parties such as Labor and Capital. When the new houseowner goes to the house in physical space, the house goes to the owner in possession space. Thus both legal transfers and de facto transfers are transfers between people or groups of people.

Labor is de facto nontransferable between people; human actions always remain in the de facto possession and direct control of the actor. Employees can only co-operate together with managers. Deciding to voluntarily obey a command to do X is only another way of deciding to do X. The employee remains de facto responsible for his or her actions together with the co-operating employees and managers.

Since Labor in fact uses up the capital services K, those services must be first de facto transferred into the possession of Labor. As in the previous example of the houseowner and house, the workers would move in physical space to take possession of the capital goods and other inputs used in production. But that constitutes the transfer in possession space of those non-labor inputs K into the hands of the workers. In short, when the workers go to the factory in physical space, the (use of the) factory goes to the workers in possession space. In our stylized example, we will assume that the non-labor inputs K start with the party Capital (although even that minimal role for Capital is not too plausible when the capital-owners are the absentee shareholders of a large corporation).

Since Labor in fact produces the outputs Q, those commodities are first in the de facto possession and direct control of Labor. The outputs Q are then de facto transferred away to the buyers. To keep our stylized example simple, we will assume that the outputs Q are de facto transferred back to Capital who, in turn, could transfer them to the buyers. The example could be easily modified by having another party, the Market, with the workers directly transferring to the Market–but nothing essential would be added by that extra complication.

The one part of the legal transaction between Capital and Labor that is de facto fulfilled is the transfer of the wages wL. In summary, the non-labor inputs K are factually transferred from Capital to Labor, while the outputs Q are factually transferred in the opposite direction. The transfer of +K from Capital to Labor can be formally represented as the transfer of –K in the opposite direction. Thus the property vector (Q, –K, 0) is de facto transferred from Labor to Capital, while the wages wL are transferred from Capital to Labor.

A legal contract that was only partially fulfilled by factual transfers is a breached contract or a fraudulent contract, and factual transfers without any corresponding legal transfers are externalities, conversions, or thefts. The system of contracts functions properly when all legal transfers or contracts are fulfilled by the corresponding factual transfers and when all factual transfers are covered by legal transfers. That state of affairs is the property-theoretic notion of "equilibrium" and it will be called a transfer-matching (between the legal and factual transfers). A divergence between the factual and legal transfers is a transfer-mismatch.

There is no mismatch on the wages part of the employment contract. The mismatch occurs in the property vectors. Labor factually transfers (Q, –K, 0) to Capital, and legally transfers (0, 0, L) to Capital so the property factually but not legally transferred from Labor to Capital is

(Q, –K, 0) – (0, 0, L) = (Q, –K, –L) = Whole Product.

The wage transfers are not shown in the table since no mismatch is involved in the wage payments. If desired, the vectors could have a fourth component for money. The de facto transfer from Labor to Capital would be (Q, –K, 0, –wL) and the legally transferred vector would be (0, 0, L, –wL). The factual-minus-legal mismatch would still be the whole product: (Q, –K, –L, 0).

There is an interesting contrast between this property theoretic analysis and Marx's analysis of capitalist production. Marx misunderstood how production and exchange fit together in the capitalist system. If something was fundamentally amiss in the sphere of production (as Marx thought), it would show up in the sphere of exchange. Marx took great pride in his alleged analysis of exploitation in production in spite of equals being exchanged for equals in the "sphere of exchange."

Marx's sarcasm is misplaced. We have already seen in a previous chapter how Marx's analysis of production in the labor theory of value and exploitation came to nought. Marx was also wrong in his acceptance that the employment contract satisfies "the innate rights of man." Even the most "bourgeois" conception of innate rights would not tolerate fraudulent contracts, and yet that is where the employer-employee contract stumbles. It pretends to alienate what is de facto inalienable so when it is validated by a system of positive law it is only a legalized fraud.

Marx accepted what he should have rejected (e.g., the Fundamental Myth and the labor contract as consonant with the innate rights of man), and Marx rejected what he should have accepted (e.g., private property ultimately based on labor appropriation, and non-fraudulent market exchanges).

Production is geared to exchange–both at the legal and factual levels. The party who is legally responsible for the whole product is the party who is the last buyer of the inputs and the first seller of the outputs. The party who is de facto responsible for the producing the whole product is the last possessor of the inputs and the first possessor of the outputs.

If there is a mismatch of legal and de facto responsibility in production or consumption then there has to be a mismatch between the legal and de facto transfers in exchange. That is the

The Theorem can also be stated in the positive form: A transfer matching implies a responsibility matching.

The Theorem is about the proper functioning of the laissez-faire mechanism of appropriation. To verbally state the proof of the Theorem we must characterize the mechanism in more precise terms and be clear about the underlying factual assumptions.

The laissez-faire mechanism relates legal tranfers and legal responsibility for the used-up inputs and the produced outputs (the whole product). The mechanism defines the party that is legally responsible for the used-up inputs and the produced outputs as the party that is the last legal transferee or buyer of the used-up inputs and the first legal transferor or seller of the produced outputs.

On the factual side, there is "no action at a distance" in possession space. Thus the party de facto responsible for using up the inputs and producing the outputs must also be the last de facto transferee and possessor of the inputs as well as the first de facto possessor and transferor of the outputs. If inputs could be destroyed accidently (no responsible party) or outputs produced accidently then the reverse might not be the case. Therefore we, by assumption, restrict attention to non-accidental deliberate human activity. Hence the last (resp. first) possessor of the inputs (outputs) must also be the party de facto responsible for using up the inputs (producing the outputs).

The fundamental theorem says that under these assumptions, a transfer matching implies a responsibility matching. A transfer matching means that all legal transfers of certain commodities are fulfilled by the transfer in the de facto possession of the said commodities (no frauds) and all de facto transfers are covered by legal transfers (no externalities). Thus a transfer matching implies that the last legal transferee of the inputs is also the last de facto possessor of the inputs and that the first legal transferor of the outputs is the first de facto possessor of the outputs. But in view of the laissez-faire mechanism of appropriation and the factual assumptions (no action at a distance and no accidents), that means the party legally responsible for using up the inputs and producing the outputs is the party de facto responsible for using up the inputs and producing the outputs, i.e., a responsibility matching.

In outline form, the argument is:

Party legally responsible for used-up inputs (which by l-f mechanism)

= last legal buyer of inputs (which by transfer matching)

= last de facto possessor of inputs (which by the factual assumptions)

= party de facto responsible for using up inputs

and similarly for the outputs. Thus in the presence of the laissez-faire mechanism and the factual assumptions, a transfer matching implies a responsibility matching. (This proof can be easily formalized using vectors and graph theoretical machinery.)

The Fundamental Theory of Property Theory (FTPT) is the key to understanding the market mechanism of appropriation. Markets are concerned with exchanges between legal parties whereas appropriation takes place in the non-exchange activities of production and consumption. FTPT shows that if the market contractual mechanism functions in a juridically correct manner (i.e., all legal contracts are fulfilled by the corresponding de facto transfers, and all de facto transfers are covered by voluntary contracts), then laissez-faire appropriation will satisfy the juridical principle of imputation (i.e., the matching between legal and de facto responsibility). In other words, the market mechanism will not violate the labor theory of property (juridical imputation principle) if all contracts are fulfilled in a non-fraudulent manner and there are no ownership externalities (all factual transfers covered by voluntary contracts).

The property theoretic analysis of capitalist production and exchange is the main case in point. There was a responsibility mismatch in production and, accordingly, there was a corresponding transfer mismatch in exchange. The factual-minus-legal responsibility mismatch for Labor was the whole product. The analysis of exchange yielded the corresponding result. The factual-minus-legal transfers away from Labor was also the whole product.

The employment system thus violates the natural system of private property and contract. The whole product is misimputed in production, and that misimputation is set up by a naturally fraudulent contract in the marketplace.

Since labor is de facto nontransferable, the facts cannot be changed to fit the capitalist legal system (without changing human nature). To set matters aright, the legal system must take "Man as the Measure" and fit the legal contracts to the de facto transfers involved in production. The non-labor inputs K de facto transferred to Labor should also be legally transferred to Labor in return for their value rK (so Labor hires capital), and the outputs should be legally sold by Labor for their value pQ. In other words, if the contractual machinery is fitted to human nature, then human beings would no longer be rented. Under the natural system of private property and contract, Labor would always hire capital and sell the outputs so all firms would be democratic firms where the insiders (workers including managers) are jointly self-employed.

The previous example can be modified to illustrate the operation of the system of private property and contract with democratic firms. Labor buys the non-labor inputs K from Capital for rK. For simplicity, we will assume that Labor also sells the outputs back to Capital in return for their market value pQ. Thus the property vector legally transferred from Labor to Capital is (Q, –K, 0) in return for the net payment pQ–rK.

The factual transfers of non-monetary property are the same as before since labor was not de facto transferable. The monetary factual transfers are the same as those legally transferred for the democratic firm.

With the democratic firm, there is a transfer matching between the legal and factual transfers. Hence, by the Fundamental Theorem, there is a responsibility matching in the productive operations. In other words, the market mechanism of imputation will correctly impute legal responsibility in accordance with de facto responsibility.

Labor is de facto responsible for producing what has been called Labor's product, (Q, –K, 0). In the democratic firm, Labor is the last buyer of the non-labor inputs K so Labor laissez-faire appropriates the liability –K. Labor is the first seller of the produced outputs Q so Labor also laissez-faire appropriates the assets Q. Thus the market mechanism of imputation imputes Labor's product to Labor yielding the responsibility matching.

Economic democracy or universal self-employment is the natural habitat of the system of private property and contract. The legal contracts can be fulfilled in a non-fraudulent manner and when all de facto transfers of commodities are also covered by voluntary contracts, then the market will automatically impute legal responsibility for the assets and liabilities created in production and consumption in accordance with the natural principle of responsibility, i.e., the labor theory of property. That is how the natural system of private property and contract should function.