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"Cost of Production and Price Over Long and Short Periods"; Knight, Frank H.
14 paragraphs found.
Cost of Production and Price Over Long and Short Periods

After a considerable amount of experimentation the writer has tentatively settled, for instruction purposes, upon a division of the problem of explaining prices into four, or possibly five, stages, relative to the time length of the changes to be discussed. *1 In all these stages or "cases" the general principle is that price is adjusted to the point at which supply and demand are equal. They differ in that supply and demand have different meanings, especially the supply. The first stage in the explanation is to state the character and condition of equilibrium of the forces operative at a given instant of time. Here the motives of both sellers and buyers are based on speculative considerations, the former entirely and the latter almost so. Supply and demand are both functions of price, meaning that the amounts that sellers will offer and the amounts that buyers will take depend upon the price. In general, sellers will offer more and buyers take less, the higher the price. The reason is that the higher the price the less is the likelihood that it will go higher and the greater the likelihood that it will go lower in the immediate future. In the primary markets, where prices are determined, this is the only consideration in the mind of sellers, and the buying is almost entirely speculative. For the moment, the demand for goods for immediate consumption is practically negligible, and purchases are determined by opinions as to the probable course of prices in the near future. *2


The second stage of the explanation deals with the production period for the good. From this point of view the supply is fixed and is on the market without reserve. The data are not sharply definable, but in general there is a fairly definite period within which supply is fixed. The situation is clear enough in the case of an agricultural product such as corn or wheat. Taking the season as a whole there is no possibility of a change in the supply between the time when final commitments are made for one season's crop and the time when the next crop becomes available. The growers may indeed market less of the crop, using more themselves, if the price is low, but if so *3 the fact is exactly like increased consumption by non-producers under the same circumstances. If the demand of the producers themselves is taken into account at all it should be regarded as demand and added in with the demand of non-producers, and not treated as a deduction from supply. In this case the suggestion made by Davenport *4 seems to be by far the most realistic manner of viewing the situation. The demand from the standpoint of the production period as a whole is the consumer's demand and is a decreasing function of price, represented by the same sort of curve as in the former case. The supply curve (again taking price as the independent variable) is a horizontal straight line (see Diagram II). The theoretical price is the marginal demand price of the existing supply, the highest price at which it will all be consumed within the period before new supply becomes available.

Diagrams I-IV. Click to enlarge in new window

These two cases, the situation at a moment and over that more or less definite production period within which supply is not subject to change, are thrown together in the conventional treatment of market price. It seems to the writer absolutely necessary for clearness to separate them. In neither, it is obvious, do conditions of production affect price. For a given supply once produced, the price which competition tends to establish is determined by demand alone. The costs of production are ancient history. The producer will get as much as he can, whether it is more or less than his costs. The tendency is to establish over the production period the highest uniform price at which the supply will be consumed and momentary price fluctuates around this level in response to the speculative estimates of traders.


Over longer periods of time supply and demand take on still different interpretations, especially important in the case of the supply. The supply now means the amount produced, viewed as a continuous average rate, and becomes a variable, controlled by producers' calculations. From this point of view price tends toward the point where the rate of production and the rate of consumption are equal, both being functions of price. It is axiomatic that goods cannot permanently be consumed more rapidly than they are produced and will not be produced more rapidly than they are consumed. *5 For short periods of time this equality does not necessarily hold, for the reason that accumulated stocks serve as a sort of buffer between production and consumption. Consumption may exceed production for a considerable time, drawing down accumulations, and production may exceed consumption by building them up; but it is evident that neither difference can exist permanently or for very long.


The effects of these long-period changes in the total situation will not be taken up in the present discussion at all. We assume that the fundamental conditions of economic life in the aggregate, on both the supply and demand sides of the relation, remain unchanged. These fundamental conditions include ( a) the total supplies of productive resources ("land, labor, and capital"); ( b) the "state of the arts" or the knowledge of productive methods and processes; and ( c) the "psychology," tastes and habits of the people. Significant changes in these things are generally progressive in character, in contrast to the readjustments to accidental fluctuations which make up the changes considered under the three cases already enumerated, and may be grouped under the heading of Social Progress. A social setting in which all such progressive changes are abstracted but in which unlimited time is assumed for all adjustments to the given conditions in these fundamental respects to work themselves out to their natural equilibrium results, is approximately what is meant by the "static state" or Marshall's conditions for the establishment of long-time normal price. *6


We turn now to the crucial problem of the relation between the supply of a commodity and its price (meaning by supply the rate of production of the commodity) or in other words the problem of the form of the long-time supply curve. If supply is some function of price the meaning of the price point as the condition of equality between production and consumption is clear. Diagram III is drawn on the superficially natural assumption that an increase in price, other things being equal, will increase the production of the good, that supply is a direct function of price. Demand (rate of consumption) is of course an inverse function, as in the other cases.


The production of the commodity depends on the action of producers who are governed by profit-seeking motives and it is in this connection that cost of production exerts its effect on price. It goes without argument that cost affects price only as it affects supply, that any given supply put on the market will sell at a price determined by the demand, irrespective of its cost. The general character of the reasoning is simple. If the price is above the cost of production (including a profit representing payment at the general market rate for the entrepreneur's own services), production will be stimulated and the increased supply will bring down the price. If price is below cost, production will be decreased and the price raised.


Under these conditions the supply curve is identical with a cost-of-production curve. The supply is a function of price because the cost of production per unit is a function of the supply, the amount produced. It follows at once from the relation between cost of production and price (see above, p. 313) that the amount which will be produced at any selling price (per unit) is the amount which can be produced at that cost per unit. That is, the same curve which shows output as a function of price shows cost as a function of output. In order to discuss the relations from the producer's point of view it is therefore advisable to reverse the axes of the diagram, treating supply as the independent variable and cost and selling price as functions of supply. This gives the same curves as before, but as seen in a mirror or looking through the paper from the back. (It is also evident that the demand curve may be regarded indifferently as showing selling price as a function of supply or the amount salable as a function of price, that these are two ways of looking at the same set of facts.) On the new diagram (IV), which represents a mirror image of Diagram III, the intersection of the curves shows in the more natural graphic way the equality between cost and selling price, which is the goal of producers' adjustments, though on either diagram, according to the direction in which it is read, it shows either equality of cost and selling price or equality of production and consumption.


Looking at the supply curve from this new point of view, it is evident that decreasing costs would mean that at higher prices less of the commodity would be produced than at lower prices. This certainly seems paradoxical and suggests that there is something wrong with the notion of costs decreasing as supply increases. The further course of the argument will show that decreasing cost as a long-run tendency is indeed impossible under a natural competitive adjustment of industry. Under the conditions assumed, an increase in the production of any commodity means a transfer of productive resources into the industry and a decrease in the production of some other commodity. But, other things being equal, this decrease in the production of other goods will raise their prices and increase the strength of the competing attraction which they exert on productive resources against the industry in question in which output is being increased. In simpler terms, an increase in the output of any industry involves increased demand for the productive goods used in it, which increased demand raises their prices, that is, raises the costs of production of the commodity turned out.


A more or less important qualification relates to the extent to which cost necessarily increases with output. For commodities which do not represent an appreciable fraction of the demand for any productive resource which goes into them, the change in cost corresponding to probable changes in output may indeed be practically negligible. The function may represent virtually constant cost. For example, the case of steel rails may be contrasted with that of carpet tacks. A considerable change in the demand for steel rails means a considerable change in the demand for the ultimate resources used in producing them, and will make a marked difference in the prices of these resources, that is, in the cost of production. No probable change in the demand for carpet tacks would make an appreciable change in the demand for any ultimate productive resource and hence within the limits of accuracy of economic measurement the long-run tendency is represented by constant cost. The supply curve of Diagram IV is for such goods a horizontal straight line, in Diagram III a vertical one. But constant cost is the "limiting case" which in strict accuracy is never met with. There is no place for a tendency to decreasing costs, when the conditions are correctly stated.


All of this reasoning relates to the ultimate goal of the competitive tendencies, with unlimited time allowed for the adjustment of production to given conditions of demand (but with long-period progressive changes in the general conditions of both supply and demand eliminated). The next question is that of the relation between cost of production and price, the shape of the curve showing cost as a function of output and hence output as a function of price, over moderate periods of time. Two main sets of facts differentiate the short-period from the long-period tendencies. The first is the physical immobility of productive resources between different uses and the second is the comparative inflexibility of the prices of productive services, in terms of which the producer makes his calculations. When the price of a product changes, owing to a change in demand, the entrepreneur cannot commonly change his price offers for productive goods immediately into correspondence with them. For many of these he is under contract over a longer or shorter period at specified rates. For others, notably labor services, psychological and social considerations prevent quick and accurate readjustments, not to mention that the entrepreneur himself does not come instantly and automatically into accurate knowledge of the facts. And when the price remunerations for "land, labor, and capital" do change relatively in different industries, transfers of these agencies from one industry to the other do not always follow quickly or freely. Even those agencies which are transferable without physical modification encounter a large amount of inertia and resistance. Others cannot be transferred without changes involving costs and still others are only indirectly movable; they must be allowed to wear out and be replaced with others of a different type. That is, the ultimate resources are largely mobile, but they are embodied in intermediate forms which are not; and finally, to some extent the ultimate resources are specialized and the only change to which they are subject is a revaluation.


The correct approach to the explanation of price in the case of partial monopoly would seem to be to apply the theory of monopoly, not that of competition. Instead of attempting to allow for a degree of monopoly in the supply, which there is no easy way of doing, it is vastly simpler to allow for partial competition as a phenomenon of substitution, on the demand side. No difficulty whatever is involved in assuming control of the supply (of the commodity defined in the narrowest sense) and allowing for competition by substitution of more or less similar goods in drawing the demand curve. And this is the more realistic view as it represents the way in which the producer would naturally envisage the situation.


One more phase of the problem of decreasing cost with decreasing output should be mentioned in conclusion. Without considering new inventions or the introduction of methods not previously familiar, there may be a possibility of using different systems of production in making a commodity, one method being more efficient for a smaller supply and another for a larger. This is under any probable conditions another phase of the variation in size of establishment, but in any case a confusion in the definition and plotting of the cost function should be pointed out. If it is true that a small output would naturally be produced by primitive methods while a larger one would justify a more elaborate organization with greater efficiency, it may well seem that the case is one of decreasing costs. There is a fallacy in overlooking the fact that any amount of the commodity could be made by any one of the methods available. A correct treatment of the cost in relation to output should plot a complete cost curve for each method separately, extending from zero output up to one of indefinite magnitude, as shown in Diagram VIII. For the simplest method we shall have the curve of slightly increasing costs which represents the normal situation as shorn early in the discussion (curve 1). For a more elaborate technology the smaller magnitudes of output will be much more costly, but as output increases up to the capacity of the equipment, costs rapidly decrease, to a level below that of the first method. Beyond this point the curve becomes parallel with the first (curve 2). And similarly for a still more capitalistic method, as shown in curve 3. The significant part of the figure presents therefore, not a curve of decreasing costs, but a series of curves of increasing costs at different levels. It is hardly supposable that there can be a plurality of equilibrium points in such a situation, at which production may go forward under competitive conditions. The substance of the matter is, as already brought out, that if more efficient methods, connected with larger-scale operations, are available, the number of organizations in the industry will be reduced until all are on the most efficient scale. Then if the demand is sufficient to maintain a plurality of organizations, each will be subject to increasing costs; if the demand is not large enough for that, the industry will be a monopoly, in which case there is no tendency for cost and price to be equal (monopoly revenue not being counted as a part of cost).

Diagrams I-IV. Click to enlarge in new window The situation in the market at a moment is represented by the familiar demand and supply curves. In the writer's view these gain enormously in reality and clearness by taking price as the base line, the independent variable, and interpreting the price point as the point where the amount off offered is equal to the amount taken (see Diagram I). This is the procedure of the so-called mathematical economists. American textbooks generally plot quantity of goods horizontally and price vertically in order to make the demand curve identical with a curve of diminishing utility (utility as a function of supply). When it is remembered that utility in the sense in which it influences price is relative utility, measured in terms of money, the value of the utility analysis for explaining price becomes somewhat problematical, especially for purposes of elementary exposition. It is not clear that such utility curves add much to the mere statement that purchases are a function of price. Certainly they have to be translated into curves of purchases as a function of price before they are usable, for a utility curve can at most represent the facts for a single purchaser. There is no possibility of comparing or adding utilities for a group of individuals differing in taste and in income, and the only way of representing the social facts is to add the amounts of the good which different individuals are willing to purchase at the different prices.

In any case utility calculations are nearly negligible in relation to price at a given moment, since prices are fixed in primary markets where purchases are made far in advance of actual consumption. Purchases in advance of immediate needs by consumers, and still more by middlemen, and controlled by speculative motives, make up the effective momentary demand.