"Cost of Production and Price Over Long and Short Periods"

Frank H. Knight
Knight, Frank H.
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First Pub. Date
Apr. 1921
Journal of Political Economy. vol. 29, no. 4, pp. 304-335. Chicago, IL: University of Chicago
Pub. Date

1. This division differs from Marshall's four cases in important respects which will be developed at length. My fivefold division corresponds more closely to his fourfold one.

This article discusses the problem of the explanation of price. It is appropriate to say that I think we have talked rather too much about prices as such, and should strive to keep more in the foreground the forces which are measured by prices and the changes which they bring about. The real subject matter of economics is the organization of production and consumption. The desideratum is to get students to see how in our social system, in so far as it is based upon private property and free contract, consumption is controlled by the prices of finished goods, how these prices are translated through entrepreneurs' calculations into price offers for productive services which control the utilization of the productive resources of society, and finally and most sadly neglected of all, the circular character of the whole process. The pecuniary demand for goods has little relation to their objective human significance. It depends on the existing distribution of ownership and opportunity and the facts as to consumers' tastes, both of which are largely molded by the workings of the system itself.

2. 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.

3. Moreover the fact itself is improbable. If the wheat is the grower's main source of income, it is at least as likely that he will consume more if the price is high, since the difference in his income due to the higher price of his produce is likely to be more important than the difference in the price as a deterrent to consumption.

4. Economics of Enterprise, pp. 48-52.

5. The latter part of the statement does not fit certain types of "durable" goods such as gold, jewelry, works of art, ideas, etc., which are not strictly speaking consumed at all. The theory of normal price (price determined by cost of production) is wholly inapplicable to such things, in the form which is valid for ordinary consumption goods.

6. The expression "unprogressive society," though less compact, seems to this writer much better than the "static state" to designate this situation. The word "static" suggests the absence of change. The idea is not however to eliminate change, but only certain changes while discussing the natural readjustment of other things to the given condition of those assumed as unchanging for purposes of the argument. The term "dynamic" contrasted with "static" is still more objectionable and "progressive" has in this case the advantage of being more euphonious as well. The distinction between progressive change and fluctuations seems to be important enough to justify a generic division along this line. It is not always true that progressive changes become practically important only over periods of time long in comparison to those in which fluctuations work themselves out, but it is so generally true as to make the division all the more significant and to make it easier to visualize the separation.

The advisability of distinguishing between short-time and long-time normal price will be taken up immediately. If this is done we have five cases or sets of data for our analysis in place of Marshall's four (Principles of Economics [6th ed.], p. 379).

It is fundamental to price theory as a whole, in which no sharp separation is possible between the prices of consumption goods and the prices of productive services or distribution (since the costs of production are identical with the distributive shares), that the data for the long-time theory of the former are the same as the data for the short-time theory of distribution. Over the period under consideration (say a few years) the supply of any consumption good is variable, a function of price, while the supply of any fundamental productive factor is fixed. The theory of progress will treat of the remunerations of productive services under the influence of changes in supply, and of what Marshall calls "secular changes" in normal prices (of consumption goods).

7. A condition doubtfully more often true of "land" than labor, bearing in mind that mineral resources are not economic land.

8. The separation of land from "artificial" productive goods is to the writer one of the hardest things to account for in the traditional economic speculation. It simply is not true that there is any productive power in land which has not been "produced" in the only sense in which men produce anything; its value is due to the form it is in, which represents previous investment, and the supply is determined by free investment in competition with other fields. The speculative element in such investment may be larger on the average but in the writer's opinion the reverse is more probably true.

These statements do not apply to mineral deposits and other exhaustible and non-replaceable natural wealth. There would be good ground for erecting these goods into a separate productive category; but this type of natural productive power is just what has been excluded from the category of land by the economists' definitions. But, detailed discussion of the classification of productive resources is outside the field of this paper.

9. See below, p. 317.

10. The division lines cut across all the conventional productive factors. Some "land," some "labor," and some "capital" (capital goods) are transferable, some transformable (over a longer or shorter period of time), and some rigidly specialized. Here as elsewhere the conventional division is irrelevant; the writer has yet to run across any real economic problem in relation to which it has practical significance.

11. It should be noted that it is impossible to be sure that we are adhering rigorously to the assumption that progressive change in total productive capacity is absent. When productive goods are changed in form there is no clear and definite meaning in the assertion that they remain the same in amount. The equivalence can be approximately preserved, in so far as the new forms represent the same amount of some more fundamental productive resource (such as homogeneous labor) as the old, but some differences in the kind as well as amount of the ultimate investment are doubtless always connected with differences in the immediate form of the production good. The question really is the extent to which production goods differing in form and specialized to certain uses do ultimately represent the investment of unspecialized resources. It is undoubtedly true that for the most part they do; but even then, some such investments never wear out and give back the unspecialized productive power which went into them for use in creating goods of some other specialized form.

12. Principles of Economics, 6th ed., p. 379. It is to be observed that even Marshall's discussion of long-time normal price does not relate to the ultimate adjustment of production to fit given conditions of demand. This is in line with his general tendency to avoid clear-cut formulations and "soften" his principles to make them cover a broader range of facts. The present writer is inclined to a very different conception of scientific procedure, though not necessarily to the exclusion or displacement of "looser" forms of treatment. Another case in point is the concept of the "representative firm" already referred to. In our view general principles are to be stated with the most rigorous accuracy attainable and pure theory sharply separated from its application to reality. From this point of view the failure of a scientific principle to fit accurately any case whatever, much less any class of cases, may be a merit rather than a defect. It is not the purpose of such principles to describe facts in realistic detail, but to state with the greatest possible accuracy general relations which form a common element in large groups of real situations, even though they may not be the whole story, may not necessarily even give an approximately complete description, of any single case.

13. Normal here means of course merely usual and has no connection with the use in "normal price" as the goal of tendencies at work.

14. A complete and accurate representation would require a three-dimensional drawing, the curves being located at successive points along a time axis perpendicular to the paper and blending into a surface increasing in inclination to the price plane with increasing distance from the zero point of the axis of time-allowed-for-readjustment.

15. A well-known problem book in economics contains the question, If a railroad is already in existence between New York and Chicago and trains are running, what added cost will the railroad incur in hauling a five-pound box from Chicago to New York? Of course the Freshman is expected to answer that the cost would be slight, and to be duly impressed with the importance of fixed costs. No reference is made to the possibility that the trains already running may be full! The added cost of the particular small increment of traffic which compels the addition of even an extra car to a train will not be negligible. And locomotives also reach their capacity and new trains have to be added; and sometimes, new tracks must be built if the traffic continues to grow, and ultimately it would be impracticable to increase the number of tracks. Perhaps about eight is a maximum before it could be cheaper to start an entire new system far enough removed from the first to avoid interference in switching and handling the shipments.

16. In European countries generally the facts were different, the traffic demands being generally up to the capacity of the railways as they were built and expanded; the foreign literature on railways is relatively free from the heresy of decreasing costs and foreign railway policies from the disorganizing tendencies based upon the idea.

The doctrine that railway rates are determined according to the principle of joint cost seems to the writer especially hard to defend, since the operation of the equipment would be actually simplified if its capacity were all employed in handling a single class of traffic. The notion of joint cost adds nothing to the simple statement of diminishing cost unless different kinds of products result in nearly fixed proportions from the same productive operations. Compare Taussig, Principles of Economics, chap. lx, and a discussion of the subject by Taussig and Pigou in the Quarterly Journal of Economics, Vol. XXVII.

The writer is inclined to believe that the "wise social policy" would be to require railways to make all charges on a ton-mile basis, over the best route, with allowance for special handling costs and any special service such as extra speed or the like. Of course this does not mean that they should be required to change quickly to such a basis from the present system, nor is the proposal expected to be taken seriously from the standpoint of that complex of auto-hallucination, humbug, and knavery which we call practical politics.

17. The curve is of course a rough sketch and merely suggestive. Drawn accurately to scale it should never be steeper than a rectangular hyperbola through the point. A decrease in cost per unit at greater ratio than that of the increase in output would mean a smaller total cost for the larger output, which is absurd.

18. It is by no means meant to imply that this should never be done. The writer would hold—in opposition for example to Taussig (Principles of Economics, chap. lx, sec. 1)—that in this field social interests very often outweigh economic advantage, as measured by pecuniary demand.

19. Professor Friday's interesting argument against the concept of "normal profit" (in Profits, Wages, and Prices, chap. iii) does not affect the proposition as stated above, if indeed it applies to any doctrine which economic theorists have traditionally advocated. He has not in any sense disproved a tendency of profit toward a normal level, or even that this tendency is reasonably effective over a moderate period of time if the variables are accurately measured in price terms.

In this connection it may be suggested that the conclusion of Professor Friday that an excess-profits tax will not discourage production may be hastily drawn. In the first place, we may question whether the anticipation of unusual profits is not in itself a vital element in the incentive to business activity. In the second place, it is admitted that profits are closely connected with fluctuations in industry and if the tax is levied annually a business which is actually losing money may pay a considerable amount of excess-profits taxes over a period of a few years.

20. The Quarterly Journal of Economics for May, 1918.

End of Notes.

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