Chapter 9—Production: Particular Factor Prices
and Productive Incomes (continued)
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Chapter 9—Production:
Particular Factor Prices
and Productive Incomes (continued)
E.
Productivity and Marginal Productivity
Great care must be taken in dealing with the productivity concept. In
particular, there is danger in using a term such as
“productivity of labor.” Suppose, for example, we
state that “the productivity of labor has advanced in the
last century.” The implication is that the cause of
this increase came from within labor itself, i.e., because current
labor is more energetic or personally skillful than previous labor.
This, however, is not the case. An advancing capital structure
increases the marginal productivity of labor,
because the labor supply has increased less than the supply of capital
goods. This increase in the marginal productivity of labor, however, is
not due to some special improvement in the labor energy expended. It is
due to the increased supply of capital goods. The causal agents of
increased wage rates in an expanding economy, then, are not
primarily the workers themselves, but the capitalist-entrepreneurs who
have invested in capital goods. The workers are provided with more and
better tools, and so their labor becomes relatively scarcer as compared
to the other factors.
That each man receives his marginal value product means that each man
is paid what he is worth in producing for consumers. But this
does not mean that increases in his worth over the years are
necessarily caused by his own improvement. On the contrary, as we have
seen, the rise is primarily due to the increasing abundance of
capital goods provided by the capitalists.
It is, then, clearly impossible to impute absolute
“productivity” to any productive factor or class of
factors. In the absolute sense, it is meaningless to try to impute
productivity to any factor, since all the factors are necessary to the
product. We can discuss productivity only in marginal
terms, in terms of the productive contribution of a
single unit of a factor, given the existence of other factors. This is
precisely what entrepreneurs do on the market, adding and subtracting
units of factors in an attempt to achieve the most profitable course of
action.
Another illustration of the error in attempting to attribute increased
“productivity” to the workers themselves occurs
within the various segments of the labor market. As we have seen, there
is a definite connexity between all the occupations
on the labor market, since labor is the prime nonspecific factor. As a
result, while wage rates are not equalized, psychic wage rates will all
tend, in the long run, to move together and maintain a given
skill-differential between each occupation. Therefore, when a certain
branch of industry expands its capital and production, an increase in
DMVP, and therefore in wage rates, is not confined to that particular
branch. Because of the connexity of the supply of labor, labor tends to
leave other industries and enter the new ones, until finally all the
wage rates throughout the labor market have risen, while maintaining
the same differentials as before.
Suppose, for example, that there is an expansion of capital in the
steel industry.
The MVP of the steel
worker increases, and his wage rates go up. The increase in wage rates,
however, is governed by the fact that the rise will attract workers
from more poorly paid industries. For example, suppose that steel
workers are receiving 25 grains of gold per hour, while domestic
servants receive 15 grains per hour. Now, under the impetus of
expansion, the MVP and hence the wage rate of the steel workers go up
to 30 grains. The differential has been increased, inducing domestic
servants to enter the steel industry, lowering steel wages, and
especially raising servants’ wages, until the differential is
re-established. Thus, a rise in capital investment in steel
will increase the wages of workers in domestic service. The latter
increase is clearly not caused by some sort of increase in the
“productivity” or in the quality of the output of
the domestic servants. Rather, their marginal value
productivity has increased as a result of the greater scarcity of labor
in the service trades.
The differentials will not remain precisely constant in practice, of
course, since changing investment and changing methods also alter the
types of skills required in the economy.
The shift in labor supply will not usually be as abrupt as in our
example. Generally, it will take place from one occupation or one grade
to a closely similar grade or occupation. Thus, more ditchdiggers might
become foremen, more foremen supervisors, etc., so that shifts will
take place from grade to grade. It is as if the labor market consisted
of linked segments, a change in one segment transmitting itself
throughout the chain from each link to the next.
F.
A Note on Overt and Total Wage Rates
It is “total wage rates” that are determined on the
market. They tend to be equalized on the market and to be set at the
DMVP of the worker. Total wage rates are the money
paid out by the employer for labor services. They do not necessarily
correspond to the “take-home pay” of the
worker. The latter may be called the “overt wage
rates.” Thus, suppose that there are two competing employers
bidding for the same type of labor. One employer, Mr. A, pays out a
certain amount of money, not in direct wages, but in pension funds or
other “welfare” benefits. These benefits, it must
be realized, will not be added as a gift from the employer to the
workers. They will not be additions to the total wage rates. Overt wage
rates paid out by Mr. A will instead be correspondingly lower
than those paid out by his rival, Mr. B, who does not have to spend on
the “welfare” benefits.
To the employer, in other words, it makes no difference in what form
workers cost him money, whether in “take-home pay”
or in welfare benefits. But he cannot pay more than the
worker’s DMVP; i.e., the worker’s total wage income
is set by this amount. The worker, in effect, chooses in what form
he would like his pay and in what proportion of net wage rates to
“welfare” benefits. Part of these benefits is money
that the employer might spend to provide particularly pleasant or plush
working conditions for all or some of his employees. This cost is part
of the total and is deducted from the overt wage rates of the employee.
The institutional manner of paying wage rates is a matter of complete
indifference to our analysis. Thus, while “piece
rates” or “time rates” may be more
convenient in any given industry, they do not differ in essentials;
both are wage rates paid for a certain amount of work. With time rates,
the employer has in mind a standard of performance which he expects
from a worker, and he pays according to that rate.
G.
The “Problem” of Unemployment
An economic bugbear of our times is “unemployment.”
Not only is this considered the preeminent problem of the
“depression” in the “business
cycle”; it is also generally considered the primary
“problem” of the “capitalist
system,” i.e., of the developed free-market economy.
“Well, at least socialism solves the unemployment
problem,” is supposed to be the most persuasive
argument for socialism.
Of particular interest to us is the sudden emergence of the
“unemployment problem” in economic theory. The
Keynesians, in the mid-1930’s, inaugurated the fashion of
declaiming: Neoclassical economics is all right for its special area,
but it assumes “full employment.” Since
“orthodox” economics “assumes full
employment,” it holds true only so long as “full
employment” prevails. If it does not, we enter a Keynesian
wonderland where all economic truths are vitiated or reversed.
“Full employment” is supposed to be the condition
of no unemployment and therefore the goal at which everyone aims.
In the first place, it should be emphasized that economic theory does
not “assume” full employment. Economics, in fact,
“assumes” nothing. The whole
discussion of alleged “assumptions” reflects the
bias of the epistemology of physics, where
“assumptions” are made without originally knowing
their validity and are eventually tested to see whether or not their
consequents are correct. The economist does not
“assume”; he knows. He concludes
on the basis of logical deduction from self-evident axioms, i.e.,
axioms that are either logically or empirically incontrovertible.
Now what does economics conclude on the matter of
unemployment or “full employment”? In the
first place, there is no “problem” involved in the
unemployment of either land or capital goods factors. (The latter
condition is often known as “idle” or
“unused capacity.”) We have seen above that a
crucial distinction between land and labor is that labor is relatively
scarce. As a result, there will always be land factors remaining
unused, or “unemployed.”
As a further result, labor
factors will always be fully employed on the free market to the extent
that laborers are so willing. There is no problem
of “unemployed land,” since land remains unused for
a good reason. Indeed, if this were not so (and it is conceivable that
some day it will not be), the situation would be most unpleasant. If
there is ever a time when land is scarcer than labor, then land will be
fully employed, and some labor factors will either get a zero wage or
else a wage below minimum subsistence level. This is the old classical
bugbear of population pressing the food supply down to
below-subsistence levels, and certainly this is theoretically
possible in the future.
This is the only case in which an “unemployment
problem” might be said to apply in the free market. But even
here, if we consider the problem carefully, we see that there is no
unemployment problem per se. For if what a man
wants is simply a “job,” he could work for zero
wages, or even pay his “employer” to work for him.
In other words, he could earn a “negative wage.”
Now this could never happen, for the good reason that labor is a
disutility, especially as compared to leisure or
“play.” Yet all the worry about “full
employment” makes it appear that the
“job,” and not the income from the job, is the
great desideratum. If that were really the case, then there would
be negative wages, and there would be no unemployment problem either.
The fact that no one will work for zero or negative wages implies that
in addition to whatever enjoyment he receives, the laborer requires a
monetary income from his work. So what the worker wants is not just
“employment” (which he could always get in the last
resort by paying for it) but employment
at a wage.
But once this is recognized, the whole modern and Keynesian emphasis on
employment has to be revalued. For the great missing link in their
discussion of unemployment is precisely the wage rate.
To talk of unemployment or employment without reference to a wage rate
is as meaningless as talking of “supply” or
“demand” without reference to a price. And
it is precisely analogous. The demand for a commodity makes sense only
with reference to a certain price. In a market for goods, it is obvious
that whatever stock is offered as supply, it will be
“cleared,” i.e., sold, at a price determined by the
demand of the consumers. No good need remain unsold if the seller wants
to sell it; all he need do is lower the price sufficiently, in extreme
cases even below zero if there is no demand for the good and he wants
to get it off his hands. The situation is precisely the same here. Here
we are dealing with labor services. Whatever supply of labor service is
brought to market can be sold, but only if wages are set at
whatever rate will clear the market.
We conclude that there can never be, on the free market, an
unemployment problem. If a man wishes to be employed, he will be,
provided the wage rate is adjusted according to his DMVP. But since no
one wants to be simply “employed” without getting
what he considers sufficient payment, we conclude that
employment per se is not even a desired
goal of human action, let alone a “problem.”
The problem, then, is not employment, but employment at an
above-subsistence wage. There is no guarantee that this situation will
always obtain on the free market. The case mentioned
above—scarcity of land in relation to labor—can
lead to a situation where a worker’s DMVP is below a
subsistence wage for him. There also may be so little capital invested
per worker that any wage will be below-subsistence for many people.
Even in a relatively prosperous society there may be
individual workers so infirm or lacking in skill that their
particular talents could not command an above-subsistence wage. In that
case, they could survive only through the gifts of those who
are making above-subsistence wages.
But what of the able-bodied worker who “can’t find
a job”? This situation cannot obtain. In those cases, of
course, where a worker insists on a certain type of job or a certain
minimum wage rate, he may well remain “unemployed.”
But he does so only of his own volition and on his own responsibility.
Thus, suppose that perhaps half the labor force suddenly insisted that
they would not work unless they received a job in New York City in the
television industry. Obviously, “unemployment”
would suddenly become enormous. This is only a large-scale
example of something that is always going on. There may be a
shift of industry away from one town or region and toward another. A
worker may decide that he wants to remain in the old town and insists
on looking for a job there. If he fails to get one, however,
the fault lies with himself and not with the “capitalist
system.” The same is true of a clerk who insists on
working only in the TV industry, or of a radio employee who refuses to
leave for television and insists on working only in radio. We are not
condemning these workers here. We are simply saying that by their
decisions they are themselves choosing not to be employed.
The able-bodied in a developed economy can always find work, and work
that will pay an over-subsistence wage. This is so because
labor is scarcer than land, and enough capital has been
invested to raise the marginal value product of laborers
sufficiently to pay such a wage. But while this is true in the general
labor market, it is not necessarily true for particular labor markets,
for particular regions or occupations, as we have just seen.
If a worker can withdraw from the labor market by insisting on a
certain type of work or location of work, he can also withdraw
by insisting on a certain minimum wage payment. Suppose a man insisted
that he would not work at any job unless he is paid 500 gold ounces per
year. If his best available DMVP is only 100 gold ounces per year, he
will remain unemployed. Whenever a man insists on a wage
higher than his DMVP, he will remain unemployed, i.e., unemployed
at the wage that he insists upon. But then this unemployment
is not a “problem,” but a voluntary choice on the
part of the idle person.
The “full employment” provided by the free market
is employment to the extent that workers wish to be employed.
If they refuse to be employed except at places, in occupations, or at
wage rates they would like to receive, then they are likely to be
choosing unemployment for substantial periods.
It might be objected that workers often do not know
what job opportunities await them. This, however, applies to the owner
of any goods up for sale. The very function of marketing
is the acquisition and dissemination of information
about the goods or services available for sale. Except to those writers
who posit a fantastic world where everyone has “perfect
knowledge” of all relevant data, the marketing function is a
vital aspect of the production structure. The marketing
function can be performed in the labor market, as well as in any other,
through agencies or other means for the discovery of who or where the
potential buyers and sellers of a particular service may be. In the
labor market this has been done through “want ads”
in the newspapers, employment agencies used by both employer
and employee, etc.
Of course “full employment,” as an absolute ideal,
is absurd in a world where leisure is a positive good. A man may choose
idleness in order to obtain leisure; he benefits (or believes
he benefits) more from this than from working at a job.
We can see this truth more
clearly if we consider the hours of the work week. Will anyone maintain
that an 80-hour work week is necessarily better than a 40-hour
week? Yet the former clearly represents a fuller employment of
labor than the latter.
One alleged example of a possible case of involuntary
unemployment on the free market has been suggested by
Professor Hayek.
Hayek maintains that when
there is a shift from investment to consumption, and therefore
a shortening of the production structure on the market, there
will be a necessary temporary unemployment of workmen thrown out of
work in the higher stages, lasting until they can be reabsorbed in the
shorter processes of the later stages. It is true that there
is a loss in income, as well as a loss in capital, from a shift to
shorter processes. It is also true that the shortening of the structure
means that there is a transition period when, at final wage rates,
there will be unemployment of the men displaced from the
longer processes. However, during this transition period there
is no reason why these workers cannot bid down wage rates until they
are low enough to enable the employment of all the workers during the
transition. This transition wage rate will be lower than the
new equilibrium wage rate. But at no time is there a necessity for
unemployment.
The ever-recurring doctrine of “technological
unemployment”—man displaced by the
machine—is hardly worthy of extended analysis. Its absurdity
is evident when we look at the advanced economy and compare it with the
primitive one. In the former there is an abundance of machines and
processes completely unknown to the latter; yet in the former,
standards of living are far higher for far greater numbers of
people. How many workers have been
“displaced” because of the invention of the shovel?
The technological unemployment motif is encouraged by the use of the
term “labor-saving devices” for capital goods,
which to some minds conjure up visions of laborers being simply
discarded. Labor needs to be “saved”
because it is the pre-eminently scarce good and
because man’s wants for exchangeable goods are far from
satisfied. Furthermore, these wants would not be satisfied at all if
the capital-goods structure were not maintained. The more labor is
“saved,” the better, for then labor is using more
and better capital goods to satisfy more of its wants in a shorter
amount of time.
Of course, there will be “unemployment” if, as we
have stated, workers insist on their own terms for work, and these
terms cannot be met. This applies to technological changes as
well as any other. The clerk who, for some reason, insists nowadays on
working only for a blacksmith or in an
old-fashioned general store may well have chosen a large dose of
idleness. Any workers who insisted on working in the buggy industry or
nothing found themselves, no doubt, unemployed after the
development of the automobile.
A technological improvement in an industry will tend to increase
employment in that industry if the demand for the product is
elastic downward, so that the greater supply of goods induces
greater consumer spending. On the other hand, an innovation in
an industry with inelastic demand downward will
cause consumers to spend less on the more abundant products,
contracting employment in that industry. In short, the process of
technological innovation shifts workers from the inelastic-demand to
the elastic-demand industries. One of the major sources of new
employment demand is in the industry making the new machines.
3.
Entrepreneurship and Income
A.
Costs to the Firm
We have seen the basis on which the prices of the factors of production
and the interest rate are determined. Looked at from the point of view
of an individual entrepreneur, payments to factors are money costs.
It is clear that we cannot simply rest on the old classical law that
prices of products tend, in the long run, to be equal to their costs of
production. Costs are not fixed by some Invisible Hand, but are
determined precisely by the total force of entrepreneurial demand for
factors of production. Basically, as Böhm-Bawerk and
the Austrians pointed out, costs conform
to prices, and not vice versa. Confusion
may arise because, looked at from the point of view of the individual
firm rather than of the economist, it appears as if
costs (at least in the sense of the prices of factors) are somehow
given, and beyond one’s control.If a firm can
command a selling price that will more than cover its costs, it remains
in business; if not, it will have to leave. The illusion of externally
determined costs is prevalent because, as we shall presently
see, most factors can be employed in a wide variety of firms, if not
industries. If we take the broader view of the economist, however, the
various “costs,” i.e., prices of factors,
determined by their various DMVPs in alternative uses, are ultimately
determined solely by consumers’ demand for all uses. It must
not be forgotten, furthermore, that changes in demand and selling price
will change the prices and incomes of specialized factors in
the same direction. The “cost curves” so
fashionable in current economics assume fixed factor prices, thereby
ignoring their variability, even for the single firm.
It might be noted that, in this work, there is none of that plethora
and tangle of “cost curves” which fill the horizon
of almost every recent “neoclassical” work
in economics.
This omission has
been deliberate, since it is our contention that the cost curves are at
best redundant (thus violating the simplicity principle of
Occam’s Razor), and at worst misleading and erroneous.
As an explanation of the pricing of factors and the allocation of
output it is obvious that cost curves add nothing new to
discussion in terms of marginal productivity. At best, the two
are reversible. This can be clearly seen in such texts as E.T.
Weiler’s The Economic System and George
J. Stigler’s Theory of Price.
But, in addition, the
shift brings with it many grave deficiencies and errors. This is
revealed in the very passage in which Stigler explains the reasons for
his switch from a perfunctory discussion of productivity to a lengthy
treatment of cost curves:
The
law of variable proportions has now been explored sufficiently to
permit a transition to the cost curves of the individual firm. The
fundamentally new element in the discussion will, of course, be the
introduction of prices of the productive services. The transition is
made here only for the case of competition—that is, the
prices of the productive services are constant because the firm does
not buy enough of any service to affect its price.
But by introducing given prices of productive
services, the contemporary theorist really abandons any
attempt to explain these prices. This is one of the cardinal errors of
the currently fashionable theory of the firm. It is highly
superficial. One of the aspects of this superficiality is the
assumption that prices of productive services are given,
without any attempt to explain them. To furnish an explanation,
marginal productivity analysis is necessary.
Marginal productivity analysis and the profit motive are
sufficient to explain the prices of productive factors and
their allocation to various firms and industries in the
economy. Furthermore, there are in production theory two
important and interesting concepts involving periods of time.
One is what we may call the “immediate
run”—the market prices of commodities and
factors on the basis of given stocks and speculative demands
and given consumer valuations. The immediate run is important, since it
provides an explanation of the actual market prices of all goods at any
time. The other important concept is that of the “final
price,” or the long-run equilibrium price, i.e., the price
that would be established in the ERE. This is important because it
reveals the direction in which the immediate-run market prices tend to
move. It also permits the analytic isolation of interest, as compared
to profit and loss, in entrepreneurial incomes. In the ERE all factors
will receive their discounted marginal value product, and interest will
be pure time preference; there will be no profit and loss.
The interesting phases, then, are the immediate run and the long run.
Yet cost-curve analysis deals almost exclusively with a hybrid
intermediate phase known as the “short run.” In
this short run, “costs” are sharply divided into
two categories: fixed (which must be incurred regardless of the amount
produced) and variable (which vary with output). This whole
construction is a highly artificial one. There is no actual
“fixity” of costs. Any alleged fixity depends
purely on the length of time involved. In fact, suppose that production
is zero. The “cost-curve theorists” would have us
believe that even at zero output there are fixed costs that must be
incurred: rent of land, payment of management, etc. However,
it is clear that if data are frozen—as they should be in such
an analysis—and the entrepreneurs expect a
situation of zero output to continue indefinitely, these
“fixed” costs would become
“variable” and disappear very quickly. The rent
contract for land would be terminated, and management fired, as the
firm closed its doors.
There are no “fixed” costs; rather there are
different degrees of variability for different productive factors. Some
factors are best used in a certain quantity over a certain range of
output, while others yield best results over other ranges of output.
The result is not a dichotomy into “fixed” and
“variable” costs, but a condition of many degrees
of variability for the various factors.
Even if none of these difficulties existed, it is hard to see why the
“short run” should be picked out for detailed
analysis, when it is merely one way station, or rather a series of way
stations, between the important periods of time:
the immediate run and the long run. Analytically, the cost-curve
approach is at best of little interest.
With these caveats, let us now turn to an analysis
of the costs of the firm. Let us consider what will happen to costs at
alternate hypothetical levels of output. There are two
elements that determine the behavior of average costs,
i.e., total costs per unit output.
(a) There are “physical
costs”—the amounts of factors that must be
purchased in order to obtain a certain physical quantity of output.
These are the obverse of “physical
productivity”—the amounts of the physical product
that can be produced with various amounts of factors. This is
a technological problem. Here the question is not
marginal productivity, where one factor is varied while others remain
constant in quantity. Here we concentrate on the scale of
output when all factors are permitted to vary. Where all
factors and the product are completely divisible, a
proportionate increase in the quantities of all the factors must lead
to an equally proportionate increase in physical output.
This may be called the law
of “constant returns to scale.”
(b) The second determinant of average costs is
factor prices. “Pure competition” theorists assume
that these prices remain unchanged with a changing scale of
output, but this is impossible.
As any firm’s
scale of output increases, it necessarily bids factors of production
away from other firms, raising their prices in the process. And this is
particularly true for labor and land factors, which cannot be increased
in supply via new production. The increase in factor prices as output
increases, combined with constant physical costs, raises the
average money cost per unit output. We may therefore conclude
that if factors and product were perfectly divisible, average
cost would always be increasing.
In the productive world, perfect divisibility does not always, or even
usually, obtain. Units of factors and of output are indivisible,
i.e., they are not purely divisible into very small units. First, the product
may be indivisible. Thus, suppose that three units of factor A
+ 2 units of factor B may combine to produce one
refrigerator. Now it may be true that 6A + 4B
will produce two refrigerators, according to our law of returns to
scale. But it is also true that 4A + 3B
will not produce one-and-a-fraction
refrigerators. There are bound to be gaps
where an increased supply of factors will not
lead to an increased product, because of the technological
indivisibility of the unit product.
In the areas of the gaps, average costs increase rapidly, since new
factors are being hired with no product forthcoming; then, when
expenditures on factors are increased sufficiently to produce more of
the product, there is a precipitate decline in
average cost compared to the situation during the gap. As a result, no
businessman will knowingly invest in the area of the gaps. To
invest more without yielding a product is sheer waste, and so
businessmen will invest only in the trough points outside the
gap areas.
Secondly, and more important, the productive factors
may be indivisible. Because of this indivisibility, it is not possible
simply to double or halve the quantities of input of every one
of the productive services simultaneously. Each factor has its own
technological unit size. As a result, almost all business decisions
take place in zones in which many factors have to remain
constant while others (the more divisible ones) may vary. And
these relative divisibilities and indivisibilities are due, not to
variations in periods of time, but to the technological size of the
various units. In any productive operation there will be many varieties
of indivisibility.
Professor Stigler presents the example of a railroad track, a factor
capable of handling up to 200 trains a day.
The track is most
efficiently utilized when train runs total precisely 200 a day. This is
the technologically “ideal” output and may be the
one for which the track was designed. Now what happens when
output is below 200? Suppose output is only 100 per day. The divisible
factors of production will then be cut in half by the owners of the
railroad. Thus, if engineers are divisible, the railroad will
hire half as many engineers or hire its engineers for half their usual
number of hours. But (and this is the critical point here) the railroad
cannot cut the track in half and operate on half a track. The
technological unit of “track” being what it is, the
number of tracks has to remain at one. Conversely, when output
increases to 200 again, other productive services may be doubled, but
the quantity of track remains the same.
What happens should output increase to 250 trains a day—a
25-percent increase over the planned quantity? Divisible services such
as engineers may be increased by one-fourth; but the track
must either remain at one—and be overutilized—or be
increased to two. If it is increased, the tracks will again be
underutilized at 250, because the “ideal” output
from the point of view of utilizing the tracks is now 400.
When an important indivisible factor is becoming less and
less underutilized, the tendency will be for
“increasing returns,” for decreasing
average costs as output increases. When an important
indivisible factor is becoming more and more overutilized,
there is a tendency for increasing average costs.
In some spheres of production, indivisibilities may be such that full
utilization of one indivisible factor requires full utilization of all.
In that case, all the indivisible factors move together and can be
lumped together for our purposes; they become the equivalent
of one indivisible factor, such as the railroad
track. In such cases again, average costs will first decline with an
increase in output, as the increased output remedies an
underutilization of the lumped indivisible factors. After the
technologically most efficient point is reached, however,
costs will increase, given the indivisible factors. The tendency for
costs to decline will, in addition, be offset by the rise in
factor prices caused by the increase in output.
In the overwhelming majority of cases, however, each factor will differ
from the others in size and degree of divisibility. As a consequence,
any size or combination chosen might utilize one indivisible factor
most efficiently, but at the expense of not utilizing
some other indivisible factor at peak efficiency. Suppose we consider a
hypothetical schedule of average money cost at each alternative output.
When we start at a very low level of output, all the indivisible
factors will be underutilized. Then, as we expand production,
average costs will decrease unless offset by the
price rise for those divisible factors needed to expand
production. As soon as one of the indivisible factors is fully
utilized and becomes overworked, average costs will rise sharply.
Later, a tendency toward decreasing costs sets in again as another
underutilized factor becomes more fully utilized. The result
is an alternating series of decreases and increases in average costs as
output increases. Eventually, a point will be reached at which more
indivisible factors will be overutilized than underutilized, and from
then on the general trend of average cost as output increases will be
upward. Before that point, the trend will be downward.
Mingling with these influences from the technological side of costs are
the continuing rises in factor prices, which also become more important
as output increases.
In sum, as Mises states:
Other
things being equal, the more the production of a certain article
increases, the more factors of production must be withdrawn from other
employments in which they would have been used for the production of
other articles. Hence—other things being
equal—average production costs increase with the increase in
the quantity produced. But this general law is by sections superseded
by the phenomenon that not all factors of production are perfectly
divisible and that, as far as they can be divided, they are not
divisible in such a way that full utilization of one of them results in
full utilization of the other imperfectly divisible factors.
Some indivisible factors, such as the railroad track, can be available
in only one particular size. Other indivisible factors, such as
machinery, can be built in various sizes. Cannot a small factory, then,
use small-scale machinery which will be just as efficient as
large-scale machinery in a larger factory, and would this not eliminate
indivisibilities and result in constant costs? No, for here too, one
particular size will probably be most efficient. Below the most
efficient size, operating the machine will be more costly. Thus, as
Stigler says, “fitting together of the parts of a
ten-horsepower motor does not require ten times the labor
necessary to fit those of a one-horsepower motor. Similarly, a
truck requires one driver, whether it has a half-ton or two-ton
capacity.”
It is also true that an oversized machine will be more costly than the
optimum. But this will be no limitation on the size of the firm, for a
large firm can simply use several (smaller) optimum-sized
machines instead of one huge machine.
Labor is usually treated as a perfectly divisible factor, as one that
varies directly with the size of the output. But this is not true. As
we have seen, the truck driver is not divisible into
fractions. Further, management tends to be an indivisible
production factor. So also salesmen, advertising, cost of
borrowing, research expenditures, and even insurance for
actuarial risk. There are certain basic costs in borrowing which simply
arise from investigating, paperwork, etc. These will tend to
be proportionately smaller the larger the
size—another indivisibility, with returns increasing
over a certain area. Also, the broader the coverage, the lower
insurance premiums will be.
Then there are the well-known gains from the increase in the division
of labor with larger outputs. The benefits from the division
of labor may be considered indivisible. They arise from the specialized
machines that must first be used with a larger product, and similarly
from the increased labor skills of specialists. Here too,
however, there is a point beyond which no further
specialization is possible or where specialization is subject to
increasing costs. Management has usually been stressed as
particularly subject to overutilization. Even more important
is the factor of ultimate-decision-making ability,
which cannot be enlarged to the extent that management can.
What any given firm’s size and output will be is therefore
subject to a host of conflicting determinants, some impelling
a limitation, some an expansion, of size. At what point any
firm will settle depends on the concrete data of the actual case and
cannot be decided by economic analysis. Only the actual
entrepreneur, through the give and take of the market, can
decide where the maximum-profit size is and can set the firm at that
point. This is the task of the businessman and not of the economist.
Furthermore, the cost-curve diagrams, so simple and smooth in the
textbooks, misinterpret real conditions. We have seen that there are a
whole host of determinants which tend at any point toward increasing
and toward decreasing costs. It is, of course, true that an
entrepreneur will seek to produce at the point of maximum profit, i.e.,
of maximum net returns over costs. But the factors that influence his
decision are too numerous and their interactions too complex to be
captured in cost-curve diagrams.
It is clear to almost everyone that the optimum size of a firm in some
industries is larger than in others. The economic optimum for
a steel plant is larger than the optimum barbershop. In industries
where large-scale firms have demonstrated the most efficiency, however,
many people have worried a great deal about an alleged tendency for
decreasing costs to continue permanently and therefore for
“monopoly” to result from ever- larger firms. It
should be obvious, however, that there is no infinite tendency for
ever-larger size; this is clear from the very fact that every
firm, at any time, always has a finite size and that,
therefore, an economic limit must have been imposed upon it from some
direction. Furthermore, we have seen that the general rule of
operating in a zone of diminishing marginal productivity for
each factor, as well as the tendency for product prices to decline and
factor prices to increase as output increases, establishes limits on
the size of each firm. And, as a neglected point, we shall see that
ultimate limits are set on the relative size of the firm by the
necessity for markets to exist in every factor, in
order to make it possible for the firm to calculate its profits and
losses.
Money
costs will equal opportunity costs to the businessman only when he plans
an investment in factors. To the extent that his money costs are
“sunk” in any production process, they are
committed irrevocably, and any future plans must consider them as
irretrievably spent.
The
businessman’s market-supply curve will depend on his present
opportunity cost, not his past money cost. For the
businessman sells his goods at any price that will more than cover any
further costs that must be incurred in selling them. As
capital goods move toward final output in any stage of the production
structure, more and more investment has been sunk into the process.
Therefore, the marginal cost of further production
(roughly the opportunity cost) becomes ever lower as the product moves
toward final output and sale. This is the simple meaning of
the usual cost-curve morass. When, for example, some costs are not
“fixed,” but irrevocable from the point of view of further
short-run production, they are not included in the
businessman’s estimated costs of such further production. As
we have seen above, the sale of immediate stock completely ready for
sale is virtually “costless,” since there are no
further costs for its production—in the
immediate run.
In the
ERE, of course, all costs and investments will be adjusted, and
irrevocably incurred costs will present no problem. In the ERE
average money costs for all firms will equal the price of the product
minus pure interest return to the capitalist-entrepreneurs, and also,
as we shall see, minus the return to the “discounted marginal
productivity of the owner,” a factor which does not enter
into the firm’s money costs.
It should be understood throughout
that when we refer to increases in wage rates or ground rents in the
expanding economy, we are referring to real, and not necessarily to
money, wage rates or ground rents.
This assumes, of course, that
there is no offsetting decline in capital
elsewhere. If there is, then there will be no general
rise in wages.
For a discussion of these
problems, see Mises, Human Action,
pp. 598– 600.
Capital goods will remain
unemployed because of previous entrepreneurial error, i.e., investing
in the wrong type of capital goods.
See
Mises, Human Action, pp. 595–98. As Mises
concludes, “Unemployment in the unhampered market is
always voluntary.” Particularly recommended is
Mises’ critique of the theory of “frictional
unemployment.”
Economics does not
“assume mobility of labor.” It simply analyzes the
consequences of a laborer’s decision to be
“mobile” or “immobile,” the
latter amounting to a voluntary choice of at least temporary
unemployment.
The “idleness”
referred to here is catallactic, and not necessarily total. In other
words, it means that a man does not seek to sell his labor services for
money and therefore does not enter the societal labor market. He might
well be very “busy” working at hobbies, etc.
Hayek, Prices and
Production, pp. 91–93.
Cf. Fred R. Fairchild and Thomas
J. Shelly, Understanding Our Free Economy (New
York: D. Van Nostrand, 1952), pp. 478–81.
Hence, when the economist
considers only the single firm (as in recent years), he goes completely
astray by ignoring the generality of economic interrelations. To
analyze means-ends relations logically, as economics does, requires
taking all relations into account. Failure to do so, either by treating
the single firm only or by treating unreal holistic aggregates or by
taking refuge in the irrelevant mathematics of the Lausanne
“general equilibrium” school, is equivalent to
abandoning economics.
Many beginning students come away
with the impression that economics consists of an indigestible brew of
“cost curves” to be memorized by rote and drawn
neatly on the blackboard.
E.T. Weiler, The
Economic System (New York: Macmillan & Co., 1952),
pp. 141–61; Stigler, Theory of Price, pp.
126ff.
Stigler, Theory of Price,
p. 126.
Robbins points out that the length
of a period of productive activity depends upon the expectations of
entrepreneurs concerning the permanence of a change and the
technical obstacles to a change. Robbins, “Remarks upon
Certain Aspects of the Theory of Costs,” pp. 17–18.
For a critique of cost-curve
theory, see the articles by Robbins, Thirlby, and Gabor and Pearce
cited above, especially Gabor and Pearce, “A New Approach to
the Theory of the Firm.” Also see Milton
Friedman, “Survey of the Empirical Evidence on Economies of
Scale: Comment” in Business Concentration
and Price Policy (Princeton, N.J.: National Bureau of
Economic Research, 1955), pp. 230–38; Armen Alchian,
“Costs and Outputs” in The Allocation of
Economic Resources (Stanford: Stanford University Press,
1959), pp. 23–40; F.A. Hayek, “Unions, Inflation,
and Prices” in Philip D. Bradley, ed., The Public
Stake in Union Power (Charlottesville: University of Virginia
Press, 1959), pp. 55f.; Hayek, Pure Theory of Capital,
pp. 14, 20–21; Harrod, “Theory of Imperfect
Competition Revised” in Economic Essays,
pp. 139–87; G. Warren Nutter,
“Competition: Direct and Devious,” American
Economic Review, Papers and Proceedings, May, 1954, pp.
69ff.; Scott, Natural Resources: The Economics of Conservation,
p. 5.
This law follows from the natural
law that every quantitatively observable cause-effect relation
can be duplicated. For example, if x + 2y
+ 3z are necessary and sufficient to form 1p,
another set will form another p,
so that 2x + 4y + 6z
will yield 2p.
See chapter 10 for more on the
theory of pure competition.
For example, suppose that 1,000
gold ounces invested in factors yield 100 units of product and that
1,100 ounces yield 101 units. All the points in the gap between 1,000
and 1,100 will yield no more than 100 units. The excess of investment
over 1,000 and under 1,100 ounces is clearly sheer waste, and no
businessman will invest within the gap. Instead, investments
will be made at such trough points for average cost as 1,000 and 1,100.
Stigler, Theory
of Price, pp. 132ff.
We are not discussing the fact
that the railroad could, of course, cut down or increase the mileage of
its track by including less or more geographic area in its service. The
example assumes a given geographic area in which the railroad operates.
See Mises, Human
Action, pp. 338–40. This is the unrealistic
condition implicitly assumed by textbook “cost
curves.”
Ibid., p. 340.
Stigler, Theory of Price,
p. 136.
It is particularly important not
to limit possible efficiencies from large-scale production to
narrow technological factors such as the “size of the
plant.” There are also efficiencies derived from the organization
of a firm owning several plants—e.g., management
utilization, specialization, efficiency of large-scale purchasing and
selling, research expenditures, etc. Cf. George G. Hagedorn, Studies
on Concentration (New York: National Association of
Manufacturers, 1951), pp. 14ff.
See Friedman,
“Survey of the Empirical Evidence on Economies of Scale:
Comment,” pp. 230–38.
For a good, largely empirical,
study of size of firm, see George G. Hagedorn, Business
Size and the Public Interest (New York: National Association
of Manufacturers, 1949). Also see idem, Studies
on Concentration, and John G. McLean and Robert W.
Haigh, “How Business Corporations Grow,” Harvard
Business Review, November–December, 1954, pp.
81–93.
Plans are relevant, not only in
the ERE, but also to all decisions on maintenance or replacement, as
well as additions to capital goods when they wear out or fall into
disrepair.
It is costless only if no rise in
the price of the good is foreseen for the near future. If it is, then
there will arise the opportunity cost of forgoing a higher price.
Hence, if there is no hope of a higher price, the businessman will
sell, however low the price (adjusting for the costs of selling minus
the costs of continued storage).
Conventional
“cost-curve” analysis depicts average cost and
demand curves as tangential in the ERE—i.e., that price =
average cost. But (aside from the unreality of
assuming smooth curves rather than discontinuous angles), interest
return—as well as return to the owner’s
decision-making ability—will accrue to the entrepreneurs even
in the ERE. Hence, no such tangency can arise. See chapter 10 below for
the implications of this revision for “monopolistic
competition” theory.
For further readings on cost, see
G.F. Thirlby, “The Marginal Cost Controversy: A Note on Mr.
Coase’s Model,” Economica,
February, 1947, pp. 48–53; F.A. Fetter’s classic
“The Passing of the Old Rent Concept,” p. 439; R.H.
Coase, “Business Organization and the Accountant,” The
Accountant, October l–November 26, 1938; and idem,
“Full Costs, Cost Changes, and Prices” in Business
Concentration and Price Policy, pp. 392–94; John E.
Hodges, “Some Economic Implications of Cost-Plus
Pricing,” Southwestern Social Science Quarterly,
December, 1954, pp. 225–34; I.F. Pearce, “A Study
in Price Policy,” Economica, May, 1956,
pp. 114–27; I.F. Pearce and Lloyd R. Amey, “Price
Policy with a Branded Product,” Review of Economic
Studies, Vol. XXIV (1956–57), No. 1, pp.
49–60; James S. Earley, “Recent Developments in
Cost Accounting and the ‘Marginal
Analysis’,” Journal of Political Economy,
June, 1955, pp. 227–42; and David Green, Jr., “A
Moral to the Direct-Costing Controversy,” Journal
of Business, July, 1960, pp. 218–26.
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