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Home | Mises Library | Frank A. Fetter, Chapter 19: Cost-Prices, Product-Prices, and Profits

Frank A. Fetter, Chapter 19: Cost-Prices, Product-Prices, and Profits

  • Frank Fetter
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Tags PricesProduction Theory

03/30/2017Frank A. Fetter

The roundabout or technological process

"Production" is the general term for the natural and artifi­cial processes by which indirect goods (or uses) are combined and advanced one or more stages toward ripeness or readi­ness for direct use by men.1 In the processes of production, goods are changed in various ways in their stuff, form, place, time, or ownership. Nature is the great primary producer. The amount of labor employed in the various processes of production — whether measured in time, trouble, effort, or price — varies from an almost negligible amount to a great deal. Man's part often might be likened to the mere pulling of a gun trigger to set off a load of natural forces, or to the unlocking of a door to release the impris­oned uses in indirect goods. Production under human guidance has been called "the roundabout process,'' because the end sought — the direct enjoyable goods — is attained by a succession of indirect steps. The adjective "technological," implying the action of one thing upon another, is also used in place of roundabout.

Technological changes are usually accompanied by increasing valuations of the goods, and it is this desired result which motivates men to produce. The increment of valuation belongs to the re­sponsible owner of the products after all the legal claims of others who supplied part of the indirect goods have been satisfied by the payment of wages, rents, purchase prices, and claims of all sorts. The erroneous notion that the increased valuation is caused solely by the labor used in the process of production is known as "the labor theory of value."

Men often have to choose between the direct and the indirect uses of concrete goods. For example, should a piece of wood be used for fuel, or as material to build a house, or to make some im­plement such as a fence or a hoe handle? These choices depend on the owner's differing valuations of present and of future uses, and durative and of consumptive uses, contained in same agents. One kind of use may be had only at the price of the other kind, as discussed further below in connection with alternative costs, or alternative valuations.

The enterpriser's function

The enterpriser, or entrepreneur, as pointed out in Chapters V and XI, is the middleman who undertakes the financial respon­sibility of carrying on some roundabout process one step further for the next group of buyers, and eventually for the final users. He is a self-appointed agent of the proximate and ultimate buyers. On his judgment of the probable difference between his outlays and his sales he risks his own time and services together with whatever capital he has embarked in the enterprise — that is, the financial fund embodied in his money, credit, lands, houses, tools, and so on.

The outcome of large or of small profits depends partly on mere chance and accidents beyond any human control or prediction, such as earthquakes, floods, fires, wars, and fashions, which are the in­calcuable risks of any enterprise. Other profits may result from unfair, fraudulent, and criminal conduct or from monopoly and special governmental favors. Under more normal conditions, how­ever, profits depend mainly on the comparative skill with which the enterpriser chooses his investment and operates his business, combining the agents in the right proportions to obtain product that may be sold at profitable prices.

The current prices at which indirect agents can be bought is rather narrowly fixed in free markets, and one enterpriser usually has little advantage over another in this regard. Except when he has some monopolistic power, he must take the system of prices for his necessary agents pretty much as he finds it. The success of the competitive enterpriser in making profits depends the agents far more after on good judgment in selecting and in proportioning the agents after he buys them, than on buying them at less than current prices.

Optimum size of an enterprise

It may be recalled that the point was made in Chapter XI that the first question the enterpriser must decide regarding his plant is that of external proportion: How big a plant should he build? For how large an output? There is an ideal, or at optimum, proportion between plant capacity and the demand at a profitable price within the market area of the plant. An excess of consumptible agents such as coal and raw materials can be used up in a short time with little loss. The greater chance of error is determining the capacity of the durable plant; if it is too small it frequently can be enlarged as output increases, only at disproportionate ex­pense. Therefore it may seem better to provide for the future by purposely building some parts of the plant larger than is needed at the time, in the hope that the present cost (recurring interest on investment) may be defrayed from future profits.

If the plant is built too large, the unused capacity, whether land, floor space, power plant, or machines, represents an outlay useless for present and near-future needs. A question of theory and of practice arises: Should a normal return on either an intentional or a mistaken original outlay for unused plant be treated as part of the "costs" of the actual smaller output?

Overhead costs

Costs for unused capacity which is already paid for are merely that part of the capital outlay on which an estimated fair annual return is expected. Often such costs are represented by outstand­ing bonds calling for regular interest payments. These costs for unused capacity, whether they be estimated or actually incurred, and a number of other costs which do not vary with the size of the output — executives' salaries, taxes, and depreciation charges — are known as overhead costs.

When overhead costs are included in the costs of the actual out­put, what happens if the output increases in response to an en­larged demand? As the external proportionality of plant to mar­ket moves during this time toward the optimum, total costs in­crease slowly, unit costs decrease, and profit increases. This period, during which a former mistake in the size of a durable plant is be­ing point has corrected, is a stage of decreasing costs. After the optimum point has been passed, unit costs in the enterprise, calculated in the same way, will again increase because of lack of proper proportion­ality in the use of the agents of production. This is the stage of increasing costs.

This use of the terms "decreasing" and "increasing costs" as applied to a single enterprise is often confused with the very different problems of diminishing physical returns2 to an entire national industry. An example is agriculture, where increasing population and the more intensive utilization of a limited ares of land results in diminishing physical returns.

Optimum internal proportion of agents

As the optimum size of a plant in relation to its market area is a problem of external proportion, so the optimum amount of each factor of production within the single plant presents a problem of internal proportion. Land, buildings, power plant, machines and tools of various kinds, and labor of all grades should be bought in just the right amounts and kinds in view of their relative prices. The two conditions are not entirely distinct, but they mutually affect each other. An unwise external proportioning of capacity of a whole plant to market demand upsets the right internal economic proportion within the plant. When the investment in durable plant is too great, the excess investment would yield a larger profit either in making other products or in other enterprises.

The internal proportion of variable agents within the plant may also be mistaken when the capacity of the plant as a whole is not out of line. Even in a small enterprise, many choices of agents must constantly he made, choices involving a comparison of costs at the prevailing prices with the expected addition to the prices of the products. At one time it is better to hire another laborer or another skilled worker; at another time it is better to buy more tools or better machines, or to use more materials of certain kinds. So far as these choices are wisely made, they serve both to ensure a profit to the single enterprise and to maintain the equilibrium in the general system of prices. As a result of the differing judgments of enterprisers, costs in various competing enterprises within the same industry may differ widely in their items and in their total amount. There is no common standard cost in this sense for an entire industry; each enterprise has its differing outlay costs.

The empirical law of costs

The total of the prices (costs) of the agents used in an enterprise tends to correspond pretty closely in amount with the total price of the products. It is assumed in this statement that costs include a "fair profit" to the enterpriser on his invested capital, as measured by the opportunity costs as explained later. If, however, profits were defined as the remainder left after deducting costs from receipts, then the wording of the principle would be that cost plus a fair profit tend to be equal to the price of products. Total costs and total price of products, divided by the number of units of product, gives unit cost and unit price of product.

This tendency of costs and product prices to come into agreement is the empirical law of costs. It is called empirical to denote that it is a simple fact of observation and not an assertion regarding causal relationship. As such it must be accepted by all economists as true, subject to various frictions and lags in practical experience.

Question of the causal order of costs and product-prices

Differences of opinion, however, have arisen among economists in their attempts to state a causal order of cost and price. Thus some have maintained that the business costs in each industry determine, set, fix, or regulate the prices in that industry — in other words, that the causal order runs from the costs in an enterprise or industry to its prices. Few have seriously attempted to oppose this view with its direct opposite, that is, to maintain that the prices in any one industry (or enterprise) determine the costs in that one industry. But seeing that costs and product prices are merely two sets of prices in the same industry, the question arises as to whether either set necessarily is the cause of the other. May not these two sets of prices in the same industry be the effect of a common cause, be merely parts of the larger system of prices determined by forces and conditions lying outside any single enterprise or even the whole
industry? Let us try to find the answer to this question.

Technological adjustment of costs to higher product-prices

It is through the action of middlemen that the empirical law of costs operates. With no such purpose in view they are constantly bringing costs and product-prices into accord; they do so merely through seeking to make a better profit by buying indirect agents more freely when their cost is low compared with the product-prices, and vice versa. If but a single kind and grade of goods is produced, as cement in a cement mill, the estimation of unit costs is simplest, and yet even here there is no problem of estimating and distributing overhead costs fairly. When a variety of by-products is produced, as in a flour mill or in a meat-packing house, nearly all items of variable costs are spread over two or more products, and, like overhead costs, are joint costs. Under such conditions the problem of relating costs to prices becomes complex.

What happens when it becomes known that an industry generally, or some plants in certain neighborhoods, are making profits higher than "normal." The output of some plants will be. in­creased, some plants will be enlarged, new plants will be started, and goods will be shipped into that territory from greater distances. The increasing supply will decrease the product-price or at least retard its rise, and at the same time the cost-price of the more limited agents (labor, local materials, and the like) will be bid up somewhat. The result is a new relationship, a tendency toward a new equilibrium between cost-prices and product-prices in such plant and in the entire industry.

Technological adjustment of costs to lower product-prices

The whole process is reversed when product-prices and profits are abnormally low. Output is curtailed by those so situated that they cannot male a profit in that area; some marginal producers go out of business entirely; some shift a part or all the capicity of their plants to the making of other products, and the industrial equipment that wears out or is otherwise destroyed goes unreplaced so long as normal profits cannot be made on the cost of upkeep. The effect of deceasing supply is to raise product-prices (or at least to check further tendency to fall), whereas the decreased demand in that market for the more limited cost goods reduces their prices until again there results a new equilibrium of product-prices and costs.

AII such methods of bringing costs and product-prices into accord by physical changes in plant capacity and in the amount of products may he grouped under the general description of the technical, or technological, adjustment of costs and product-prices.

Friction and lag in adjustments

Solely by such technological methods the equilibrium between costs and product-prices might eventually be brought about but here is much friction and lag in the process. To explain these facts the doctrine of quasi rents, with its contrast between the long- and the short-time relationship of costs and prices, was developed by the English economist, Alfred Marshall. In this view of the cost and adjustment process, it is assumed that original investment has the same capital value as long as the physical agents last, and that the "fair" rate of return on this investment may be accounted as parted of the costs of present products.

Adjustment of costs by resale

But this is not all. A certain flour mill which cost originally $100,000 continued for years to earn the expected annual return on that investment. Fifty years later it was still in good repair and usable, yet no one was willing to pay more than $10,000 for it, and that only because of the water power. Why so? Because that  region no longer produced wheat, the chief raw material of the mill, and no buycr could be found who thought the present and prospective net income (rental value) of the mill would justify his paying that much for it.3 On the other hand an old business may sell for more than its original cost as a result of various changes in economic conditions.

This illustration of the mill is no imaginary case, and there have been thousands like it. That particular mill is now entirely abandoned. If someone did buy it for $10,000, implying that he estimated its net earning power (rental value) at about $500 or $600 a year, neither he nor anyone else could assume that a fair allowance for annual overhead costs would be $5,000 (say 5 per cent of the original cost). Was that, then, a fair estimate of costs by the former owner up to the moment of sale? Can or ought nothing change the fair estimate of overhead costs, based on original capital investment until the property changes hands?

Adjustment of costs by recapitalization

Original investment cost is merely the price paid by the investor at the moment he buys the business, at a valuation reflecting his forecast and hopes of its future earning power (rental value). Experience must tell whether that valuation (capitalization) was right. If he discovers by the end of the first, or any later, year that he has made a mistake, the original cost figure merely records that error.

In the price system economic agents are worth what they will earn, not what they cost, and the capital value of agents with future uses is the present worth of their expected incomes. Fre­quently, present worth is much greater than past cost, a fact which business men are rarely slow to recognize by reappraising their assets upward. In other cases present worth is less than past cost.4 Past costs are ancient history, and if an enterpriser continues to carry his original capital costs and inventory unchanged on his books, and to use these figures as the basis for "fair" prices based on costs, he is, to say the least, a laggard accountant. If he is in a competitive enterprise, his error will cost him dearly, but if he has sufficient monopoly power, it will cost the public dearly.

The cost-of-reproduction doctrine

If present and estimated future earning power is the logical and practical basis for the present "capital value of business agents for a new owner, why was it not likewise so for the old owner before the sale? Once one departs from original investment price (less depreciation) as the standard of costs, even in the case of resale at a lower or a higher price, it is hard to find any logical stopping place in modifying the theory that past costs determine the just and fair basis of present prices.

Recognizing this, some economists,5 seeking a way out of the difficulty, many years ago adopted the view that present "cost of reproduction," not past cost of production, is what determines product-prices. If, as is clearly implied by this doctrine, the present cost of indirect agents is not determined by their past cost, what does determine it? To this no direct answer is given by the cost­-of-reproduction theory, although the thought is near that costs somehow are shifted up or down with current prices of products.

In one text which professes to accept the cost-of-production theory, the doctrine is developed that future costs of production de­termine present prices. Whatever else that may mean, it is some­thing very different from the older cost-of-production doctrine.

Actual costs versus costs from past investment

If all costs in an enterprise were actual current outlays, and all products were sold within a single year, it would be comparatively easy to calculate costs and profits. The real conditions, however, as to the time and form of costs and sales are usually such that any statement of the amount of costs and profits is largely the result of somebody's conjecture rather than the outcome of com­pleted business transactions. Note a few of the difficulties.

Besides the agents bought and used at once (or within a single year), there are usually some stocks of consumable things such as coal, oil, lumber, cotton, grain left over from previous years; and in turn some such things bought this year may not be all used up. The current prices of these stocks at the time they are used is usually either more or less than their actual cost, and the longer the lapse of time the more the two figures are likely to diverge. Even greater changes occur in the costs of durable agents such as land, buildings, and machinery, and of intangible rights such as patents, charters, good will, and the like, acquired in the past for a price, but the benefits of which continue over a series of years. Of the total original monetary costs of such durable agents and rights, evidently only that fraction of separable uses that goes into the making of one year's output could reasonably be counted in the current costs.

Guesswork in calculations of annual cost items

The amount of cost allotted to the making of one year's output is decided only by somebody's valuation. There is, first, an estimate of the "fair" capital value of the durable agents, and, second, an estimate of the "fair" annual rate of return upon that capital value (as say $100,000 at 10 per cent, giving $10,000 as one year's cost). The question has been raised above whether the original cost of the durable plant should remain unchanged through the years, regardless of changed conditions which have revealed such facts as that the location was a mistake, or that the plant has become obsolete and nearly worthless, or that there is no longer a market demand for the output. Or the conditions might seem to call for an increase in the valuation of the present worth.

Then a further question arises. Whatever be the capital value, is the rate at which the investor merely hoped to profit to be taken now as the "fair" rate regardless of whether it is the rate which new investors now expect to earn? Evidently such cost figures are merely personal estimates and contain a large element of guesswork. Calculations of cost made by sellers for the purpose of convincing the public that their prices afford them only a "rea­sonable" profit over costs of production are peculiarly open to suspicion of biased judgment.

Opportunity costs

Under our system of private property and enterprise a producer is entitled to decide whether to continue in business at all or to continue making any specific product. He may get out of his business at once by selling it outright; or he may gradually reduce its scope, neglect repairs, and finally sell the rest at its salvage value; or he may choose not to rebuild after a fire; or he may shift its uses to products of another industry (sewing machines to bicycles, phonographs to radios, and so on). Whatever he does in this way tends to reduce the supply of the products and thus to raise or to check the fall of their prices as already described. The reverse process occurs when profits are temptingly high.

Any of these things may happen even if the enterpriser owns his entire plant without indebtedness and even if he and his family do all the labor so that his actual cash outlays are very small. His leaving the business would be evidence that his valuation of his fund of economic agents (lands, buildings, tools, working capital in the form of cash, his own labor and that of his family) is greater for some other uses than it is for this particular business. This is true, even if he loses a large part of his original investment in making the change. The estimate of the return which can be obtained from economic agents in an alternative use has been called an opportunity cost, which is merely an alternative valuation. If in any given employment the use of an agent will not yield as great a return as its valuation in another use, the agent will tend to be shifted to the other use. It is plain that opportunity cost is not an actual cost but an estimate or personal valuation. The costs in every business in which the enterpriser owns and supplies a part of the economic agents are partly actual costs and partly the owner's personal valuations of alternative applications.

Personal preferences in alternative valuations

Such valuations are often made by the residual method of com­parison. As a simple example, suppose a small manufacturer calculates that he is making an average annual income of $9,000, this being both for his investment and for his own services. He can get a salary of $5,000 in another business, and thinks he can sell the business for $100,000 and invest the proceeds safely at 5 per cent and get an income of $5,000. His total alternative valuation in money incomes is therefore $10,000, as against $9,000 which he is now getting. Under these circumstances he might sell, but again for purely personal reasons — habits, sentiments, hopes, and so on — he might not. Or he might shift the factory to other products in which he believes he could earn a net income of $12,000. He might make this shift, or he might not if he prefers the business he is in. There are factors of psychic income in all such personal decisions; estimates of incomes and oppor­tunity costs merely in terms of dollars are not alone decisive, The example shows, too, that the marginal producers, those most likely to come into or go out of the production, are not necessarily the least efficient. When price falls, those who drop out may be among the most efficient as measured by their monetary costs of production and by profits, but they may have other better alterna­tives, and may be influenced by psychic factors such as prestige, social ambition, health, temperament, aesthetic and personal tastes, and other considerations.

Price relationship implicit in demand

In all their transactions in search of profits, entrepreneurs and other middlemen operate within an all-embracing system of prices which no one of them makes, but which each has to take as he finds it. Let us consider further how the price system takes form, and how it influences the demands and supplies of individual enterprisers. Recall here some elementary truths of valuation. Every individual valuation is the numerical expression of the im­portance to that person of one thing in terms of another. The quantity of any valuation is finite, because purchasing power is limited in amount. If more money is given for a commodity having a direct use to its owner, the marginal valuation to him of his remaining money rises in terms of that commodity.

The market demand at a certain price is merely the sum of individual demands. It is the number of units of a given com­modity for which buyers are willing to pay the total price called for (unit price times units bought, say 100,000 bushels of wheat at ninety cents a bushel, or $90,000). Buyers will buy to that point because, individually and collectively, they value that amount of wheat more than any assortment of other goods they could buy at the time for that sum of money. Beyond that point further (extramarginal) units of wheat have not so great a valuation as the marginal units of the remaining purchasing power.

And what is the source of the value of purchasing power in terms of money? It is merely the reflected value to its possessor of the other desirable things which money can buy. Whatever be the actual demand for any specific commodity in a market, each and every buyer is choosing it in preference to every other good which could be bought for the same price. Of course, lack of vision, impulse and various accidents cause many mistaken choices which later may be recognized as such. Every personal and family budget is a system of valuations, linked through exchange with the existing system of prices.

Middlemen and final buyers

The market demand for a commodity is a cumulation of the demands of many individuals who have many different uses for the goods and many motives for their demands at various prices. Two classes of buyers particularly may be distinguished here: The first class consists of final or ultimate buyers, whose valuations are based on their own uses; the second class consists of intermediate buyers, or middlemen, who buy not with any purpose of using the goods for their own enjoyment but only to sell again. Such resale may be of goods in nearly unchanged form (as in mer­chandising), or after fabrication (as in manufacturing), or after their use as agents in various other sorts of enterprise (as seed and fertilizer in agriculture, or fuel for power in transportation). Middlemen may sell either to buyers for personal use or to other middlemen who, in turn, sell either to other middlemen or to final users. But in any case, the analysis finally gets to the starting point of all valuations, namely, valuation for direct use. All inter­mediate market-demand valuations are but reflections, or forecasts, or estimates, of the prices which ultimate users of goods may be expected to pay for them.

Middlemen's supply and demand reserve valuations

In only a comparatively small number of trades, mostly retail, have many of the buyers direct-use valuations for the things they are buying. Even more rarely is this true of the sellers. In our developed system of exchange, raw materials and fabricated products pass through numerous hands before coming in completed form to the final users. Therefore, in the markets for most goods, both demand and supply are determined immediately, though not ultimately, by businessmen's valuations. In viewing the ordinary diagram of demand and supply, we must not think that demand is determined immediately by final users and that only supply is determined by businessmen's estimates. In most business deals, both the buying and selling groups are made up of businessmen and middlemen, and, to repeat, their estimates determine immedi­ately both demand and supply. But what is the basis, or the final criterion, of their valuations?

Business demand and ultimate buyers' demand

Follow this process step by step, starting from the valuation of the direct commodity by the final users. The commodity being scarce and valuable (say bread), enterprisers in stage one (bakers) undertake to produce more of the commodity by combining other indirect things. The limit which they dare pay (their total costs) for these means is fixed by the valuations of the direct users of bread, and this limit will be approached under competitive condi­tions. In turn, the millers purchase wheat and advance it one step further toward completion (flour). Their demand for wheat is fixed by the amount which bakers will pay for flour. Continuing, the original step in roundabout production will be the ultimate factors of natural resources and human labor; the demand for them, too, is at valuations determined from the valuations of the direct users, not of one final product only (bread), but of the various products for which any part of these original factors are used.

The valuation in each of these possible uses is an opportunity cost, or alternative valuation, for each of the other uses. Such original factors as land and labor have no prior, or original money cost: their price is derived from the price of the final products.6

Supply valuation determined by ultimate buyers' demand

The answer to the question: "What is the ultimate source of middlemen's supply valuations?" is suggested in what has just been said of middlemen's demand valuations. Every enterpriser is operating in the midst of a system of prices. All business costs at each stage of the roundabout process are incurred in the expectation of selling the product for enough above costs to allow a profit. The enterpriser buys each agent up to the point where his marginal valuation of it is just equal to that of any other factor which he can buy with the same amount of money. The costs include the prices not only of the physical materials — textiles, lumber, metals, grains, and the like — but rents, wages and salaries, advertising, freights, taxes, and many minor outlays. Why are the agents which are an enterpriser buys worth what he pays for them, or worth any amount whatever? Evidently it is because each enterpriser in turn expects, or hopes, to sell the products for more than they cost him, selling always in the direction of the ultimate buyers. Any one middleman may not need to consider the source of demand beyond the sale of his own product, and usually he does not try to. He bids for and buys the indirect agents needed by him on the basis of the prices for which he in turn hopes to sell his products. And this goes on in every stage of production until the final user of the finished goods is reached. A middleman has no independent buying or selling valuations for agents, outside the system of prices in which he operates. In final analysis, therefore, all middlemen's buying valuations are traceable to, or derives from the value of goods to final direct users.

The moment a middleman has paid a price for any factor of production it becomes a cost of production to him. Product-prices and costs are both prices within the price system, the former for more nearly direct uses, the later for less direct uses or goods at each stage of production. There is, however, no antecedent price for scarce natural agents at the very first stage of production in the roundabout process. Their price is, so to speak, the auction price which competing ultimate users pay for these agents through the medium of middlemen competing at each stage of production. Business costs of indirect goods are reflections of the prices of the final direct goods of all kinds with which they are connected in the whole system of prices.

Various conditions of the theoretical price equilibrium

The various prices constituting a system of prices at a certain time in a community are not the result of separate accidents, and they are not arrived at independently. As the very word "system" implies, they are related by some principle in a more or less orderly way. That principle is the marginal valuation of both direct and indirect goods.

First, the final buyers of direct goods apportion their purchasing power (money and other salable goods in their possession, including their labor power) among the various direct goods so that to each user the direct-use valuations are brought into equilibrium. Then each middleman apportions his purchasing power among the various indirect agents at this stage of production so that in his business the marginal valuations of the indirect uses are in equilibrium. When this condition is attained, there is, for the moment at least, no motive for anyone to rearrange his budget either of personal and family expenditures or of business outlays. Each budget is for the moment at its optimum proportionality. The outside limit of middlemen's valuations, either in buying or selling indirect goods, lies in his estimation of the valuations and demands of the buyers of his products, and so on to the final buyers. Under these conditions of equilibrium of individual valuations, demand and supply for each king of goods also tend to be brought into equilibrium, thus forming a system of prices which for the moment is also in approximate equilibrium.

A perfect equilibrium of valuations and of prices is a theoretical ideal, an abstraction never fully realized. It is an end toward which the forces of human desire and choice at each moment are always tending without every fully attaining. There is a lag and friction in choice and in the processes of production; in the meantime changes occur in desires as well as in the material conditions of plenty and scarcity of goods — weather, plagues, crops, accidents, discoveries, sickness and health, peace and war, a thousand vicissitudes. Each new total set of conditions involves a new theoretically correct equilibrium. Despite the ceaseless flow of the tides toward adjust­ment with the forces of gravitation, the oceans never come to rest.

Prices under static and dynamic conditions

There is no need of two distinct price theories, a static thenry, concerned only with a condition of rest and equilibrium, and a quite different dynamic theory to explain the behavior of contem­porary prices when new forces violently disturb such an equilibrium. The function of price theory is to give a rational explanation of the choices and actions of men which tend to bring about an equilibrium of valuations and prices, rather than to study and explain a mere motionless equilibrium itself. The most static human society of which we have any knowledge, one with the least progress in the technical arts and with population stationary during long periods, is yet full of much internal movement and fluctuation. Children are born, grow to maturity, are well or ill, suffer accidents, grow old and finally die and are replaced in the population by other individuals. Education must be constantly repeated; the young must chose and master their occupations. There is the constant round of the seasons, changes of weather, heat, cold, floods, drought, insect pests, plant blights, scanty or bountiful harvests, for years, lean years, pestilence, plague, famine, and war.

A price theory which serves to explain how an equilibrium of contemporary prices tends to be constantly re-established in these conditions merely needs to be extended — speeded up, as it were — to apply in more dynamic conditions of society where there is rapid population growth, revolutionary progress in science and in the practical arts, and striking changes in manners, tastes, education and culture, with accompanying changes in human tastes and desires and in the kinds and amounts of goods and services. We have not undertaken to treat the special dynamic problems of price changes during the successive time phases of the business cycle — the sudden disruptions, the marked inequalities between the price changes of the various commodities and industries, and the differing lags in their recovery. However, numerous passages in chapter and the next one are not without bearing upon those questions.

Summary and conclusions

In this chapter our attention now returns to man's part in the process of production. The purpose is to consider particularly the part played in the determination of prices by middlemen who have no use-valuations of their own for the goods they buy or sell, but only exchange-valuations.

The roundabout process in production is directed by enterprisers who, if successful, thereby obtain profits on their investments and for their efforts. To obtain profits it is essential that the enterpriser keep his outlays (costs) below the receipts frm the sale of his products.

The observed tendency is for the product-prices and costs (including normal profits) of the various industries and separate enterprises to come into accord, through with frequent lags and imperfect adjustment. This statement is called the empirical law of costs. Business costs are merely one sort of prices in the price system. The theory of price has to explain the relationship of two sets of prices in the price system, those of direct final goods and those of indirect or intermediary goods, or agents of production. The motives which lead businessmen to pay any amount whatever for the agents of production (that is, to incur costs) is the hope of reselling the goods (further fabricated) in the direction of the final users.

The enterpriser's "costs" are in business language understood to include not only actual cash outlays for a specific agent, but also estimated (opportunity) costs of various kinds. Costs of both kinds are traceable immediately to the marginal valuations of the purchasers of the products of each stage of production and ultimately to buyers' demand for final direct goods.

The price system as a whole is made up of a number of sets of prices, each of which is constantly tending toward internal and external equilibrium. These various equilibria are constantly being upset by new forces. When the disturbance is gradual and moderate, the condition is called relatively state; if rapid and extensive, it is spoken of a dynamic.

Suggested Readings

Böhm-Bawerk, Eugen von. The Positive Theory of Capital. D.E. Stechert and Co. New York. 1923. Reprint. Pp. 428.

Carter, Thomas N. The Distribution of Wealth. The Macmillan Co. New York. 1904. Pps. xvi, 290. Chap. 2 contains a statement of the principle of proportionality.

Clark, John M. Studies in the Economics of Overhead Costs. The University of Chicago Press. Chicago. 1923. Pp. xiii, 502.

Davenport, Herbert J. The Economics of Enterprise. The Macmillan Co. New York. 1913. Pp. xvi, 544. An analysis of opportunity costs is found in Chaps. 6 and 8.

——. Value and Distribution. The University of Chicago Press. Chicago. 1908. Pp. xi, 582.

Fetter, Frank A. Economic Principles. The Century Co. New York. 1915. Pp. x, 523. Chap. 28 contains an analysis of the relation of cost to price. In Chaps. 12 and 31 will be found additional data on the internal and external proportioning of the productive agents.

Green, D.I. "Pain-cost and Opportunity-cost." The Quarterly Journal of Economics. 1894. Vol. 8. Pp. 218–229.

Mund, Vernon A. "The Financial Adjustment in the Empirical Law of Cost." The American Economic Review. March, 1936. Vol. 36. Pp. 74–80.

Robinson, E.A.G. The Structure of Competitive Industry. Harcourt, Brace and Co. New York. 1932. Pps. viii, 184. A consideration of the optimum size of an enterprise.

Questions and Problems

1. How would you characterize an enterpriser? What is the function of the enterpriser?

2. Distinguish between the optimum external and the optimum internal proportion of the agents in productive activity.

3. What is the "empirical law of costs"? What individuals bring about the operation of the law?

4. By what methods or adjustments is the correspondence of cost and price effected? Explain fully.

5. When is the price of a good "normal"?

6. How is market price determined by the interplay of demand and supply?

7. Distinguish between actual (contractual) costs and estimated costs. Give examples of each.

8. What are "opportunity costs"? Give examples of conditions in which agents have an opportunity cost; of conditions in which they do not have an opportunity cost.

9. Show by means of an illustration the way in which opportunity costs influence the use made of economic agents.

10. How would you characterize the "marginal" producer? Give an example. In what sense is he the weakest? In what sense not?

11. What is the basis for ultimate buyer's valuations of direct use goods? For intermediate buyers' or middlemen's buying valuations?

12. What is the basis for the selling valuations of middlemen?

13. Trace the process of making valuations in each principal stage involved in the making of a wool dress or suit. In your answer show how product-prices become cost prices.

14. What is the final source of demand for goods of any degree of indirectness?

15. A business executive recently said: "Over a period of years, from 1925 to 1934, the steel industry averaged only  2 1/2 per cent return on its aggregate investment. In the best of those years, it showed a return of only a little more than 9 per cent and in the four years, 1925 to 1928 inclusive, the industry averaged less than 4 per cent return after all charges but before dividends." How was the "aggregate investment" of the whole industry determined, and by whom?

  • 1. See Chaps. V, X, and especially the section on "direct and indirect uses" in Chap. 17.
  • 2. See Chaps. V and VI.
  • 3. See the capitalization theory in the chapter on Interest.
  • 4. See the chapter on Interest.
  • 5. For example, Francis A. Walker, as early as 1880.
  • 6. In and old country, however, present owners may have bought natural agents directly or indirectly from the first owners, at prices determined by the bidding of the whole community for these useful and scarce indirect economic agents. In such cases these agents have a monetary price constantly readjusted the same as that of any other agents in the price system.
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