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while prices (whether bid or asked) are measured along the vertical axis.
Since we deal with a non-producible commodity, a certain fixed quantity
of it is owned (during each period of time) by market participants as a
whole. (This quantity of the commodity, we assume, is endowed by nature
to holders of it, during each period.) It is from this stock that any pur-
chases must be made in a given period. The size of this stock of the com-
modity is represented in the diagram by the distance OR'. RR' is a vertical
line erected on R'. The line KK'K" is drawn so that the abscissa of any
point on the line represents the quantity of the commodity that the holders
of the commodity would like, in aggregate, to own, when the market price
of the commodity is represented by the ordinate of the point. Thus, when
the price of the commodity is OA, holders of it wish to keep for their own
use, in aggregate, only the quantity AB. Since AB is less than AC (=OR'),
which is the aggregate quantity that holders actually do own, it follows
that at price AB, holders of the commodity seek to sell the quantity BC out
of their holdings. At a lower price, OG, holders of the commodity do not
wish (in aggregate) to sell any amount at all; they wish to keep their entire
endowments for their own use. Should price be lower yet, holders would
attempt (vainly, of course) to increase their holdings by buying more. Thus
at price OH, the owners of the commodity would be seeking to buy the
additional aggregate quantity EF (besides the quantities of the commodity
that ??orc-holders might seek to buy). It is clear, then, that the segment
37
MARKET PROCESS IN A PURE EXCHANGE ECONOMY

K'K" (of the KK'K") line represents (with K' being on the price axis) the
(aggregate) demand curve for the commodity of the group of market partici-
pants who are naturally endowed with holdings of the commodity. (Simi-
larly, it is clear, the horizontal distances between the KK' segment, and RK',
represent the quantities of the commodity that will be supplied to the mar
ket, at various prices greater than OG.)

Price




In Figure 7-3(a), the K'K" segment is drawn separately (with K' on the
price axis). In Figure 7-3(b), the line LL' represents the demand curve for
the commodity of all market participants who are not naturally endowed
with quantities of it. Figure 7-3(c), shows the line DD' obtained by lateral
summation of the K'K", LL' lines. Any point on the line shows the aggre-
gate quantity that will be purchased at a given price by the entire market.
It is clear that for prices higher than OG, the DD' line is identical with the
LL' line (since we have seen that no holders of the commodity would wish
to buy at prices higher than OG).

Price




N X

Figure 7-4

In Figure 7-4, the SS' line is the market supply curve for the commodity.
This shows, for each possible price, the aggregate quantity that would be
138 MARKET THEORY AND THE PRICE SYSTEM

offered for sale by the initial commodity holders. It is clear that for any
price (such as OB), the abscissa of the corresponding point on the supply
curve (such as C) is identical with the horizontal distance between the KK'
and K'R lines in Figure 7-2 (such as BC). (In fact it is obvious that the
supply curve is derived from Figure 7-2 simply by reversing the KK' segment
about the axis K'R. Keeping K' in its initial position in Figure 7-2, and
transposing the KK' line until it lies symmetrically to the right of the K'R
line, yields the line 55'. Thus, OS=OG=R'K'; OR'=ON; and NS'=OK).

Price




D' X

Figure 7-5
In Figure 7-5, the DD' line [from Figure 7-3(c)] has been superimposed
upon the SS' line (of Figure 7-4). This is the typical supply-demand dia-
gram. It demonstrates that the equilibrium market price will be p and that
the quantity of commodity sold will be q, yielded by the intersection of the
curves. A higher price would mean that sellers would be induced to offer
a quantity greater than that which buyers wish to buy at the price; a lower
price would mean that buyers would seek to buy a quantity greater than that
which sellers are prepared to sell at the price.
It is unnecessary, in the case of the non-producible commodity that we
are considering to isolate the market supply curve (as was done in Figures
7-4 and 7-5). Since the SS' line was derived, as we have seen, directly from
Figure 7-2, it is clear that market "supply" is nothing else but an indirect
reflection of the strength (or weakness) of the demand for the commodity
by its initial holders (as seen in the line KK'K" in Figure 7-2). This can be
seen very clearly by considering Figure 7-6. In this figure the line T T ' is
obtained by the lateral summation of the line KK'K" (from Figure 7-2), and
the line LL' [from Figure 7-3(b)]. This line is not the market demand curve.
This line represents, for each price, the aggregate quantity of the commodity
that the market would like to own at that price. (This quantity thus includes
some quantities of the commodity that the initial holders of it do, in fact,
139
MARKET PROCESS IN A PURE EXCHANGE ECONOMY

already own.) By erecting the ordinate R'P on R' (where OR', as in Figure
7-2, represents the entire endowment o£ the commodity), it can be shown
that equilibrium market price must be R'P. At any price below R'P, the
market as a whole would be seeking to acquire or to retain an aggregate
amount greater than is in existence. Competition would drive prices
higher. On the other hand, at any price greater than R'P, the market
would seek to hold in aggregate a quantity falling short of the natural en-
dowment. The competition of unwilling commodity holders would drive
price down.




T' X

Figure 7-6

It can be shown easily that the result obtained in Figure 7-6 is identical
with that obtained by isolating supply from demand, as in Figure 7-5. The
abscissa of a point on the TT' line is the sum of the abscissas of the cor-
responding points on the KK'K" line and the LL' lines. The first of these
latter two abscissas is equal to the distance OR' minus the horizontal dis-
tance between the point and the RR' line (for prices above OG). For the
price at which the abscissa of the point on the TT' line is equal to OR' (as
at P in Figure 7-6), therefore, it follows that the abscissa of the correspond-
ing point on the LL' line equals the horizontal distance between the KK'
line and the RK' line. But this latter distance is equal to the abscissa of
the corresponding point on the SS' line (for all prices above OG); while the
former distance is equal to the abscissa of the corresponding point on the
DD' line (for prices above OG). Thus, the price the TT' line intersects
the R'P line at (in Figure 7-6) is the same price the DD' and SS' lines inter-
sect at (in Figure 7-5). (The proof is formally valid also for prices below
OG, but at such prices no exchange at all would ensue, since no quantities
at all of the commodity would be supplied by holders of it at such prices.)
Figure 7-6 (as compared with Figure 7-5) emphasizes the supremacy of
demand considerations in the determination of the price of a non-producible
140 MARKET THEORY AND THE PRICE SYSTEM


good. Price is determined by the strength of the demand for the com-
modity; the demand of those who already hold some of it, and the demand
of those who hold none of it. On the other hand, the diagrams leading
up to Figure 7-5 demonstrate also the quantity of the commodity that will
be bought at the market price, depending on the initial distribution of
holdings. Figure 7-6 emphasizes, then, that the initial distribution of hold-
ings, while it affects the equilibrium quantity sold, can in no way affect the
equilibrium market price (with a given demand situation).17
The line TT' can be considered as ranking the degrees of eagerness with
which all market participants desire to hold successive single units of the
commodity. (In this ranking, therefore, are merged both the "sellers'
list" and the "buyers' list" referred to in the text of this chapter.) When
the unit is reached that exhausts the entire endowment of the commodity,
market price is represented directly by the eagerness to hold this unit of
the market participant involved (that is, the market participant who is more
eager to own this unit”in terms of his readiness to pay higher prices for it
or to forgo the opportunity to sell it for higher prices”than is anyone else).
All the more eager owners (or would-be owners) enjoy a consumer's surplus
to the extent that they need sacrifice, for a unit of the commodity, only the
amount that the marginal consumer of the commodity is prepared to sacri-
fice (instead of the higher sums that they themselves would be prepared to
sacrifice, if this were necessary).
Finally we may notice the special case where the KK'K" line (of Figure
7-2) is a vertical line at the origin (and thus coinciding with the price axis).
This case corresponds to the situation where those holding the commodity
initially have no desire to own any of it, no matter how low the price. The
SS' line corresponding to such a situation is, of course, also a vertical straight
line erected at a distance OR' from the price-axis (since the quantity sup-
plied at a given price is the horizontal distance from the KK'K" line at
that price to the RR' line, and this distance is now the same for all prices,
the distance OR'). Demand in this case is dependant entirely on the de-
mand of the non-holders. Supply is completely inelastic. With a given
aggregate commodity endowment, market price will depend entirely on the
strength of the demand of non-holders; supply will be completely passive in
this respect. The standard example of this kind of situation is that of a
market for perishable fish caught by fishermen. Ignoring the demand of
the fishermen forfishas food for their own families, it is clear that the entire
catch will be thrown on the market for whatever it can bring. With given
demand strength, price will depend on the quantity endowed (that is, the
size of the catch); with a given sized catch, price will depend solely on the
I 7 For further discussion of this point, and of other matters discussed in this appen-
dix, see Wicksteed, P., Common Sense of Political Economy, Routledge and Kegan Paul
Ltd., London, Bk. 2, Ch. 4.
141
MARKET PROCESS IN A PURE EXCHANGE ECONOMY

strength of demand for fish on the part of the public. This situation is
illustrated in Figure 7-7. Here SS' is a vertical line; market price will de-

Pr¡ce




0 S X
Figure 7-7

pend only on (a) the shape and position of the DD' line, and (b) on the
distance OS.
8

Production Theory



JL HUS FAR, our analysis of individual
economic activity and of the interaction in the market of the economic
activity of numerous individuals has been confined to a world where no pro-
duction was considered possible. The market process we were able to
analyze was a process where all participants participated directly as con-
sumers. Our principal purpose in this book, however, is to analyze a market
process where the wants of participants in their role of consumers may be
met not only through exchange but also by acts of production from re-
sources. In the pure exchange economy of the preceding chapter, a partici-
pant could improve his position (from that he finds himself placed in by
natural endowment at the start of each day) only through acts of exchange.
In the full market process, which we wish to investigate, a participant may
improve his position not only by direct exchange of endowed consumer good
for endowed consumer good but also by acts of production and of exchanges
of resources and products for the resources and products of others.
In this and the following chapter we take up the analysis of the
activity of the individual participant in his role of producer. In Chapters
10 and 11 we will examine the market process forged out of the interactions
of numerous individuals acting in their capacities of resource owner, pro-
ducer, and consumer. The economic analysis of production affects the
analysis of the market process, of course, through the supply side. In this
chapter and the next we inquire into the way the quantity of product that
will be offered to the market at a given product price depends upon the
pattern of production costs. In this chapter we lay the groundwork by set-
ting up the problem of production in its proper economic framework, indi-
cating the kinds of alternatives a would-be producer is free to choose among,
and showing especially how this range of alternatives is circumscribed by
what we will discover to be the Laws of Variable Proportions. In Chapter
142
PRODUCTION THEORY 1 43


9 we will proceed to show how the principles of production theory, de-
veloped in the present chapter, can be applied to the analysis of production
costs and upon the way these costs affect supply.

THE ECONOMIC ASPECT OF PRODUCTION
The economist examines production from a very special point of view.
From a purely physical perspective, of course, production is simply the
process where quantities of raw materials and labor are transformed into
quantities of product, the quantities being rigidly determined by the laws
of physical science. For the technologist the interest lies wholly in these
physical laws, describing the various results that can be expected to follow
on different patterns of resource combination.
The economist's perspective on production, however, is a quite different
one. Production is a process not of physical nature but of human action.
In seeking to improve their positions, men find it worthwhile to act as pro-
ducers as well as consumers. As consumers they act to spend their incomes
on the goods and services they consider most important. In exactly the
same way they may seek to improve their positions by producing goods and
services”either those they consider most important for themselves or those
that can be sold to command the goods they consider most important. The
very same categories, such as purpose, means, ends, and cost, which make
possible the analysis of consumer demand, reappear unchanged in connec-
tion with the actions of men engaged in production. And the economist
analyzes production with these categories making up the focus of his atten-
tion, rather than the physical laws within whose framework productive
activity is carried on.
The essence of the economist's outlook is thus that he sees the pro-
ducer as a man making choices among alternatives of a certain order of
complexity. By considering the range of possible alternatives, the econo-
mist is able to analyze the way these choices are made and the way action
will change in response to changes in the range of alternatives that choice
is made from.

PRODUCTION BY THE ISOLATED INDIVIDUAL
Production would take place of course, even in the absence of a market.
Robinson Crusoe and his production plans are accorded frequent attention
in economic treatises. An isolated individual finds himself with a severely
limited stock of goods ready for immediate consumption. These may not be
sufficient to satisfy even his immediate subsistence needs and fall very short
of satisfying all his "wants." On the other hand, he finds himself in com-
mand of productive resources of certain kinds and in certain quantities. He
Ì44 MARKET THEORY AND THE PRICE SYSTEM


himself is capable of supplying labor power”for a more or less definite
number of hours per day and possibly capable of being applied in a number
of directions requiring special skills and aptitudes. He has possibly at his
disposal raw materials of various kinds, as well as perhaps a number of
tools, or, at any rate, natural objects capable of being used, with or without
alteration, as rough implements. He finds himself, finally, subject to
rigid physical laws that determine quite precisely the outcomes of different
ways resources are combined. These are the data.
With these data at his disposal, the isolated individual recognizes that
he is faced with choice among rather definite alternative situations. It is
a physical law that a plot of land, a quantity of seed, a number of imple-
ments, and a good deal of labor can yield a crop of grain. This fact is
translated by man as constituting an opportunity; the discovery of this fact
means the recognition of one alternative open to him, if he sees fit to adopt
it. The individual, however, will be aware that the data afford other oppor-
tunities as well. He may see himself capable of building a house, plant-
ing a vegetable garden, or catching fish or game. Finally, he is certainly
aware of the opportunity, through leisure, to avoid expending labor alto-
gether, and thus to leave untapped also the other resources”except inso-
far as they can be used for direct enjoyment such as sunning oneself on the
plot of land. Of course, ignorance on the part of the individual may blind
him to a number of possible opportunities that the data of his situation
actually make feasible. He may not know his own skills, he may not know
the full capabilities of the soil, raw materials, and implements at his dis-
posal. He may be ignorant of the techniques by which his resources can
be most successfully exploited. But the opportunities he is ignorant of
simply do not enter into the range of alternatives he recognizes his power to
choose from, and in no way affect his actions (except, of course, insofar as
he may believe there are opportunities he is ignorant of and for whose dis-
covery he is prepared to forgo other already known alternatives).
Even the known alternative courses of action the individual "producer"
is able to choose from, it must be further noticed, are by no means certain
in their outcomes. The physical laws the farmer knows and on the basis
of which he plants his crops, tell him also that unfavorable weather can
drastically alter the results of his activities. And the farmer can know little
of weather conditions months in the future. To some extent, in fact,
every course of activity open to him leaves some range of uncertainty con-
cerning the outcome.
Thus, when the isolated individual has finally ploughed his field;
sown, grown, and reaped a crop of wheat; the productive process consti-
tutes in retrospect an example of human action capable of analysis from
the economic point of view. In producing his crop of wheat the farmer
has made and carried out a chain of decisions, (a) He decided to put his
PRODUCTION THEORY 145


resources to productive use rather than leave them unused, or used only for
leisure purposes, (b) He decided to grow wheat rather than produce
another type of product, and to grow wheat rather than any other crop.
(c) He decided on the method of production that he used, what tools to use,
what kind of ploughing and planting methods to employ, how to irrigate,
and so on. (d) He decided on the size of crop to raise; that is, he decided on
the quantity of his total supply of resources to apply to this one branch of
production.
These decisions meant choice among alternatives. They meant the
rejection of other alternatives in favor of those adopted. In order to obtain
his wheat the farmer sacrificed possible leisure; he sacrificed those other
goods whose production would have been possible with the resources
actually devoted to wheat; he rejected alternative methods of raising wheat,
alternatively proportioned combinations of the resources, and alternatively
proportioned allocation of the resources between wheat and other uses.
To the isolated individual these rejected and sacrificed alternatives are his
costs of production. The production of wheat cost him leisure; it cost him
a possible tobacco crop, corn crop, a house, or anything that could have been
produced with any other disposition of the resources that the farmer de-
voted to wheat.
The decision to incur these costs of course, was simply the decision to
produce wheat rather than any of these other goods with any other methods.
Its basis was the preference of the producer for what he could obtain from
his resources when devoted to wheat (in the way they were devoted), over
what he believed he could obtain from these resources on any other disposi-
tion. This preference, of course, was completely subjective; it expressed his
taste for wheat as compared with other goods and other crops; it expressed
his relative degree of confidence in his success as a wheat grower in the face
of the inevitable uncertainties, as compared with his assessment of the
uncertainties in the other kinds and methods of production; and through-
out, this preference expressed his subjective beliefs as to the objective efficacy
of the different ways of using resources, these beliefs being based perhaps
on supposed scientific knowledge, religious convictions, or reliance on
magic. One of the main differences between such "preference" for the pro-
duction of wheat (with a specific method of production), on the one hand,
and "preference" as it appears in direct consumer behavior, on the other
hand, lies merely in the complexity of the operating influences expressed
in the former. While it is true that production yields a product that is
measurable and thus differs radically from the utility that is involved in
the analysis of demand, nevertheless these subjective factors, especially when
an obtainable product is considered ex ante, go far to maintain the essential
homogeneity of human action in both consumption and production.
Whether or not the costs conceived in this sense of forgone alterna-
1 46 MARKET THEORY AND THE PRICE SYSTEM


tives were justified in retrospect depends on a number of factors. Looking
back at this use of his resources, the producer may regret his decisions. He
may have discovered that the alternatives he chose among were not quite
as he had imagined them to be. Perhaps the soil was less fertile than
imagined; perhaps he discovered himself to dislike agricultural labor more
than he had thought; perhaps events proved him over optimistic to the
uncertain factors in farming, and perhaps over pessimistic to the uncertain-
ties in other kinds of production; perhaps experience showed him mistaken
in the supposed scientific or other knowledge on whose basis he assessed the
outcomes of different productive efforts. And, of course, during the wheat
production, the farmer's tastes may have changed so that he no longer pre-
fers wheat over, say, vegetables. Under these circumstances, the producer's
product proves to be worth less than it cost to produce”he has incurred a
"loss." In other words, the producer thinks he made the "wrong" decisions;
one or more of the rejected alternatives has proved preferable to the one
adopted.
But, of course, it may well be that the producer is highly satisfied with
his course of actions. Events may have proven his choice among alterna-
tives an eminently wise one. The costs in this case are considered well
expended”the producer has "profited" by his actions. All this means is
that the wheat produced is still preferred over the goods that might have
been produced with the same resources.
Looked at in this way, it is not difficult to understand how production
decisions depend on the data of the situation and to envisage the alterations
in the production pattern of the individual that would be the consequence
of changes in these data. The same isolated individual might engage in
a different kind of production if the available alternatives were different, or
if his subjective tastes or his way of gauging future uncertainties were differ-
ent. If the available resources were different in kind, relative quantities, or
quality, the individual wrould find the opportunities he could choose among
rather different. The discovery of a new tract of fertile land, the discovery
of new techniques”even the discovery, through bitter experience, of the
mistakes made in the past use of the same resources”will alter the range of
alternatives and may well bring about different production patterns.
The analysis of the productive activity of the isolated individual could
be carried much further. But our principal interest is in the theory of pro-
duction as it is carried on in the market economy. The case of Crusoe pro-
duction was merely an introduction to the more complex kind of production

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