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potential uses. This sacrifice constitutes the cost of production of a pro-
duced good. Every product is produced at the cost of some other product.
This is the idea of opportunity cost.
Where production takes place within the framework of a market econ-
omy, the conception of cost of production is not quite so simple. While it
is true that a firm owning a fleet of taxicabs might conceivably use the
services of the cab drivers whom it employs to drive transcontinental freight
trucks, this opportunity may not be an alternative normally taken into
serious consideration. With effective division of labor, we have seen that
an entrepreneur finds himself able”and called upon”to decide on the
kind of product he is to produce only at relatively infrequent intervals.
A taxicab firm does not ordinarily weigh the relative usefulness of its
employees as cab or truck drivers. When it sends men into the streets
COSTS AND SUPPLY ] 85


with its cabs, the firm has immediately rejected, not the opportunity to
send them into the highways with trucks, but the opportunity to refrain
from hiring the men altogether. The rejected opportunity is normally
thus the chance to save money costs paid to its cab drivers”including, of
course, the chance to use the money saved to improve the quality of other
inputs”perhaps to buy new cabs more frequently, perhaps to install a
radio-dispatch system. In a market economy the individual entrepreneur
considers as his costs of production the sums of money he is required to
pay for factors in the market. A product is produced with the sacrifice of
these sums of money. The alternative that is rejected is the opportunity
to avoid both the act of production and the expenditure of money that it
entails.
But the concept of opportunity cost, which we found in the case of
the isolated individual producer, plays an important role in costs of pro-
duction as they emerge in a market economy as well. There is an im-
portant sense in which the cost of production of any product is in fact the
sacrificed opportunity of producing either some other product or the same
product elsewhere. While it is true that the notion of cost pertains
essentially to the alternatives forgone by an individual in his act of choice,
a secondary connotation also is attached to it. The term "cost" is applied
somewhat loosely to the effects of a given act of choice even where these
are felt by an outsider. The decision of a man not to open up a particular
business, in order to preserve a friendship with a potential competitor,
may be said to have "cost" the consumers the advantages that would have
ensued from their competition. In the same way, while the employment
of drivers in one branch of industry costs the individual employers only
definite sums of money, this employment, in a very real sense, "costs"
other branches of industry the opportunity to use the services of these
drivers. And, similarly, one can say that the employment of drivers by
a particular employer "costs" other employers in the same industry the
services of these drivers.
From this opportunity cost point of view, the "cost" of a particular
decision may take on a number of quite different dimensions, depending
on the point in the economic system upon which the effects of the decision
are being assessed. From the point of view of taxicab firms, the employ-
ment of a driver by taxicab fleet A has the effect of withdrawing a potential
driver from each of fleets B, C, and so on. From the point of view of
consumers, however, such an employment has hardly any effect at all on
cab service; but it has an effect on consumers insofar as other branches
of industry are concerned. The cab driver's employment costs the con-
sumer virtually nothing in terms of cab service, but it does cost them the use
of the drivers in other kinds of service.
These considerations are not merely a questionably ingenious way of
1 86 MARKET THEORY AND THE PRICE SYSTEM


stretching the meaning of the word "cost." They point, in fact, to sig-
nificant relationships in the operation of the market system. The key to
the matter is that the sums of money that the individual producer con-
siders as his costs of production tend to depend in a sensitive fashion upon
these other opportunity costs of production. For a cab driver to be em-
ployed by any one employer, it is necessary that he be paid a wage (which
are money costs of production from the employer's point of view) at least
high enough to keep him from selling his services either to employers in
other industries or to other employers in the taxicab industry itself. The
employment of a driver at one point in the economy means the withdrawal
of his potential services from other points in the economy. The values
of these potential services to employers at these respective points are the
measures of the relevant "costs" of the employment. At the same time
these values set the amounts of money that these other employers will be
willing to bid for these services. The wage actually paid must be at least
high enough to outbid these amounts. Thus, an entrepreneur's money
costs of production reflect in part also the value of the opportunity costs
of production as felt by other employers and other industries.
The sums of money paid by the entrepreneur for a factor of production
(and thus entering into his costs of production) can thus be analyzed into
a number of distinct amounts. First, one part of the sum paid to a factor
by a producer of a given product was necessary to attract and keep the
factor in the industry producing this product. This amount would have
to have been paid by any employer producing this product to prevent
the factor from being successfully bid for by entrepreneurs producing other
products. The size of this amount thus depends on the value placed by
the entrepreneurs in these other industries, on the usefulness of the factor
to them in their production activities. This element in the money costs
of production paid out by the eventual employer of the factor, thus meas-
ures that cost to consumers”often loosely termed the "social cost" of
production”which takes the form of the lost products that might have
been produced by entrepreneurs in other industries (the measurement
being made by the appraisals of these entrepreneurs). This element is
frequently termed the transfer cost of the factor, the amount that must
be paid to the factor to keep it from being used by another industry. Any
amount of money paid to a factor over and above its transfer cost cannot
be considered as "costs," from the point of vieiu of the consumers choosing
between products. The assignment of a factor to the production of a
particular product has not implied any loss of other possible products to
consumers that can be valued above the transfer costs of the factor.
From this point of view, sums of money paid for a factor above transfer
costs are termed economic rent to the factor owner. The importance
of the recognition of this second element, in the sums of money paid for
COSTS AND SUPPLY 1 87


factor services, lies in the realization that any payment of rent in this
sense involves no exercise of influence upon the allocation of factors be-
tween industries.
Although from the point of view of consumers only transfer costs are
true costs, insofar as the choice of product is concerned, there may be
valid points of view from which the cost element in the payments to fac-
tors is considerably larger. What is rent from one point of view may
well be true cost from another point of view. The amount of money
that a particular employer must pay to ensure that the services of a factor
are not snapped up by a rival producer of the same product is a true
cost, in the sense that this sum is the decisive factor in the allocation of
productive factors between producers of the same product. And even
from the point of view of the consumer this kind of allocation is not a
matter of indifference, since different producers may have different degrees
of ability in efficiency of production. What is a rent, viewing the industry
as a single unit, may be a cost, when the industry is viewed as consisting of
producers of different entrepreneurial skills. An oilfield being exploited
by a particular oil company commands a price a small part of which is
necessary to withstand the competition of farmers for the land, the rest
being necessary to outstrip the competition of other oil companies. This
second portion of the price is rent from the viewpoint of the oil industry
as a whole, but cost from the viewpoint of any one oil company.1

OPPORTUNITY COSTS AND SUPPLY THEORY
When it is realized that in a market economy as well, the costs that a
producer's accountant reports to him are to be seen as reflecting opportun-
ity costs in a real sense, then the dependency of the supply of particular
products upon costs of production becomes visible in its proper context.
It is apparent, for example, that the reason why all the resources of an
economy are not channeled into the production of a single product is that
the costs are too high, in tivo senses that are ultimately equivalent to one
another. First, after a point the price that must be paid for the necessary
factors would become very high indeed, far higher than could be justified
by the value of the product produced. Second, the channeling of all re-
sources into a single product means the complete cessation of the supply
of any other goods; this sacrifice is too great. Both interpretations are
ultimately equivalent in that the intolerable magnitude of the sacrifice
of all other products manifests itself in the high prices that will be offered
in the market for the other products, and hence for the resources required
for their production.

l Sec p. 230, ftnt. 12.
1 88 MARKET THEORY AND THE PRICE SYSTEM


These considerations point up a general tendency operating upon
the supply of any one product.
The per-unit costs of production of any particular product tend in
general to rise as the margin of output of this product is advanced.
Economic analysis of the conditions of supply of particular commodities
hinges ultimately upon the degree to which this tendency is actually ful-
filled as against the degree to which this tendency is thwarted by special
circumstances. As more and more of a particular commodity is produced
during a given period of time, fewrer and fewer other commodities can
be produced. By the principle of diminishing marginal utility, this means
that the advancement, by successive units, of the margin of output of a
particular product would involve the simultaneous reduction in impor-
tance of each additional unit of this product, and increase in importance
of the units at the respective margins of output of other products. But
this can only mean that the expansion of any one kind of production tends
to entail, for each additional unit to be produced, the rejection of alterna-
tives that are more and more difficult to ignore; a tendency toward in-
creasing costs prevails. For the isolated individual, as for the market,
the tendency toward increasing costs determines the margin of production
for each good. The market process strives, as do the actions of the isolated
individual, for a production pattern that strikes a balance between goods
so that the opportunity costs of the production of each good be minimized.
The output margin for each good tends to be at the point where an ad-
ditional unit of it (whose utility falls with increased output) would no
longer justify the opportunity cost of its production (which rises with
increased output).
Ultimately, this is a general tendency that can hardly be escaped. The
competitive market process may in fact be viewed as enforcing that or-
ganization of production that is enjoined by this principle of increasing
cost. Nevertheless, this process is complicated by the different ways the
tendency toward increasing cost actually makes itself felt in the cost data
facing the individual entrepreneur. It is vastly complicated further by the
possibility of ranges of production where there is no apparent tendency to-
ward increasing costs. Most of this chapter is concerned with these com-
plications. Our task will be to understand the selection by the entrepreneur
(who produces one commodity) of that quantity of output that he will seek
to supply to the market, out of the alternative output levels available to him.
As was the case in the analysis of consumer demand, understanding the way
the individual producer makes his output decisions will clarify the nature
of the forces acting upon the market supply of particular products.
COSTS AND SUPPLY 1 89


PROSPECTIVE AND RETROSPECTIVE COSTS
The insights afforded by viewing production costs as sacrificed op-
portunities are of particular value in distinguishing sharply between the
costs of production concerning which the accountant informs the entre-
preneur after a process of production has been completed on the one hand,
and those costs of production that are, on the other hand, involved in the
entrepreneur's decision making before embarking on a production process.
We are directly concerned only with the latter in the analysis of supply
(although, of course, the entrepreneur's anticipations of future costs are
built on his experiences in previously completed production ventures).
An entrepreneur has produced a quantity of goods and wishes to de-
termine in retrospect the total costs of his production. His financial rec-
ords provide information concerning a large number of outlays that had
to be incurred in order for the production to take place. First of all, far
in advance of the actual production, the entrepreneur built or bought
some kind of manufacturing plant. The books record both the sum paid
for the plant and the interest the entrepreneur has had to pay (and which
he may still be paying) on the capital raised to make the initial investment
in the factory. These sums were incurred, it is true, in order to engage
in production over a long period of time; they were not paid solely in
order to produce the particular batch of goods whose costs of production
the entrepreneur is now examining. Nevertheless, if these sums had not
been paid, these particular goods could not have been produced. The
entrepreneur is immediately conscious, in retrospect, of the difficulty in
stating precisely what portion of these initially incurred sums of money
are to be included in the costs of production of any particular batch of
produced goods.
In addition, the entrepreneur's records mention sums paid, both in
the past and during the period the goods were being manufactured, for
maintenance and repairs to the plant and equipment. These sums also
were incurred not only to produce one particular batch of goods. All these
sums were more or less necessary in order that the particular batch of goods
be produced, but the amounts thus paid seem to have little relation to the
size of this batch of products. These sums, too, do not vary in any simple
manner, in relation to the size of the batch of products whose costs of
production are under examination.
But the entrepreneur's accounts may show further sums that do relate
very precisely to this batch of goods. It may be possible to calculate, for
example, the amount of money paid for the raw material used up in the
production of these goods; it is possible to calculate the amount of money
paid for the labor directly employed in their manufacture. These sums
depend very plainly on the size of the batch of products under considera-
1 90 MARKET THEORY AND THE PRICE SYSTEM


tion. If a smaller batch had been produced, less raw material would have
been bought and less labor would have been hired. It is quite possible,
however, that some expenses, incurred for raw materials, labor, power, and
other factors used up entirely in the production of this batch of goods, were
undertaken in advance and would have required payment regardless of
the quantity of goods produced. It is possible, for example, that some
of the labor employed in the production is engaged under a contract pro-
viding for an annual salary, or that certain raw materials were already
bought (or agreements for their purchase completed) well before the actual
production decisions were made.
This wide variety of circumstances surrounding the expenses incurred
in connection with the production of the goods may not altogether frus-
trate the entrepreneur who is trying to discover ex post facto what total
figure to assign to the payments made for all the factors of production
employed.2 But this variety does point clearly to the fact that the costs
of production involved in the decisions to produce may be quite different
from the costs of production used to calculate the profit or loss relating
to a completed venture. The key point is that a process of production
takes time;3 thus, there are typically a number of opportunities to make
production decisions, to revise them, to carry them forward, or to abandon
them. At each such opportunity the entrepreneur makes his decision,
based partly on the anticipated costs of production of the process. For
each such decision the relevant costs of production are different.
When a process of production is being contemplated from the very
beginning, the entrepreneur must try to anticipate all the expenses that
the process will necessitate. These "full costs" are identical, in the en-
trepreneur's mind, with the costs that he expects to use at the end of the
process in calculating the final profit or loss of the entire venture. But as
the plan of production is put into operation, the entrepreneur again and
again is called upon to decide whether the process should be continued as
planned, continued with changes, or simply be abandoned. In making
2
It will be remembered throughout the chapter that costs of production must, from
the opportunity cost viewpoint, include not only the actual money expenditures that
the producer makes to buy resources, but also those values of his own resources that
he employs in production. The latter values are known as i?nplicit costs and must be
included in any economic tally of costs of production both prospectively and retrospec-
tively. A producer who devotes his own labor to production is obviously sacrificing what
he could earn in the market by his labor. (The accountant will, in this respect especially,
frequently furnish records or estimates of "costs" that are different from those relevant
to economic theory.) It should be observed that from the theoretical point of view,
which sees production carried on by "pure" entrepreneurs who own no resources, all
costs will be explicit. Implicit costs arise only in a real world where different market
functions are performed in combination by a single market participant.
3 For further analysis of the time-consuming aspect of all production, see pp. 316 ff
in the Appendix on multi-period planning.
COSTS AND SUPPLY 191


these decisions, the entrepreneur must still consider the costs of production
necessary for a continuation of production. He must, as in all entrepre-
neurial decision-making, balance expected revenue against expected costs.
But in making this calculation,
he pays no attention whatsoever to the expenses of production that he
has already paid out (or that he has irrevocably committed himself
to pay).
What has been paid has been paid. To be sure the entrepreneur will be
conscious that his past actions and commitments have determined, in
part, the circumstances under which future activity must be carried on.
(He will be aware, for example, that a past commitment to pay annual
interest sums on capital sunk into a plant will limit his future cash posi-
tion.) But in comparing anticipated costs with anticipated revenues, the
entrepreneur pays no heed to those amounts that do not depend on his
present decisions. These past amounts may have been wisely or unwisely
incurred, but there is nothing that can be done to alter the past. The
aim must be to exploit now the favorable position the entrepreneur may
find himself in (as a result of the past decisions that now appear to have
been wise ones); or to make the best of a poor situation he may find himself
in (as a result of past decisions that now appear to have been unwise ones).
In either event, the way to achieve this aim is to make that decision, with
respect to the continuation of the production process, that promises the
widest margin between the revenue anticipated on the one hand, and the
costs of production yet to be incurred through continuation of production,
on the other hand.
When the statement is made that the quantity supplied to the market
by the individual entrepreneur depends on his costs of production, the
proposition may thus refer to many different situations in each of which
it is valid, mutatis mutandis. It is true that the quantity supplied by an
entrepreneur depends on his decisions as to the size of factory to build,
and it is equally true that the quantity supplied depends on entrepreneurial
decisions as to how heavily to utilize a given plant once it has been built:
on the decisions as to how many machines to install; and, again, on sub-
sequent decisions as to how fully to employ the available machines once
they have been installed; and so on. For each of these decisions the rele-
vant "costs of production" are different; yet there is clearly a sense where
supply depends on each of these different conceptions of costs of produc-
tion. The crucial point is obviously the time factor. There are forces
acting upon supply which make themselves felt both frequently and rapidly;
there are other forces, no less powerful, which influence supply less fre-
quently and less rapidly.
In the economic literature it is sometimes convenient to group together
the short-run influences upon supply, as distinct from the long-run forces.
1 92 MARKET THEORY AND THE PRICE SYSTEM


The latter are conceived as being felt only over those periods of time long
enough to warrant reconsideration of the size of the firm's fixed plant.
The "short-run" forces are felt whenever there is room for decisions as
to the level of output to be achieved with given plant. While this dichot-
omy is of considerable convenience (as will be seen in later chapters), it
must not be regarded as more than a simplification. The truth is that a
decision that an entrepreneur is called upon to make may vary, in respect
to the permanence of its impact on production, through a wide spectrum.
A sudden change in market conditions may influence the entrepreneur to
step up production sharply. The immediately felt consequences, possibly,
will be overtime employment of the labor force and intensive utilization
of existing machinery. Should the change in conditions persist, the en-
trepreneur might initiate more frequent replacement of machines, recruit-
ment of a larger permanent work-force, and so on. Finally, the entre-
preneur might be called upon to decide whether or not to expand the
size of the factory, whether or not to build an additional factory, and so
on. Supply depends, in a different sense, upon each of these kinds of
decisions. Each such decision is based on the relevant costs of production.
In each case the entrepreneur is aware that the total relevant costs of pro-
duction will vary with the size of the output concerning which the decision
is to be made. Costs that do not vary in total amount with production
are simply not relevant costs of production. They are sums that have
already been incurred in past production decisions and therefore do not
depend on, and cannot influence decisions concerning, the level of output
now to be undertaken.4


CAPITAL GOODS AND COST THEORY
The foregoing discussion indicates the role played by capital goods
in a theory of costs and supply. We have seen that the forces influencing
the supply of a particular product are as numerous, and as different in their
impact, as are the opportunities available to the entrepreneur to alter the
progress of production. The main reason for the differences between the

4 The distinction between long-run and short-run forces is responsible for the
corresponding distinction, current in economic literature, between fixed costs and variable
costs. Fixed costs are unchanging for the duration of the short run; variable costs are
those that do change with changes in output even in the short run. From the long-run
viewpoint there are no fixed costs; all are variable. The discussion in the text will have
made it clear (a) that from the short-run point of view, expenditures that do not fall
under the heading of variable costs are best considered, not as "fixed," but as not being
costs at all; (b) that there may be a number of degrees of "fixity" in costs corresponding
to the numerous junctures at which a producer may be forced to make decisions (and
at which the expenditures previously irrevocably incurred are no longer weighed as cost
factors in arriving at decisions).
COSTS AND SUPPLY 1 93


impacts of these various forces lies fundamentally in the specificity of the
capital goods introduced at various stages of the process of production.
The concept of specificity in a factor of production refers, we have
already seen, to the limitation of the usefulness of the factor to a narrow
range of purposes. A specific factor is either used for these definite pur-
poses, or it can be of no use at all. Factors of production, we saw in the
previous chapter, are more specific or less specific, depending on their degree
of versatility in production.
Any produced factor of production capable of yielding productive serv-
ices over a period of time is a durable capital goody Capital goods emerge
as a result of past production of goods that were not consumed. Men pro-
duced, sacrificed labor and the services of other factors, in order to obtain
goods that should yield their services in later production. Where the
capital good is a durable one, the past production and utilization of produc-
tive services were undertaken in order to obtain a stream of such productive
services in the future.
Now it is in the nature of things that capital goods are (at least to some
degree) specific. When labor and raw materials have been combined to
produce any material object, this object is more suitable for some purposes
than for others. The labor applied in its manufacture might have been
used to produce something else; but it happened to be used up in the pro-
duction of this object. While it is sometimes said that capital goods repre-
sent "saved-up" labor (along with other productive services), the capital
good cannot serve, in general, as a store of the versatility of the invested
labor. A man may be able to dig holes in the ground with his bare hands.
Instead he uses them to fashion a spade. The production of this capital

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