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good enables him to "save" his original labor for later use. When he uses
his spade later to dig holes, he reaps (with more or less "profit") the fruits
of his originally invested labor. But the spade, which serves as the "store"
of labor, has stored it in a form that is specific; the original labor services
(which might have been used to chop down trees) can be exploited, in their
stored-up form, only to dig holes.
This necessarily specific character of capital goods is responsible for the
heterogeneous nature of the cost forces acting upon supply. If capital
goods were completely versatile, then the fact that past decisions have been
made would in no way interfere with the necessity to weigh the full costs
of production in making later decisions. Complete versatility in capital
goods (conceived broadly as the capacity of a good to serve equally valuably
in any productive process”and thus including complete mobility and ease
of transfer ability between firms and industries) would mean that expenses
paid out as a result of past decisions are completely retrievable. A new
5 For additional remarks on the nature of capital goods and their role in production
and in market theory, see in the Appendix on multi-period planning, pp. 317-320.
194 MARKET THEORY AND THE PRICE SYSTEM


decision to continue a particular process of production will thus have taken
into account the fact that this course of action means abandoning for the
time being the possibility of recovering all the sums already sunk into the
productive venture. Each decision made during the production process
would then be made by comparing expected revenues with expected total
costs”the latter including all sums, those already spent as well as those
expected to be paid. The level of output will be determined on the basis of
the same cost at each state of decision making (assuming no change in the
market data concerning costs). Changes in the market prices of finished
products would set up forces influencing supply that would not depend for
their impact upon the time available for the impact to be felt. Forces able
to exert a certain long-range impact would not exert any different pressure
on supply than that exerted by forces felt within a very short time.
Capital goods, however, are not completely versatile. Once a decision
has been made to invest in a certain machine, it is a commonplace that the
sum invested can be recovered only at considerable loss, should the original
production plans be abandoned later on. The machine will hardly be able
to be used in other productive processes; and its value as scrap will be far
less than the price paid for it. Moreover, even where the machine can be of
use to similar firms, or to firms in other industries, the cost of transfer is
likely to be such as to make full recovery of its purchase price impossible.
Later decisions concerning the use to be made of the machines will therefore
disregard a large part of the sums originally paid for the machines. The
determination of supply in periods short enough to warrant no purchase of
new machines will therefore be governed by cost considerations different
from those influencing supply when longer periods (during which the costs
of machines may be a pivotal factor) are under consideration.
The more durable the capital goods involved, the longer will be the
time periods during which it may be possible, and wise, to ignore the cost
of the capital goods. The more durable the capital goods, the longer it
will be possible to use their services in production, without having to worry
about their costs”since these services have been paid for already anyway.
A typical situation the entrepreneur finds himself in is where a factory,
more or less well-equipped with certain machinery, has been already con-
structed. The existence of such a complex of durable, immobile, and spe-
cific factors exercises a profound influence on the relative attractiveness of
the various alternatives available to the entrepreneur. The entrepreneur
may be aware of new techniques of production that would enable a modern
factory equipped with up-to-date machines to produce a larger output at a
fraction of his present cost. He may be deterred from embracing this
possibility because the wonderful new factory requires the outlay of money
”new money, while the old factory, inefficient as it is, is available for use
at almost no cost at all. The opportunity costs at this stage of producing a
COSTS AND SUPPLY 1 95


given output with the more "efficient" plant are greater than with the less
"efficient" plant. Both from the point of view of the entrepreneur himself,
and from that of the consumers, the relevant opportunity costs indicate using
up the old plant while it is still worthwhile. Only when the gap between
the technical efficiencies of the new and the old plants has become so wide
as to outweigh the cost disadvantage involved in the initial construction of
the new plant (as compared with the old) will it be economically advanta-
geous to scrap the old factory. Such a gap may occur while the "old" factory
is still quite new; revolutions in technology may render recently constructed
plants completely obsolete. But, more likely, it is necessary for the old
plants to depreciate physically to a greater or lesser extent before it pays to
build a newer and more efficient plant. In the interim period, during
which repeated entrepreneurial deliberations pronounce the old factory the
most advantageous, output levels will depend on the additional costs in-
curred by producing with the existing plant.
These additional costs required to cover the raw materials, labor, and
other productive services used directly in the manufacture of the product
will be found to vary, per unit of output, with the level of output itself.
The existence of a fixed plant, which for the time being is not to be changed,
exerts in itself a powerful influence on the relation between output level
and per-unit production costs. This relationship must now be explored.

FACTOR DIVISIBILITY AND SHORT-RUN PER-UNIT COSTS
Production is carried on, we have seen, with the aid of capital goods.
The more advanced the organization of production in an economy, the
more durable will be the capital goods used in production, and the greater
will be the proportion in which capital goods are combined with other com-
plementary factors of production. The existence in a plant of any given
complex of capital goods has two distinct implications for costs of produc-
tion that the entrepreneur must consider in his daily production decisions.
First, as discussed in the previous sections, the relevant costs in daily deci-
sions will not include sums incurred in the past for the acquisition of the
capital goods, insofar as these involve no current opportunity cost. Second,
and it is this influence that is discussed in this section, a given complex of
capital goods is itself the source of a definite pattern that the entrepreneur
will find to characterize the way his relevant costs of production depend on
the volume of output. This pattern in the costs of production is an inev-
itable consequence of the limited divisibility of capital goods; the pattern
itself is an implication of the laws of variable proportions.
An entrepreneur has at his disposal a fully equipped plant. A decision
to alter output will have the short-run effect, not of a plant being closed
196 MARKET THEORY AND THE PRICE SYSTEM


down (or another erected), but of a different quantity of variable factors
being used complementarily with the given plant.
Any decision to alter production would thus have the immediate effect
of altering the proportions in which the fixed plant and the variable
productive factors are combined.
If capital goods and other factors were highly divisible, then a change
in the volume of output would not necessarily entail an alteration in the
input proportions of the different factors. For each level of output the
optimum combination of factors would be employed. A 10% increase in
the volume of output would call for alteration in the quantity employed
of each of the factors wherever”and only wherever”this would meet the
requirements for the new optimally proportioned input mix. With com-
plete divisibility, there would be no obstacle preventing the exact desired
adjustment in the employment of any factor. Thus, no efficiency in produc-
tion would be gained, nor would any efficiency be lost, by an alteration in
output volume, insofar as efficiency depends on input proportions.
But, of course, capital goods are only imperfectly divisible. An en-
trepreneur who owns one sewing machine can hardly increase or decrease
his employment of sewing machines by 10%. An airline can alter the size
of its fleet of planes only by adding or discarding planes in whole numbers.
Therefore, an entrepreneur who slightly decreases the volume of his output
must do so typically by combining a smaller quantity of variable inputs with
an unchanged quantity of fixed capital equipment. Only if the cutback
in production is considerable will the input of these capital goods be de-
creased. The more elaborate the capital goods involved, the greater the
cutback (or the boost) in production will have to be before any alteration in
the input of this factor is feasible.
The consequence of capital-goods-indivisibility is thus that different
volumes of output are inevitably associated with differently proportioned
input combinations. Thus, the laws of variable proportions clearly become
relevant. Differently proportioned input combinations are in turn asso-
ciated with different efficiencies in production. A change from one level
of production to another means a change in the output that can be obtained
from a given quantity of inputs. Put the other way around, this means
that different volumes of output will be obtained at the cost of respectively
different quantities of input per unit of output. Costs of production must
change, per unit of output, with changing output itself, simply as a conse-
quence of the laws of variable proportions.
We have already seen how the cost forces acting upon the supply of
a product may exert their influence over different time periods. Some
forces will be felt more swiftly, others will be felt only gradually, through-
out longer periods of time. The main reason for this heterogeneity in cost
forces stems, we have seen, from the existence of more or less fixed blocks of
COSTS AND SUPPLY ¬ 97


specific capital goods that are introduced at various stages in the process of
production. Factor indivisibility, in which we are now directly interested,
plays an obvious part in emphasizing this heterogeneity. The costs of
erecting the firm's plant are "fixed," for considerable lengths of time, be-
cause it is only infrequently that it becomes feasible to change the entire
plant. But if plant size were capable of being altered by small percentages,
such alterations would seem profitable at far more frequent intervals. The
fact that items such as heavy machinery and plant are not capable of such
nicely adjusted alterations in size makes their costs relatively fixed over
considerable periods. If plant size were easily variable, then even a rapid
change in output volume might bring about some change in the size of
plant.6
With the imperfect divisibility of capital goods, a fairly well-defined
pattern of per-unit costs of production emerges. An entrepreneur finds
himself with given fixed capital equipment, plant, and machinery. If the
forces of demand were to move him to produce smaller and smaller output
volumes, the immediate consequences would be that the variable inputs
would be combined with the fixed inputs in smaller and smaller propor-
tions. These proportions might be so low that the marginal increment of
product corresponding to a small hypothetical increase in the fixed input
might possibly be negative for low levels of output; in such a situation any
increase in the variable inputs must raise the output per unit of variable
inputs. The proportion of variable to fixed inputs would be less than
optimal: the fixed plant would be greatly underutilized. If, on the other
hand, the entrepreneur were moved by market demand to produce larger
and larger volumes of output, the situation would be reversed. Variable
inputs would be combined with fixed inputs in greater and greater propor-
tions. For one particular volume of output, the input proportions would
be optimal. For greater outputs the fixed plant might be used more inten-
sively than would be optimal; the average efficiency of the variable inputs
would be falling. Although variable inputs would never be added by the
entrepreneur in such volume as to make the corresponding marginal incre-
ments of product negative, nevertheless, the proportion of variable to fixed
inputs may be so high as to render the marginal increment of product very
low.

6 Even if plants were perfectly versatile but able to be built only in a limited number
of sizes, this indivisibility would mean that plant alteration is feasible only at fairly wide
intervals. On the other hand, even if plants could be built in any desired size but
were completely specific to one kind of production (or were, at any rate, completely
immobile and thus unable to be transferred to other branches of production), plant
alteration, once again, would be feasible only at long intervals. In the real world, then,
both specificity and indivisibility combine to make expenditures for plant a cost only
from the long-run view, and to bring about the typical pattern of variable costs discussed
in the text.
198 MARKET THEORY AND THE PRICE SYSTEM


Translated into cost terms, our analysis thus yields fairly straight-
forward conclusions insofar as short-run entrepreneurial decisions are con-
cerned. We recall that in day-to-day decision making, the fixed inputs
entail no costs. The entrepreneur is called upon to make pecuniary sacri-
fices in order to obtain product, only through his purchases of variable
factor services. The average efficiency in production of these services has
been seen first to rise and then to fall as output is increased from very low
to very high levels. Thus, the sacrifice of factor services, per unit of out-
put, which the entrepreneur is called to make, would tend to fall, reach
a minimum, and then rise for outputs raised higher and higher from very
low levels. We may assume for the time being that the prices of factor
services, which the entrepreneur is required to pay, do not depend on vol-
ume of output. It is then clear that the per-unit costs of production rele-
vant to short-range entrepreneurial decisions will be high for low outputs,
fall to a minimum for higher outputs, and then rise to higher levels once
again as output is increased to the point where the fixed plant is being over-
utilized, so that decreasing average returns to the variable inputs prevail.

SHORT-RUN COSTS AND THEIR EFFECT ON SUPPLY
We have discovered that per-unit costs of production follow a character-
istic pattern when the volume of production is changed within the frame-
work of a given plant. This pattern suggests the way a producer with a
given plan will make short-run output decisions, and the way these decisions
will change with changes in the market conditions for his product. As we
have seen, once a producer has constructed a plant, changes in market condi-
tions only in fairly exceptional cases will bring him immediately to seek a
different scale of plant. For the most part changes in market conditions
will merely bring about revisions in the decisions concerning how heavily
to utilize the given plant (that is, what quantities of variable inputs should
be combined with the plant). These revisions will be made in the light of
the short-run per-unit cost pattern that we have discovered.
Generally, a producer will seek to produce that volume of output (dur-
ing a given period) that will yield the highest surplus of aggregate revenue
over aggregate (relevant) costs of production. In contemplating any pro-
posed volume of output (per period), an entrepreneur will always ask him-
self whether he could not do better by producing an output volume slightly
larger, or slightly smaller, than that proposed. An output slightly larger
than a proposed level would involve an increase in aggregate (relevant)
costs of production; on the other hand, the increase would bring an increase
in aggregate revenue. If the marginal revenue involved in this way (by
the contemplated expansion of output beyond the level originally proposed)
exceeds the marginal cost involved (the latter, of course, referring to the
199
COSTS AND SUPPLY

increment in short-run costs that are relevant with a given plant), then
clearly the larger output is to be preferred over that originally proposed.
Similarly, in contemplating a contraction of output below a proposed level,
the producer will compare the reduction that this will allow in aggregate
short-run production costs, with the associated reduction in aggregate rev-
enue from product sales. Should the former exceed the latter, then the
smaller output is to be preferred over that originally proposed.
Diagrammatically, therefore, a producer will seek to produce that out-
put (during each period) at which his marginal revenue curve intersects
his marginal cost curve from above. In the diagram [Figure 9-1 (a)] AVC is
the curve of per-unit costs patterned according to the analysis of the pre-
ceding section. It shows that when the plant is combined with only a


$ *
MC
per per
unit unit

A V C
/ ^^
7¯ `<r'
5


MR
Quantity
AC Quantity 0
(b)
(a)
Figure 9-1


small quantity of variable inputs, the costs (of these variable inputs) per
unit of output are high. These costs are shown to fall with increased
utilization of the plant until (at the output OA) variable inputs are com-
bined with the plant in optimum proportions, so that when the plant is
combined with still greater quantities of variable inputs, the average effi-
ciency of the latter fall and result in rising per-unit costs of production.
MC is a curve showing the increments to aggregate variable costs correspond-
ing to each successive unit of output.7 This curve lies below the AVC line
for outputs less that OA, and above the A VC line for larger outputs. For
the output OA (at which per-unit costs are at a minimum), marginal cost
is the same as per-unit cost.8 An average revenue curve (AR) and a mar-
ginal revenue curve (MR) are also drawn in the diagram. The AR line
expresses the producer's expectations respecting the prices at which he can
expect to sell (during each period) the various possible output volumes

7 The cost curves arc drawn continuous. In a real world we might find, of course,
that discontinuous curves would be a more faithful representation.
8 See p. 98.
200 MARKET THEORY AND THE PRICE SYSTEM


under consideration.9 (In drawing this AR line, we make, therefore, the
somewhat questionable assumption that the entrepreneur does in fact possess
definite expectations on these points.) The MR line, then, expresses a set
of implications of the AR line as drawn: it sets down, for each successive
unit of output, the increment to aggregate revenue associated with its pro-
duction and sale. (For any outputs qn, qn+1, which the producer expects to
be able to sell at prices per unit, pn, pn+1, respectively, the marginal revenue
associated with the (n+l) st unit of output, is therefore (qn + 1 * pn + 1) ”
qnPn·)
With the cost and revenue curves shown, the producer will seek to
produce an output volume OC. This he will be able to sell at a price CS.
Any output greater than OC would be less than optimal from his point of
view, since for each unit of output beyond OC the increment in costs exceeds
the increment in revenue. Similarly, any contraction of output below OC
would involve a sacrifice of revenue in excess of the diminution of aggregate
costs of production. With output OC the firm is doing the best it can.10
It is clear, then, that short-run output decisions will depend upon the
expected demand for the producers product, since upon this will depend his
average revenue curve, and, in turn, his marginal revenue curve. Should
expected demand be so weak that the producer can discover no volume of
output where average revenue is greater than the relevant average cost of
the variable inputs, he will produce no output. Thus in the diagram [Fig-
ure 9-1 (b)] were he to produce even the quantity OC (where MR = MC),
while doing better than at any other positive output, he would still be pay-
ing out variable costs for each unit of output that exceeds the correspond-
ing revenue by the amount ST. (In addition, from the long-run point of
view, he would be failing to earn anything toward the recovery of the costs
sunk, in the past, in the fixed plant.) The producer, in this case, finds
himself saddled with a plant that it does not pay to use at all, since nothing

9 On the shape of the demand curve facing an entrepreneur, see pp. 94-96.
!OA word may be added here concerning the quantities of the various factors of
production that the producer will be employing in order to produce the optimal output
OC. These factors, of course, will be employed so as to make up the "least-cost com-
bination" (discussed at the end of Ch. 8). An alteration in the price of a factor of
production will thus affect the quantity a producer will employ (as reflected in his
demand curve for it) in two distinct ways. First, as we have already seen in Ch. 9
(ftnt. 15), an alteration in the price of one factor will induce the producer to substitute
a factor that has become relatively less expensive in place of one that has become
relatively expensive (even if no alteration were to occur also in the scale of production).
Second, an alteration in the price of a factor will change the level of output at which
the marginal cost curve (duly modified to reflect the new least-cost combinations marked
out by the new factor prices) intersects the marginal revenue curve. At all possible
prices of a factor, however, it remains true that a producer will purchase that quantity
of it such that the last dollar spent upon it yields a marginal product worth just more
than a dollar.
201
COSTS AND SUPPLY

that it can be used to produce can be sold for enough to cover even the addi-
tional inputs that would now be required.
Should demand conditions be such that the output, for which marginal
revenue just balances marginal cost, can be sold at a price per unit greater


per
unit
AVC




Quantity
C
Figure 9-2

than the per¯unit cost of variable inputs, then it will pay the producer to
produce this volume of output. As we have seen, this volume of output
(OC in the diagram) is to be preferred over any other positive output level
(since MC = MR); and since for this output AR > AVC, the producer is
better oil with this output than with no output. Even if the excess of aggre-
gate revenue over aggregate cost of variable inputs (that is, the amount
ST — OC in Figure 9-2) is insufficient to cover the current quota of costs sunk
in the fixed plant (so that from the longer-run point of view the decision to
build the plant is seen to have been a mistaken one that has caused losses),
nevertheless, the producer (who now cannot retrieve the past and can only do
the best he can with the plant) can improve his position through producing
OC. By so producing he earns enough revenue on each unit produced to
cover all costs of variable inputs, and, in addition, to leave over the amount
•ST per unit of output (or the aggregate amount ST — OC) toward the re-
covery of the sunk costs. From the short-run point of view this amount
(ST X OC) is "profit": the decision to produce can improve the entrepre-
neur's position by this whole amount. (Should this amount of ST — OC ex-
ceed the entire sum sunk in the fixed plant, then, of course, the operation will
be pronounced a profitable one from the longer-run point of view as well.)
In general, it will be observed that the entrepreneur will in the short
run be prepared to use his plant more intensively as the average and mar-
ginal revenue lines are higher on the diagram. Since marginal costs rise
with increased output (after an initially falling phase), it follows that when,
with a given cost picture, the intersection of the marginal revenue and
marginal cost curves occurs at higher values of marginal revenue (due to
an upward shift of both AR and MR), this intersection corresponds to a
greater output volume. The more urgently his product is desired by con-
202 MARKET THEORY AND THE PRICE SYSTEM


sumers, the more willing a producer will be to employ his fixed plant more
intensively.
In the special case where an entrepreneur feels that he faces a perfectly
elastic demand situation (so that he believes himself able to sell any quantity
he pleases at a given price), the average and marginal revenue curves coin-
cide as a horizontal line (at the level of the given price). In this case the
quantity of output that it will pay to produce can be seen simply as given
by the intersection of the price line with the marginal cost curve. When
different possible profitable prices are considered (still assuming perfectly
elastic demand), the marginal cost curve itself now appears as the supply
curve of the firm. For each possible profitable price, the quantity that it

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