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will pay the firm to produce is expressed, for this case, by the corresponding
abscissa of the marginal cost curve.
Our understanding of the way the short-run output decisions of the
individual producer depend on the intensity of the demand for his product
suggests, in addition, the likely immediate consequences for industry supply
of the product, of a change in the intensity of over-all market demand for
it. As the general demand for a particular product grows more intense,
it is likely that each of the entrepreneurs (possessing plants designed for
this product) will discover that the demand and marginal revenue curves
for their respective individual outputs have shifted upwards. Each pro-
ducer will discover that additional units of input promise to add greater
revenue increments than previously. Each will seek to expand output in
the short run so that for the group of producers as a whole, the change in
demand tends to bring about an immediate output expansion with existing
plants. The process whereby the market achieves this kind of short-run
adjustment of supply to changes in demand conditions will be more fully
discussed in the succeeding chapters.

LONG-RUN COSTS AND SUPPLY
When an individual entrepreneur considers the wisdom of entering a
particular industry, his basic decisions will not be governed by the pattern
of short-run costs. From the long-run point of view an entrepreneur must
decide whether or not an output level exists for this product that (when
produced as efficiently as he knows that this output can be produced, and
sold for as high a price as he knows that this output can be sold) promises
net proceeds greater than he knows to be obtainable elsewhere. In estimat-
ing how cheaply various possible levels of output can be produced, the
entrepreneur is in the long run free to consider production in various dif-
ferent sizes of plants. Of course, in taking the long-run view of production,
he will have to include (in the costs of production of any proposed level of
output) the cost of erecting the most appropriately sized plant, as well as
COSTS AND SUPPLY 203


the cost of the variable inputs that will subsequently be required. An
entrepreneur who has already been producing in the industry must also
constantly review his position from the long-run point of view. He must
constantly ask whether some alternative plan of production (of the same
product), possibly with a different size of plant, could not yield him higher
net proceeds (even after considering the foremost advantage of his existing
production set up, namely, the fact that he already has his given plant and
does not have now to incur costs for it, as he would have to do with alterna-
tive production plans). And as his existing plant reaches the end of its life,
the entrepreneur must certainly make his decisions with predominantly long-
run considerations in mind.
In making these long-run decisions, therefore, entrepreneurs will ex-
amine the various proposed levels of output with so-called "long-run" costs
in mind. The relevant cost of producing any proposed output volume,
during each period of time, will now be the sum required for production
when the scale of plant, together with all the inputs, can be selected with
complete freedom out of all possible sizes and combinations (subject only
to the constraint that the resulting cost sum be then the lowest known pos-
sible amount).11 In contemplating any proposed volume of output, during
each period of time, an entrepreneur taking a long-run view will ask whether
a better position might not be secured by producing an output slightly
larger, or slightly smaller, than that proposed. In comparing the proposed
output with one slightly larger, he will compare the relevant marginal cost
with marginal revenue. The marginal cost relevant for the long-run view
is the difference between the aggregate costs of production (of the two vol-
umes of output under consideration) when each of the respective aggregate
costs is that which would result from the use of the plant size selected as
best for the particular volume of output under consideration.12
11 In a real world where entrepreneurs hold expectations concerning the future only
with considerable uncertainty, even this constraint will not necessarily be operative.
The producer may well deliberately construct a plant, even though this plant will result
in higher costs of production for the expected output volume than need be incurred
with a differently constructed plant. He may make this decision simply because the
first plant, while more expensive than the second, has the advantage of being more
adaptable to possible deviations from the expected conditions. Concerning this see
Stigler, G., "Production and Distribution in the Short Run," Journal of Political Economy,
June, 1939.
12 Long-run cost curves are drawn to reflect these considerations. An assertion that
the line LAC in the diagram is a long-run average cost curve amounts to the following
statement. For the level of output expressed by the abscissa of any point on the line,
its ordinate corresponds to the lowest per-unit costs of production possible for the
output when (a) the producer is free to select any size of plant for each output level,
and (b) the costs of production include all expenditures (which an entrepreneur who
starts out without owning any resources must incur in order to produce the output).
Although, once the entrepreneur has built his plant only "variable" costs need be
considered in subsequent decision making, this is of course not the case for long-run
purposes. Prospective costs, from the long-run view are the sum of (a) the "fixed" cost
204 MARKET THEORY AND THE PRICE SYSTEM


The pattern that long-run costs will follow as the entrepreneur considers
a wide range of successively larger volumes of output will depend on the
technological conditions governing the particular kind of production.
Since there is freedom to vary the proportions of all factors used, there
would seem (if we assume long-run divisibility of all factors) to be no room
for the laws of variable proportions to operate. Divisibility of factors would
permit the production of any proposed output with the least-cost combina-
tion of factors. With all factors divisible, this identical proportion of in-
puts, if desired, can be reproduced for the production of any other scale
of output. It follows that (if we retain our temporary assumption of
constant factor prices) any change in the per-unit cost of production, result-
ing from a change in output, must be attributed to the change in scale of
production, not to any change in factor proportions. During a portion of
the preceding chapter the analysis proceeded on the assumption of constant
returns to scale. On this assumption the per-unit long-run costs of produc-
tion would remain unchanged regardless of the scale of output (so long as
factor prices do not change). Any proposed volume of output could then
be produced, in the long-run view, at as low a per-unit cost as any other
volume of output. Long-run marginal cost would be unchanged for all
proposed output changes and would be the same as long-run per-unit cost.
Any increase in intensity of market demand for the product of the industry

of erecting the desired plant and (b) the variable costs appropriate to the selected size
of plant. With respect to a given proposed size of plant, prospective costs per unit of

* r
j


TAC
P·"¯
unit



” ” •



LMC

A Quantit;
0

Figure 9-3
output, from the long-run view, are thus obtained by dividing the sum of these two
cost figures (for each output level possible with the plant) by the corresponding output
quantity. (The cost curve thus derived is thus higher than the corresponding short-run
[variable] average cost curve for this plant size, at each output level, by the quota of
"fixed" cost assigned to a unit of output for that output level.) In the diagram the
line TACX is such a curve (for one size plant); TAC 2 is another. If one were to imagine
such curves to be drawn for each possible size of plant, it is clear that the curve that
cuts the vertical line A A' at the lowest point corresponds to the size of plant most suited
to the production of the output OA; and similarly for all levels of output. AB thus
emerges as the long-run cost per unit for an output volume OA; and the line of long-
run average costs LAC is seen to be the "envelope" of all the TAC curves relevant respectively
to all the various proposed levels of output.
The long-run marginal cost curve is drawn bearing the usual geometrical relationship
to the corresponding average curve. At any given level of output, long-run marginal
cost is equal to the short-run marginal cost for that level of output when the optimum
sized plant for the output is being used.
COSTS AND SUPPLY 205

could result in a larger aggregate supply, without any increase being neces-
sary in the product price.13
Where, however, the required factors of production are only imperfectly
divisible, it will not in general be possible to expand output by simply
increasing the input of each factor in the same proportion. If there is a
particular volume of output for which inputs, by chance, can be combined
in an optimum proportion, a relatively small increase or decrease in out-
put will result, with some inputs indivisible, in a less than optimally propor-
tioned input combination. When an indivisible input is underutilized,
expansion of output will lower per-unit costs. When output has expanded
sufficiently so that optimal proportions are attained, further employment
of additional units of the divisible factors without a corresponding increase
in the input of the indivisible factors (due to this indivisibility) must raise
per-unit costs. Thus, even where production might otherwise yield constant
returns to scale, factor indivisibilities may cause rising or falling long-run
costs.14 In fact, it is possible (and sometimes convenient) to view all de-
partures from constant returns to scale as being in principle the conse-
quences of "indivisibilities."
Whatever the pattern of long-run costs, which the technological condi-
tions of the industry determine, an entrepreneur will formulate his long-run
plans by comparing marginal cost with marginal revenue for each possible
output. If there is no output at which the long-run average costs are fully
balanced by expected average revenue, the entrepreneur will not enter the
industry. Where the demand for his product is sufficiently strong for a
range of outputs to be possible for which average cost is not greater than
13 The long-run average (and marginal) cost curve would thus be a horizontal
straight line passing through the minimum points of all the TAC curves. (Of course,
once a given sized plant has been built, the [short-run] marginal costs will nevertheless
be rising.)
TAC, TAC.
per




O OuonTity


Figure 9-4
14 Many economists (for diverse reasons) have believed that the accompanying diagram
illustrates the typical pattern of long-run costs.


LAC




Quantity

Figure D-5
206 MARKET THEORY AND THE PRICE SYSTEM


average revenue, the entrepreneur will choose to produce that output for
which long-run marginal cost is just balanced by long-run marginal revenue.
When he produces this output volume with the size of plant that minimizes
its costs of production, he is doing the very best that he can.15 Any other
output, no matter how efficiently produced, must yield either a smaller sur-
plus of aggregate revenue over aggregate costs, or even a deficit.
For the special case where an entrepreneur believes the demand for his
product to be perfectly elastic (so that he can sell any volume of output
without lowering the price), he will, attempt, if it pays at all to be in the
industry, to expand output (that is, to build larger and larger plants) so
long as long-run average costs decline (that is, so long as there are increasing
returns to scale). The size of plant that he should erect will be limited
only by eventually rising long-run costs (when he will seek to build a size
of plant for which his long-run marginal costs just balance his product
price).

FACTOR PRICES AND SUPPLY
Cost curves and supply have been analyzed in the preceding sections
on the assumption that the prices of productive factors do not change re-
gardless of the level of output. So long as this assumption was retained, the
only changes in the per-unit costs of production that were possible, as output
increased, were those resulting from the technological conditions governing
production. Thus, in the short run, per-unit costs changed as a result of the
laws of variable proportions, while in the long run, costs depended on re-
turns to scale. It was possible, we found, to make statements concerning
supply (especially for the short run) based solely on these considerations.
But we have already seen that the costs (and therefore the supply) of each
product are governed by a paramount additional economic consideration.
We know that when the output of any one product is expanded, a with-
drawal is required of more and more units of factors away from potential em-
ployment in other branches of production. By the principle of diminishing
marginal utility, therefore, the steady advancement of the margin of output
of any one product involves the simultaneous reduction in importance of

13 It needs to be stressed that long-run cost considerations do not require that the
producer erect a plant of such a size that he use it subsequently at its most efficient level
of utilization. In other words the LAC curve does not necessarily pass through the
minimum points of the TAC curves. All that is necessary is that, for whatever output
level it is decided to produce, a plant of necessary size be erected that minimizes its costs
of production. This may well mean that this plant will then be used at less (or more)
than its optimum level of utilization. This does not matter; the output that would be
yielded by such "optimum" utilization of the plant could be produced more cheaply,
it is likely, by underutilizing or overutilizing a different size of plant. Anyway, the
aim is not to use plants at their most efficient levels of use, but to produce a given
output with its most efficient combination of inputs.
COSTS AND SUPPLY 207


each additional unit of this product, and increase in importance of the
units at the respective margins of output of other products.
This tendency must eventually express itself through the price mechan-
ism. (In the succeeding chapters we will examine more closely hoiv the
market process would tend to make prices reflect such a tendency.) Even-
tually, entrepreneurs in the expanding industry would find on the one hand
that their product has a lower price, and on the other hand that the various
inputs can be bid away from other industries only at higher prices. As a
result of the latter tendency, it is clear, producers will find that the per-unit
costs of producing their product will tend to rise. Producers will attempt
to escape some of the consequences of higher factor prices by altering the
proportions of the various inputs, substituting factors whose prices have not
risen (or which have risen less) in place of the factors whose prices have
risen most. But the rising factor costs will ultimately raise the costs of
production, and this will exert an appreciable effect on supply. The output
for which an entrepreneur finds that marginal revenue is balanced by mar-
ginal cost will be a smaller one, as a result of rising factor costs. With a
given intensity of demand for his product, the entrepreneur will therefore
be prepared to supply only a smaller volume of output to the market.
If the entrepreneur is a relatively important buyer of a particular re-
source, he may find that the price of this input rises directly (and signifi-
cantly) as a result of his own expansion of output and consequent increased
purchases of the input. In such a case his own cost curves will directly
incorporate the rising factor prices. Where the individual entrepreneur
is a relatively unimportant purchaser of a particular input, its price will
not rise appreciably as a result of his output expansion alone. But where
a larger number of entrepreneurs are simultaneously expanding output (as
a result, let us say, of an increase in demand) their competition will even-
tually force up the price of the required inputs.16 In this case an individual
entrepreneur will incorporate the consequences of rising factor prices in his
long-run cost estimates only if he is able to forecast correctly the general ex-
pansion of his industry (and thus the higher prices). Entrepreneurial deci-
sions made subsequent to a rise in factor prices, of course, will take them
fully into account; thus, as the aggregate quantity supplied of the product

10 Where a producer's cost curves rise in consequence o£ an expansion not of his own
output, but of the output of his entire industry, the industry is said to be subject to
external diseconomies. Rising costs come to the producer due to reasons "external" to
his own operations. In theoretical literature attention is also paid to the industry that
enjoys external economies. Here the costs of the individual producer falls as a con-
sequence of expansion of the output of the industry as a whole. External economies
are usually identified with such eíFects o£ expansion as more wide-spread knowledge,
the possible cheapening of factors used, the increased possibilities of economies due to
specialization, and so on.
208 MARKET THEORY AND THE PRICE SYSTEM


increases, the resulting rise in factor prices will very definitely act as a drag
upon further increases in supply.
It is not difficult to understand the various factors that determine the
extent of the price rise of a particular resource consequent to expansion of
production in a particular industry. The more important the industry
(relative to all the industries employing this resource), the more sensitive
the resource price will be to the expansion of the industry. Again, on the
other hand, the more elastic the over-all supply of this resource, the smaller
will be the rise in its price necessary to expand output in one industry
(since a small rise in price will call into production a greater aggregate
supply of the resource, making it unnecessary to withdraw a great deal of
the resource from other industries). The more easily a given resource
can be replaced by other inputs (both in the expanding industry and in the
others), the less rapidly will the industry expansion bring about a rise in
the resource price. A small rise in its price will lead to its substitution by
other inputs. Another consideration indirectly relevant to a rise in input
prices, consequent on expansion of an industry, will be the demand condi-
tions for the other products employing the inputs. The more sensitively
the quantity demanded of the other products shrinks as a result of a rise
in their prices (consequent on increases in factor prices and thus also in
the production costs of these other products), the less sharply will factor
prices rise further as a result of the further growth of the expanding industry.
An analysis of all these determining factors is merely a way of assessing
the actual opportunity cost of withdrawing productive resources from one
use for more extensive employment in a different use. The pricing process
conveys all the relevant information on this score through the extent that
input prices rise. The entrepreneur in the expanding industry considers
this information in assessing his own cost of production for different possible
levels of output. His decision of the quantity of output to supply the
market will then reflect his desire (motivated by the search for profit) to
serve the market most faithfully in the light of (a) the intensity of demand
for his product, and (b) the loss to the market of other potential products
involved in the production of each successive unit of his own product.

SUMMARY
In Chapter 9 the analysis of the forces of supply is continued. Relying
on the principles of production developed in the preceding chapter, the
present chapter examines the way costs of production depend upon the level
of output, and thus how producers make their output decisions.
The economist views cost from the opportunity cost point of view.
(Any portion of a price paid for the use of a factor that does not reflect the
foregone product that the factor could have rendered elsewhere is not a cost
COSTS AND SUPPLY 209


but rent.) From the opportunity cost point of view, the market governs the
supply of any one product by balancing its value against that of the other
products sacrificed through its production. This control is expressed
through the impact of the producer's costs of production. The costs rele-
vant to any particular production decision are those alternatives that, availa-
ble immediately before the decision, were rejected by that decision. Since
in the course of the production of a product it may be necessary to make
successively a number of decisions, it is clear that the "cost of production" of
the product cannot be unambiguously described unless a particular decision
is identified as the focus of attention.
This relativity of costs springs partly from the specificity of the capital
goods used in production. Because the costs incurred for capital goods at
an early stage in production planning cannot subsequently be retrieved
through switching them to other uses, it follows that these sunk costs are not
costs at all from the point of view of subsequent production decisions.
The limited divisibility of capital goods is responsible for the typical
way short-run costs depend upon the level of output. Output changes in-
volve, as a consequence of the laws of returns, therefore, changes in factor
efficiency, and thus in the per-unit cost of output. The resulting pattern
of short-run costs makes it possible to understand the way a producer will
make short-run adjustments in output as a consequence of changes in the
data facing him.
In making decisions for the long run, on the other hand, producers
must consider all prospective costs in a production process. In planning
the size of plant, a producer must consider the way prospective changes in
long-run output affect these over-all costs. Involved in such alterations is
the question of returns to scale, rather than the effect of changes in factor
proportions.
A more complete analysis of producer's decisions must consider, in ad-
dition, the possibility and the consequences of alterations in factor prices.
The impact of such alterations will depend on the size of the producer with
respect to the relevant factor market. The extent of the changes to be ex-
pected in factor prices as a result of the expansion of a given industry
depends on the alternative uses of the factor and the conditions surrounding
the elasticity of the factor's supply.

Suggested Readings
Viner, J., "Cost Curves and Supply Curves," Zeitschrift fur Nationalökonomie
(1931), Reprint in Readings in Price Theory, American Economic Association.
Chamberlin, E. H., The Theory of Monopolistic Competition, 7th Ed., Harvard
University Press, Cambridge, Massachusetts. 1956, Appendix B.
Aíises, L. v., Human Action, Yale University Press, New Haven, Connecticut, 1949,
pp. 336-347, 499-510.
10

Partial Market Processes ” The
Determination oj Product Prices
ana Factor Prices



W E RETURN now to consider the mar-
ket process. In Chapter 7 we considered the kind of market process that
would emerge in the absence of production. We assumed a society nat-
urally endowed with a daily income of consumption goods of various
kinds, and we then followed through the logic governing the emergence of
exchange and prices. For that analysis the only prior theory that was
required was the theory of consumer demand. On the basis of the theory
of the demand of the individual consumer, we were able to work out the
results of the interaction of the activities of numerous individuals for whom
there are no production opportunities. However, in a society where men
are able to further their purposes, not only by consuming what they find
easily available, but also by using their resources to produce other goods,
the market process becomes much more complex. (We have already ob-
tained a bird's-eye view of this process in Chapters 2 and 3.) This process
is based on the actions of individual human beings not only as consumers,
but also as producers and as resource owners. The preceding two chapters
have been devoted to the theory of production and costs, clarifying the
behavior of the individual producer. In this chapter and the next we

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