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5 In the diagram SS' represents the perfectly inelastic market supply curve for the
product (appropriate to the very short run); DD represents the initial market demand

0 S Quantity

Figure 10-2
curve for the product; D'D' shows the market demand curve after the change. Clearly,
the equilibrium position of the market has shifted, for the very short run, from the posi-
tion K to the position K'.
6 This may be illustrated diagrammatically for the special case where the entrepreneur
faces a perfectly elastic demand curve. With the original average revenue line AR, the

Thus even if the market had achieved, by the end of the first month,
"equilibrium" at the new higher price, this is equilibrium only for the
very short run”until entrepreneurs have the opportunity to step up the
rate of output under the new conditions.
When entrepreneurs do increase the daily rate of output, it should
be noticed, the aggregate output might be so much greater than that of
the previous month that the higher price prevailing at the end of the first
month (during which the increase in demand occurred) may be too high.
Consumers eager, after the change in demand, to buy the smaller daily
output available previously at this higher price are not willing to buy
any larger quantity at the same price. Of course, if entrepreneurs had
perfect knowledge they would step-up output exactly enough for the mar-
ginal cost of the output of each producer to fall just short of the correspond-
ing marginal revenue, as determined by the prices aggregate outputs can
be sold at to the consumers. In the absence of perfect knowledge we can
expect months to go past before entrepreneurs, through the pulls and
pushes of market forces, might have completely adjusted their outputs
to the new demand situation. When such adjustment has been completed
the market will be in equilibrium”but only until the date arrives to review
plans for the entire plant for the next five years.
The equilibrium attained in the previous paragraph is, for two reasons,
only a short-run equilibrium. First, entrepreneurs outside the industry
who had previously been deterred from entering the industry may eventu-
ally find it profitable to do so. Since the price attained in the short run
after the increase in demand is higher than before the increase, some of
these entrepreneurs may discover that they can do better here with a cer-
tain combination of resources, than they can do elsewhere. When the
opportunity for entry presents itself, the entrepreneurs will build plants
and swell the daily supply. Second, entrepreneurs who have been pro-
ducing in this industry are now producing daily outputs with plants that
were built years ago on plans that called for only smaller daily outputs.
When the opportunity arrives for an alteration in the size of plant, en-
position L was the best for the producer. As the product price rises, the AR' line is
itself raised. Units to the right of L, previously not worthwhile to produce (because


Figure 10-3
MC > MR), have now become worthwhile. The producer's best position has changed
from L to L\

trepreneurs will certainly expand the scale of plant in order to produce
the current larger daily output most economically, if they were to plan
to continue at this rate of output. But in fact the entrepreneurs will not
be seeking at this time a scale of plant most suited for the production of
this current rate of output. Instead, each entrepreneur seeks to produce
most efficiently the output that appears most advantageous under the
possibilities opened up by the very opportunity of altering the scale of
plant. It is likely that the output most advantageous with the old given
plant is not the most advantageous output when the entrepreneur is free
to select any plant size he wishes. The most advantageous output from
the long-run point of view is that which is, when produced in the most
economical scale of plant (for the output), just short of the unit that would
make an addition to the variable costs (using this scale of plant) that just
exceeds the addition which it makes to revenue. Thus, entrepreneurs
will increase the sizes of their plants accordingly.
Once again it may happen that the aggregate daily output that will
be produced, in the new scales of plant, will be greater than the quantity
that can be sold at what had been the short-run equilibrium price. In this
case the market process will lead, during the second five-year period, to a
somewhat lower price than had been in effect at the close of the previous
five-year period. This will mean that entrepreneurs will find that they are
not yet perfectly adjusted, since their plans, in this eventuality, must have
been made in the mistaken expectation that the old short-run equilibrium
price was to continue indefinitely. The situation will thus still not be
one of long-run equilibrium, since at the start of the following five-year
period entrepreneurs will again alter their plant sizes in order to come
closer to their most advantageous production possibilities. In this way
the market process will bring about an adjustment in plant size every five
years. This process of adjustment will cease only when the industry has
once again been restored to long-run equilibrium, under the new demand
We have in this section been illustrating the adjustment process of a
single product market in response to one change, with all other relevant
factors remaining unchanged. The market model used in this illustration
was characterized by a very artificial kind of timetable governing the op-
portunities to make decisions. In any real world market we will probably
expect the various kinds of decisions to be made on a far more flexible
schedule, and, especially, we would not expect the decisions of all entre-
preneurs to be made simultaneously, as they were in our hypothetical case.
Thus, in a realistic market the course of adjustment would be far less
even. We would no longer be able to say that, after the occurrence of
a particular change, there is a definite span of time during which only
decisions relevant to equilibrium in the very short run will be made,

followed by a second definite span during which, in addition, decisions
affecting equilibrium in the short run will be made”free of long-run
decisions until a further definite period of time should have elapsed. Some
producers will be altering the rate of output in their plants in response
to an increase in demand, while other producers are not free to alter their
output at all; still other producers, perhaps, will already be making de-
cisions to increase the scale of plant altogether. Nevertheless, it will still
be generally true, even under these conditions, that some effects of a par-
ticular change will tend to make themselves felt earlier than others; some
effects, perhaps, working themselves out completely only after a very long
time. When it is desired to separate analytically these various effects from
one another, the mental tools to be used are the different abstractions of
incomplete equilibrium that we have been considering.

The illustration worked out in the preceding section indicates the way
the market process exerts pressures on the producers of particular products
to make their various levels of decisions consistent with each other and
with those of consumers. We will explore this process further in this
section, still adhering to our assumption that resource prices (along with
all background data) remain unchanged.
If a market is not in equilibrium, we have seen, this must be the result
of ignorance by market participants of relevant market information. The
market process, as always, performs its functions by impressing upon those
making decisions those essential items of knowledge that are sufficient to
guide them to make decisions as if they possessed the complete knowledge
of the underlying facts. Let us assume that the given factor prices are
perfectly known, and that both consumers and producers also know the
current market price of the product. We can ignore, then, possible price
differentials for the product in various areas of the market.
Market disequilibrium, under these assumptions, must mean that the
output of the producers is not consistent with the prevailing market price
of the product. Producers are in aggregate producing either (a) more
than can be sold at the prevailing price, or (b) less than could be sold at
the prevailing price, or (c) they may be producing the precise quantity
that can just be sold at the prevailing price, but are using methods of
production not best suited for production under these price-output con-
If producers are producing more than can be sold at the prevailing
price, the disappointments of sellers will force them either to cut back
output or to offer to sell at a lower price. If producers are producing less

than can be sold at the prevailing price, the disappointments of buyers
will force them to offer to buy at a higher price. These adjustments are
not greatly different from those we became familiar with in Chapter 7.
If producers are producing in aggregate the precise quantity that is
just small enough to be sold completely at the prevailing price, but are
not using the "correct" production methods for this output, there are
several distinct cases to be considered. There will in any event be no
direct pressure for the price of the product to be changed. Adjustments
will take place, initially, on the supply side of the market. The initial
absence of full adjustment on the supply side of the market stems, as
always, from ignorance of market conditions. Our analysis of the eco-
nomics of production and costs in earlier chapters suggests the various
kinds of ignorance that may be involved. These kinds of ignorance, and
the respective kinds of corrective adjustments that will be brought about
by market forces, relate closely to the analytical framework within which
we have discussed, in the earlier sections of this chapter, the various pos-
sibilities of incomplete equilibrium.
An individual producer may find that his own daily rate of output is
too large or too small in relation to the product price. He finds that his
marginal cost far exceeds or falls far short of his marginal revenue; thus,
he would be better off with his margin of output drawn back or advanced
to the point where the marginal cost of output is as close as possible to
marginal revenue. This situation can have arisen only because of prior
ignorance on the part of the producer. When he last had the opportunity
to adjust the daily-output volume, he had apparently acted on mistaken as-
sumptions as to the product price to be expected. Since that time market
experience has taught him what the product price is, and hence he dis-
covers that he must adjust his output accordingly, at the earliest oppor-
tunity. Those entrepreneurs who are most speedily informed of the correct
market price are in the position to most rapidly gear their production
decisions for the appropriate output volume. The gradual discovery by
producers of what the current market conditions really are will then set
into motion an adjustment of aggregate output that may in turn generate
a series of price adjustments until there is consistency between consumers'
and producers' decisions. Market agitation will reflect the impact of the
changes in producers' plans in their successive attempts to bring these
plans into consistency with the market.
On the other hand, the discovery by an individual producer that his
output is too large or too small may reflect decisions made on the basis of
incomplete knowledge, not recently, but in the relatively distant past. In
other words, the decisions that an entrepreneur has made most recently,
with respect to the level of plant utilization and the purchase of variable
inputs, may have been made with complete knowledge of all relevant market

information. The fact that output volume is too large or too small may
be the result of mistaken investment decisions in the distant past, decisions
made when market conditions of the then distant future were incorrectly
perceived. The scale of plant may be too small or too large in relation to
current sale possibilities.7 The gradual discovery by the different producers,
of true market conditions, will lead to a gradual reshuffling of plant sizes.
Some entrepreneurs will build larger plants, some smaller, and some will
close down their plants altogether. During this process aggregate output
will gradually change, and bring in its train gradual movements in the
product price and subsequent further adjustments in plant size and rate of
output. These long-run market forces will be felt less perceptibly in any
one short period, but over the long period will exert overriding influences.
So long as complete long-run equilibrium has not been attained, this kind
of market agitation will continue. The point is that for production to be
completely adjusted both to the tastes and incomes of consumers, and to
the wishes of producers, decisions must be made at numerous different stages,
all of which must be mutually consistent. Lack of consistency in the de-
cisions made at any one level will bring about possible inconsistency at subse-
quent levels of decision making as well. All this leads to change, as the
operation of the market reveals these inconsistencies through the disappoint-
ments suffered in the market by decision makers. The entrepreneur who
made a complete mistake in entering an industry altogether, for example,
will sooner or later discover that his decision to produce at one particular
cost of production is altogether inconsistent with the degree of eagerness
of consumers to buy his product. His losses will eventually force him to
leave the industry.
Thus far we have analyzed the market process in a single product market
on the assumption not only that factor prices were constant, but also that
consumers' tastes and basic buying attitudes were maintained unchanged
throughout the time long-run adjustments were being made. As soon as
one relaxes this assumption, market agitation must at once assume far
more formidable proportions. Even if we continue the assumption of no
change in factor prices and production techniques, and merely allow the
attitudes of consumers to change, it is clear that the picture becomes far
less simple. In making short-run and long-run decisions, producers must
plan not only on the basis of current market data, but also on the basis of
the expected changes in buyer attitudes for a long time to come. The scope
for entrepreneurial activity, based on a superior ability to forecast future
conditions in the market, becomes immediately wider. The pressure of
market forces will now lead the organization of production to be consistent
7 Since we are assuming perfect knowledge and forecasting of factor prices, we do not
take notice here of the possibility that an entrepreneur discovers his plant to be too
large or too small, due purely to the unexpected high or low prices of variable inputs.

with the expectations of producers and consumers as to future changes in
attitudes and tastes. Market disequilibrium will now be the result of
(past) imperfect forecasting of (then future) conditions, in addition to
imperfect knowledge of the present.

Thus far in this chapter we have been examining one special kind of
sub-market”that for a single product”within the market as a whole. We
have seen how market forces would manipulate the decisions of producers
and consumers in such a sub-market, under specified assumptions with re-
spect to the variability of other market phenomena. Prominent among
these restrictive assumptions was our specification that factor prices should
not change throughout the analysis. Our purpose in making this obviously
artificial assumption was deliberately to illustrate the operation of the
market process in a very limited area, as an introduction to the more compli-
cated process to be taken up in the next chapter. In the present section,
for similar reasons, we once again consider the market processes operating in
a severely limited area, which we insulate from the impact of outside market
forces. This time we consider the market for a particular factor of produc-
tion. We will imagine a large number of resource owners endowed by
nature with a daily supply of this factor of production. We will assume,
for the purposes of the analysis, that the prices oi¯ all the products (especially
those in whose production the factor is able to cooperate) are given, known,
and constant. In addition, since we confine our inquiry to the market for
only one factor, we assume that the prices and quantities employed of all
other factors of production are given, known, and constant.8
Our problem is to understand the nature of the market forces that
determine the prices our factor of production is sold at in the market, and
the quantity of it sold to entrepreneurs and employed in the production of
the various products. As before, we will proceed by first spelling out the
conditions for equilibrium in this factor market (indicating how these would
be achieved were knowledge perfect), and thereafter searching for the market
processes that would be set into motion by the absence of equilibrium condi-
For the market for a particular productive factor to be in equilibrium,
it is necessary that no resource owner nor any entrepreneur-buyer or pro-
8 In this discussion, we will not be making explicit reference to a market for a
produced factor of production. This case too. however, can be analyzed on the lines
developed both in the following discussion, and in the preceding sections.

spective buyer of the resource should have any reason to alter his market
behavior with respect to the factor. The decisions of the resource owners
in aggregate to sell a given quantity of the resource at a given price must
mesh completely with the decisions of entrepreneurs to buy the resource.
Entrepreneurs must plan to buy currently, at a given price, the precise
quantity of the resource that resource owners are planning to sell at that
price. Moreover, the long-range plans of entrepreneurs must also call for
no change in the quantity of the resource that they will employ. (Since we
ignore the possibility of a resource being bought to be stored for future use,
we will consider the purchase by an entrepreneur of a resource as reflecting
a decision to employ that resource in current production.)
Let us consider the alternatives facing both a resource owner and an
entrepreneur-producer when they make their decisions to sell or to buy a
resource. For the resource owner the alternatives are relatively clear-cut.
He finds himself endowed daily with a given quantity of the factor. He can
do one of two things with each unit in his factor supply. He can sell it
in the factor market, or he can keep it for himself for direct consumption.
For example, a man finds that he can supply twelve hours of labor per day.
He can choose between selling all or part of this in the labor market, or
enjoying the whole time for himself as leisure. A landowner can supply
physical space each year to entrepreneurs who may wish to erect plants upon
it, or he may if he wishes retain the land for himself as a private garden.
At any given market price for the resource, a resource owner will sell a
quantity of the factor such that the marginal utility for him of the additional
commodities that he can buy through the sale of the last unit of the factor
is just higher than the marginal utility for him of the factor unit itself. He
will retain for himself that quantity of factor such that the marginal utility
for him of a factor unit that he possesses is just higher than the marginal
utility for him of the additional commodities that he might have acquired
through the sale of one more unit of factor.9 Of course, in contemplating
9 See Ch. 5, p. 63, ftnt. 1. The analysis of consumer demand developed in Chs. 4
and 5 can be used to examine the decisions of the resource owner. In the diagram
any point represents a combination of (1) a laborer's available labor service that he does
not sell (that is, which he consumes as leisure) and (2) a quantity of a commodity a.

Figure 10-4
OA represents the greatest quantity of labor that the laborer can sell in a given time
period. The line AB represents the possible positions that the laborer can take up
assuming him to be interested in consuming only the one commodity a. The slope

the sale of a quantity of a resource, a resource owner will seek the highest
price obtainable in the market, so far as he knows.
An entrepreneur who is deliberating on the purchase of a quantity of
factor, faces a rather different set of alternatives. Moreover, he may con-
template such a purchase in the context of decisions on any of several levels,
in each of which a separate set of alternatives will be relevant. An entre-
preneur knows, on our assumptions, the prices of the various products that
he can produce, and he also knows various possible methods of production
available to him. In the long run his problem is to decide what branch
of production he should enter. In the shorter run he must decide how
much of the factor, along with other inputs, he should buy to obtain his
current output goals. In the long run he will choose to enter that branch
of production where his investment promises him the greatest profits. In
making such a decision an entrepreneur commits himself to the purchase of
necessary resources, in long-range preparation for future productive activity.
The particular combination of resources that he will select will be again
one that promises him the greatest net profit advantages. In such a resource
combination, planned correctly from the very beginning, all the factors
that contribute eventually to output will be present (a) in the correct propor-
tions, and (b) in the correct scale. We know, from earlier chapters, what
these two conditions involve. They require first of all that the marginal
increment of product gained in the long run by the additional expenditure
of a given sum of money upon any one factor be approximately equal to
the corresponding marginal increment that would be gained by the addi-
tional expenditure of the same sum upon each of the complementary factors.
They require, moreover, that in the production of any one product, factors
be hired up to the point where the value of the marginal increment of
product corresponding to the last unit of each factor employed be just greater
than the increment in expenditure involved by this unit.10
In making long-range plans, therefore, in the light of the known pro-
ductive possibilities of each of the factors, and of the prices of the factors and
the products, entrepreneurs will commit themselves to the purchase of a
particular factor, only in sharply defined quantities. For each product
produced an entrepreneur will seek to buy a quantity of the factor so that,
in cooperation with other factors, he will have erected the scale of plant

of the line AB reflects the relative prices of labor and of a. The analysis of the quantity
of labor that the laborer will sell can then be continued completely parallel to the
analysis of the consumer in Ch. 5. (Of course, where institutional conditions make it
possible to sell labor only in large units, then the continuous line AB must be replaced
by a series of discrete points. In such cases the marginal unit is large. In extreme
cases the resource owner may not be able to vary the quantity that he sells; he may
be faced with "all-or-nothing" conditions. In this special case, his entire resource
endowment is the relevant marginal "unit.")
10 See Ch. 9, p. 200, ftnt. 10.

optimally suited to the future daily production of the most desirable volume
of output. This will depend, as we have seen, on the respective marginal
increments of product associated with the various factors. Thus, our
factor will be purchased by the producer of each product, insofar as his
purchase involves long-range preparation for production, so that when
expected productive activity is under way, the volume of output and the
proportion of the various inputs will fulfill the above conditions for opti-
In addition, an entrepreneur may contemplate purchase of the factor
in making decisions to regulate the current output volume. Here the factor
will be one of the variable inputs to be used in cooperation with the fixed
plant and equipment. If the original long-range plans were well-laid, the
variable factors will be employed in the proportion and on the scale orig-
inally envisaged”and therefore again will be fulfilling the optimality condi-
tions. Once again then the employment of our factor will depend upon
its efficiency at the margin of employment.
However, as a result of current conditions, the best output that should
be maintained with the given plant might be different from that originally
envisaged. In this case it will no longer be true that the variable factors
are now to be purchased so that the optimal relationship between their
prices and their productive efficiency at the margin are to be achieved.

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