The Principles of Economics Part 26

CHAPTER 30

COST OF PRODUCTION

-- 1. COST OF PRODUCTION FROM THE ENTERPRISER'S POINT OF VIEW

[Sidenote: The enterpriser's cost]

1. _The task of the enterpriser is to get together the essential factors to secure valuable products._ The enterpriser must first decide what product he will endeavor to secure, and the kind, the place, the time, the quant.i.ty, and the quality. He must then select in the right proportion the materials, labor, plant, and machinery necessary for that product. He must purchase these factors in the market at the lowest price he can, unite them and sell the product to recover the expenses in the selling price. A thousand items enter into the cost and perhaps a single product emerges. What the business man thus pays out, expressed in money form, are the costs that are here to be considered.

[Sidenote: Several meanings of cost]

2. _The term cost of production is used in several senses, the chief of which are money cost, psychic cost, and alternative cost._ The ambiguity of this term is a source of much confusion. _Psychic cost_ is the pain, fatigue, irksomeness of labor. This is not definitely measured except at rare points. When the pain of work more than offsets the value of the product, the worker who is free to determine the length of his own working-day, stops. At that point the psychic cost and the utility of the marginal unit are almost equal in intensity--the one as a positive, the other as a negative quant.i.ty. But the value of the product as a whole cannot be related to the psychic cost or sacrifice, and therefore it cannot serve as a measure of cost in every-day business.

_Alternative cost_ is any good or gratification that must be given up when any other good is chosen. One may stay at home and read a book or go on a picnic; the pleasure of reading the book will cost the pleasure of the picnic. A good dress may cost a happy vacation that must be given up for it. In this sense, each thing is a cost of every other thing that might be chosen in the place of it. Alternative cost is therefore manifold and indefinite. The thought is significant at the moment of a choice, but it is not constantly measurable for practical purposes. The _money cost_ is the practical cost generally implied in the term cost of production. It expresses not the pain of the laborer in doing the work, not the sacrifice of the owner of the capital in saving the money, but merely the sum of money paid out by the producer. There is frequent confusion of these ideas in economic discussion, few even of the leading economists of the nineteenth century having quite escaped it.

[Sidenote: The cost of the factors is their market price]

3. _The enterpriser, looking upon the cost of most of the factors as fixed, seeks to combine them as economically as possible._ Whether the enterpriser is running a factory or a farm, is engaged in a retail or a wholesale store, is conducting a school, or a railroad, he has to solve much the same problem. By close attention, good judgment, skilful bargaining, he may be able to buy slightly cheaper than his compet.i.tors, and thus have an advantage over them at the outset. When he does this, it is usually by searching out a better market in which to buy, buying at a better time, and judging better than his compet.i.tors the quality of goods. If, in a given market at a given time, goods are sold to one more cheaply than to others, it is an act of generosity. Even the best buyers pay nearly the prevailing market price for agents. The most successful enterprisers are not found to be those paying lower wages or lower ground-rent than their compet.i.tors. It must not be forgotten that the main forces fixing the prices of agents are impersonal, and can be only slightly modified in most cases by a particular buyer. He looks therefore upon the cost of the elements as an ultimate fact which he can change little, if at all, and he shows his judgment chiefly in the selection of quality. Cost determines and limits the extent of his business and determines the price at which he sells.

[Sidenote: The right proportioning of the factors]

4. _The right proportioning and skilful subst.i.tution of the factors is a delicate technical task for the enterpriser._ Good buying and good selling must precede and follow the central part of the enterpriser's task, that is, the combining of the various factors. Each factor is applied, subject to diminishing returns, up to a point where its addition will not secure the value attributed to it in its cost. The enterpriser is constantly studying the question whether the application of another unit of any one factor at the price will add to the value of the product as much or more than the cost. This calculation is made for every one of the minor factors entering into the business, and for the business as a whole. The proper proportion varies at different prices, or costs. If wages rise, "it pays" to get machinery; if wages fall, it pays to let the machinery deteriorate and to do more by hand-labor.

Likewise there is constant subst.i.tution of the various materials. The right proportions change constantly with inventions. A model factory is so proportioned that the buildings hold the right number of machines, with the right amount of s.p.a.ce for the workmen, and the right amount of power. If there is more of a single factor than the ideal proportion, it is an unnecessary cost. Even the model factory begins to be out of date almost as soon as the walls are dry, and the latest method is to build as nearly as possible on the unit system, so that new parts may be added without the loss of harmony and proportion.

[Sidenote: Pressure of price toward cost at certain points]

[Sidenote: The enterpriser in contact with costs]

5. _The enterpriser's costs determine the lowest price at which he can continue to sell, but if successful he may have a wide margin of profits._ New factories are constantly arising with new and better adjustments. In industries of competing products, also, the processes are changing. Hence there is always a pressure of compet.i.tion on some enterprisers who constantly complain that they must sell below the cost of production. The organizers of a trust always declare, some no doubt truly, that they have been selling below the cost of production.

Business men say that compet.i.tion is destructive, and it certainly does destroy the less favorably situated enterprises. Each enterpriser's price is the highest he can get in the market for his product; it may far exceed his costs; it may even fall below them, but only temporarily, for if sales continue to encroach on capital, the sheriff soon closes the doors. Successful compet.i.tors are constantly pressing upon the marginal enterpriser, fixing a price that leaves themselves a profit, but is below his cost. Even the most successful enterpriser comes into contact with cost, and seems to be compelled by it. He reaches out for trade, and sells some (not all) goods at a price which leaves him no profit. He enlarges his factory and ships goods farther, paying the freight, which means a lower price at the factory. The expanding business, therefore, comes at length to the point where it cannot go farther at the prevailing prices. Hence the business man's view of the costs is that they determine value. It is true in the sense that the supply of a particular product in any market is at last limited by cost of marginal producers or of marginal portions of supply. But it is not true of all the units of product that costs determine, or equal, market price. There is a margin above costs to the successful enterpriser on a large portion of his output. The margin may be narrow or wide, according to the business. The margin is "profit," or the gain of the enterpriser.

-- II. COST OF PRODUCTION FROM THE ECONOMIST'S STANDPOINT

[Sidenote: Money cost not the ultimate explanation of value]

1. _The economist should view money cost as an intermediate and not as an ultimate explanation of value._ The value of all things must be traced back to gratification, to the relation of goods with psychic income. This being true, the value of the factors which the enterpriser uses must be derived from the value of the products, and not the reverse. This does not mean that the business man is deceived into the belief that he has in cost of production a final explanation of value.

He simply is not interested in that question. He knows that there are many influences determining the cost of the factors he buys, but they are distant; he cannot influence them, and in the single stage of his production they seem to fix the price. In some purchases, and on the stock exchange, a marvelous recognition and a.n.a.lysis of the most distant influences is necessary; but in general a superficial view of value is taken in business; it does not pay to do other. The logical treatment, however, must go deeper into the question and trace the cost of agents back to the ultimate cause of value, that is, to want-gratifying power.

To say that the price of a product is determined by the money cost, or price, of the factors is simply to postpone the answer to the question of value; one has still to ask, What determines the money cost, or price, of those factors themselves?

[Sidenote: The cost of agents is fixed by their marginal utility in alternative uses]

2. _The demand for any factor entering into products is reflected, in an increased price, to its cost in all competing products._ Figuratively speaking, products compete with each other for the factors that enter into them. According to location, quality of the soil, and improvements, a certain area of land has various rival uses. These uses bid for the land, or put in an economic claim for it. Products of a higher value outbid and exclude those of a lower. If fine wine can be raised on a piece of land, potatoes ordinarily will not be planted in it. But if there is such a supply of that quality of land that it continues to be used side by side for both products, it will have the same value and yield the same rental in both uses. The least utility yielded by any portion of the supply fixes the value of all the units. Machines are usually made for some product determined in advance, but often they are only partially specialized and within limits they can be adapted.

Sewing-machine factories were readily turned to the making of bicycles at the time of greatest demand, and bicycle factories later were used for the making of automobiles. Thus, in general, machinery is used for the product to which it contributes the most value. Any enterpriser seeking it for any other use finds its "cost" affected by its various alternative uses. The same is true of all the materials and of all the grades of labor entering into products. The enterpriser's _cost_ is therefore the reflection of the want-gratifying power of the productive agent in all its other uses as well as in the particular product he desires. To the enterpriser, cost seems the cause of the value of a product. To the economist it should be clear that the utility found in the various products is the basis of value in the factors, _i. e._, of the costs.

[Sidenote: A single source of a single product]

3. _The genealogy of value may thus be traced through the various intermediate products to consumption goods._ A single product having a single source of supply shows most clearly the reflection of value directly from the product. The discovery of a mineral spring or of a good quality of building-stone on worthless land, will cause a value to attach at once to the source of supply. When a great singer like Adelina Patti commands several thousand dollars for each appearance in concert, the source is the magical throat of the singer, and the salary reflects the utility of the music in the minds of delighted hearers.

[Sidenote: One source of several products]

When the one source of supply yields several different kinds of products there is just one new condition which confuses the thought and suggests the error that value begins in the source (with costs therefore) and not in the product. Looking at the products severally, no one of them explains the value of the source, and, on the contrary, each one is seen to have a value independent of the particular use to which it is put. To make the ill.u.s.tration most simple: a savage finds in a wreck on the coast a number of bars of iron. His fellows wish them for various purposes: to make arrow heads, spears, knives, hatchets, hoes, ornaments, nails, needles, etc. Value is in this case derived in part, through the source, from the alternate uses. Taken jointly and considered as one sum, the value of the various products accounts as completely and exclusively for the value of the source as if they were merged into one product. The source (_S_) is distributed to each of the products in accordance with their marginal utility, and therefore the value of the various products from any source of supply constantly tends to equality. Any unit of product sought for any purpose must be paid for according to a marginal utility determined in all the applications. The genesis of the value is in the utility of the product; the value of the source is derived.

[Ill.u.s.tration: _1. A single Product_

_2. Several Products from one Source_]

[Sidenote: Complex conditions with intermediate products]

In actual life the problem is far more complex, and yet, through its settlement runs just the same principle. There is constant bidding for materials, and through their price the claims of rival products are adjusted. A point is reached where it does not pay to use any more of an agent in a certain industry; the production of another unit results in a loss. There is a most complex relation among many different industries using the same factors, the value of a unit of product (at _a_) being reflected up to the source, and through successive links to the most distant product (_z_). The effect of this is to reduce the sale (of _z_) and correspondingly the use made of the agent in question. A higher price of leather, due to the increased use of shoes, raises the value of hides and cattle (this increasing the extent of cattle raising) and raises thus the cost of carriage-tr.i.m.m.i.n.gs, pocket-books, foot-b.a.l.l.s, leather belts, and every other leather product. As the price rises, subst.i.tutes for leather, and imitations of it, are used for such of the products as cannot bear the increased cost of leather.

[Ill.u.s.tration: _3. Complex Relations Through Intermediate Products_]

[Sidenote: The enterpriser the medium of price movements]

[Sidenote: Costs are an expression of consumers' estimates]

4. _The enterpriser does not fix the value of products or of agents, but is the medium through which consumers express their estimates._ The enterpriser who antic.i.p.ates aright and satisfies the public taste is the good medium. He readily transmits and accurately focuses the rays of public judgment. One that misjudges is a poor medium. The enterpriser is himself the servant of costs. Laborers sometimes a.s.sume that the employer can dictate wages, prices, and markets, can rule things with a lordly hand. With rare exceptions the ultimate control in these matters by business men is very slight. In the main the enterpriser masters the situation only by bowing to it, just as the scientist and the engineer gain mastery over nature because they know when to bend and how to obey.

The consumer, by deciding to buy this or that product, sets in motion waves of value. The consumers of products are the true purchasers of labor, materials, and uses of agents. The enterpriser must conform closely to cost, to the price prevailing for the moment, or his compet.i.tors in this day of narrow margins will seize the opportunity.

The enterpriser is merely the distributor or equalizer of cost among all the different products for which different agents can be used. If he acts efficiently, profits arise.

CHAPTER 31

THE LAW OF PROFITS

-- I. MEANING OF TERMS

[Sidenote: Broadest use of the term profit]

1. _The term profit is popularly used as any gain or advantage secured by any means in business._ The terms used in economics, being taken from popular language, vary in meaning according to the context. It is necessary to clear thinking to reject some words entirely and when using others to define them more strictly. The broad usage of the term profits just noted includes every kind of return to industry: such as interest on capital, and wages or services of the man owning the industry.

Precise thinking requires its use in a much narrower sense.

[Sidenote: Used of gross gains on sales]

2. _A common meaning of profits in retail business is the gross gain on a given sale._ Buying an article for one dollar and selling it for two dollars, is said by the merchant to be selling at one hundred per cent.

profit, jocularly called, "The Dutchman's one per cent." The cost price is considered to be that paid to the manufacturer or wholesaler. In different lines of goods there is added regularly to this cost twenty, thirty, or fifty per cent., as the case may be, as the merchant's profit on the sale. This is of course a gross profit, and not net, or true profit. It leaves out of account rent, interest on capital, clerk hire, freight, and many other minor items that enter into the cost of running a store. It often happens that the Dutchman's way of reckoning is nearer the truth, and that the gross profit of one hundred per cent. proves at the end of the year to be only a net profit of one per cent. This evidently is a loose meaning, impossible in the discussion of theoretical questions. This meaning is sometimes developed, making profits the sum of all the gross profits on separate sales within a year, or the difference between the wholesale and retail prices of goods sold within the year.

Another meaning given to the term is gross profit (as above) compared with the capital invested. The "profit" in this case varies partly with the rate of the turnover. To ill.u.s.trate: if the amount invested in a printing-office is $100,000, and the annual business done is $300,000, the capital is said to be turned over three times; if the gross profits on sales averaged twenty per cent., they would be sixty per cent. on the investment; but, if the capital had been turned over four times, the gross profit would have been eighty per cent. on the investment.

[Sidenote: Of net gains as a percentage of invested capital]

3. _Another meaning of profits is the annual net gain of the business, as compared with the average investment of capital._ This is a long step toward greater definiteness. If at the end of a year it were found that after paying all outside expenses there were $10,000 to set aside, this would be accounted a profit of ten per cent. on $100,000 invested. But confusion still reigns because of wide variation in the methods of estimating costs before fixing net profits. In one case the enterpriser rents lands and buildings, in another he owns them; in one case he has borrowed money and counts interest as a cost, in another he is free from debt; in one case he counts as a part of cost an estimated fair salary for himself and his partners, in another (usually in a small business) no such allowance is made Such a variation in business usage is most perplexing. In all these cases one must have the exact conditions in mind before it is possible to make any comparisons and draw any conclusions as to the relative profits of different industries.

[Sidenote: Profits in economic theory]