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Monday, September 10, 2012

Prices and Costs

Since the majority of economic goods can be increased by the act of production it is clear that the scale on which such goods are supplied reflects their costs of production. If prices were insufficient to cover costs, producers would incur losses which would no longer permit them to maintain production to the previous extent; supply, in such case, diminishes, causing prices to climb until they have once again attained the level of costs.

One might suppose that with prices remaining below the level of costs, a given industry would cease operations altogether. This, however, need not be the case, to the extent that the costs of production differ for different levels of output and for the different firms within an industry. When prices decline, only that segment of the total output of the industry is immediately affected whose production costs are highest (marginal output). The remaining segments continue to manage on the lower prices. If, however, these remaining segments of output are unable to meet demand, prices will be forced up until marginal production again becomes profitable. Thus, if the costs for each segment of the total supply differ (which is usually the case), it is the highest costs at the time (marginal costs) which determine the over-all height of prices (for a given industry). But as the prices offered for all the segments of supply (of the same type of good) are ordinarily the same, the favored producers realize an extra profit which results from the gap between the market price and their low costs of production (producers’ rent).

It would seem that in making this observation we have once again tapped on that hollow place in our economic system for which we moderns have developed such a sensitive ear. Is it not a provocative notion that at the existing level of prices we are paying fat profits to these privileged producers? The first and most important reply to such a complaint is that insofar as our economic system is not completely permeated with and ruled by rigid monopolies, there will always be powerful forces at work to lower marginal costs. On the one hand, the favored producers will seek to increase their cheaper output in order to drive the marginal producers from the market; on the other hand, the marginal producer will seek to attain the lower cost levels of his more favored competitors. In this way, unrelenting competition gnaws away night and day at producers’ rents to the exceeding displeasure of the producers who strive by every available means to curb competition, including the (unfortunately) easy matter of getting the state to lend them a sympathetic ear. But as we shall see later, in detail, this is a circumstance which cannot be charged to the market economy as such. In any case, producers’ rents are sources of gains which are sooner or later dried up, even in agriculture, as the experience of the last decades has forcefully made clear. But should these observations fail to remove concern, it need only be pointed out that tax powers are always available to satisfy our desire for social justice without a total overthrow of the economic system.

We can see, then, that the concept of “costs of production” is by no means a simple one. A further complication is that not all of the factors entering into the costs of production have the same bearing on the determination of prices. The influence of these costs on the determination of prices is obviously not due to the fact that a well-meaning authority, out of its love of justice, reimburses producers for their expenses in the same way as the government indemnifies a functionary for expenses incurred on an official journey. If this were true, then it would be only right that the producer agree to a minute examination of his costs by a kind of supreme economic “accounting department” and that for every productive undertaking he secure an official authorization of the kind required by governments for official missions of their functionaries. This is something which the producer, who would like to have a government guarantee for the complete indemnification of his costs, would do well to reflect upon. Only a little thought is required to realize afresh that such a road, once embarked upon, leads straight to Moscow (or, in the National Socialist era, to Berlin). If that is not what the producers want, then they ought, with good grace, to accommodate themselves to the laws of our economic system.

These laws are so constituted that the costs of production exercise an influence on price only insofar as their indemnification is necessary for future production. If this indemnification is not assured, the means of production can go on strike in order to find more remunerative employment. This they can do, however, only where there exist alternative opportunities for employment. If the price of coal falls to the point where the owners are unable to retain their workers or to meet current costs, then the mines will close down. The workers, the lubricating oil, and the fuel can be used elsewhere. But for the mine pits themselves there exists no alternative use. The capital invested in them cannot be “retrieved.” Normally, the price should be sufficient to cover the payment of interest and amortization on this fixed capital. But if the price falls to the point where the payment of interest and amortization on the fixed capital is no longer assured, the owner of the mine would still do well, as a rule, to continue operations rather than bring them to an abrupt stop, even though the price no longer covers the full costs of production. The fixed capital in such cases may be “written off” either through the depreciation and consolidation of the extant shares of stock or, in the last resort, through bankruptcy proceedings. The certain result of this is that there will be no inflow of new capital to allow for the replacement or the expansion of physical facilities. These consequences, however, will only manifest themselves over an extended period of time. We can, at this point, sympathize with the melancholy utterance of a pessimistic banker that a new hotel is generally profitable only as a “second hand” operation.

The preceding reflections on the nature of the costs of production should serve to stiffen our resistance to laments that this or that branch of production is in imminent danger of collapse because prices are too low, and to harden us a little against the demand that this or that industry be assured a satisfactory level of prices by means of tariff protection or similar measures on the grounds that otherwise it faces “certain ruin.” We are now aware of the exaggeration concealed in this extremely popular tactic. In the first place, a fall in prices seldom renders a given industry altogether unprofitable and this because production costs for individual producers are not uniform but different. We find that in almost every instance a given industry comprises firms which are graduated in terms of their efficiency: at the top of the scale, the most efficient, capable of weathering severe price declines, and at the bottom, the firms on the margin of existence—those that just get by. Hence, if prices fall, e.g., as the result of foreign competition, the immediate casualties will be confined to the group of marginal firms. What we may expect, then, is not the disappearance of the whole of a particular industry but principally a change in the relative size of operations of the several firms in the industry. Were foreign competition to be eliminated by protective tariffs or import quotas, the state would be guaranteeing, in effect, the profits of the most efficient producers, the very ones who least require protection. In the second place, to justify such somber prognostications as the above, the drop in prices would have to be severe enough to affect not only fixed capital costs but variable costs as well.

Economics of the Free Society

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