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Saturday, December 22, 2012

The Criterion Of Marginal Costs by F. A. Hayek

It will probably be objected that these strictures may be true of capitalist monopolies aiming at maximum profits, but that they would certainly not be true of the integrated industries in a socialist state whose managers would have instructions to charge prices which just covered costs. And it is true that the last section has been essentially a digression into the problem of planning under capitalism. But it has enabled us not only to examine some of the supposed advantages which are commonly associated with any form of planning but also to indicate certain problems which will necessarily accompany planning under socialism. We shall meet some of these problems again at a later stage. For the moment, however, we must once more concentrate upon the case where the monopolized industries are conducted not so as to make the greatest profit but where it is attempted to make them act as if competition existed. Does the instruction that they should aim at prices which will just cover their (marginal) cost really provide a clear criterion of action ?
It is in this connection that it almost seems as if perhaps excessive preoccupation with the conditions of a hypothetical state of stationary equilibrium has led modern economists in general, and especially those who propose this particular solution, to attribute to the notion of costs in general a much greater precision and definiteness than can be attached to any cost phenomenon in real life. Under conditions of widespread competition the term cost of production has indeed a very precise meaning. But as soon as we leave the realm of extensive competition and a stationary state and consider a world where most of the existing means of production are the product of particular processes that will probably never be repeated ; where, in consequence of incessant change, the value of most of the more durable instruments of production has little or no connection with the costs which have been incurred in their production but depends only on the services which they are expected to render in the future, the question of what exactly are the costs of production of a given product is a question of extreme difficulty which cannot be answered definitely on the basis of any processes which take place inside the individual firm or industry. It is a question which cannot be answered without first making some assumption as regards the prices of the products in the manufacture of which the same instruments will be used. Much of what is usually termed cost of production is not really a cost element that is given independently of the price of the product but a quasi-rent, or a depreciation quota which has to be allowed on the capitalized value of expected quasi-rents, and is therefore dependent on the prices which are expected to prevail.
For every single firm in a competitive industry these quasi-rents, although dependent on price, are not a less reliable and indispensable guide for the determination of the appropriate volume of production than true cost. On the contrary, it is only in this way that some of the alternative ends which are affected by the decision can be taken into account. Take the case of some unique instrument of production which will never be replaced and which cannot be used outside the monopolized industry and which therefore has no market price. Its use does not involve any costs which can be determined independent from the price of its product. Yet if it is at all durable and may be used up either more or less rapidly, its wear and tear must be counted as true cost if the appropriate volume of production at any one moment is to be rationally determined. And this is not only true because its possible services in the future have to be compared with the results of a more intensive use at present, but also because while it exists it saves the services of some other factor which would be needed to replace it and which can meanwhile be used for other purposes. The value of the services of this instrument is here determined by the sacrifices involved in the next best way of producing the same product ; and these services have therefore to be economized because some alternative satisfactions depend on them in an indirect way. But their value can only be determined if the real or potential competition of the other possible methods of producing the same product is allowed to influence its price.
The problem which arises here is well known from the field of public utility regulation. The problem how, in the absence of real competition, the effects of competition could be simulated and the monopolistic bodies be made to charge prices equivalent to competitive prices, has been widely discussed in this connection. But all attempts at a solution have failed, and as has recently been demonstrated by Mr. R. F. Fowler,1 they were bound to fail because fixed plant is extensively used and one of the most important cost elements, interest and depreciation on such plant can only be determined after the price which will be obtained for the product is known.
Again it may be objected that this is a consideration which may be relevant in a capitalistic society, but that since even in a capitalistic society fixed costs are disregarded in determining the short run volume of production, they might also with much more reason be disregarded in a socialist society. But this is not so. If rational disposition of resources is to be attempted, and particularly if decisions of this sort are to be left to the managers of the individual industry, it is certainly necessary to provide for the replacement of the capital out of the gross proceeds of the industry, and it will also be necessary that the returns from this reinvested capital should be at least as high as they would be elsewhere. And it would be as misleading under socialism as it is in a capitalistic society to determine the value of the capital which has thus to be recouped on some historic basis such as the past cost of production of the instruments concerned. The value of any particular instrument and therefore the value of its services which have to be counted as cost must be determined from a consideration of the returns expected, having regard to all the alternative ways in which the same result may be obtained and to all the alternative uses to which it may be put. All those questions of obsolescence due to technical progress or change of needs, which were discussed in the last section, enter here into the problem. To make a monopolist charge the price that would rule under competition, or a price that is equal to the necessary cost, is impossible, because the competitive or necessary cost cannot be known unless there is competition. This does not mean that the manager of the monopolized industry under socialism will go on, against his instructions, to make monopoly profits. But it does mean that since there is no way of testing the economic advantages of one method of production as compared with another, the place of monopoly profits will be taken by uneconomic waste.
There is also the further question whether under dynamic conditions profits do not serve a necessary function, whether they are not the main equilibrating force which brings about the adaptation to any change. Certainly when there is competition within the industry the question whether it is advisable to start a new firm or not can only be decided on the basis of the profits made by the already existing industries. At least in the case of the more complete competition which we have yet to discuss, profits as an inducement to change cannot be dispensed with. But one might conceive that where any one product is manufactured only by one single concern it will adapt the volume of its output to the demand without varying the price of the product except in so far as cast changes. But how is it then to be decided who is to get the products before supply has caught up with an increased demand? And even more important, how is the concern to decide whether it is justified in incurring the initial cost of bringing additional factors to the place of production? Much of the cost of movement of transfer of labour and of other factors is of the nature of a non-recurrent investment of capital which is only justified if interest at the market rate can permanently be earned on the sums involved. The interest on such non-tangible investments connected with the establishment or expansion of a plant (the “ goodwill ”, which is not only a question of popularity with the buyers but equally one of having all the required factors assembled in the proper place) is certainly a very essential factor in such calculations. But once these investments have been made it cannot in any sense be regarded as cost but will appear as profit which shows that the original investment was justified.
And these are by no means all the difficulties which arise in connection with the idea of an organization of production on State monopolistic lines. We have said nothing about the problem of the delimitation of the individual industries, the problem of the status of a firm providing equipment needed in many different lines of production, nor of the criteria on which the success or failure of any of the managers would be judged. Is an “industry” to include all processes that lead up to any single final product or is it to comprise all plants which turn out the same immediate product, in whatever further process it is used ? In either case the decision will involve also a decision on the methods of production to be adopted. Whether every industry is to produce its own tools or whether it has to buy them from another industry which produces them at large scale will essentially affect the question whether it will be advantageous to use a particular instrument at all. But these or very similar problems will have to be discussed in some detail in connection with proposals for readmitting competition in a much more complete form. What has been said here seems however sufficient to show that if one wants to preserve competition in the socialist state in order to solve the economic problem, it would not really help to get a satisfactory solution to go only half-way. Only if competition exists not only between but also within the different industries can we expect it to serve its purpose. It is to the examination of such a more completely competitive system that we have now to turn.

Collectivist Economic Planning

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