Front Page Titles (by Subject) IV - Cost of Production and Price Over Long and Short Periods
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IV - Frank H. Knight, “Cost of Production and Price Over Long and Short Periods” 
Journal of Political Economy, April 1921, xxix, no. 4, pp. 304-335.
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All of this reasoning relates to the ultimate goal of the competitive tendencies, with unlimited time allowed for the adjustment of production to given conditions of demand (but with long-period progressive changes in the general conditions of both supply and demand eliminated). The next question is that of the relation between cost of production and price, the shape of the curve showing cost as a function of output and hence output as a function of price, over moderate periods of time. Two main sets of facts differentiate the short-period from the long-period tendencies. The first is the physical immobility of productive resources between different uses and the second is the comparative inflexibility of the prices of productive services, in terms of which the producer makes his calculations. When the price of a product changes, owing to a change in demand, the entrepreneur cannot commonly change his price offers for productive goods immediately into correspondence with them. For many of these he is under contract over a longer or shorter period at specified rates. For others, notably labor services, psychological and social considerations prevent quick and accurate readjustments, not to mention that the entrepreneur himself does not come instantly and automatically into accurate knowledge of the facts. And when the price remunerations for "land, labor, and capital" do change relatively in different industries, transfers of these agencies from one industry to the other do not always follow quickly or freely. Even those agencies which are transferable without physical modification encounter a large amount of inertia and resistance. Others cannot be transferred without changes involving costs and still others are only indirectly movable; they must be allowed to wear out and be replaced with others of a different type. That is, the ultimate resources are largely mobile, but they are embodied in intermediate forms which are not; and finally, to some extent the ultimate resources are specialized and the only change to which they are subject is a revaluation.
In consequence of these facts of immobility the adjustment to changing conditions of demand is generally far from complete. And especially when it can be foreseen that the new condition of demand will probably be short-lived in comparison with the time required for perfect adjustment to it, the tendency to make these adjustments is enfeebled and for those adjustments which require an especially long time to carry out the tendency may be entirely abrogated.
To fit the theory more accurately to the facts of life the doctrine of short-time normal price has been formulated, notably by Marshall. The idea is that over short periods supply is a different function of price, cost a different function of output, from what is true of the ultimate adjustment. Marshall separates the two cases by saying that for short periods of a few months or a year supply means the amount which can be produced for the price in question with the existing stock of plant, personal and impersonal, in the given time, while for long periods, of several years, it means the amount which can be produced by plant which itself can be remuneratively produced and applied within the given time.12
We question the validity of a separate formulation of short-period tendencies along the line adopted by Marshall or the recognition of a special "case" along any lines. It seems rather that the facts are sufficiently covered by recognizing that in a limited period only a corresponding part of the readjustment described as the final goal will be brought about. We argue that there is no division between short-period and long-period changes; that they are of the same character and differ only in the degree of completeness and that this variation in degree of completeness is smooth and gradual, without break or sudden change of character as the time interval considered is longer from zero up to indefinitely long periods.
Marshall's distinction between variation in output from the equipment, personal and impersonal, already in an industry and a variation due to a change in the amount of equipment itself, seems to involve confusion and difficulty if not definite error. It may be doubted whether a variation in the output from given equipment in response to variation in price is to be regarded as probable on a significant scale. To some extent the productive life of machinery in terms of total output may be greater at lower speeds (enough greater to offset the interest charge connected with stretching the yield out over a longer time) and if so machinery could be economically operated at higher speed as the price of the product increased. But it is improbable that this factor would be important, and the discussion quickly narrows down to the human element in the equipment. The argument assumes that at higher product prices, higher wages will be paid and that at higher wages, the same labor force will work the material equipment more intensively and turn out a greater output, through speeding up or overtime work.
Examination of this reasoning raises serious doubts. Everything depends on the assumptions as to the psychology of the workers. Suppose to begin with that the working day and speed are normal. It is pretty well demonstrated that what industry considers a normal13 working day is too long and normal speed probably too high for maximum efficiency over even moderate periods of time. Labor cannot produce more than normal output except for a temporary spurt. Moreover, if the inducement is a simple increase in piece wages, it is at least as likely that workers will choose to work less hard as that they will choose to work harder, and if they behave like the rational economic man they will be more likely to choose the former. They will take part of their increased income in the form of leisure time, earning more money but doing less work as the rate of pay rises. We are therefore thrown back upon special forms of wage payment such as bonuses for extra production, higher rates for overtime, and the like. It is undeniable that such expedients may stimulate production to some extent for a short time, but accumulating observation, notably the experience of the recent war [World War II], shortens the time to very narrow limits, and emphasizes the stupendous cost of the temporary increase through reduced efficiency later on.
Moreover, it is quite clear that in fact the temporary increase in output going with high prices does not come altogether from the equipment, material and human, already in the industry. When prices rise the less specialized forms of labor and tools are taken on and when prices fall they are laid off; the longer the time available, and the greater the price change, the more highly specialized is the equipment, material and human, which will be involved in this change, varying continuously and smoothly in both directions and without limit.
When the fluctuation is below the normal (usual) working adjustment in the industry, the case is somewhat different. Here the dominating fact is that the entrepreneur usually bargains for his fixed equipment, or the capital which it represents, on long-term contracts and has to pay for its use whether it works or not. Under these conditions it is indeed true that the industry will be subject to decreasing costs. If the entrepreneur owns the equipment himself or hires it on terms of its momentary value to him, the long-run principle applies with the modification that with reference to time periods for which any particular equipment is specialized, its remuneration is not a price-determining factor, and this element in cost will be reduced by revaluation of the service in question. In regard to labor, the more expert and specialized branches are in much the same position as fixed equipment. The entrepreneur cannot generally afford to lay off such men and their wages are in large part a fixed cost with reference to short-period changes. With unskilled labor the tendency is to keep piece wages fairly constant for actual employment but reduce the number employed or the hours of work or both. It is by no means a negligible element in the actual calculation that both these facts mean increased labor efficiency at lower outputs, since in general the men laid off are the less capable, and the psychological influence of a depression in the industry works in the same direction in other ways.
The facts as to the relation between output and price are represented roughly in Diagram V. The point b corresponds to a normal adjustment in which price and cost are equal, which is assumed as a starting-point. For increases in price the output may be assumed to increase in greater degree as the time for readjustment is longer, little or not at all for very short periods as shown by curve 1 and more steeply without limit as the time increases (curves 2, 3, 4, and 5).14 For decreases in demand the same curves would be continued to the left as shown, again becoming steeper with increase in the time interval taken into view. It may aid in visualizing the situation to imagine that the curves to the right of the intersection (b) represent output of some commodity, demand for which is greatly increased by the outbreak of a war, while the portion to the left of the intersection represents the facts for some luxury good, for which the demand is largely cut off; the different curves showing production according to different anticipated durations of the war. (It is to be assumed that the productive readjustments are effectuated by price motives alone.) With reference to a new commodity not previously produced the curves will start from a zero point on the price axis as shown in Diagram VI. The dotted curves in Diagram VI relate to the possibility of producing the commodity on an entirely different scale by an entirely different, more highly organized, and more efficient process; this possibility will be discussed presently (p. 332). By this large-scale process small amounts of the good would not be produced or if they were the price would have to be very high; beyond a minimum point the rate of production will be an increasing function of both the price and the time allowed, as in the previous case.
[12.]Principles of Economics, 6th ed., p. 379. It is to be observed that even Marshall's discussion of long-time normal price does not relate to the ultimate adjustment of production to fit given conditions of demand. This is in line with his general tendency to avoid clear-cut formulations and "soften" his principles to make them cover a broader range of facts. The present writer is inclined to a very different conception of scientific procedure, though not necessarily to the exclusion or displacement of "looser" forms of treatment. Another case in point is the concept of the "representative firm" already referred to. In our view general principles are to be stated with the most rigorous accuracy attainable and pure theory sharply separated from its application to reality. From this point of view the failure of a scientific principle to fit accurately any case whatever, much less any class of cases, may be a merit rather than a defect. It is not the purpose of such principles to describe facts in realistic detail, but to state with the greatest possible accuracy general relations which form a common element in large groups of real situations, even though they may not be the whole story, may not necessarily even give an approximately complete description, of any single case.
[13.]Normal here means of course merely usual and has no connection with the use in "normal price" as the goal of tendencies at work.
[14.]A complete and accurate representation would require a three-dimensional drawing, the curves being located at successive points along a time axis perpendicular to the paper and blending into a surface increasing in inclination to the price plane with increasing distance from the zero point of the axis of time-allowed-for-readjustment.