Front Page Titles (by Subject) V - Cost of Production and Price Over Long and Short Periods
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V - 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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The foregoing abstract formulation of principles may be brought down to earth, made concrete and connected up with practical social policy by a brief discussion of what is in a sense the stock example of decreasing costs, the railway industry. The effects of so-called fixed charges or burden and the resulting decrease in cost per unit as output (traffic handled) increases are as conspicuous and as familiar here as in any field. The decrease in cost is a concomitant of surplus capacity in important elements of the equipment.15 The crucial question is, why do certain elements of the equipment contain surplus capacity? The answer, in the case of American railways, is obvious. The roads were built in the first place long in advance of the economic development justifying the investment, in order to pre-empt the locations and to speculate upon the unreflecting optimism of a frontier community, where every junction point habitually looks upon itself as a budding metropolis. And being built, they were (more or less wisely) laid out upon large lines, with a view to future expansion in the traffic. It requires no explanation that such an establishment, while it is working up to the capacity for which it is designed, will show large fixed charges and diminishing costs. It is just as obvious that this is a temporary condition.
The present confusion in the railway field in this country is in no small degree a product of the fact that for more than a generation the roads and the public were habituated to thinking of the industry as one of decreasing costs. The roads were encouraged by publicists and writers on railway affairs to make rates that would enable the traffic to move, oblivious even of the fact that the traffic increases were largely at the expense of other lines operating under the same conditions. The result is our impossible system of rate-basing and traffic classification. In the early years of the present century, the country grew up to its railway system; since then the equipment has been behind rather than in advance of the needs and railway finance has been floundering in bewilderment trying to find itself in relation to a situation in which increased business is no longer an advantage.16
The actual shape of the curve showing cost as a function of output (traffic) is intended to be suggested by Diagram VII.17 Beginning at an exceedingly high cost for the first small increments of business—so high that a railway would not of course be built for them alone—the cost descends for a time, rapidly on the whole but very irregularly. There is an upward "kink" in it not only for every new car, train, track, etc., but for every freight-handler, freight shed, bookkeeper, etc., necessitated by the expanding traffic. For a time the drops in the curve are much larger than the rises and the trend is sharply downward. A ten-car train is more efficient than a one-car train, and a double-track road, than a single track. But soon this tendency slackens, and still later it is reversed. The writer is not a railway expert, but is told that beyond somewhere around three or four tracks the efficiency falls instead of rising, and surely it need not be argued that a road of twenty tracks would be quite unmanageable.
The foregoing assumes a rapid expansion. If the growth is slow and related to conditions accurately known far enough in advance, the curve will be smoothed out to the trend line, as shown. Cars can be built a little larger instead of adding standard cars one at a time. Even a man, the most indivisible productive unit, can generally be employed for part of his time only in any one occupation, or "smaller" men can be replaced by "larger" ones. Even the capacity of the given number of tracks can be increased by varying the amount of auxiliary equipment, and additional tracks may be added gradually, beginning with the busiest sectors.
Diminishing costs are generally real in the very early stages of the expansion of the demand. There are minimum limits to the divisibility of important elements in cost. If a pipe is to be laid, a ditch must be dug wide enough for a man to work in, and the right-of-way for two railway tracks will not cost nearly twice as much as for one. Such gains, however, decrease very rapidly with expanding size, and though many of them will never fall to zero, they are quickly offset by just as inevitable losses which increase from the first, the varied and multiplying costs of maintaining internal stability as size increases. No fallacy is more pernicious with reference to intelligent economic policy than the popular illusion that large-scale business is in general more economical than small-scale. If the scale of operations expands very far, it will always run into increasing costs; and as the facts stand the gains are more conspicuous than the losses so that even careful study inevitably overestimates the advantages and underestimates the critical size at which increasing costs set in.
But it may naturally be objected that if decreasing costs are significant up to the capacity of two tracks and real, even if small up to three or four, the operation of the greater part of the railway mileage of the United States would still in fact be subject to decreasing costs. This is doubtless true, in an accurate adjustment; and it may also be true to some extent that in a rapidly growing society it is wise at certain stages to overbuild the fixed equipment of public utilities in relation to current needs. It may even be true that a certain amount of price classification may be theoretically justifiable. But all consideration of the merits of the case serves to emphasize the very limited extent to which any of these conclusions hold and the importance of the practical considerations on the other side. The outstanding fact is that most if not nearly all the actual consequences of these policies are bad. Price differentiation either gets business at the expense of competing equipment operating under the same conditions or develops traffic which ought not to move, artificially distorting the natural lines of social growth, while the monopoly rate on the traffic which will "bear" it encourages socially unwise investment in the industry which makes the charge.
Getting business away from competing establishments similarly subject to decreasing costs raises again the question earlier discussed of the tendency of competition to force all the establishments to adopt the most efficient size. If a four-track railway is most economical, how can lines on a smaller scale continue to exist? The answer obviously is that only a part of the service rendered by a railway (the through traffic) is subject to competition, while a large part (local traffic) is a natural monopoly. The social problem as to how far the possibility of securing monopoly prices for local service ought to be allowed to influence railway-building is a vast and intricate problem which cannot here be gone into in detail. While the effect of free competition in railway-building and rate-making would be to concentrate economic development to some extent along favored transportation routes, the effect of forbidding new lines to compete with established ones at rates which would cut their traffic below the point of maximum efficiency would be to concentrate it much more. The policy of permitting free railway-building (and still more that of fostering competition), if consistently followed out, tends to diffuse population and industry over a wider area, reducing the natural advantage of proximity to superior transportation routes. As noted above, the writer would favor the policy of restraining competition. Then if "society" wants to encourage artificially the development of the newer regions or subsidize the movement of any particular class of freight,18 it should be done directly and consciously, out of taxation levied so far as possible according to the benefit conferred. But again, in practical politics, it is doubtless rash to suggest that society should do anything consciously and deliberately where it is possible to "muddle through."
[15.]A well-known problem book in economics contains the question, If a railroad is already in existence between New York and Chicago and trains are running, what added cost will the railroad incur in hauling a five-pound box from Chicago to New York? Of course the Freshman is expected to answer that the cost would be slight, and to be duly impressed with the importance of fixed costs. No reference is made to the possibility that the trains already running may be full! The added cost of the particular small increment of traffic which compels the addition of even an extra car to a train will not be negligible. And locomotives also reach their capacity and new trains have to be added; and sometimes, new tracks must be built if the traffic continues to grow, and ultimately it would be impracticable to increase the number of tracks. Perhaps about eight is a maximum before it could be cheaper to start an entire new system far enough removed from the first to avoid interference in switching and handling the shipments.
[16.]In European countries generally the facts were different, the traffic demands being generally up to the capacity of the railways as they were built and expanded; the foreign literature on railways is relatively free from the heresy of decreasing costs and foreign railway policies from the disorganizing tendencies based upon the idea.
[17.]The curve is of course a rough sketch and merely suggestive. Drawn accurately to scale it should never be steeper than a rectangular hyperbola through the point. A decrease in cost per unit at greater ratio than that of the increase in output would mean a smaller total cost for the larger output, which is absurd.
[18.]It is by no means meant to imply that this should never be done. The writer would hold—in opposition for example to Taussig (Principles of Economics, chap. lx, sec. 1)—that in this field social interests very often outweigh economic advantage, as measured by pecuniary demand.