Front Page Titles (by Subject) VI - Cost of Production and Price Over Long and Short Periods
The Online Library of Liberty
A project of Liberty Fund, Inc.
Search this Title:
Also in the Library:
VI - 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.
About Liberty Fund:
Liberty Fund, Inc. is a private, educational foundation established to encourage the study of the ideal of a society of free and responsible individuals.
The text is in the public domain.
Fair use statement:
This material is put online to further the educational goals of Liberty Fund, Inc. Unless otherwise stated in the Copyright Information section above, this material may be used freely for educational and academic purposes. It may not be used in any way for profit.
The foregoing discussion is all relative to an expanding demand. In our rapidly growing society contractions in demand are a relatively short-period phenomenon. When from any temporary cause an industry is working below the correct capacity of the fixed equipment, there is a tendency toward decreasing costs with their concomitant of cutthroat competition. Here the fixed costs represent either contractual remunerations not subject to quick readjustment or the physical immobility of the intermediate forms in which ultimately mobile ultimate resources are temporarily embodied. The amount of such physical immobility depends upon the suddenness and extent of the change. At one extreme a large part of both the material and human productive resources of society would be included. At the other, practically nothing. It is the writer's belief that if we abstract front the disturbances due to progressive change in demand and in productive methods and front those affecting business as a whole (the "business cycle") the assumption of perfect mobility corresponds closely with the facts for all changes not so short in duration as to iron out through the mere tendency of business calculations to base themselves on average conditions.19
This high degree of mobility is to be sure largely the result of social growth or progress, making possible a shift in the relative investment in different industries through differential growth, without an actual transfer of equipment from one to another. Productive power, to repeat, is in its ultimate form either transferable from one use to another or else is not price-determining in its one special use; but at any particular time it is more or less largely committed to particular forms specialized to particular uses. It cannot be quickly recovered in its fluid form without loss, and for much of it the commitment is permanent or practically so. There is no contradiction between assuming a degree of mobility dependent in fact on the steady accumulation of capital and assuming at the same time the absence of disturbances due to progressive change. For, though accumulation is a phenomenon of progress, it is a type of progress which has no appreciable effect in upsetting business calculations or producing fluctuations. In any case it is legitimate methodology to separate the effects of mobility from other effects of progress even if there is some connection between the two, if there is also a large degree of independence of one upon the other.
One of the most serious oversights in the discussion of decreasing cost is the neglect of the mixture of competition and monopoly which is a general characteristic of the type of business supposed to exhibit this type of cost function. Just as part of the traffic of a railroad is competitive and part monopolistic, nearly every manufacturing and mercantile business has a monopoly on some feature of its product; its good or service is differentiated from others in some manner and to some degree. To the extent that any business is monopolistic it may manifest decreasing costs due to the "economy of large-scale production." We have only argued that such a cost curve is incompatible with long-run competitive conditions.
The correct approach to the explanation of price in the case of partial monopoly would seem to be to apply the theory of monopoly, not that of competition. Instead of attempting to allow for a degree of monopoly in the supply, which there is no easy way of doing, it is vastly simpler to allow for partial competition as a phenomenon of substitution, on the demand side. No difficulty whatever is involved in assuming control of the supply (of the commodity defined in the narrowest sense) and allowing for competition by substitution of more or less similar goods in drawing the demand curve. And this is the more realistic view as it represents the way in which the producer would naturally envisage the situation.
In still another sense the presence of partial monopoly is a qualifying factor in determining short-run price. When an industry is in a depressed state, working below the capacity of equipment not transferable within the period in which reduced demand operates, a feeling of community of interest tends to prevent that reduction of prices to the level of prime costs which would follow from perfect competition. It is to be emphasized that a considerable degree of one or both sorts of monopoly exists over a large part of the field of manufacturing industry. The influence of both sorts of monopoly on price, that is, of the striving after the greatest possible degree of real or fictitious uniqueness in product by different makers and the strengthening of a sort of "professional ethics" against price-cutting, has been emphasized by Professor Spurgeon Bell in his paper on this subject.20
One more phase of the problem of decreasing cost with decreasing output should be mentioned in conclusion. Without considering new inventions or the introduction of methods not previously familiar, there may be a possibility of using different systems of production in making a commodity, one method being more efficient for a smaller supply and another for a larger. This is under any probable conditions another phase of the variation in size of establishment, but in any case a confusion in the definition and plotting of the cost function should be pointed out. If it is true that a small output would naturally be produced by primitive methods while a larger one would justify a more elaborate organization with greater efficiency, it may well seem that the case is one of decreasing costs. There is a fallacy in overlooking the fact that any amount of the commodity could be made by any one of the methods available. A correct treatment of the cost in relation to output should plot a complete cost curve for each method separately, extending from zero output up to one of indefinite magnitude, as shown in Diagram VIII. For the simplest method we shall have the curve of slightly increasing costs which represents the normal situation as shorn early in the discussion (curve 1). For a more elaborate technology the smaller magnitudes of output will be much more costly, but as output increases up to the capacity of the equipment, costs rapidly decrease, to a level below that of the first method. Beyond this point the curve becomes parallel with the first (curve 2). And similarly for a still more capitalistic method, as shown in curve 3. The significant part of the figure presents therefore, not a curve of decreasing costs, but a series of curves of increasing costs at different levels. It is hardly supposable that there can be a plurality of equilibrium points in such a situation, at which production may go forward under competitive conditions. The substance of the matter is, as already brought out, that if more efficient methods, connected with larger-scale operations, are available, the number of organizations in the industry will be reduced until all are on the most efficient scale. Then if the demand is sufficient to maintain a plurality of organizations, each will be subject to increasing costs; if the demand is not large enough for that, the industry will be a monopoly, in which case there is no tendency for cost and price to be equal (monopoly revenue not being counted as a part of cost).
[19.]Professor Friday's interesting argument against the concept of "normal profit" (in Profits, Wages, and Prices, chap. iii) does not affect the proposition as stated above, if indeed it applies to any doctrine which economic theorists have traditionally advocated. He has not in any sense disproved a tendency of profit toward a normal level, or even that this tendency is reasonably effective over a moderate period of time if the variables are accurately measured in price terms.
[20.]The Quarterly Journal of Economics for May, 1918.