Essentials of Economic Theory / As Applied to Modern Problems of Industry and Public Policy

by John Bates Clark

Improvements and Prices under Competition

The figure represents a subgroup in which five producers, a, b, c, d, and e, are operating. Later, a new establishment f, is introduced. The upper dark line represents the price of a unit of the product, and the lower dark line the cost of making a unit in the establishment which is for the time the most efficient.

The dotted lines represent the respective costs of production in the different mills, ranging from a, the most efficient, to e, which can barely hold its own. What the figure represents as happening is as follows:—

b first makes an improvement which lowers his cost of production, as shown by the descending dotted line. This enables him to increase his output, and so has its effect on the price, which descends. Now, producer e was already selling goods at cost, but he is not at once driven out of the business. Instead, even though he cannot earn full interest on the original cost of his fixed establishment, he will continue to run as long as he can make his plant earn anything at all. The result is a virtual reduction of the capitalized value of the plant (the interest on which is an item of cost), and this is what is represented by the descent of the dotted line which represents e's cost of production. The situation is now represented by the series of points,—b´, a´, c´, etc., representing at their second stage the differing levels of cost in the case of different producers.

The next thing that happens is an improvement made by a, causing his cost of production to fall below that of b. The resulting fall in price now finally drives e out of business; he can no longer earn anything at all on his fixed plant. We may assume that producers a, b, and c, who have been making profits, have enlarged their productive capacity enough to supply the market fully without e's contribution. d is now in the same position in which e was at the preceding stage,—earning nothing on his fixed establishment and barely induced to remain in the business.

The next occurrence represented is the opening of a new, large, and very efficient mill by f. The effect is like that of improvements, but more violent. The fall in price drives both d and c out of business. b is now on the margin, but saves himself from loss by a second improvement, which makes him again the most efficient producer. And so the process goes on ad infinitum.

This figure illustrates the fact that, while at any time the price of a good roughly equals the cost of it to the least efficient producers, still this cost does not govern the price. The ruling factor is the cost in the most efficient mill, toward which the price tends; and all that the cost in the least efficient mill determines is how long that mill shall continue running.

In order that the claim here made—that price equals cost in the establishment which is about to be crowded out of the field—may hold good it is necessary to define terms with some care. In a typical case an employer who is destined soon to close out his business has, perhaps, an antiquated mill, which itself pays nothing, but enables its owner to use circulating capital and labor in a way that affords interest on that capital and wages for the labor. No interest on the cost of the antiquated mill is chargeable to the business unless the site and the building can be sold for a new purpose. If they have completely lost all productive power, they are not, as we use terms, capital goods at all; and in that case the only interest which the entrepreneur should reckon as a cost is that which accrues on other capital used in connection with the worthless mill. If the site and the building have some value for another purpose, and if the machinery has some value as junk, then whatever the owner can get by disposing of the plant constitutes a sum the interest on which constitutes a cost of producing goods in this mill. It is a sum which the plant owner foregoes as long as he refrains from selling the plant. He can afford to use it in production as long as the price of the product covers the cost as thus defined, but must stop when it ceases to do so.

[3] It will be seen that the maintenance of the present exchange ratios between A´´´, B´´´, C´´´, etc., when costs of all of them are reducing, would require that these costs be reduced in exactly the same degree in each case, and that the quantities sold at the new cost prices should be increased in unequal degrees, so as to bring the different prices to cost levels. The demand for one article is more elastic than is the demand for another. A slight increase in the supply of A´´´ may cause a large reduction of the selling price, while it may require a great addition to the supply of B´´´ to produce this effect. There must, therefore, be some changes in the relative quantities of labor in the different subgroups, even though there has been an equal amount of "labor saving" or cost reducing in all of them. This change is so slight in amount as compared with what would be caused by improvements confined to one subgroup, that it is effected with relatively little hardship and mainly by disposing the constant inflow of new labor at the points where it is needed.