Chapter IV
Cost and the Margin of Production
§1. An Illustration from Coal. We have already had occasion to note the symmetry which characterizes the relations of demand and supply to price. This symmetry was apparent throughout the argument of Chapter II, and it was a striking feature of the diagrams which we employed to illustrate the argument. We shall do well to cultivate a lively sense of this symmetry, for it will frequently save us from ignoring factors which have a vital bearing on the problems we are considering. We should never leave an important feature of demand without turning to see whether it has a counterpart on the supply side, though indeed we may not always find one. In the last chapter we examined the relation between utility and price, and found that the true relation was between the price and what we termed the marginal utility. Corresponding to utility on the demand side is cost of production on the supply side. The question should thus at once suggest itself—"Can we speak appropriately of the marginal cost of production, and will this serve to make clear the relation between cost and price?" To answer these questions, let us take one of the instances in which we found that price could not be explained satisfactorily by the bare phrase "cost of production."
An important feature of the coal industry, which recent events have brought into sharp prominence, is the great diversity of conditions between different coalfields and different collieries. We speak of rich seams and poor seams, of fertile and unfertile mines, and we are aware that the costs of raising coal to the surface differ very widely in accordance with these diverse natural conditions. Nor must we confine our attention to the cost price at the pit-head. If we wish to speak of cost of production as a factor determining price, we must use the term in a broad sense to include the transport and other charges necessary to bring the coal to market.
In this respect also one coalfield differs greatly from another. Some are well situated close to a large market, or within easy reach of the seaboard; others must incur very heavy transport charges to bring their coal to any considerable centre of consumption. These varying conditions lead, as we well know, to great variations in the financial prosperity of different colliery concerns. In Great Britain, under the abnormal conditions which prevailed during the war, and subsequently, these variations were so huge as to constitute a most formidable embarrassment and to contribute, more perhaps than any other single factor, to the unrest and instability by which the industry has been afflicted. But they are always with us, if usually upon a more modest scale.
What, then, is the normal relation between price and cost in the case of coal? Should we direct our attention to the average costs over the whole industry, or the costs incurred by the richer and better situated mines, or, lastly, that of the poorer and worse situated? Now, as things are, it is clear enough that no concern will continue indefinitely producing at a loss. It may do so for a time, rather than close down altogether, hoping to recoup itself later when the market has taken a more favorable turn. But, in the long run, taking good years with bad, it must expect to obtain receipts sufficient not only to cover its necessary expenditure, but to provide also a reasonable profit on the capital employed. Of course, once the capital has been sunk and embodied in plant and buildings, which are of little use for any other purpose, a business may continue for many years, with a rate of profit far below what it had anticipated. But plant and buildings gradually wear out, and need to be replaced; the course of technical improvement calls continually for fresh capital outlay, which a business in a bad way is reluctant to undertake. The tendency, therefore, when profits rule low over a considerable period, is for the plant to fall gradually into disrepair and obsolescence, and finally for the business to disappear. We can thus include an ordinary rate of profit under the head of cost of production, and say with substantial accuracy that for no business can this cost for long exceed the price if the business is to continue to exist. If then the relatively poor and badly situated mines are to be worked, the price of coal, taking good years together with bad, must cover the costs at which these mines can produce. If the price rules lower than this, sooner or later they will close down, and we will be left with a smaller number of mines, among which great variations of conditions will still prevail. Once more, the price must cover the cost incurred by the least profitable of these remaining mines, unless their number is still further to be diminished. Thus we can conceive of a "margin of production" which will shift backwards to more profitable or forwards to include less profitable mines, according as the demand for coal contracts or expands. But, wherever this margin may be, there is no escaping the conclusion that it is the cost of production of the "marginal mines," of those that is to say which it is only just worth while to work, to which the price of coal will approximate.
It follows that there is no real connection between price and cost of production throughout the industry as a whole. It follows incidentally that those concerns which can market their coal at an appreciably lower cost than the marginal concerns, are likely to reap more than an ordinary rate of profit, though royalties may absorb part of the excess.
§2. The Various Aspects of Marginal Cost. This relation cuts much deeper than the particular system under which the mines are at present owned and worked. If, for instance, we supposed that the various mines were amalgamated together in a few giant concerns, each of which comprised some of the richer and some of the poorer mines, the preceding argument would need to be recast in form, but its substance would be unaffected. For though a great coal trust could in a sense afford to sell at a price lower than the marginal cost, setting its losses on the poorer against its gains on the better pits, is it likely it would do so? Why should it dissipate its profits in this way? It is clearly more reasonable to suppose that it would close down the poorer pits (unless it could advance the price of coal), and thereby maintain its profits at a higher figure. If, indeed, the mines were nationalized the deliberate policy might be pursued of selling coal at a price which left the industry no more than self-supporting as a whole. Some coal might thus be sold at less than its cost price, and the selling price would conform roughly to the average cost. But such a policy, though in special circumstances it might be justified, would represent a very dangerous principle, which could not be applied widely without the most serious results. Nothing could be more fatal to any enterprise, whether it be in the hands of an individual, a joint-stock company, a State department, or a Guild, than that the management should content themselves with results which in the lump seem satisfactory, and regard losses here or there with an indifferent eye. That way lies stagnation, waste, progressive inefficiency and ultimate disaster. To inquire searchingly into every nook and cranny of the business, to construct, as it were, for each part a separate balance-sheet of profit and loss, to expand in those directions where further development promises good results, and to curtail activity where loss is already evident, is the very essence of good management. Here, it will be observed, we are using language very similar to that in which we described the principles which govern a business man's expenditure. The resemblance is inevitable and significant, for we are dealing here with what is essentially another aspect of the same thing. The object is to secure that nowhere does expenditure fail to yield a commensurate return. This we express, when we consider a business in its aspect as a consumer, by saying that its consumption of anything will not be carried beyond the point at which the marginal utility exceeds the price it will have to pay. When we consider it as a producer, we say that its production of anything will not be carried beyond the point at which the marginal cost exceeds the price it will obtain.