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Elements of
ECONOMIC ANALYSIS
PRENTICE-HALL ECONOMICS SERIES
E. A. J. JOHNSON, EDITOR
Elements of
ECONOMIC ANALYSIS
by
ARCHIBALD M. McISAAG
Professor of Economics
Syracuse University
New York PRENTICE-HALL, INC. 1950
Copyright, 1950, by
PRENTICE-HALL, INC.
70 Fifth Avenue, New York
All rights reserved. No part of this book may
be reproduced in any form, by mimeograph or
any other means, without permission in writing
from the publishers.
Printed in the United States of America
PREFACE
This book was written to provide a brief introduction to eco-
nomic analysis for students in liberal arts, business administration,
engineering, forestry, and other fields, the majority of whom do
not expect to continue with advanced work in economics or to be-
come professional economists. The primary objective, therefore,
has been to present the essentials of economic analysis in a form
that will be useful to them in later life, either in attacking busi-
ness problems or in understanding questions of public policy that
relate to the functioning of business enterprise and of the econ-
omy as a whole. By adopting certain analytical techniques now
widely employed in industry, but not hitherto commonly utilized
by economists, it appears possible to achieve a very considerable
simplification of economic analysis without any loss of effective-
ness or rigor. Additional gains in simplification have been
achieved by dropping out concepts and analytical tools that, al-
though a part of the equipment of the professional economist, are
of little use or interest to the nonprofessional.
This book is, frankly, experimental in a number of important
respects.
In the first place, although this book approaches economic anal-
ysis in terms of the individual firm or industry, it seeks to bridge
the apparent gap between the economics of the firm and the eco-
nomics of the entire economy, and to present a picture of micro-
economics and macroeconomics in terms of the relations between
the parts and the whole. Much emphasis has been placed upon
the strategic role of entrepreneurial decisions and motivation, and
on the interaction of the particular and the aggregate processes of
vi PREFACE
the economy. It is hoped that, through such a presentation, the
student can achieve an appreciation of the fact that what happens
in the economy in the aggregate is the resultant of the decisions
and actions of millions of people and business firms, and that these
decisions and actions are themselves conditioned by what is hap-
pening, or is expected to happen, in the economy as a whole.
A second major objective has been to introduce into the teach-
ing of economic principles some of the devices that, in recent years,
have been widely employed in industry as guides to managerial
decisions, notably the break-even chart technique. Experimental
use of this device during the past two or three years has led to the
conviction that very material advantages may be achieved by em-
ploying an adaptation of this technique in place of the now con-
ventional approach based on explicit marginal analysis. The fact
that the break-even chart is now extensively used in industry gives
this approach a context of realism that is difficult to achieve in an
exposition of marginal analysis, for which few, if any, examples of
actual practical employment can be found. Even a casual com-
parison of the two techniques will suffice to show the economy of
the technique here employed, because it by-passes completely the
difficulties inherent in presenting the concept of differentials or
rates of change, which is inherent in conventional marginal anal-
ysis. Yet the results achieved are at least as rigorous, and involve
fully as deep an understanding of the fundamental relationships
involved, as can be achieved with the aid of the marginal analysis.
A further gain that may be achieved is the possibility of treating
total revenue and total cost curves or schedules in terms of statisti-
cal estimates or probabilities, rather than as definitely fixed and
known functions. This statement should not be interpreted as an
attack on the validity of marginal analysis itself, within an ap-
propriate context, but simply as a claim that the framework of a
simple and effective, and withal realistic economic analysis can be
developed without taking aboard the impedimenta of the marginal
concepts.
A third feature of the book is the deliberate concentration of
attention upon types of market organization that are predominant
in the contemporary economy, and the relegation of the case of
pure competition to a subsidiary role as one of the more extreme
variants among possible market situations. No attempt has been
made to develop a detailed classification of market forms or to deal
PREFACE vii
at length with such variations. Other steps toward simplification
include the virtual elimination of the analysis of elasticity, and a
corresponding increase in emphasis upon shifting or changes in
demand, reflecting the impact of income changes and changes in
expectations. Here again the way is opened for the explicit recog-
nition of the interrelations of the particular and the aggregate
processes of the economy.
This book was originally undertaken to provide a brief intro-
duction to formal economic analysis to be used in the elementary
economics course at Syracuse University as a supplement to a
widely used introductory text that is focused primarily on the
structural and institutional aspects of the present-day American
economy, and on the major economic and public policy problems
of that economy. It has been organized and written, however, in
such a way that it could be used, with some supplementary ma-
terials, as the basis of a one-term introduction to economic prin-
ciples, or as a supplement to other content in a basic course in
business administration.
The author is deeply indebted to several friends and colleagues
who have read the manuscript at various stages in its preparation,
and whose comments and suggestions have contributed greatly to
its evolution. Among these particular mention should be made
of Professors Theo Suranyi-Unger, W. Nelson Peach, Jesse V.
Burkhead, and Mr. Paul Hirseman. Mr. Herbert Sim has been of
great assistance in the final editing and checking of the manuscript.
ARCHIBALD M. MclsAAC
TABLE OF CONTENTS
Part One Price Analysis
CHAPTER PAGE
1 DEMAND 3
2 SUPPLY AND COSTS OF PRODUCTION 17
3 PRICE FORMATION 37
4 PRICE AND PRODUCTION POLICY 47
5 PRICE STRUCTURES, LEVELS, AND TRENDS 70
Part Two Enterprise, Factor Pricing,
Employment, and Incomes
6 PROFIT EXPECTATIONS AND INCENTIVES OF ENTERPRISE . 91
7 PRODUCTION, EMPLOYMENT, AND INCOME Ill
8 EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS . . . 126
9 SUPPLY OF PRODUCTIVE FACTORS 149
Part Three Investment
10 REAL INVESTMENT AND THE VALUATION OF DURABLE
ASSETS 165
11 DEMAND FOR INVESTMENT FUNDS 179
12 FINANCIAL INVESTMENT AND TRADING IN SECURITIES . . 191
13 SUPPLY OF INVESTMENT FUNDS 207
14 SAVINGS, PROPERTY INCOMES, INVESTMENT, AND EMPLOY-
MENT 217
INDEX 233
ix
Part One
PRICE ANALYSIS
Chapter 1
DEMAND
Demand as an Expression of Consumer Attitudes
and Preferences
A noted economist once said, "Teach a parrot to say 'supply and
demand' and you have made a political economist/' That many
people are inclined to take his prescription at face value is indi-
cated by the glibness with which they invoke the "law of supply
and demand" to prove the unworkability of any proposal of which
they happen to disapprove. For the sake of precision of thought
and accuracy in analysis it is, however, desirable to examine the
concepts of demand and supply a little more closely.
As ordinarily used in economics, the term demand is used to ex-
press the attitudes and preferences of consumers at a given mo-
ment of time. These attitudes may be those of an individual or
of a group. An individual's demand for a certain commodity,
whether shoes or sealing wax or cabbages, stands for the amounts
of that commodity that he or she would be willing to buy, at a
given time, at various possible prices. Depending on the amount
of income at his disposal, on his personal tastes, and on the num-
ber of alternative attractions, there would ordinarily be some price
above which the prospective consumer would not go, if necessary,
in order to secure a single unit of the commodity. He would,
however, be quite glad to pay less, and if the price were less he
might be willing to buy in larger quantity.
Commodities differ greatly in the degree to which a lower or
higher price would tend to evoke larger or smaller purchases. By
the same token there are marked differences in the ability and
3
4 DEMAND
willingness of different people to buy the same commodity at any
given price, even though all other circumstances are the same.
Thus at any given time the group of potential buyers of a com-
modity will generally include some who would be prepared to buy
even if the price were relatively high, and others who would be
induced to buy only if the price were relatively low.
There are also marked differences in the frequency with which
different commodities are purchased by individual consumers, and
in the deliberation with which people make up their minds to buy
or not to buy. Many items of personal consumption are bought
from day to day or week to week, often on a habitual basis, as,
for example, newspapers, cigarettes, gasoline, or the weekly gro-
ceries. Less frequently does the average person find himself in
the market for major items of wearing apparel or housefurnish-
ings. At still less frequent intervals does the practical problem
present itself of choosing an engagement ring or purchasing a new
house. There are, therefore, endless variations in the patterns of
individual expenditure of income. But in any sizable community
or trading area the number of people actively "in the market" for
any staple commodity at a given time is likely to be large. If so,
even though individual consumers' purchases may be made only
occasionally, there will be a more or less regular off-take of a com-
modity from the market by the entire group of potential buyers.
The rate of demand at a given time
For the great generality of commodities that are continuously
being produced and offered for sale, it is convenient to think in
terms of rates of demand; that is, in terms of the quantities of a
particular good that would be purchased, per unit of time, at dif-
ferent possible prices.
If, for example, the price of ground beef were sixty cents per
pound at the neighborhood butcher shop, how many pounds would
the butcher's customers buy per day or per week? Would they be
likely to buy more pounds per day if the price were fifty cents?
And still more if the price were forty cents? Suppose that the
butcher made an estimate of the number of pounds that he could
sell per day at various prices, from a dollar a pound down to thirty
cents, assuming that all other conditions affecting the customers'
choices, excepting price, were unchanged. These estimates could
be summarized in the form of a demand schedule, as in Table 1.
DEMAND 5
This schedule represents the current demand situation as visualized
by the butcher. In terms of such a schedule he must make his own
calculations as to the "best" price to charge and the amount of
meat to order each day in serving his trade.
TABLE 1
HYPOTHETICAL DEMAND SCHEDULE
If price were
Entire group of customers
would be willing to buy
Total amount that
would be spent per day
$1.00 per pound
10 pounds per day
$10.00
.90
15 "
13.50
.80
20 "
16.00
.70
40 "
28.00
.60
80 "
48.00
.50
140 "
70.00
.40
190 "
<
76.00
.30
240 "
(C
72.00
In the ensuing discussion the word demand, when used without
other qualifying words, will be used in the sense of a demand
schedule, indicating the quantities of a given commodity that the
prospective buyers would be willing to purchase per day or per
week, or during any other appropriate unit of time, at various pos-
sible prices.
The demand curve: Graphic representation of demand
It has become customary to make frequent use of a simple
graphic device to picture the demand conditions for a commodity
at a given time. This device is the demand curve as represented
in Figure 1, which is based on the price and quantity figures as-
sumed in Table 1 . The various possible prices are indicated on a
scale on the vertical axis, or ordinate, and quantities are measured
on the base line or abscissa. To the right of the price scale a point
is plotted, opposite each price, and directly above the quantity that
the group of buyers would be willing to purchase, per unit of time,
at that price. A demand curve may then be drawn in, by connect-
ing the plotted points, to represent the functional relationship of
price and quantity that might be sold, the implication being that
at intermediate prices there would be a more or less proportionate
adjustment in potential sales. Note that the demand curve in Fig-
6 DEMAND
ure 1 slopes downward to the right, indicating that the lower the
price asked, the larger the quantity that could be sold. Such a
curve is said to be negatively sloped.
100
.80
tn
K
3.60
o
Z
g.40
<L
.30
\
\
\
----.
^^
\
DEMAND
'CURVE
"0 40 60 120 160 200 240 28
QUANTITY
FIGURE 1. HYPOTHETICAL DEMAND CURVE
The responsiveness of demand
Under the demand conditions assumed in Table 1 and Figure 1,
a reduction in price would, over a certain range, result in a more
than proportionate increase in sales per day, and as a consequence
total consumer expenditures would be increased. In the range
below forty cents per pound, however, a further lowering of price
would not be fully compensated by the increased volume of con-
sumer purchases, so that total consumer expenditures on this com-
modity would be smaller than if the price were higher. This sort
of relation between price, quantity that would be purchased, and
total amount that would be spent, has been found to prevail for
many different kinds of commodities. Over a certain range of
prices, a lowering of price would increase the quantity that could
be sold and also the total amount that would be spent out of
consumer budgets. But beyond a certain point, a further lowering
of price, although it would increase the quantity that could be sold,
DEMAND 7
would nevertheless involve reduced consumer expenditures. This
fact is obviously significant both from the standpoint of consumer
budgeting and also from the standpoint of planning by merchants
and manufacturers.
The term responsiveness of demand l will be used to describe the
reaction of consumers to lower, as compared with higher, prices for
a certain commodity, other things being equal. A responsive de-
mand would be one in which a lowering of price would induce a
more than proportionate increase in purchases, and therefore a
larger total expenditure for the commodity under consideration.
Unresponsiveness of demand describes the situation in which a
lowering of price would be accompanied by an increase in pur-
chases, but not sufficient to cause an increase in total expenditures
for the commodity in question. If a lowering of price would in-
duce an increase in purchases just sufficient to keep total expendi-
tures the same, the responsiveness of demand would be said to have
a value of unity.
It should be noted that the responsiveness of demand is not the
same throughout the entire demand schedule or along the entire
length of the demand curve. In the previous example demand
would be responsive over the range of prices down to forty cents,
or slightly less, and unresponsive below that price.
The total expenditures or total sales revenue curve
An even more complete picture of the entire demand situation,
including the responsiveness of demand, may be obtained by re-
plotting the data from Table 1 in the form of a cumulative total
expenditures curve, as in Figure 2. This figure will repay very
careful study, as it constitutes the basic pattern for much of the
analysis in this and the following chapters on cost and price anal-
ysis.
In Figure 2 the abscissa scale is used to indicate the quantities of
the commodity (in this case chopped beef) that the consumers
would purchase per day at various possible prices. The ordinate
scale is employed to measure in dollars the total amount that con-
sumers would spend in purchasing the indicated amounts of the
!The term responsiveness of demand as used here is identical in meaning with
the term elasticity of demand as commonly used in economic literature. It seems
desirable to reserve the term elasticity of demand to describe other features of eco-
nomic behavior, particularly those relating to changes in economic conditions
occurring over a period of time.
8
DEMAND
commodity. For example, a point is plotted at the $10 level di-
rectly above the point representing 10 pounds of meat. Another
point is plotted at the $16 level, directly above the point repre-
senting 20 pounds of meat, and so on.
200
180
160
140
5120
Ul
&ioo
5 80
o
< 60
I 40
20
40
80
120 160
TOTAL QUANTITY
200
240
280
FIGURE 2. TOTAL EXPENDITURES OR TOTAL SALES REVENUE CURVE
A indicates the price and quantity at which the responsiveness of
demand is "unity."
The various prices at which the chopped meat might be offered
for sale are not represented on either the abscissa or the ordinate
scale, but rather by a series of price radials, that is, straight lines
sloping upward and to the right from the origin or zero point on
the graph. A low price is represented by a gradually sloped radial;
a high price by a steeply sloped radial. In each case the slope is so
determined that the line serves as a graphic means of indicating
the total amount that the buyers would spend for the commodity
in question if they were to buy a certain number of units at the
particular price in question.
By this method of representing prices it is possible to show in
the same graph the three important aspects of estimated consumer
demand, namely the quantities that the buyers would be prepared
to take at each of the possible prices, and the total amounts that
would be spent in purchasing the commodity at each of the pos-
sible prices.
DEMAND 9
In fact, Figure 2 may be regarded as a nomograph, that is, a
graph that can be used to make computations by reference to a
series of scales instead of arithmetically. In this case the use of
Figure 2 would make it unnecessary to calculate arithmetically
the amounts that consumers would be prepared to spend on the
commodity at each of the possible prices.
For example, it was assumed in Table 1 that if the price of
chopped meat were thirty cents per pound the customers would
buy 240 pounds per day from the obliging butcher. In Figure 2
a dotted line is drawn perpendicularly from the point on the ab-
scissa scale representing 240 pounds to a corresponding point on
the thirty-cent price radial. Another horizontal guide line is
drawn from this point to the ordinate scale representing total con
sumer expenditures. In this case the horizontal guide line cuts
the total expenditure scale at a point representing a total expendi-
ture of $72. Thus, by drawing two guide lines, with the price
radial as a turning point, the computation of the total amount that
would be spent (i.e., 240 X $-30 = $72) is accomplished graphi-
cally.
In like manner a vertical guide line drawn from 190 on the
abscissa to the forty-cent price radial and another horizontal guide
line drawn from that point to the ordinate scale indicate that if
the consumers would buy 190 pounds of chopped meat at forty
cents per pound, their total expenditure for that purpose would
be approximately $76. In the same way the total amount that
would be spent by the consumers for the purchase of chopped
meat if the price were fifty cents, sixty cents, and so on upward
can be determined graphically. Each total is represented by a
point plotted on the corresponding price radial.
To complete the graphic picture of the demand situation, all
that is necessary is to draw in a smoothed curve connecting the
various plotted points on the various price radials. This curve
may be called a total expenditures curve, and is labeled TE in
Figure 2. As will be seen subsequently, it also may be looked
upon as presenting the total sales revenue picture for the supplier
of the commodity in question and, in later figures, will be identi-
fied by the symbol TR.
The total expenditures curve starts at the origin and rises to the
right, at first rather steeply and then more and more gradually,
until it reaches a maximum value and thereafter it declines. In
10 DEMAND
this example the maximum point on the total expenditures curve
is reached at a point representing an estimated total expenditure
of about $78 for the purchase of about 200 pounds of chopped
meat at a price of thirty-nine cents per pound. (See point A
on the graph.) For any higher price (represented by a more
steeply sloped price radial), the price radial would cut the total
expenditures curve at a point where it was still rising, so that a
lowering of price would result in a further increase in total ex-
penditures. For any price lower than thirty-nine cents, the price
radial would cut the total expenditures curve at a point where it
was declining, indicating that a further lowering of price would
reduce the total amount spent by the consumers, although they
would purchase a larger quantity.
So long as the total expenditures curve is rising, the demand is
responsive. If the total expenditures curve is declining, the indi-
cation is that demand is unresponsive over the corresponding
range of prices (represented by the price radials). The maximum
point on the total expenditures curve indicates the price-quantity
combination for which the responsiveness of demand has a value
of unity.
Demand as affected by changes in income and other changes
occurring over a period of time
Over a period of time there may be substantial changes in the
quantities of a given commodity that could be sold at various pos-
sible prices. For example, a change in tastes might increase or
decrease the quantity of cigarettes, food, or other consumers' goods
that people would be willing to buy at given prices. Or changes
in the prices of other commodities that are substitutes for the one
immediately under consideration may react upon the demand for
it. Thus, if the price of pork is low in comparison with the price
of beef, less beef will be bought at a given price than if the price
of pork were also high. Changes in income also affect the willing-
ness and ability of people to buy, and so affect the demands for all
kinds of goods. This is true not only of increases or decreases in
the incomes of individuals, but also of changes in the total income
received by the people in the community or nation occurring in
the course of the business cycle.
Such changes in the entire pattern or structure of demand are
referred to as changes in demand or shifts in demand, and should
DEMAND 11
be thought of as entirely distinct from the responsiveness of de-
mand, which refers to the willingness of the consumers to buy
more or less of a given commodity if its price were lower or higher,
other things being equal. From a practical standpoint, changes or
shifts in demand, occurring as a consequence of changes in the
prices of other commodities or in general economic conditions, or
in the structure of people's tastes, are often of greater importance
for businessmen than is the responsiveness of demand at a moment
of time. Nevertheless, estimates of the responsiveness of demand
may play a very considerable role in the formulation of price and
production policies of business firms, as will be seen in the later
discussion of price formation.
In Figure 3, two total expenditures curves have been drawn in,
one labeled TE l and the other TE 2 . A comparison of these two
curves will indicate that at each of the prices represented by the
various price radials, the number of units that could be sold under
the conditions represented by TE 2 would exceed the number that
could be sold under the conditions represented by TE r Thus,
TE 2 as compared with TE l may be taken as representing an in-
crease in demand, or a positive shift in demand, if TE l be regarded
as representing the original demand conditions. Or, if TE 2 be
taken as representing the original demand conditions, then TE l
may be regarded as illustrating a decrease in demand or a negative
shift in demand.
Estimates of Demand as a Basis for Producer's Calculations
The businessman, whether he is a retailer, a manufacturer, or a
producer of ultimate raw materials, has an obvious interest in the
demand for the product, because there is little gain to be made by
piling up stocks of unsalable goods. At the same time, it is fre-
quently difficult to determine, in advance, just how much the cus-
tomers would be willing to buy at any given price, particularly if
economic conditions are changing.
Many different methods are utilized by business firms in an
effort to ascertain consumer attitudes and preferences. These
methods include opinion polls, market research studies on a local,
regional, or national basis, studies of past experience with varia-
tions in prices for similar products, and various other techniques
for forecasting the prospective level of business activity and in-
12
DEMAND
come. On the basis of such information as is available, supple-
mented by his own experience or "hunches," the businessman
must make some sort of forecast of the demand for his own prod-
uct to serve as a guide in formulating production plans, purchas-
ing materials and supplies, hiring labor, and setting or revising the
price of the product to be turned out.
200
> 160
2 120
ui
g
80
40
40
80
120 160
UNITS
200
240
280
FIGURE 3. CHANCE IN TOTAL EXPENDITURES CURVE, REFLECTING CHANGE IN
DEMAND
A represents increase in total amount that would be spent if price remained
unchanged at $.50; B, increase in total amount that would be spent if price
were raised and quantity sold were held the same; C, increase in quantity
that could be sold if price remained unchanged at $.50.
Sometimes the sales organization for the firm will prepare two
forecasts of demand, one representing the most optimistic and the
other the most pessimistic estimates that can reasonably be made
in the light of the information available at the time the forecasts
are made. The two total expenditures curves, TEi and TE 2 , in
Figure 3 might be taken to represent the pessimistic and optimis-
tic forecasts of expected consumer expenditures and purchases at
various possible prices. Plans might then be made on the assump-
tion that actual consumer purchases and expenditures at the vari-
ous possible prices would fall somewhere between these limits.
It should be noted that from the standpoint of the business firm
the consumers' total expenditures curve for the product offered by
DEMAND 13
the firm constitutes its own expected total sales revenue curve.
It represents the best estimate that can be made of the quantities
of the firm's product that the customers would take at various pos-
sible prices, and the corresponding amounts of total revenue that
could be expected to accrue to the firm from the sale of the prod-
uct at any price that might be chosen. In discussing the pricing
and production policy of the firm, the term total sales revenue will
be used to indicate that consumer demand is being considered
from the business firm's point of view. Thus, the total expenditures
curves of Figure 3, TE and TE 2 , may also be regarded as estimated
total sales revenue curves, and in subsequent figures such curves
will be identified by the symbol TR.
On the basis of its forecast of the consumers' demand for its own
product, the management of the firm must decide what volume of
output would be most advantageous to produce and what price
would be the "best" to choose. If a low price were chosen, it
would probably be possible to sell a larger quantity of product
than if a higher price were set, and the total sales revenue might
be greater at the lower price. Whether a high price and a low
volume of sales would be better from a profit standpoint than a
lower price and a larger volume depends in part upon the respon-
siveness of demand (as reflected in estimated total sales revenue)
and in part upon the costs of producing the product.
Presumably the firm would not sell at a loss if that could be
avoided. Presumably, also, some particular combination of price
and sales volume would afford the largest possible prospective
profit under current demand and cost conditions. The formula-
tion of production and pricing policy therefore involves a consid-
eration of both the estimated demand for the product and the cost
structure of the firm itself. The cost aspect of the problem will be
dealt with in the following chapter.
Limitations on the producer's freedom to set prices
The initiative in setting the price or prices at which goods are
sold lies with the seller (the merchant or manufacturer) in the great
majority of cases. But the range within which the price may be
set is often narrowly limited by a variety of factors affecting the
demand for the product, and therefore the expected total sales
revenue curve for the firm. In some instances the merchant or
the manufacturer has virtually no choice at all, but finds that the
14 DEMAND
price is determined by circumstances entirely beyond his own con-
trol.
Take, for example, a retailer who is selling a popular brand of
women's hosiery. It is common for the manufacturers of such
hosiery to stipulate the retail price at which the brand may be sold,
and to utilize the provisions of state and federal Fair Trade laws
to prevent deviations from the specified price. In that event, the
retailer's volume of sales will depend entirely on the willingness
of consumers to buy from him at the |ri^I^ed^price.rat.her jtfran.
fromother retailers offering the same merchandise at the same
price. *
Or suppose that the retailer, in order to achieve some freedom
in pricing, should elect to purchase an equivalent quality of hosiery
and sell it under his own brand name, as many large department
store and mail order organizations have done. Even so, it m^y
prove inexpedient to establish a price substantially higher or lower
than the prices fixed for widely advertised and popular brands. If
the price set by the retailer for his own brand were higher, many
customers would prefer to buy the widely advertised brands. As
a consequence, his volume of sales and total sales revenue would
be limited. If his price were set substantially lower, consumers
who take price as an indicator of quality would be hesitant to buy,
at least until experience had convinced them that the quality was
satisfactory. Moreover, a change in the prices at which other
brands were offered would react upon his own volume of sales at
any given price. One purpose of brand advertising is, of course,
to build up consumer acceptance of, and loyalty to, familiar brands,
and to reduce the inclination to shift from brand to brand in re-
sponse to moderate changes in the relative prices of different
brands. The effect of advertising, if successful, is to raise the total
sales revenue curve and make it less subject to adverse changes if
the prices of other brands are altered.
In general, the more closely the brands or kinds of goods offered
by different firms resemble one another in use, appearance, and
quality, from the standpoint of consumers, and hence are good
substitutes for one another, the narrower is the range within which
any particular seller is free to set his own price. The extreme
limiting case is presented by the comparatively rare situation in
which a large number of sellers offer identical goods to the same
body of customers, and there are no other considerations, such as
DEMAND 15
convenience, differences in credit terms, or variations in the qual-
ity of services provided, that would cause some customers to prefer
to buy from one seller rather than another. In such a situation,
any significant difference in price would lead all the customers to
attempt to buy from the seller who offered the goods at the lowest
price, and to purchase nothing from those who asked higher prices.
No significant difference in price could persist for any length of
time; all of the sellers would be forced to sell at the same price if
they wished to sell at all. Such a situation is commonly described
as a case of pure competition. There are, however, few examples
of pure competition in real economic life, although in some
branches of agriculture conditions approaching those of pure com-
petition may be found.
At the opposite extreme is the almost equally rare situation of
the seller for whose product there are no acceptable substitutes.
In such a case, prospective buyers would have no alternative source
of supply; if they wished to purchase the commodity in question,
they would of necessity deal with the single supplier. Under such
circumstances the seller might have a fairly wide range of choice
in setting the price. But there are comparatively few commodities
for which some sort of substitute does not exist. And even where
there are no substitutes capable of serving the same purposes, con-
sumers still have limits beyond which they are unwilling to go in
purchasing particular kinds of goods. Thus, an attempt to exact
a very high price would tend to reduce total sales revenue for the
seller. The case in which there are no close substitutes for a par-
ticular firm's product is commonly referred to as the case of pure
monopoly.
In technical economic literature, an elaborate classification of
"market forms' 1 has been developed to aid in identifying and
analyzing the principal types of market situations that are encoun-
tered in real economic life. The most common situations, how-
ever, are those described by the terms oligopoly and monopolistic
competition.
The word oligopoly literally means "a few sellers." It is used
to describe the situation in which the number of rival firms offer-
ing the same type of goods to the same group of buyers is so small
that each firm has to take careful account of the reactions of its
rivals to any change in its own price and production policy. The
term is commonly employed in analyzing a situation where the
16 DEMAND
rival sellers are few in number, whether the products turned out
are identical, or similar to each other but differentiated to some
degree by branding, advertising, and other methods of product
identification. The steel industry may be taken as an example of
an industry in which a few major producers are turning out vir-
tually standardized products. The automobile industry is an
example of an industry in which a few major producers are turn-
ing out clearly differentiated, but still closely substitutable, prod-
ucts.
The term monopolistic competition is usually applied to the
situation in which many firms are offering closely related, but not
identical, products to the same group of buyers. The term suggests
that there is an intermixture of some elements of competition
(because of the relative ease of substitution of products on the part
of the buyers) with some elements of monopoly (ability to pursue
a somewhat independent pricing policy within limits set by con-
sumer loyalties). Many kinds of consumers' goods are produced
and sold under conditions of monopolistic competition, familiar
examples being packaged foods, drugs, cosmetics, and other
branded and widely advertised wares.
In formulating price and production policies, the business firm
is inevitably concerned with the prospective demand for the prod-
uct to be turned out. It is with this phase of the producer's prob-
lem that this chapter has been concerned. But before a decision
can be reached as to the price to be set and the production sched-
ule to be established, it is necessary also to consider what costs
would be entailed in production. Only with that information
also at hand would it be possible to determine what price and out-
put would probably be most profitable. The next chapter will
turn to the other side of the picture and investigate the problems
of supply and costs of production, as they present themselves to
the businessman or enterpriser.
Chapter 2
SUPPLY AND COSTS OF PRODUCTION
The Meaning of Supply
The meaning of the term supply, as commonly used in economic
analysis, is correlative with that of the term demand. Supply
stands for the quantities of a given product that an individual
seller or group of sellers would be prepared to offer for sale within
a given period of time at each of several possible prices. A supply
schedule for a given commodity may therefore be thought of as
expressing a functional relationship between possible prices for a
commodity and the rates at which that commodity would be
offered for sale at a given time, other things being equal.
In comparatively few cases, however, is it possible to think of the
supply of a commodity as being determined independently, or
without direct reference to the prevailing conditions of demand.
In the great majority of cases, apart from the comparatively rare
examples of pure competition, it is not possible to determine just
what quantities of a given product would be offered for sale by
each of several different producers at different possible prices by
referring solely to the costs that would be incurred in production
by each of the producers. Under conditions of monopolistic com-
petition, for example, each of the rival producers has a group of
customers who are more or less firmly attached to his own product.
And although some of them would shift to other suppliers if there
were a significant difference in price as between substitute brands,
each supplier has some range of freedom in picking his own price.
The actual choice of a price will depend on a simultaneous con-
sideration of the estimated demand of the customers for the par-
17
18 SUPPLY AND COSTS OF PRODUCTION
ticular brand in question and of the prospective costs of turning
out the product.
Having selected a price, each firm will ordinarily be prepared to
deliver whatever quantity of goods its customers choose to purchase
at that price. On the basis of actual sales experience, a given firm
may decide that it would be advantageous to raise the price, even
though that might reduce sales somewhat. Or it may appear ex-
pedient to reduce the price in an effort to increase the sales volume
and total sales revenue of the firm. But there is, literally, no
specific quantity that the firm would be prepared to offer, at a
given time or at a given price, without reference to the demand
for its own product. That is what is meant when it is said that the
supply offered by a particular firm is not independently deter-
mined. Such a firm, under conditions of monopolistic competi-
tion, has something of a market of its own and possesses some
degree of freedom in formulating its own price and production
policy. To be sure, the "markets" of the various sellers may over-
lap a great deal, and the possibilities of substitution may be so
numerous as to impose strict limits on the pricing policy of each
firm; but still the initiative in pricing lies with the seller in each
case, and therefore each must necessarily take the demand condi-
tions into account.
Herein lies the chief difference between the usual demand situ-
ation and the usual supply situation. Only occasionally is the
buyer of consumers' goods in position to take the initiative in
naming the price. Usually the price is set by conditions beyond
the control of the individual buyer, and his decision, therefore,
is confined to determining how much of a commodity he would be
willing to take at any given price. If the price were high, he
might take nothing; if it were low, he might purchase a consid-
erable quantity; but whatever he may decide to do as an individual
will ordinarily have a negligible influence on the prevailing price.
Thus for the individual buyer and for buyers as a whole, the de-
mand for the product is not directly affected by, or does not react
to, the conditions of supply.
Only under conditions of pure competition, with numerous sell-
ers offering identical goods to the same group of buyers, is the
individual seller powerless to influence the price of the product
by his own actions. Only under such conditions, therefore, is the
SUPPLY AND COSTS OF PRODUCTION 19
action of the individual supplier limited to determining how much
of the product it would be to his advantage to offer for sale at a
price set by forces beyond his own control. And only under such
conditions is it feasible to think of either the supply by the indi-
vidual firm, or the supply offered by the entire group of sellers, as
being independently determined. Only under conditions of pure
competition is there a group of sellers facing a group of buyers
under circumstances such that no individual in either group can,
by his own action, influence the prevailing level of prices. Only
under such circumstances is the level of market price determined
impersonally by the interplay of market forces.
But, as was noted in the preceding chapter, there are few in-
stances, in real economic life, of markets in which the conditions
of pure competition are fully realized. In reality, then, the dis-
cussion of supply is largely concerned with an analysis of the role
which a consideration of production costs will ordinarily play in
the formulation of price and production policies of individual
firms, whatever the market conditions under which the finished
product may be sold.
Costs of Production
The term cost is used in various ways in economic literature.
For some purposes it is significant to think of costs as representing
the efforts and sacrifices entailed in producing goods that people
want. This sense of the word is most appropriate when people
are engaged in providing goods and services for their own use, or
when the living standards of people in different communities or
countries are being compared.
Suppose that a family decides to raise vegetables or fruit for its
own use. Then the cost of producing the crop includes more than
the amounts spent for seed, fertilizer, and insecticides. It includes
also the effort expended by the members of the household in pre-
paring the ground, planting, cultivating, and harvesting the crop,
and preserving that crop for future use. To an enthusiastic gar-
dener, the effort involved might seem to be nothing but healthful
recreation, whereas to another it might appear to be unadulterated
drudgery. Obviously, the cost in terms of effort or sacrifice might
be quite unequal in the two instances, even though the time spent
20 SUPPLY AND COSTS OF PRODUCTION
and the crops produced were identical. And in neither case
would the cost of a can of peas be the same as the cost of an equiv-
alent can of peas to the person who preferred to do his gardening
at the shelves of the chain store.
Actually, there is no satisfactory way of measuring the "real"
costs of production in terms of the efforts and sacrifices incurred
by different people in producing the same kind of goods. Such a
conception of cost has little significance in explaining the proc-
esses of price determination in a modern economy.
Another sense in which the term cost is often used is that of
opportunity cost or alternative cost. The opportunity cost of pro-
ducing one commodity is the necessity for giving up something else
in order to produce it. Suppose that the amateur gardener is also
an enthusiastic fisherman. If he chooses to spend his leisure time
in fishing, he cannot raise a garden. In that event, the oppor-
tunity cost of the fish that he catches is the garden produce that
he otherwise could raise. Here again difficulties arise in any effort
to measure opportunity costs. Nevertheless, the concept helps to
cast light on many problems of choice that arise in the course of
economic life. Some of these applications will become apparent at
a later stage in the analysis.
Money Costs of Production
For the business firm or enterprise, the most important concept
of cost is money cost of production, that is, the money outlays (or
their equivalent) that are necessary in order to produce goods
destined for sale in the market. It is in this sense that the term
cost will be used in this and in ensuing chapters, unless there is a
clear indication to the contrary.
The money costs of production, from the standpoint of the indi-
vidual producing firm, include all the outlays that must be made
in order to carry through the productive activities in which the
firm is engaged. If the firm is engaged in retailing, its money costs
include outlays for the purchase of goods, for the employment of
clerical and sales staffs, for the conduct of store operations, and for
the myriad other processes connected with retail distribution. If
the firm is engaged in manufacturing, the money costs include
all the outlays that must be made for raw materials or component
parts, fuel, labor and supervision, the use of plant buildings and
SUPPLY AND COSTS OF PRODUCTION 21
machinery, and the sale of the finished product to jobbers or
wholesalers or to whatever group of buyers comprises the imme-
diate market for the product.
At this point, however, certain difficulties arise. Some of the
outlays that must be incurred in order to carry on production de-
pend more or less directly on the amount of output to be turned
out each day, or each week, or each month, whereas others do not.
More raw materials and more labor, for example, might be re-
quired to turn out a large output than would be needed for a small
output. A decision to expand production schedules would entail
greater expenditures for raw materials and for certain types of
labor. But within limits, an expansion of output would require
no increase in the amount of machinery in place, no expansion of
the plant building, no increase in the number of foremen or office
staff, and perhaps no increase in the sales force. Conversely, a
reduction in output would reduce the total outlays necessary for
raw materials and for certain types of labor, but might not permit
a reduction in supervisory or office staff, or the disposal of a part
of the plant and machinery. It thus appears that certain costs of
production tend to increase or decrease in total amount as output
is increased or decreased, whereas other costs of production tend to
vary only slightly in total amount as output is changed within
comparatively wide limits.
This difference in the behavior of different types of production
costs is of very great significance for the individual business firm.
Its recognition leads to a broad distinction between two categories
of cost: (1) variable costs and (2) fixed costs of production.
Variable costs and fixed costs
Variable costs of production include all elements in cost that
tend to increase or decrease in total amount as output is increased
or decreased, within the limits of existing plant capacity. Fixed
costs of production include all elements of cost that tend to remain
constant in total amount as output is increased or decreased, within
the limits of existing plant capacity.
It is difficult in practice to draw a sharp line of distinction be-
tween these two broad types of cost, and many items required for
production are partly variable and partly fixed. Although labor
costs may be thought of as largely variable, the employer might be
reluctant to lay off certain types of labor in a period of reduced
22 SUPPLY AND COSTS OF PRODUCTION
production because of possible difficulties in getting the laborers
back when production schedules are stepped up again at some later
date. Or if a machine breaks down, the wages of the machine
operator are temporarily a fixed cost while the machine is being
put back in running shape. Moreover, there are instances in
which just one man with a certain type of skill or ability is needed,
and there is little chance of partially "firing" him. Half of a sales
manager, for example, might be less desirable than no sales man-
ager at all.
By the same token, costs that are ' 'fixed" at a certain time may
become "variable" over a period of time. If the demand for the
product is increasing, more and more output may be produced in
the already existing plant. But a point may be reached where the
existing plant facilities are being crowded to the limit. Any fur-
ther expansion of production would require the purchase and in-
stallation of more machinery, the enlargement of plant buildings,
the employment of a larger administrative and supervisory staff,
the expansion of the sales organization, and so on. At such a
time, the "fixed" costs also increase in total amount and hence
become variable with output, at least while plans for expansion
are being considered and executed.
Although the distinction between fixed and variable costs may
sometimes be blurred, it is still important to recognize the fact that
at any given time some elements of cost are fixed in total amount,
and some are variable, as output is increased or decreased. This
fact is of major significance for the analysis of the processes of price
determination.
"Out-of-pocket" versus calculated costs
One other point must be kept in mind in discussing the money
costs of production for the individual firm. That point is that
some of the costs of current production involve immediate cash
outlays or "out-of-pocket" expenditures, whereas others are merely
calculated money costs that do not necessarily involve any imme-
diate cash expenditures. Much of the physical plant and ma-
chinery employed in production is durable and, if properly
maintained, may be utilized for many years. The plant building
may last for half a century before it has to be replaced, and much
of the machinery likewise may have a service life of ten, twenty,
or thirty years. The cost of using this durable plant and equip-
SUPPLY AND COSTS OF PRODUCTION 2$
ment in any one year, or in any one month or week, will be only
a small fraction of the total investment involved.
This means that the money cost of using the plant facilities for
current production will often not be an actual money outlay, but
merely a calculated figure to account for the wear and tear or
depreciation of the plant facilities in the process of production*
together with some sort of a return on the investment tied up in
the existing productive facilities.
The calculation of an adequate provision for the use of the plant
and equipment is the task of the accountant, involving estimates of
expected service life, the possibility of obsolescence, and other
considerations. Failure to make adequate provision for deprecia-
tion would understate the current costs of production and might
involve the enterprise in ultimate losses. An excessive allowance
for depreciation, and for similar calculated elements in cost, would
overstate current costs of production and understate the profits on
current operations. Such calculated costs for the most part are not
substantially altered by changes in the current rate of production*
and hence are normally included in "fixed" costs.
30.000
5,000 10,000 15,000 20,000 25.000 30,000 55,000 40,000
OUTPUT
FIGURE 4. TOTAL COST AND TOTAL VARIABLE COST CURVES
A represents the assumed fixed cost of $5,000.
24
SUPPLY AND COSTS OF PRODUCTION
Graphic Analysis of Costs
With the foregoing distinction between variable and fixed costs
in mind, it is possible to construct a graphic picture to show how
changes in output would affect the total costs of production for the
individual business firm. Such a graphic analysis is presented in
Figure 4.
In Figure 4, the construction is much the same as in Figures 2
and 3 in Chapter 1, except that in this figure total costs are plotted
against total output, instead of total consumer expenditures or
total sales revenue against quantity sold. The quantity of output
is measured on a scale on the base line (abscissa), and the total cost
of production for each amount of output is plotted against the
ordinate scale. The total cost of production is broken down into
two major components: (1) total variable cost and (2) total fixed
cost. It is assumed that the figures presented represent a month's
operations. The data used in the construction of Figure 4 are set
forth in Table 2.
TABLE 2
TOTAL VARIABLE, TOTAL FIXED, AND TOTAL COSTS,
AVERAGE VARIABLE AND AVERAGE COSTS
(Data for Figures 4 and 5)
Output
Total Variable
Cost (TVC)
Total Fixed
Cost (TC)
Total
Cost (TC)
Average
Variable
Cost (AVC)
Average
Cost (AC)
2,500
$3,000
$5,000
$8,000
$1.20
$3.20
5,000
4,100
5,000
9,100
.82
1.82
7,500
5,400
5,000
10,400
.72
1.39
10,000
7,000
5,000
12,000
.70
1.20
12,500
8,750
5,000
13,750
.70
1.10
15,000
10,500
5,000
15,500
.70
1.03
17,500
12,250
5,000
17,250
.70
.99
20,000
14,000
5,000
19,000
.70
.95
22,500
15,750
5,000
20,750
.70
.93
25,000
18,000
5,000
23,000
.72
.92
27,500
21,200
5,000
26,200
.77
.95
30,000
26,400
5,000
31,400
.88
1.05
Look first at the curve in Figure 4 that is labeled total variable
cost (TVC). It originates at the zero point or origin and slopes
SUPPLY AND COSTS OF PRODUCTION 25
upward to the right, indicating that increased output would in-
volve increased total outlays for labor, raw materials, power, and
the other variable factors of production. Note also that at the
lower end, and also at the upper end, the curve bends rather
sharply, but that the mid-section is virtually straight.
The curvature at the lower end reflects the fact that with a given
size of plant it is difficult to maintain efficiency at very low levels
of output, inasmuch as essential machines have to be manned
whether they are working continuously or not. The curvature at
the upper end of the graph reflects the fact that when the plant is
being operated under "forced draft" it is also difficult to maintain
full efficiency. When all machines are being operated continu-
ously it is difficult to make repairs or to carry on normal main-
tenance activities, and to see that the mechanical equipment of the
plant is "balanced up" so that bottlenecks do not develop in cer-
tain processes, thus impairing the flow of work through the plant
as a whole. If a further expansion of output is attempted by put-
ting the plant on a multi-shift basis where one-shift or two-shift
operation is normal, it is also often difficult to maintain full pro-
duction schedules on the third shift. Under such circumstances
the total variable cost of production may rise more rapidly than
output as production schedules are pushed to high levels. In fact,
one may say that the "capacity" of a plant is represented by the
level of output at which the total variable cost of production be-
gins to rise sharply as output is increased.
But how about total fixed cost of production? By definition,
fixed costs are elements in total cost that do not vary significantly
as output is varied. Suppose that such elements in cost (deprecia-
tion, minimum return on investment, supervision, and general
administrative and sales expenses) amount to $5,000 per month.
Even if the plant were shut down temporarily, these expenses
would continue without significant change. This fact can be
shown on the graph by plotting a point on the ordinate scale at
$5,000, which indicates that even though output were zero, $5,000
in expenses would still be incurred. (See point A on the graph.)
From this point another curve is drawn in, labeled total cost (TG),
each point on this curve being plotted $5,000 higher than the cor-
responding point on the total variable cost curve (TVC). This
simply represents the fact that the total cost of producing any
specified quantity of product will be equal to the sum of the total
26 SUPPLY AND COSTS OF PRODUCTION
variable cost of producing that output, plus the total fixed cost,
namely $5,000. Total cost is equal to total variable cost plus total
fixed cost.
This method of showing the effects of changes in output upon
total costs of production is widely used in industry as a guide to
managerial decisions. It represents the first step in the construc-
tion of a break-even chart, a device first introduced about forty
years ago by Dr. Walter Rautenstrauch as an industrial manage-
ment technique. 1
Graphic determination of average costs from the chart
The preceding section has shown how total costs of production
tend to vary as output is increased or decreased. But often the
business management is interested in figuring the average cost of
production, that is, how much it would cos? per unit of product
turned out, if the plant were operating at various levels of pro-
duction.
Obviously, the average cost of production is equal to the total
cost of production divided by the number of units of product
turned out. However, it is possible to estimate the average cost
of production (and also the average variable cost) directly from the
graph, without any arithmetical calculations. Such estimates are
made possible by including in the graph itself a series of cost
radials, which are constructed in precisely the same way as were
the price radials of Figures 2 and 3 in the preceding chapter.
Suppose that 20,000 units of product were being turned out. An
inspection of the chart indicates that the total cost of producing
20,000 units would be approximately $19,000, and that this point
on the total cost curve lies about halfway between the $.90 and the
$1.00 cost radials. The average cost of production might there-
fore be estimated at about ninety-five cents. Carrying through the
actual division gives the computed average cost as ninety-five cents
(19,000/20,000 = $.95).
The average variable cost of producing 20,000 units may be esti-
mated in the same way and with about the same degree of accuracy.
The total variable cost curve shows the total variable cost of pro-
ducing 20,000 units of product to be approximately $14,000.
That point on the curve lies directly on the $.70 cost radial.
i See page 48.
SUPPLY AND COSTS OF PRODUCTION
27
Hence the average variable cost may be estimated to be about
seventy cents. Although the calculations of average and average
variable cost could be as easily performed by mental arithmetic for
the examples given above, the graphic method of estimation is
convenient if a rough measure of such costs is desired for odd
quantities of output, such as 7,700 units, or 8,400 units, or 16,700
units.
It is interesting to calculate (or estimate) the average cost and
average variable cost of production for different levels of output,
particularly in the middle and upper ranges of output, and to plot
these figures in the form of an average cost graph, such as is pre-
sented in Figure 5. In this chart the abscissa scale again measures
quantity of output (per month), but the ordinate scale now repre-
sents average variable costs and average costs rather thajti total
variable and total costs.
300
250
3 200
- 150
o
o
100
.50
\
\
5.000 10.000 15.000 20.000 25.000 30.000 35.000
OUTPUT
FIGURE 5. AVERAGE VARIABLE COST AND AVERAGE COST CURVES
Note that the average variable cost drops as output is increased
from very low levels, remains comparatively low over a certain
28 SUPPLY AND COSTS OF PRODUCTION
range of output, and then rises sharply as output approaches plant
capacity. Average cost, however, continues to decline over a wider
range of output than does average variable cost, and bends upward
as capacity is approached, but not as sharply as does the average
variable cost curve. Note that the two curves in fact tend to ap-
proach each other as output is increased. This is true because the
total fixed cost ($5,000) does not change as output is increased.
Consequently, the average fixed cost tends to decrease as output is
increased. For example, if 10,000 units were being produced, the
average fixed cost would be fifty cents per unit, whereas if 20,000
units were being produced, the average fixed cost would be only
twenty-five cents.
The difference between average cost and average variable cost
represents average fixed cost, and as total fixed cost is "spread" over
more units, the difference becomes smaller and smaller; therefore,
the average cost curve and the average variable cost curve tend to
approach each other.
Inasmuch as average fixed costs do tend to become smaller as
output is increased, it is normally to the advantage of the firm to
operate at a high level of production. However, it may not be
possible to reach that level of operations, particularly in periods
when the demand for the product falls short of what was expected
at the time the plant was built and the level of "fixed" costs estab-
lished. It is possible to determine what price and volume of pro-
duction would be most advantageous to the firm only by consider-
ing both the current conditions of cost (as reflected in the total
cost curve) and the current conditions of demand (as reflected
in the expected total sales revenue curve). This analysis will be
carried forward in Chapter 4.
Before passing to the discussion of the formulation of pricing
and production policy, it is desirable to consider briefly how the
pattern of total cost would be affected by changes in certain of the
components of total cost. Specifically, how would the total cost of
production be affected by (1) an expansion of plant facilities, in-
volving an increase in total fixed costs, (2) an increase in the gen-
erally prevailing prices of raw materials or in wage rates, or (3) an
increase in raw-material prices or in wage rates that was a direct
result of an increase in output by the particular employing firm?
Each of these possible changes in conditions will be considered in
turn.
SUPPLY AND COSTS OF PRODUCTION
29
Increase in total fixed costs resulting from plant expansion
Suppose that the management of the firm were to decide to ex-
pand the plant facilities by adding a new building and installing
additional machinery and equipment. This expansion would in-
volve an added investment, increased provision for depreciation,
and other added costs of administration and supervision. Suppose
that these additional fixed costs amounted to $5,000 per month,
increasing the total fixed costs from $5,000 per month to $10,000.
35,000
30,000
25,000
g 20,000
z
is
8 15,000
I
10.000
5,000
?*
^
JO,
TVC 2
'
W 5,000 10.000 15,000 20,000 25,000 30,000 35,000 40,000
OUTPUT
FIGURE 6. CHANGES IN COSTS ACCOMPANYING CHANGE IN INVESTMENT
This would have the effect of pushing the origin of the total cost
curve upward from $5,000 to $10,000, and would also tend to raise
the total cost curve all along the line. But with the new plant
facilities it is probable that the labor force could be redeployed
and used more effectively, particularly at higher levels of produc-
tion. It is reasonable to suppose, therefore, that the total variable
cost of producing any given output would be altered somewhat,
and that output could be carried to considerably higher levels
30
SUPPLY AND COSTS OF PRODUCTION
before total variable costs would tend to increase sharply. In
other words, the plant capacity would normally be greater than
before the expansion of plant was undertaken.
This situation is depicted numerically in Table 3 and graphically
in Figure 6, in which the first total variable cost curve, TVC ly is
the same as the total variable cost curve of Figure 4, and the total
cost curve, TC 19 is also the same as the total cost curve of Figure 4.
The second total variable cost curve, TVC 2 , reflects the change in
total variable costs attributable to the increase in plant facilities,
and the second total cost curve, TC 2 , takes account of the increase
in total fixed costs from $5,000 to $10,000 per month.
TABLE 3
CHANGES IN COSTS ACCOMPANYING INCREASE IN INVESTMENT
Output
Total Variable
Cost
Total Fixed
Cost
Total Cost
Average
Average
Cost
2,500
$2,500
$10,000
$12,500
$1.00
$5.00
5,000
3,900
10,000
13,900
.78
2.78
7,500
5,000
10,000
15,000
.67
2.00
10,000
6,100
10,000
16,100
.61
1.61
12,500
7,250
10,000
17,250
.58
1.38
15,000
8,500
10,000
18,500
.57
1.23
17,500
9,750
10,000
19,750
.56
1.13
20,000
11,000
10,000
21,000
.55
1.05
22,500
12,375
10,000
22,375
.55
.99
25,000
13,750
10,000
23,750
.55
.95
27,500
15,125
10,000
25,125
.55
.91
30,000
16,500
10,000
26,500
.55
.88
32,500
17,875
10,000
27,875
.55
.86
35,000
19,300
10,000
29,300
.55
.84
37,500
20,700
10,000
30,700
.55
.82
40,000
22,400
10,000
32,400
.56
.81
42,500
24,500
10,000
34,500
.58
.80
45,000
27,800
10,000
37,800
.62
.84
47,500
33,000
10,000
43,000
.69
.91
Note that the second total variable cost curve lies below the first,
particularly for the upper range of output, at which the smaller
plant would have been working near its capacity. Note also that
the second total cost curve, TC 2 , lies above the first total cost curve,
TCv for low and intermediate levels of output, but below TC t at
higher levels of output. If it were expected that the normal out-
SUPPLY AND COSTS OF PRODUCTION 31
put of the plant would fall in the intermediate range, the smaller
plant would be preferable, for the total cost of producing any
output in that range would be less with the smaller plant than
with the larger one. But for higher levels of output the larger
plant would have an increasing advantage over the smaller one.
In this range of output the total (and average) variable cost would
be less with the larger plant than with the smaller one, and this
would more than offset the greater total (and average) fixed cost of
production.
It is thus apparent that any decision as to the size of investment
to be made in fixed plant and equipment must be based on the
forecasts of the firm with respect to the probable demand for the
product and the volume of production that is likely to be called
for. If the demand for the product is incorrectly forecast, the firm
may find itself operating with a plant that is either too small or too
large to achieve the maximum gains from its operations.
Effects of increased raw-material prices or wage rates
Suppose, as the second case, that there is no change in plant
facilities or equipment, so that the total fixed cost remains the
same as in the original example, namely $5,000 per month. Raw-
material prices, however, have gone up, and wage rates for labor
likewise, the increase in each case amounting to about 10 per cent.
This situation is illustrated numerically in Table 4 and graphically
in Figure 7. In this case the total variable cost curve, labeled
TVC 2 , would rise more steeply than would the original total varia-
ble cost curve, labeled TVC V (TVC l is identical with the TVC
curve of Figure 4 and with the TVC l curve of Figure 6.) The
steeper slope of TVC 2 reflects the increased amounts payable for
raw materials and wages, which obviously will increase the total
variable cost of producing any given output in more or less direct
proportion. In other words, a general increase in raw-material
prices and in wage rates will tend to swing the total variable cost
curve upward, assuming that there is no change in the physical
efficiency with which the materials and labor are employed. By
the same token, the total cost curve, TC 2 , would exceed the new
total variable cost curve, TFC 2J at all points by $5,000, or the
amount of the total fixed cost. Thus TC 2 would also rise more
steeply throughout its length than would the original total cost
curve, TC r
32
SUPPLY AND COSTS OF PRODUCTION
3D.UUU
30.000
25,000
<
o 20,000
z
i-
o 15,000
1
10,000
K f\()f)
-
1
TC 2
TC,
//I
TVC 2
TVC,
//
7J
^
/'''
f
^
^
/s''
A
x'' '
* Q
A
"0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40.000
OUTPUT
FIGURE 7. CHANGES IN COST RESULTING FROM INCREASES IN FACTOR PRICES
Effects on total costs when factor prices react to the volume
of employment by the particular firm
Another situation occasionally arises in which an employer finds
that an expansion in the output of the firm (without any change
in plant facilities) would involve the payment of higher prices to
obtain additional raw materials, or higher wages to attract addi-
tional labor, needed for the production of the additional output.
Suppose that the plant had already been operating two shifts a day,
and it is proposed to add a third shift to step up production. In
recent years it has been a common requirement of union contracts
that workers employed on a third shift be paid a premium rate.
Time-and-one-half rates are also commonly stipulated for overtime
work beyond the basic day or the basic week. Also, attempts to
recruit additional workers often involve the offering of higher
wages to induce them to commute or move from adjacent com-
munities, or to hire them away from other employers. Under such
circumstances as these, an expansion of output may involve con-
siderably more than proportionate increases in total costs. Such
increases differ from those discussed in the preceding section in
SUPPLY AND COSTS OF PRODUCTION
33
that they arise only if output is expanded, and they would not
occur if the increase in output were not attempted.
This situation is illustrated graphically in Figure 8, in which
TVC l and TC l are the same as the corresponding curves in Figures
4 and 6. The second set of total variable cost and total cost curves,
TABLE 4
CHANGES IN COSTS ACCOMPANYING CHANGES IN FACTOR PRICES
A. Data for Figure?:
Output
Total Variable
Cost Before
Change (TVCi)
Total Variable
Cost After
Change (7TC 2 )
Total Cost
After
Change (TC t )
2,500
$3,000
$3,300
$8,300
5,000
4,100
4,510
9,510
7,500
5,400
5,940
10,940
10,000
7,000
7,700
12,700
12,500
8,750
9,625
14,625
15,000
10,500
11,550
16,550
17,500
12,250 '
13,475
18,475
20,000
14,000
15,400
20,400
22,500
15,900
17,490
22,490
25,000
18,000
19,800
24,800
27,500
21,200
23,320
28,320
30,000
26,400
29,040
34,040
32,500
35,000
B. Data for Figure 8 TVCz is the same as TVC\ above except for the following range of
output:
22,500
$15,900
$20,900
25,000
18,800
23,800
27,500
24,000
29,000
30,000
29,000
34,000
TVC 2 and TG 2 , represent the situation in which raw-material costs
and wage rates are bid up progressively as output is increased be-
yond a certain critical level. The two sets of curves coincide for
low and intermediate ranges of output, but TVC 2 and TC 2 rise
above TVC 1 and TCj respectively beyond a point which may be
thought of as representing the change from a two-shift to a three-
shift basis. Inasmuch as total fixed costs are assumed to be un-
34
SUPPLY AND COSTS OF PRODUCTION
changed as output is increased, the spread or difference between
the total variable cost curve, TVC 2 , and the total cost curve, TC 2 ,
remains the same throughout, namely $5,000.
9O.UUU
30.000
25.000
CO
20,000
z
g 15,000
H 10,000
5,000
c
-
M
TC 2
TC,
-
fii
TVC 2
TVCi
y
"i
X
/-
X
X
X
X
X
X
,x
\ 5^000 10,000 15,000 20,000 25,000 30,000 35,000 40,000
OUTPUT
FIGURE 8. CHANGES IN COSTS DUE TO INCREASE IN PRODUCTION SCHEDULES
Composite situations
It is unlikely that in reality any one of the changes in cost con-
ditions just discussed would occur in isolation, that is, unaccom-
panied by changes of the other types. Thus, a more realistic
picture would be one that showed some change in aggregate
fixed cost, combined with some changes in variable costs, as output
was either increased or decreased. Such changes would be reflected
in some raising of the total cost curve as output was increased,
together with some reduction of its slope over certain ranges of
output (reflecting gains in efficiency due to increased plant invest-
ment) and some steepening of its slope over the higher ranges (re-
flecting the bidding up of raw-material prices and wage rates
needed to turn out the additional output). Just how important
each of these possible effects upon total cost might be would be
SUPPLY AND COSTS OF PRODUCTION 35
difficult to determine in advance; thus, some element of guesswork
attaches to forecasts of future costs of production, just as it attaches
to forecasts of demand for the product.
Other Problems of Cost: Multiple Products, Joint Products,
and Cost Allocations
Thus far it has been assumed that the business firm is engaged
in producing a single product, so that all expenses incurred can
appropriately be allocated to that one kind of product. Fre-
quently, however, the firm is engaged in producing several, or per-
haps hundreds of, different products. The same administrative
staff, the same factory building, and perhaps much of the same
machinery and labor force may be employed in producing several
different products. How are the total fixed costs of production to
be allocated to the various items turned out in such a plant? How
are the raw-material costs and the labor costs to be apportioned?
How are sales expenses to be distributed?
Many different techniques have been employed by cost account-
ants and others in trying to answer questions such as these. One
common method of distributing overhead expense is to make an
allocation based on the relative values or sales revenues derived
from the various products. To a certain extent it is possible to
determine what raw materials and what percentage of labor time
are devoted to different lines of product, and to make an allocation
of such expenses on that basis. Nevertheless, at best, a considerable
element of judgment and arbitrary allocation is unavoidable. The
primary intent, in any case, is to obtain some sort of an estimate
of total costs to provide a basis for determining the price and pro-
duction policy to be applied to each of the different products
turned out.
A special case arises occasionally in which the production of one
commodity involves by-products or joint products. In many cop-
per mines, for example, traces of silver occur along with the copper
ore. Thus it happens that silver is frequently recovered as a by-
product in the process of producing metallic copper, the quantity
of silver produced being determined by the quantity of copper that
is produced. If copper production be regarded as the primary
activity of the firm, and if the processing costs be allocated to the
copper that is produced, then the costs of silver production are
36 SUPPLY AND COSTS OF PRODUCTION
negligible, except for such additional processes as may be necessary
to isolate the silver. But should all the costs of processing be
allocated to the copper produced? Here again there is room for
considerable difference of opinion and practice, resulting in corre-
sponding differences, from one firm to another, in the estimated
total costs of producing each of the joint products.
In the public utility field the problem of joint cost is frequently
encountered. It is necessary to have electric power plants with
sufficient generating capacity to meet the peak load of demand for
service, which may occur during certain hours of the day and early
evening. During the night, however, industrial, commercial, and
residential lighting and appliance loads decline, and part of the
generating facilities are not needed. Yet the cost of the fuel
needed to keep the plant running to capacity is very small, and
hence the direct or variable cost of providing additional electric
energy in off-peak hours may be a fraction of a cent per kilowatt-
hour. The utility plant is in position to provide a large quantity
of off-peak energy as a joint product to the energy provided at the
peak. This situation is sometimes described as a case of time-
jointness.
To build up off-peak loads, many utility companies have offered
separately metered energy to residential customers and others for
water-heating and other power-consuming uses at very much re-
duced rates, on condition that timing clocks or other control de-
vices be installed to prevent the use of power for such purposes
except during off-peak hours. Here again it is apparent that the
calculation of the costs of providing off-peak service as contrasted
with on-peak service poses many interesting and often perplexing
problems. These problems carry over into the determination of
the pricing policy to be followed in dealing with different com-
modities or services that are joint in character.
Chapter 3
PRICE FORMATION
Methods of Pricing
Impersonally determined market prices
In the past, the processes of price determination have often been
treated chiefly in terms of market pricing under conditions now
described by the term pure competition, with the implication that
this was the "normal" pricing situation. In this analysis it was
assumed that the number of firms producing and selling a partic-
ular commodity in a given market was sufficiently large that no
one of the firms would be in position to provide a substantial part
of the total market supply. With freedom on the part of the buy-
ers to shift their purchases from one supplier to another if any
advantage could be gained by doing soit would be impossible for
any individual seller to charge a higher price than was asked
by any other supplier because, if he did, he would be unable to
make any sales.
The price, under such circumstances, would be established, by
the interplay of the forces of market demand and supply, at what-
ever level would just equate the total quantity demanded and
the total quantity offered by the entire group of sellers. At any
higher price, the quantity demanded by the potential buyers
would be less than the quantity offered by the suppliers, and com-
petition among the latter would force the price down toward the
equilibrium level. At any price lower than the equilibrium price,
the quantity demanded by the potential buyers would exceed the
quantity offered by the sellers, and competition among the buyers
to obtain the goods that they desired would force the price up to
37
38 PRICE FORMATION
the equilibrium level. The price, under such circumstances,
would be impersonally determined, or market determined, rather
than set by the "price policy" of any particular seller or group of
sellers, or of any particular buyer or group of buyers. A graphic
illustration of price determination in a purely competitive market
is presented in Figure 9.
500
400
300
2.00
UJ
o
E
100
10.000 20,000 30,000 40,000 50,000 60,000
QUANTITY
FIGURE 9. PRICE DETERMINATION IN A PURELY COMPETITIVE MARKET
Market-determined prices are not only impersonally determined
prices but they also tend to be flexible prices, in the sense that they
are free to move upward or downward from day to day or from
week to week, in response to changes in demand or in supply con-
ditions, to whatever extent is necessary to equate the quantities
demanded and offered for sale at any given time.
In few segments of the present-day American economy is it
possible to find examples of prices determined under conditions
approximating those of pure competition. The great agricultural
staples, wheat, corn, cotton, livestock, and the like, were commonly
cited in the past as examples of purely competitive, market-
determined pricing and production. Such commodities are pro-
duced on hundreds of thousands of farms, and there is no way of
distinguishing the wheat or corn produced on the Smith farm from
PRICE FORMATION 39
wheat or corn of the same grade produced on the Jones farm, or
on thousands of other farms. There is no way in which Jones
could command a higher price for his wheat than could be ob-
tained by any other farmer producing the same grade of wheat,
and if Jones were to withhold his entire output from the market,
it would not make an appreciable dent in the total quantity of
wheat of that grade that was offered for sale. Conversely, if Jones
were to double his production of wheat, the increase in his own
output would not appreciably increase the total quantity offered
for sale, and so would have a negligible influence upon the market
price. Thus, all that Jones could do, in making his plans for a
particular year, would be to forecast as best he could the probable
price at harvest time, and operate accordingly. If he thought that
the price would be high, in relation to costs, he would plan for a
larger crop. If he thought that the price would be low, he might
plan to cut his wheat production and shift a part of his acreage
into some other crop. In either case, however, he had to take the
price as he found it; he could exercise no personal initiative in
determining the price. His discretion was limited to determin-
ing what output to attempt to produce, in the light of his expecta-
tions as to the probable market price.
But even for the staple agricultural commodities, the situation
has been altered in the past two decades by the development of
measures to "stabilize," or at least to "support," the prices of basic
agricultural commodities. In the early 1930's, cooperative mar-
keting organizations for several of the major agricultural com-
modities, with the backing of the Federal Farm Board, attempted
with relatively little success to prevent a drastic decline in prices
by withholding a part of the total production from the market.
After 1933, the Agricultural Adjustment Administration in turn
attempted to raise the prices of "basic" agricultural commodities
by various measures, including crop controls, marketing arrange-
ments, and the withholding of "surplus" production from the
market by means of loans to finance the storage of a part of the
crop or by outright purchase. Thus the prices of agricultural
commodities can no longer be regarded as purely "market deter-
mined"; but to the extent that they are determined or influenced
as a matter of policy, the initiative lies in the first instance with
the government, rather than with the producers.
40 PRICE FORMATION
"Administered" prices
In the great generality of cases, the initiative in setting prices lies
with the seller. This is true in retail and wholesale trade, in the
services and in the professions, and in most branches of manufac-
turing. It is true also of the production of many basic raw mate-
rials or commodities such as copper, steel, lead, chemicals, lum-
ber of many types, cement, petroleum, and the like. There are,
however, great differences in the ways in which the prices of dif-
ferent commodities are "set" or chosen by sellers in different
branches of trade or industry. A brief review of some of the dif-
ferent ways in which prices may be set will help to put the sub-
sequent discussion of pricing and production policy in proper
perspective.
It is chiefly at the retail trading level that the flow of goods and
services produced in the economy reaches the ultimate consumer,
and therefore the pattern of retail pricing is of major significance
in relation to ultimate consumer demand. Studies of the pricing
of consumers' goods and services have disclosed many different
ways in which different types of consumers' goods are commonly
priced.
Many "convenience" goods are priced largely on a conventional
basis, as, for example, the newspaper or the five-cent candy bar.
Another technique is described by the term in-line pricing; that
is, a particular seller may set the price on a certain item or serv-
ice by "shopping" adjacent stores to see what prices they are
getting for comparable merchandise, and then establishing his
own price in line with theirs. For many widely advertised con-
sumers' goods the retail price is set by the manufacturer under
state and federal Fair Trade laws. For such items the retailer has
no freedom of choice with respect to the price at which he will sell
the items in question.
In many branches of retail trade, it is customary to set retail
prices by adding a conventional mark-up to the wholesale price of
the goods to cover the costs of store operation. Such mark-ups
vary greatly from one type of merchandise to another and often
appear to be established by convention or custom rather than by
any precise calculation based on the costs of operation in the par-
ticular store. Mark-ups tend to be larger on types of merchandise,
such as furniture, that ordinarily have a slow "turnover." Mark-
PRICE FORMATION 41
ups on goods that have a high unit value are frequently smaller
than on goods having a lower unit value, but that is not always
true.
In the women's apparel field price-lining is a widely followed
pricing practice. There are certain well established price lines or
brackets in which dresses are sold-$3.98, $4.98, $5.98, $8.98, $1 1.98,
and so on. In selecting merchandise the buyer chooses items that
will "go" in a particular price line, taking into account the normal
mark-up for the particular type of garment and also the percentage
of mark-downs that will be necessary to clear out slow-moving
items at the end of the season. Price-lining is not confined to the
apparel field by any means, for many examples may be found even
in the merchandising of such durable goods as refrigerators, ra-
dios, and washing machines.
No attempt to list representative examples of the diversity of
pricing techniques would be complete without a reference to the
loss-leader an item priced on a very narrow margin, and some-
times even below invoice cost, in order to attract customers to the
store. In some states resort to this pricing technique is limited by
laws forbidding "selling below cost."
In industry the variety of pricing techniques is nearly as great
as in the field of retail trade. Usually the manufacturer has to
deal with a smaller number of items than does the average retailer,
and so he is frequently in position to give more consideration to
the pricing of a particular item. In some lines, particularly the
manufacture of specialized industrial equipment, in which the
product is designed and manufactured to meet the special require-
ments of the buyer, the price is established by negotiation. Stand-
ard types of equipment, however, may be priced on the basis of
production costs and offered for sale at regularly listed prices.
Consumers' durable goods, such as automobiles, refrigerators,
washing machines, stoves, and other appliances, are often produced
in a variety of models to sell to the ultimate users in fairly well
defined price lines or brackets. Often a "standard" or "competi-
tive" model is produced to sell at the bottom price bracket, it
being left to the ingenuity of the salesman to switch as many cus-
tomers as possible from the stripped model to the more elabo-
rately trimmed and more expensive "de luxe" offering. In many
fields in-line pricing is a practical necessity for the particular man-
ufacturer, because he cannot hope to maintain sales volume if his
42 PRICE FORMATION
price deviates substantially from the prices established by other
manufacturers whose products, in the eyes of the ultimate buyers,
are of approximately the same quality as his own.
Whatever techniques are employed in setting prices, so long as
the initiative in establishing those prices lies with the seller the
price may be said to be administered. This term has often been
used in a way that suggests the sinister: that administered prices in
some way involve the abuse of a strategic position enjoyed by the
seller, or the exploitation of the consuming public generally. Yet
as a practical matter it is difficult to see how business could be
carried on if manufacturers or wholesalers or retailers did not an-
nounce the prices at which they are prepared to sell their wares.
Indeed, few people would find it convenient to trade if every pur-
chase involved a process of negotiation, as in an Oriental bazaar.
Actually, the real point at issue is not the way in which prices
may be established, but the conditions that in particular instances
may put particular business firms or groups of firms in position to
exploit strategic advantages or to wield a substantial element of
monopoly power. Of perhaps even greater importance is the fact
that where the initiative in pricing lies with the sellers, a whole
complex of considerations may impede, if not prevent, price
changes that appear to be necessary to preserve balance between
different segments of industry or that conform to changes in gen-
eral business conditions. The objection, in other words, is not so
much to the way in which prices are initiated, but to the type of
price and production behavior that is often associated with ad-
ministered pricing.
Organizational influences in pricing
From what has already been said it is apparent that prices are
not set in a vacuum. Each business firm must formulate its pric-
ing policy and set prices in the light of what is known about its
"own" market. This market includes the buyers who are accus-
tomed to trade with the firm, or who possibly may be induced to
do so. In a particular trading area or in a particular industry each
of the rival sellers or producers may be thought of as having a
market of its own, which, however, may touch or overlap the
markets of other sellers or producers. Unless the products turned
out and offered for sale by the various firms are completely alike,
moderate variations in relative prices would not result in a com-
PRICE FORMATION 43
plete transference of trade from one supplier to another. In a
technical sense, each of the firms may be said to have a monopoly
in its own market, but that monopoly is tempered, in the great
majority of cases, by the possibility of shifting patronage on the
part of the buyers. This is the significance of the term monopo-
listic competition. No one seller can afford to get very far out of
line with his rivals, because to do so may involve a serious loss of
trading volume.
If the number of rival sellers is small, then each one may be-
come highly conscious of the interaction of the pricing policies of
the several members of the group. If one firm should reduce its
price in comparison with the others, it might thereby achieve a
significant increase in sales volume. But the other firms, in turn,
would experience significant losses of sales, as a consequence of the
shifting of customers, and might therefore feel compelled to make
countervailing price adjustments to halt the shift. Under such
circumstances it is possible for a price war to develop, with alter-
nating price cuts being made by the various rivals in an effort to
maintain (or increase) their respective "shares" of the "market."
Such a price war may achieve such proportions, and drive prices
down so far, that the prospective profits of the participants are
reduced below the level at which they stood before the reductions
were initiated. Long experience has engendered in businessmen
a deep fear of the consequences of price warfare. There is a cor-
responding inclination to anticipate the reactions of business rivals
to price change and to avoid anything that might touch off an ex-
plosive chain reaction in the pricing field. At times this desire to
avoid "too much" competition may lead to informal agreements
among the "competitors." This simply means that price-making,
like any other human activity, is not carried on in isolation, but is
a social process. And even though the business firm undertakes
to formulate its own policies independently, it seldom can do so
without giving some consideration to the prices prevailing for
similar products and to the probable attitudes of its business rivals.
Not infrequently the practice of "price leadership" develops in
an industry, particularly if there are one or two outstanding firms
in the industry. In such a case the smaller firms commonly pat-
tern their own prices on those established by the "leader," with
perhaps minor variations to reflect differences in the popular ac-
ceptance of their products as compared with those of the dominant
44 PRICE FORMATION
firm. In the steel industry, the United States Steel Corporation
was for many years the recognized leader, and other firms cus-
tomarily quoted prices that conformed closely to those announced
by Big Steel. Where such a pricing practice is followed, there is
relatively little price competition among the rival firms, although
at times "price-shading" or concealed price-cutting assumes sub-
stantial proportions. For the most part, however, competition is
chiefly in speed of delivery and in various forms of service.
If business firms wish to maintain their prices in line with those
of rival firms (either to assure themselves of a share of the total
sales volume or to avoid unintentional price competition and its
attendant hazards), it is important that they know what those
prices are. Very often trade associations have undertaken to col-
lect and disseminate to their members trade statistics that will
enable the members to keep track of current prices. It may, how-
ever, be difficult to determine just what prices are being charged,
particularly for commodities involving relatively high transporta-
tion costs for delivery to the point of use.
In a number of basic industries, particularly those producing
heavy and relatively standardized products, such as steel, cement,
lead, lumber, and the like, it has been a common practice for all
the firms to sell on a delivered-price basis, the delivered price
being calculated by taking the "base" prices currently in force at
a number of key points or "basing points" and adding to each base
price the rail freight charges from the corresponding base to the
point of delivery. The price actually quoted would then be the
lowest combination of base price plus transportation, even though
the firm quoting the price might actually make delivery from a
plant located elsewhere than at one of the basing points. So long
as this practice was observed by all of the rival producers, each one
could quote prices with reasonable assurance that no other pro-
ducer would undersell in dealing with any particular customer or
group of customers. Thus, competition was put largely on a
service or "nonprice" basis, and price competition was likely to
occur only surreptitiously or as an accident.
Although it has been strenuously maintained in industrial cir-
cles that the basing-point system of pricing was a "natural" evo-
lution and not established or maintained by agreement among the
producers concerned, it was condemned by the Supreme Court of
the United States in 1948 as a violation of the antitrust laws. The
PRICE FORMATION 45
court took the position that although an individual firm might
sell its product on whatever basis it chose, the adherence of all the
firms to a systematic procedure of price quotation set the stage for
the elimination of price competition by price leadership or by
agreement, and hence was contrary to public policy as expressed
in the antitrust laws.
Much more highly organized controls of pricing and production
have been not uncommon in the annals of American industry.
These include price agreements and pools, under which the vari-
ous firms in an industry agree among themselves on the prices to
be charged, and perhaps on the output to be produced by each
firm. At times, firms holding important patents have incorpo-
rated provisions covering prices and production in licenses granted
to other firms to operate under the patents, thereby achieving
some measure of organized control of the entire industry. Many
of the devices employed have been condemned by the courts as
violations of the antitrust laws. As a consequence, there has been
a marked trend over the years toward the outright consolida-
tion of once separate firms into large single enterprises, it being
thought that the legal status of such combinations was less doubt-
ful than that of the looser types of combination.
It is not to be inferred that the sole reason for the growth of
large corporate enterprises through the process of corporate con-
solidation or merger has been the desire to eliminate competition.
But the fact remains that the growth of large corporate enterprise
has resulted, in many industries, in the reduction of the number of
rival firms to the point where strategic considerations of the sort
discussed previously are likely to deter aggressive price competi-
tion on the part of any of the rivals.
In this chapter an attempt has been made to sketch briefly
some of the principal ways in which prices may be arrived at in
different segments of trade and industry, and to suggest the role
that considerations of business strategy may play in the formula-
tion of the price policies of rival firms. But prices are only a
means to an end. If the business firm is to prosper, it must find a
price that will afford a volume of sales and a total sales revenue
that compare favorably with the total cost of producing the corre-
sponding quantity of output. The following chapter, therefore,
will be devoted to the analysis of pricing and production policy
as related to the prospective demand for the product of the firm
46 PRICE FORMATION
and to the prospective costs of production. Inasmuch as the great
majority of business enterprises operate under conditions which
leave the initiative in price determination in the hands of the
firm itself, primary emphasis will be placed upon the problems of
price and production policy that present themselves to the firm
under such circumstances. Only brief reference will be made to
the problems facing the firm operating under conditions of pure
competition.
Chapter 4
PRICE AND PRODUCTION POLICY
The Basic Problem
It is commonly assumed in economic analysis that business ac-
tivity is motivated primarily by the desire for gain or profit, and
that price and production policies of business firms are formu-
lated in an effort to achieve the maximum profit possible under
prevailing conditions of demand and cost, as appraised by re-
sponsible business managements. This view is in accord with the
attitude frequently assumed by hard-boiled businessmen who say
that they are not in business for their health. There may, how-
ever, be a considerable difference between maximizing immediate
profit opportunities and achieving maximum gains for the enter-
prise over the long pull, that is, over the "planning horizon" of
responsible management. Many examples exist of business firms
that have refrained from exploiting immediate profit opportuni-
ties to the utmost.
Thus far, little systematic study has been directed to the moti-
vation of business decisions; indeed, grave difficulties are likely to
beset such a study. But it seems clear that increased emphasis
must be placed upon elements in motivation other than the desire
for profits. These motives may include the attainment of pres-
tige, the maintenance of a position of security for the enterprise
that has already "arrived," the protection of capital investment
in the enterprise, and many considerations of long-range business
strategy.
Nevertheless, it also seems clear that no responsible business
management would willingly or for long undertake to operate at
47
48 PRICE AND PRODUCTION POLICY
a loss if that loss could by any legitimate means be avoided. Thus,
although it may be an oversimplification of the problem to say
that business policies are constantly framed in an effort to maxi-
mize profits, it can be said with some degree of confidence that an
effort will be made to maintain a profit position if at all possible,
and to conduct business operations in such a way as to more than
"break even/' To understand what this means it is appropriate
to turn to a device that is widely used as a guide to managerial
decisions in industry, the break-even chart, by which it is possible
to bring together the basic information in the light of which price
and production policies must be formulated.
The Break-Even Chart as a Guide to Pricing
and Production Policy
Construction of the break-even chart
Break-even charts of several different types are widely used in
industry. 1 Figure 10 is an adaptation of one of the simplest types
of break-even chart. It is constructed by bringing together, in a
single graph, a total sales revenue curve similar to the one pre-
sented in Figure 2 of Chapter 1 and a total cost curve similar to
the one presented in Figure 4 of Chapter 2. For the cost and
revenue data used in Figure 10 see Tables 2 and 4 A, pages 24
and 50.
The abscissa scale represents units of output (and sales) while
the ordinate scale represents total sales revenue and total costs in
terms of dollars. Note that the total sales revenue curve, labeled
TR, starts at zero (since there would be no sales revenue if no
goods were produced and sold) and slopes upward to the right.
In Figure 10 it is assumed that the firm in question is operating
under conditions of monopoly or monopolistic competition and
that at any given time, unit sales could be increased only by reduc-
ing the price. This assumption is reflected in the gradual leveling
out of the total sales revenue curve. The total cost curve, labeled
TC, on the other hand, originates at $5,000 (representing total
fixed costs, which would exist whether any goods were produced
i Many references to break-even analysis can be found in trade journals for the
steel, automotive, and other industries. Interesting explanations of the uses to be
made of this type of analysis may be found in Fortune for February, 1949, and in
Modern Industry for December 15, 1948. See also Walter Rautenstrauch and Ray-
mond Villers, The Economics of Industrial Management, Funk & Wagnalls Co. (1949).
PRICE AND PRODUCTION POLICY
49
or not) and slopes upward to the right. The slope of the total
cost curve becomes increasingly steep as output approaches plant
capacity, for reasons outlined in Chapter 2.
33.000
30.000
! 25000
o 20,000
e
U 15,000
z
UJ
s
cc
10.000
o
5.000
Y
5.000 10.000 15.000
20.000
OUTPUT
25.000 30,OOO 35.000 40.000
FIGURE 10. PRICING BY THE INDIVIDUAL FIRM
A represents lower break -even point; B, maximum profit position; C, a profit
position, but not maximum profit; D f upper break-even point.
For very low levels of production, total sales revenue would be
insufficient to cover the total cost of producing the corresponding
volume of output, even though the price at which that output could
be sold were quite high. (The price at which any quantity of
output could be sold, under the current demand conditions, is
represented by the price radial that cuts the total sales revenue curve
at a point corresponding to the output in question.) A glance at
the chart will show that at an output of about 7,000 units the
total sales revenue of $10,000 (represented by the height of the
total sales revenue curve, TR) would be just equal to the total
cost of producing that output (represented by the height of the
total cost curve, TC). At that output, the total sales revenue
curve cuts or intersects the total cost curve; therefore, 7,000 units
50
PRICE AND PRODUCTION POLICY
of product is the break-even output under the demand and cost
conditions assumed. (See point A.) A change either in demand
or in costs would alter the total sales revenue curve or the total
cost curve and hence would alter the break-even output or the
break-even point. Under the conditions here assumed, the price
at which the break-even output could be sold can be estimated
with a fair degree of accuracy by seeing what price radial cuts the
total sales revenue curve nearest to the point representing an out-
put of 7,000 units. In this case, the nearest price radial is the one
labeled $1.40, and therefore the price at which 7,000 units could
be sold may be estimated at $1.42. By calculation it proves to be
$1.43 (i.e., $10,000/7,000 = $1.43).
TABLE 4A
CHANGES IN TOTAL SALES REVENUES ACCOMPANYING A CHANGE IN DEMAND
(Data for Figures 10, 11, 13, 14, 17, and 18)
Output That
Before Change in Demand
After Change in Demand
Could Be
Sold (units)
Price
Total Sales Revenue
Price
Total Sales Revenue
2,500
SI .70
$4,250
$1.98
$4,950
5,000
1.50
7,500
1.70
8,500
7,500
1.41
10,600
1.58
11,800
10,000
1.35
13,450
1.50
15,000
12,500
1.28
16,000
1.42
17,800
15,000
1.21
18,150
1.36
20,400
17,500
1.15
20,000
1.30
22,750
20,000
1.08
21,500
1.27
25,200
22,500
1.02
23,000
1.21
27,250
25,000
.97
24,300
1.16
29,000
27,500
.92
25,300
1.11
30,500
30,000
.88
26,250
1.05
31,500
32,500
.85
27,000
1.04
34,000
At a price of $1.43, then, the firm would just break even. At
any higher price, the total cost of producing the output that could
be sold at the higher price would exceed the total sales revenue,
and the firm would be involved in a loss. At a price less than
$1.43, a larger quantity of product could be sold, and total sales
revenue would exceed the total cost of producing the output that
could be sold, as is indicated by the fact that the total sales revenue
PRICE AND PRODUCTION POLICY 51
curve, TR, lies above the total cost curve, TC, for the range o
output from about 7,000 units to about 26,700 units. (See point
D on the graph.) Beyond an output of about 26,700 units, the
total cost curve, TC, would again rise above the total sales reve-
nue curve, TR, and the production and sale of more than that
quantity of output would also entail losses.
As a practical matter, therefore, the problem facing the man-
agement of the concern is to determine, as nearly as possible, what
price and quantity of output and sales would afford the greatest
spread or difference between total sales revenue, as represented by
the TR curve, and total cost of production, as represented by the
TC curve. The output at which this spread would be greatest can
be determined with reasonable accuracy by comparison of the two
curves to ascertain where they are farthest apart. In this case the
spread would appear to be greatest (and profits therefore at a
maximum) with an output and sales volume of approximately
17,500 units per month. The price at which that output could be
sold would be about $1.15 per unit (as estimated by reference to
the nearest price radial) and total sales revenue would be about
$20,000. The total cost of producing 17,500 units would be about
$17,250, and the total profit would be about $2,750. (See points
B on the graph.)
If a lower price were chosen, say $1 per unit, the total sales
revenue would be still greater (approximately $23,500, indicated
by the point at which the $1 price radial cuts the TR curve), but
the total cost of producing the 23,500 units that could be sold at
that price would be about $21,750, and hence the total profit
would be reduced from about $2,750 to about $1,750. (See
points C on the graph.) And if a still lower price of approxi-
mately $.93 per unit were chosen, the total sales revenue of about
$25,000 would be just equal to the total cost of producing the
26,700 units that could be sold at that price. (See point D on
the graph.)
This illustration has assumed a somewhat greater degree of pre-
cision in the information available to the firm with respect to de-
mand conditions, and perhaps also with respect to cost conditions,
than is to be found in most real situations. Nevertheless, even
though precise information is lacking, the management of the firm
must estimate its demand and cost conditions as best it can, and if
52 PRICE AND PRODUCTION POLICY
the curves of Figure 10 be regarded as reflecting these estimates,
then it is at least possible to say that the choice of price and output
would fall somewhere in the range between the lower and upper
break-even points, with the "best" choice lying somewhere in the
middle. In this case, a choice of $1.15 would give a close approxi-
mation to maximization of profits under the assumed demand and
cost conditions.
Relation to "marginal" analysis of price determination
The approach to the price and production combination that
would afford maximum profits to the firm, under given market
conditions, is very often expressed in terms of the relationship be-
tween marginal cost and marginal revenue. The marginal cost of
production represents the increase in total cost that would accom-
pany a small increase in output, and is represented, approximately,
by the upward slope of the total cost curve over a small range cor-
responding with the range of output under consideration. The
marginal revenue represents the increase in total sales revenue that
could be obtained from the sale of a small additional quantity of
output, assuming that the price of the product were readjusted to
whatever extent appeared necessary to sell the additional output.
The marginal revenue is represented, approximately, by the slope
of the total sales revenue curve over a small range corresponding
with the range of output under consideration.
A glance at Figure 10 will show that the spread between the total
cost curve, TC, and the total sales revenue curve, TR, is greatest
(and therefore profits are at a maximum) when the output is such
that the upward slopes of the two curves are parallel to each other.
At that point a small increase in total output would increase total
sales revenue and total cost by equal amounts, so that total profit
would be neither increased nor decreased. At any smaller total
output, a small increase in total output would increase total sales
revenue more than it would increase total cost, and therefore would
result in an increase in total profits. At any still larger total out-
put, a small increase in total output would increase total sales
revenue by a smaller amount than total cost, and therefore would
tend to reduce total profit.
This analysis may be summed up by saying that the firm in ques-
tion would maximize its profits by producing the output at which
the marginal cost and marginal revenues are equalthat is, the
PRICE AND PRODUCTION POLICY 53
output at which the slopes of the total sales revenue and total cost
curves are the same.
Effects of a Change in Demand Unaccompanied
by Changes in Costs
Suppose that the demand for the product turned out by the
firm were to increase, perhaps as a consequence of increased in-
comes at the disposal of customers, or a skillful advertising cam-
paign, or for any other reason, and that this change in demand
were regarded as more than temporary. Whatever the cause, it
becomes apparent that the customers would be willing to buy a
larger quantity of the product, at each of the possible prices, than
previously. Demand for the product has shifted positively, and
the total sales revenue curve will be altered correspondingly.
How may such a shift in demand affect the firm's price and pro-
duction policy? Will it be advantageous to keep the price un-
changed and simply sell the larger quantity that the customers are
willing to take at that price, or will it appear preferable to raise
the price somewhat and expand output and sales volume some-
what less?
Many considerations may enter into the decision in such a case.
The management may feel that an increase in price, although of
immediate profit advantage, would have adverse effects in the long
pull. Many customers might be irritated by the price increase,
particularly if it did not appear that production costs had in-
creased, or had not increased sufficiently to justify the price in-
crease. Or, if the price increase were to result in a very obvious
increase in profits for the firm, other firms in related fields of pro-
duction, or completely new firms, might be led to offer closely
competitive products. The offering of such substitutes might
have the effect, in time, of attracting away some of the customers,
and therefore of causing a reduction or negative shift in the de-
mand for the product of this particular firm, the effects of which
would be unfavorable in the long run. Such strategic considera-
tions may lead the firm to refrain from taking full advantage of
every opportunity to maximize immediate profits.
With these reservations in mind, it can be seen how an increase
in demand would affect the break-even chart for the firm under
consideration, assuming that there are no significant changes in
54
PRICE AND PRODUCTION POLICY
raw-material prices or other variable costs of production, so that
the cost situation remains virtually the same as it was before the
shift in demand occurred. Figure 11 represents these assumed
conditions. (For the cost and revenue data used in Figure 1 1 see
Tables 2 and 4A.) In this figure the total cost curve, TC, is the
same as in Figure 10. The effect of the shift in demand is repre-
sented by the inclusion of a second total sales revenue curve,
labeled TR 2 , which rises more steeply than did the original total
sales revenue curve, TR ly and continues to slope upward over a
greater range of output before leveling off toward a maximum.
This simply means that at each possible price (represented by the
successive price radials) a larger quantity of product could be sold
than before. For example, the $1.15 price radial cut the original
total sales revenue curve, TR lf at an output of about 17,500 units;
it cuts the new total sales revenue curve, TR 2 , at an output of
about 25,700 units.
35,000
5,000 10,000
15,000 20,000 25,000 30,000 35,000 40,000
OUTPUT
FIGURE 11. PRICING AS AFFECTED BY A CHANGE IN DEMAND
A indicates maximum profit position under original demand conditions; B,
profit under increase in demand, if no change in price; C, profit under in-
crease in demand, if price is raised; D, maximum profit position under in-
crease in demand; E, profit if demand is decreased to original level, with no
change in price from D.
PRICE AND PRODUCTION POLICY 55
Suppose that the firm were to maintain the price of the product
unchanged at $1.15, which would have afforded maximum profits
of about $2,750 under the original demand conditions. (See points
A on the graph.) Under the new conditions, the sale of 25,700
units at that price would bring in a total sales revenue of approxi-
mately $29,500 (as indicated by the height of the TR 2 curve at an
output of 25,700 units). The total cost of producing that quantity
of product (indicated by the height of the total cost curve, TC),
would be about $24,000, leaving a total profit of about $5,500.
(See points B on the graph.) Approximately the same total profit
could also be attained, under the new demand conditions, by hold-
ing the production and volume of sales constant at about 17,500
units and raising the price from $1.15 to about $1.30. This pro-
cedure would give a total sales revenue of about $22,750, as com-
pared with a total cost, for 17,500 units, of about $17,250, leaving
a total profit of about $5,500. (See points C on the graph.) The
largest possible profit, under the new demand conditions, would
be attained by raising the price to about $1.21. At this price,
about 22,500 units could be sold, with a total sales revenue of
about $27,250 and a total cost of about $20,750, giving a total
profit of approximately $6,500. (See points D on the graph.)
The manufacturer would have to decide whether the additional
profits that would result from raising the price from $1.15 to $1.21,
as compared with those that could be obtained by holding the price
unchanged at $1.15, would be worth while, in view of the disturb-
ance of the price structure that would result and the resentment
that might be built up among the customers. No gain, however,
would be achieved by raising the price above $1.21. Thus the
price range within which price may be changed, as a consequence
of a change in consumer demand, may be quite narrow, as long as
cost conditions are not changing at the same time.
Suppose that demand were to decrease rather than increase.
The effects of such a negative shift in demand may be visualized by
assuming that the total sales revenue curve, TR 2 , represents the
"original" situation as viewed by the manufacturer, and that the
lower total sales revenue curve, TR lf represents the new situation
prevailing as a consequence of the shift. Assume that the price
had been set initially at $1.21, which under the "original" demand
conditions would have afforded maximum profits of $6,500. (See
points D on the graph.) If the manufacturer were to maintain this
56 PRICE AND PRODUCTION POLICY
price unchanged in the face of the decline in demand, it would be
necessary to cut back production and sales from 22,500 units to
about 14,500 units, which would bring in a total sales revenue
of about $17,500. The cut-back in production would reduce total
costs to about $15,000, leaving a total profit of about $2,500. (See
points E on the graph.) It would be possible to gain a larger total
profit by reducing the price from $1.21 to $1.15 and selling an
output of about 17,500 units. This would give a total sales rev-
enue of $20,000, a total cost of $17,250, and a total profit of about
$2,750. (See points A on the graph.)
Again it would be necessary to decide whether the slightly
greater profit that might be achieved by reducing the price would
be sufficient to offset the disturbing effects of the price reduction.
Such a reduction would doubtless be welcomed by the customers.
But if it led them to think that perhaps still larger reductions
might be made later, they might be stimulated to hold off in buy-
ing, with the effect of reducing still further the current demand
for the product. There is also the possibility that the reduction in
price might stimulate other manufacturers of similar products to
reduce their prices, with the chance that a price war would result.
Hence, strategic considerations might stand in the way of a price
reduction, even though some improvement in immediate profit
position might appear to be possible if that step were taken.
Effects of Changes in Costs
Change in variable costs not accompanied by a change in
demand
Turn now to the other side of the picture and examine the
effects of changes in manufacturing costs, assuming that there are
no changes in demand occurring at the same time. Certain raw-
material prices may have gone up, or higher wage rates may have
been established in the course of negotiating a new labor contract
covering the workers employed in the plant. Such changes would
tend to steepen the slope of the total variable cost curve, as was
indicated in Chapter 2. How would such changes in variable
costs tend to alter the price and output policy of the manufacturer?
Suppose that the increase in total variable costs is about 10 per
cent. The effect, of this change is reflected, in Figure 12, by the
steeper slope of the total cost curve, TC 2 , as compared with the
PRICE AND PRODUCTION POLICY
57
original total cost curve, TC V (For the cost and revenue data used
in Figure 12, see Tables 4 and 4A. The TCi curve is the same as
the TC curve in Figures 10 and 11.) 2
35,000
5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000
OUTPUT
FIGURE 12. PRICING AS AFFECTED BY A CHANGE IN VARIABLE COSTS
A indicates maximum profit before change in cost; B, profit after change in
cost, if price is held unchanged; C, maximum profit position after change in
cost, with price and output readjusted.
Before the increase in costs occurred, the manufacturer would
have obtained the largest possible profit by setting the price at
$1.15. At that price about 17,500 units could have been sold,
with a total sales revenue of about $20,000, a total cost of about
$17,250, and a total profit of about $2,750. (See points A on the
graph.) As a result of the increase in raw-material prices and in
wage rates, the total cost of producing 17,500 units would be in-
creased to about $18,500. This would cut the total profit, on that
output, to about $1,500. (See points B on the graph.)
No possible change in output and price could restore profits to
the original level as long as demand conditions remained the same.
However, it would appear, from a comparison of the new total cost
2 The TCj and TC 8 curves are also the same as the TC^ and TC a curves of
Figure 7 in Chapter 2.
58 PRICE AND PRODUCTION POLICY
curve, TC 2 , and the total sales revenue curve, TR, that a slightly
larger profit could be obtained by raising the price to about $1.21
and cutting back production to about 15,000 units. This would
give a total sales revenue of about $18,150, as compared with a
total cost of about $16,550, leaving a total profit of about $1,600.
(See points C on the graph.)
Although the customers would not be elated at the increase in
price, they would be less inclined to regard the price increase as
unjustified, particularly if the manufacturer's public relations
counsel were successful in explaining that the step was taken with
extreme reluctance and only under the pressure of increasing costs
for which the manufacturer was not responsible. Furthermore,
if other manufacturers of similar products were faced with similar
increases in costs, their prices also would presumably be increased.
Changes in fixed costs resulting from plant expansion
It was indicated in Chapter 2 that an increase in fixed cost re-
sulting from an increase in the amount invested in plant and
equipment would tend to raise the total cost of production. This
would increase the average cost of production (cost per unit of
product) for low levels of output, but it might tend to reduce the
average cost of production for higher levels of output by increasing
the efficiency of plant operation and extending the limits of plant
capacity. (See pages 29-30 and Figure 6.) This possibility sug-
gests that one way of coping with an increase in variable costs, such
as was considered in the preceding section, would be to expand the
investment in fixed plant facilities. Such a step would appear to
be particularly appropriate in the case of increases in wage rates,
if the installation of additional machinery would "save" labor and
hence reduce the amount of labor required to turn out a given
quantity of product.
This possibility is illustrated graphically in Figure 13. Here it
is assumed, as in Figure 12, that there is no change in demand, so
that the total sales revenue curve, TR, remains unchanged. If
there were no increase in plant investment, the increase in wage
rates would raise total costs, thus swinging the total cost curve from
TC to TC 2 . (TC l and TC 2 in Figure 13 are the same as the TC t
and TC 2 curves of Figure 12 and are also identical with the TC X
and TC 2 curves of Figure 6 of Chapter 2. For the cost and rev-
enue data used in Figure 13, see Tables 2, 3, and 4A.) Suppose,
PRICE AND PRODUCTION POLICY
59
however, that plant investment were increased, with the effect of
raising the total fixed cost from $5,000 per month to $10,000 per
month. This increased investment would raise very substantially
the total costs of production for low levels of output, as is indi-
cated by the lower portion of the total cost curve, TC 8 , which rep-
resents the cost situation as it would exist after the expansion had
been completed. But for higher levels of output the enlarged
plant would permit greater economy of operation, due to the rela-
tive reduction in the amount of labor required. This effect is
indicated by the more gradual slope of the TC 3 curve as compared
with TC 2 .
35,000
30,000
Cft
<
25,000
O 20,000
. 15.000
10,000
5.000
5,000 'lO.OOO I5p00 ' 20LOOO ' 25.0OO ' 30,000 ' 35,000 ' 4QOOQ
OUTPUT
FIGURE 13. PRICING AS AFFECTED BY AN INCREASE IN INVESTMENT
A indicates maximum profit position with original plant and original demand
situation; B, maximum profit position with increased total variable cost and
original demand situation; C, maximum profit position with increased plant
investment and increased demand.
Would the change in total cost of production attributable to
plant expansion be sufficient to improve the profit position of the
firm, in comparison with what it would be if the expansion were
not undertaken? The answer depends on the extent of the change
60 PRICE AND PRODUCTION POLICY
in costs that could be obtained by so doing, and also upon the de-
mand for the product.
Assume to begin with that the demand for the product remains
unchanged, as represented by the original total sales revenue curve,
TR V which is the same as the TR l curve of previous figures. With
cost conditions as represented by TC l (before the increase in vari-
able costs occurred), maximum profits of about $2,750 would have
been obtained by producing about 17,500 units and selling at a
price of $1.15. (See points A on the graph.) After the increase in
variable costs occurred, but before the plant expansion was under-
taken, maximum profits of about $1,600 would have been obtained
by producing about 15,000 units and selling at a price of $1.21.
(See points B on the graph.) If the plant expansion program were
carried through, the total cost of producing 15,000 units would be
raised from about $16,550 to about $18,506. With a total revenue
of $18,150 obtainable under the demand conditions as represented
by TRi, the total profit would be reduced to zero or less. Thus,
unless an increase in demand were anticipated, no advantage
would be gained by a plant expansion on the scale here assumed.
Nor would there be any other output, greater or less than 15,000
units, at which the profit would be as large as could be obtained
by producing 15,000 units in the "original" plant.
Suppose, however, that demand were to increase to the extent
indicated by TR 2 . If the increase in demand were expected to be
permanent, the proposed plant expansion would be advantageous.
With an output of 30,000 units, for example, which, under the
demand conditions as represented by TR 2 , could be sold at a price
of about $1.05, total sales revenue would be about $31,500, as
against a total cost (with the enlarged plant, as represented by
TC 3 ) of about $26,500, giving a total profit of about $5,000. (See
points C on the graph.) This profit would be greater than the
profit of $2,750 that could have been obtained, before the increases
in costs and demand occurred, on an output of 17,500 units. It
would also substantially exceed the profit that could be obtained
by any other adjustment of price and output that could be made,
subsequent to the increase in variable costs, without expanding the
plant.
Thus a rise in variable costs would provide an incentive to ex-
pand plant facilities, in so far as such an expansion would tend in
part to offset the effects of the increase in variable costs, provided
PRICE AND PRODUCTION POLICY 61
demand conditions were also such as to permit the sale of a volume
of output sufficiently enlarged to achieve the cost-reducing effect
of plant expansion.
It should be noted that in this example the enlargement of plant
is assumed to lead to a reduction in average cost of production
when the plant is being worked toward capacity. Such a situation
is described by the phrase "decreasing costs to scale." It is not,
however, always true that an expansion of plant would reduce the
average cost of production. If the average cost runs about the same
for plants of different sizes, when each size of plant is being oper-
ated at the output that is most economical for it, the situation is
described by the phrase "constant costs." Or if an expansion in
the size of plant would give no output at which the average cost
for the larger plant would be as low as the average cost in a smaller
plant, when operated at the most economical output, the situation
is described by the term "increasing costs to scale."
Industries differ considerably in the effect of changes in plant
investment upon the level of production costs, but it is generally
believed that in most instances there are limits to the reductions
in average costs that can be achieved by increasing the size of the
individual plant. These limits may be associated with technologi-
cal problems or with problems of management and supervision
that arise when the plant becomes very large.
Changes in technology
The development of improved methods of production as well as
improved methods in management and distribution would tend to
have effects on total production costs somewhat like the effects of
an increase in plant investment, that is, they would tend toward
a reduction in the total cost of production, at least over certain
ranges of output. If they did not, there would be little incentive
to introduce such changes. The analysis thus far developed would
seem, therefore, to provide a basis for the study of the effects of
technological changes on pricing and production policy.
No attempt will be made at this point to deal with the ramifica-
tions of the problem of technological changes, except to note that
they have played a very important part, over the years, in reducing
the costs of production of many familiar products. In general,
although not always, such changes have involved an increase in the
size of plant that is most economical to operate and have, as a con-
62 PRICE AND PRODUCTION POLICY
sequence, been closely associated with the increase in the scale of
manufacturing operations.
Very often the full import of technological change cannot be
appraised in advance. There is frequently a reluctance on the
part of responsible industrial management to plunge into large-
scale commitments for the reconstruction of plant facilities until
the possibilities of a new technique have been tested on a pilot-
plant basis, or tried out in practical operations by some of the
more venturesome firms in an industry. There is, however, a
strong incentive to carry on experimental and developmental
work and, wherever possible, to maintain a strong strategic posi-
tion by acquiring patents, or patent licenses, covering the use of
all developments that seem to have some possibility of assuming
practical significance in the future, even though there may be no
occasion to put them into operation at once. Otherwise there is a
danger that the firm may find itself hampered in subsequent
periods by an inability to gain access to the most advantageous
technical methods of production.
Effects of Advertising
It is a commonplace of modern economic life that demands for
goods do not just exist they are created. Although it may be true
that the man who invents a better mousetrap will find the world
beating a path to his door, the world has to know that a better
substitute for a cat has been invented. To this end the arts of
modern advertising are bent.
Suppose, then, that the manufacturer becomes convinced that
some people are still unaware of the virtues of his product, and
feels an urge to dispel their ignorance. Assume that the total
sales revenue curve, TR^ of Figure 14 reflects the demands of
those who are already familiar with this product. Assume also
that the total costs of production are as represented by the total
cost curve, TC r (TR l and TC l are the same as the TR and TC
curves of Figure 10. For the cost and revenue data used in Figure
14 see Tables 2 and 4 A.) Under these assumed demand and cost
conditions, the maximum total profit would be obtained by pro-
ducing 17,500 units and selling them at a price of $1.15.
Now suppose that the manufacturer decides to spend $3,000 per
month in advertising the product (or, if he were already doing some
PRICE AND PRODUCTION POLICY
63
advertising, to increase the advertising budget by that amount).
Would that advertising expenditure be worth while? Obviously
it would be if the effect of the advertising expenditure were to
increase the total sales revenue more than sufficiently to offset the
additional expense involved in the advertising campaign. This
does not mean that the entire total sales revenue curve would have
to be boosted by $3,000 throughout its entire range, but only over
a certain range. Suppose that the effect of the advertising expendi-
tures were to raise the total sales revenue curve from TJRj to TR 2 .
Total sales revenues would be materially increased in the inter-
mediate range. But at the same time total costs would also have
been increased by $3,000 per month all along the line, so that the
total cost situation would now be reflected by TC 2 rather than by
TC r The effect is much the same as that of an increase in total
fixed cost, except that there is no corresponding change in variable
costs, such as was assumed in Figure 1 3 and in the discussion of an
expansion in plant investment.
35.000
30.000 -
i
a 25.000
<* 20.000
I
w 15.000
10,000
5.000
TR,
5.000 10,000 15,000 20,000 25,000 30,000 35,000 40,000
OUTPUT
FIGURE 14. PRICING AS RELATED TO ADVERTISING
A indicates maximum profit position without advertising; B, profit if price
is held unchanged with demand increased by advertising; C, maximum profit
position with demand increased by advertising.
64 PRICE AND PRODUCTION POLICY
With the conditions here assumed, the effect of the advertising
campaign would be to increase the quantity of product that could
be sold at a price of $1.15 from 17,500 units to about 25,700 units,
giving a total sales revenue of about $29,500. The total cost of
producing that output would be about $24,000, and, with an addi-
tional $3,000 spent on advertising, the total profit remaining
would be about $2,500. That would be slightly less than the total
profit that could have been obtained from the sale of 17,500 units
at the same price, without advertising. (See points A and B on the
graph.) But better results, in terms of profits, could be obtained
by undertaking the advertising program to stimulate demand and
at the same time raising the price to about $1.21. At that price,
approximately 22,500 units could be sold, bringing in a total rev-
enue of about $27,250. The total cost of producing that output
would be in the neighborhood of $20,750, and with an additional
expenditure of $3,000 on advertising, the total profit remaining
would.be about $3,500, or an amount considerably greater than
the $2,750 representing the maximum profit obtainable without
advertising. (See points C and A on the graph.)
In this instance it would appear that the advertising program
would be of advantage to the firm. It is not equally clear that the
customers who were already familiar with the product would gain
any advantage from the institution of the campaign and the asso-
ciated increase in price, except, perhaps, the satisfaction of seeing
more people using the same product, and whatever satisfactions
they might derive from the art work of the advertising agency or
from the appeal to their vanity.
However, the situation presented here covers only one of several
possibilities. It was chosen primarily to illustrate the point that
expenditures on advertising could be extended, with advantage to
the firm, so long as the effect of such expenditures was to increase
total sales revenue more than total costs (including both the costs
of producing the additional goods that could be sold and the ad-
vertising expenditures themselves). Obviously it would not pay to
incur added costs for advertising if it were probable that there
would be no addition to total profits as a consequence.
If advertising were to result in a substantial increase in the de-
mand for the product, that might, in turn, make possible a substan-
tial increase in the scale of plant operations, of the sort dealt with
on pages 58-61, accompanied by a reduction of total production
PRICE AND PRODUCTION POLICY 65
costs for higher ranges of output. In that event the ultimate
effect of the advertising program might be a reduction, rather than
an increase, in the price that would be most advantageous for the
manufacturer to set.
One further point in connection with advertising designed to
increase the demand for the product of a particular firm is that the
same technique of influencing demand is available to rival firms as
well. And to the extent that advertising techniques are utilized
by the entire group, the effectiveness of any one firm's program
may be largely canceled out by counter-advertising, just as the
effectiveness of a price reduction designed to attract customers
from business rivals may be canceled out by offsetting cuts in their
prices. Thus, one of the possible effects of "competitive" advertis-
ing is an increase in total costs (including advertising expenditures)
not matched by corresponding gains in total sales revenues. But
once an extensive advertising program has been undertaken and
matched -by similar progress of rival firms, it may be virtually im-
possible for any one of the firms to abandon the competitive adver-
tising struggle. This situation is not peculiar to advertising alone;
it is also characteristic of many other devices that may be employed
to promote sales to ultimate consumers or to secure favorable dis-
tributive outlets. 8
Production and Supply Under Conditions of Pure
Competition
Reference has already been made to the case of pure competition
in which a large number of producers is engaged in turning out
the same product for sale to the same group of customers, that is,
for sale in the same market. Where the customers have no basis
for preferring the product of one producer to that of another pro-
ducer, no one producer can follow an independent pricing policy
of his own. He must take the price prevailing in the market and
adjust his own undertakings as best he can to the prevailing level
of that price. The price is set by the joint forces of total market
8 In this discussion it has been assumed that advertising appropriations are made
in a lump sum, so that they can be treated as a fixed cost item for the accounting
period under consideration. In some cases, however, firms follow a policy of ear-
marking a certain percentage of total sales revenue for advertising purposes. In
that event, it would be more appropriate to treat advertising expenditures as a
deduction from total sales revenue rather than as an increase in the total cost curve.
66 PRICE AND PRODUCTION POLICY
demand and supply. The total market supply will reflect the
quantities that individual producers would be willing to sell at
different possible prices at a given time, other things being equal.
To visualize the conditions determining the supply that would
be offered by an individual producer at a given time, it is con-
venient to construct a break-even chart of the sort represented by
Figure 15. In this figure a total cost curve similar to the TC curve
of Figure 10 represents the cost conditions confronting the indi-
vidual producing firm. The total sales revenue curve, TR, how-
ever, is somewhat different, because any individual producer,
under the assumed conditions of pure competition, could sell any
quantity of product that he might turn out (up to the capacity of
his plant) at the prevailing market price. If the market price were
$1.20, represented by the $1.20 price radial, the individual pro-
ducer's total sales revenue curve would be a straight line sloping
upward to the right, lying on the $1.20 price radial. If he sold
10,000 units, his total sales revenue would be $12,000; if he sold
20,000* units, his total sales revenue would be $24,000, and so on.
If the market price were $1 per unit, then the total sales revenue
curve for the individual producer would coincide with the $1 price
radial. If he sold 10,000 units, his total sales revenue would be
$10,000; if he sold 20,000 units, his total sales revenue would
be $20,000. Thus, under conditions of pure competition, each
price radial may be regarded as representing the total sales revenue
curve for each individual producer of that commodity, providing
that happened to be the prevailing market price.
Suppose, to begin with, that the market price were $1.30. At
that price the individual producer here under consideration would
break even on an output of about 8,500 units (see point A on the
graph), but maximum profits would be obtained with an output
of about 26,500 units. At that volume of sales, total sales revenue
would amount to about $34,450, as against a total cost of about
$24,750, giving a total profit of approximately $9,700. Thus the
quantity that this producer would find most profitable to produce
at a price of $1.30 would be in the neighborhood of 26,500 units.
(See points B on the graph.)
Suppose, however, that the market price were $1.20 rather than
$1.30. At a price of $1.20, the greatest spread between the $1.20
price radial (which may be taken to represent the TR curve if the
market price were $1.20) and the total cost curve, TC, would be
PRICE AND PRODUCTION POLICY
67
reached with an output of about 26,000 units. The total sales rev-
enue of $31,200 would exceed the total cost of producing that
output, approximately $24,100, by some $7,100. Thus the quan-
tity that this producer would be prepared to sell at a price of $1.20
would be approximately 26,000 units.
35,000
5.00O 10,000 15,000 20,000 25,000 30,000 35,000 40,000
OUTPUT
FIGURE 15. PRICE AND PRODUCTION UNDER PURE COMPETITION: THE FIRM
A indicates break-even point at a price of $1.30; B, maximum profit position
for the firm at a price of $1.80; C, minimum price at which the firm could
break even ($.92); curve S connects points indicating outputs that would give
maximum profits to the firm under each of the indicated prices.
In the same way the quantity which it would be most advan-
tageous for the individual producer to turn out at other possible
prices may be determined. At any price below ninety-two cents,
however, there would be no output at which the producer in ques-
tion could fully cover his costs. At ninety-two cents, the producer
would just break even on an output of about 24,400 units, with
total sales revenue and total costs of about $22,500. (See point C
on the graph.)
At any price below ninety-two cents the individual producer in
question would fail to break even, but this does not mean that he
would discontinue production. As long as there was some output
68
PRICE AND PRODUCTION POLICY
at which total sales revenue would exceed total variable cost it
would be better to produce and sell the output that would give
the greatest excess of total revenue over total variable cost, inas-
much as some contribution would still be made toward the fixed
cost. The producer, of course, would not be delighted by the
prospect of making a loss, but if loss were unavoidable, a small
loss would be preferable to a larger one. Thus, at a price of
ninety cents the producer would keep his loss to a minimum by
producing about 24,000 units, with total revenues of about $21,600
and total costs of $22,000, giving a loss of some $400. At a price
of eighty cents, the producer's loss would be held to a minimum
with an output of about 23,500 units, giving a total revenue of
$18,800 as against a total cost of about $21,500, or a total loss
of some $2,700. And at a price of seventy cents, an output of
22,500 units would bring in a total sales revenue of $15,750, barely
sufficient to cover the total variable cost of producing that output;
the fixed cost would be entirely uncovered. At any price below
seventy cents, total sales revenue would be insufficient, at any out-
put, to cover total variable costs, and it would be preferable to
suspend operations entirely. (See point D on the graph.)
Summing up this analysis, it is possible to construct a supply
schedule to show how much the individual producer under con-
sideration would be willing to sell, under the given cost condi-
tions, at each of several different possible prices. Table 5 presents
such a schedule for the individual firm.
TABLE 5
SUPPLY SCHEDULE FOR INDIVIDUAL FIRM
Price
Units Produced
Total Sales Revenue
Total Cost
Total Profit
$1.30
1.20
1.10
1.00
.92
.90
.80
.70
26,500
26,000
25,500
25,000
24,400
24,000
23,500
22,500
534,450
31,200
28,000
25,000
22,500
21,600
18,800
15,750
$24,750
24,100
23,500
23,000
22,500
22,000
21,500
20,750
$9,700
7,100
4,500
2,000
-400
-2,700
-5,000
Not all producers in the industry would have precisely the same
costs of production; some might find themselves in a position to
make losses (as a consequence of a drop in price), whereas others
PRICE AND PRODUCTION POLICY
69
were still able to show a profit. Hence, a fall in market price would
tend to cause some producers to drop out sooner than others, al-
though all would have an incentive to curtail output somewhat in
the face of a fall in price and to expand somewhat in response to a
higher price. Thus, for the entire group of producers supplying
a particular market, the responsiveness of supply to a change in
price would tend to be somewhat greater than is indicated by the
schedule for a single producer.
In Figure 15 a dotted line is drawn to connect the quantities;
that it would be to the advantage of the individual firm to turn
out at the different prices indicated. If the indicated prices and
quantities be replotted as in Figure 16, with quantities indicated
by the abscissa scale and the various possible prices by the ordinate
scale, the curve fitted to the plotted points constitutes the supply
curve of the individual firm. A similar figure, representing the
quantities that would be offered by the entire group of producers
at various possible prices, would depict the market supply.
1.40
1.20
i.oo
o
o
80
g.60
<E
CL
.40
.20
5,000 10,000 15,000 20,000 25,000 30,000 35,000
OUTPUT
FIGURE 16. SUPPLY CURVE FOR THE FIRM UNDER PURE COMPETITION
Chapter 5
PRICE STRUCTURES, LEVELS, AND
TRENDS
Price Structures
Preceding chapters have dealt with the analysis of the price and
production policy of an individual firm, as influenced by the man-
agement's appraisal of the prospective demand for the product of
the firm and of the prospective costs of production. It was also
noted that business firms seldom find themselves in the position of
being able to formulate their price and production policies with-
out giving close attention to the pricing and production policies of
other firms which are in position to offer similar goods or substi-
tute goods in the market in competition with the firm immediately
under consideration. Frequently the manufacturer of a particular
commodity also finds that the sales of his own product are influ-
enced, not only by the offering of similar goods by rival suppliers,
but also by the competition of quite different goods turned out by
other industries. Thus a radio manufacturer may find that his
prospective customers are influenced not only by the blandish-
ments of other radio manufacturers but also by the sales appeals of
television receivers, household appliances of various kinds, and
countless other goods on which the customers may spend their
dollars.
It would be almost impossible for any single producer to recog-
nize and take into account all of the alternative forms of expendi-
ture that may influence the willingness of his prospective customers
to purchase his own product, but it may be possible to single out
a few alternatives that seem to be most significant. As a practical
70
PRICE STRUCTURES, LEVELS, TRENDS 71
matter, market research studies often seek to determine the prob-
able demand for the particular product under study, taking into
account the relative prices of three or four other products that
seem most likely to be chosen as substitutes.
It will be helpful in understanding the way in which the whole
economy functions to think of the prices of different kinds of goods
as being tied together in a price structure which includes all kinds
of goods and services. The structure as a whole embraces many
different groups of commodities and services, or many different
industries; and these groups, in turn, embrace many different com-
modities, some of which are close substitutes for each other.
Any individual firm is most immediately concerned with that
part of the general price structure which embraces his own prod-
uct and the products of his close rivals; his price and production
policies will be chiefly influenced, at any time, by a consideration
of his relationships with them. Individually and collectively they
represent the "competition" in terms of which he must formulate
his own plans. For example, a reduction (or an increase) in the
price of Plymouth automobiles would react most directly upon
the prospective sales of Fords and Chevrolets, and somewhat less
directly on prospective sales of cars in adjacent price brackets; it
would have comparatively little influence on the prospective sales
of cars in the higher price brackets. There are, of course, great
differences in the sensitivity of the demand for the product of one
firm to changes in the relative prices at which similar products are
offered by other firms.
In general, the greater the real or fancied differences between
products of the same type, the less is the likelihood of a substantial
transfer of patronage from one firm to another in response to small
changes in relative prices. The greater the degree of standardiza-
tion of the products turned out by several rival firms, the greater is
likely to be the response to small changes in relative prices. A
representative of one of the major cement companies once testified
that a difference of a few cents a barrel for Portland cement, which
is produced to meet well established specifications, would suffice to
drive the higher-priced brand almost completely out of the market.
Much the same could be said of standardized steel products and
many other kinds of producers' goods.
The working of the competitive process is also greatly affected
by the number of close rivals facing one another in competition
72 PRICE STRUCTURES, LEVELS, TRENDS
for the favor of the buyers in the market. If there are many rivals
offering the same type of goods in the market, it may be difficult,
if not impossible, for any one firm to appraise the impact on its
own sales which results from small changes in the prices at which
other firms are offering their wares. This is the sort of situation
that is commonly described by the term monopolistic competition.
If the number of rivals facing one another in the market were
small, as in the case of oligopoly, it is more likely that a change in
price initiated by one firm would have an immediate and substan-
tial reaction on the sales prospects of the rival firms, and that those
firms would be forced to take immediate defensive counter-
measures. In the ensuing pages consideration will be given first
to the workings of the competitive process under conditions of
monopolistic competition, and thereafter to the competitive process
under conditions of oligopoly. Consideration of the hypothetical
case of pure competition, with a large number of firms producing
and selling a completely standardized product, will be postponed
to the end of this section.
Interfirm price and production relationships under
monopolistic competition
Under conditions of monopolistic competition, each firm's price
and production policy must be formulated in the light of its own
estimates of the demand for its own product (as depicted graphi-
cally by its total revenue curve) and its own expected production
costs (as depicted graphically by its total cost curve). But the
demand for its own product at any given price will be influenced
by the prices at which similar products are available in the market
and will be changed if those prices are changed. By the same
token, the sales of the product of any one firm might perhaps be
substantially increased by reducing its price slightly, in comparison
with the prevailing level of prices for comparable products, pro-
viding they were not reduced at the same time. Alternatively,
increased sales might be obtained without a reduction in price if
the firm were to increase its advertising expenditures or to make
improvements in the product that would increase its appeal to
prospective customers, in comparison with similar products.
Take first the possibility of increasing sales volume and total
sales revenue by reducing the price of the product in comparison
with the prices of similar products. This situation is illustrated
PRICE STRUCTURES, LEVELS, TRENDS 73
graphically in Figure 17, in which the first total revenue curve,
TR V represents the estimated total sales revenues obtainable at
various possible prices, assuming that other firms selling in the
same market would make roughly comparable changes in their
own prices at about the same time. The second total revenue
curve, TR Z , represents the estimated total sales revenues obtain-
able at various possible prices, assuming that other firms would not
make corresponding changes in their prices if this firm were to
reduce (or increase) the price of its product. It is assumed, in TR 2 ,
that the generally prevailing price for similar products offered by
other firms is in the neighborhood of $1.15 per unit. In line with
this assumption, the TR 2 curve cuts through the TR curve at a
point representing a price of approximately $1.15 per unit. (See
point A on the graph.) For prices higher than $1.15 per unit, the
TR 2 curve lies below the TR l curve, suggesting that if the firm in
question were to raise its own price substantially above the pre-
vailing level it would rapidly lose sales to its competitors. For
prices below $1.15, the TR 2 curve sweeps above the TR l curve,
suggesting that as the firm reduced its price below the prevailing
level it would gain rapidly in sales at the expense of the other
firms, unless the prospective customers felt that the lowering of
the price was incident to a deterioration of quality.
If the firm in question felt that it could "get away with" a
moderate price reduction, the extent of the gain to be achieved by
so doing would be determined by the additional costs involved in
producing the added volume of output. The effect of an expan-
sion of output on total costs of production is illustrated by the
total cost curve, TC, in Figure 17. In this particular case a reduc-
tion in price to about $1.08 would result in an increase in esti-
mated profits (indicated by the greater spread between the TC
curve and the TR 2 curve. See points B on the graph). But this
gain, it must be remembered, can be realized only if the general
level of prices for similar products is not reduced at the same time.
If it is, the estimated total revenue at a price of $1.08 would be
smaller, as indicated by the TR l curve, and the total profit would
be less than could be obtained by holding the price at the original
level. (See points C as compared with A.)
It is apparent, therefore, that in formulating its own price policy
the management of the firm must take into account the probable
impact of any change in its own prices upon the pricing policies of
74
PRICE STRUCTURES, LEVELS, TRENDS
other firms, and therefore on the prevailing level of prices for the
same type of product. An aggressive management might feel dis-
posed to take the chance, whereas a conservative management
might feel that it was safer to avoid rocking the boat by taking the
lead in price reductions.
35,000
5,000
IO.OOO 15,000 20,000 25,000 30,0
OUTPUT
40,000
FIGURE 17. PRICING AS AFFECTED BY ANTICIPATED REACTIONS OF RIVAL FIRMS
TRi represents anticipated sales revenues if other firms are expected to vary
their prices concurrently; TR a , anticipated sales revenues if other firms are
expected to hold their prices constant; A, situation in which the price of this
firm is roughly in line with prices of rival firms; B, possible profit if a price
reduction by this firm were not countered by price reductions by rival firms;
C, possible profit if a price reduction by tnis firm were countered by cor-
responding price reductions by other firms.
Much the same analysis may be applied to the possibility of in-
creasing sales volume and total sales revenue by increasing the
advertising outlays of the firm or making product improvements.
The chief difference is that such steps would also tend to raise the
total cost curve, as well as to alter the total sales revenue curve.
If increased advertising outlays were not matched by correspond-
ingly increased outlays by other firms, the gains in total sales
revenues would be clinched; if they were offset by increased adver-
tising outlays by other firms, the total sales revenue curve would
PRICE STRUCTURES, LEVELS, TRENDS 75
tend to be shifted back toward its original position. The added
outlays, however, would have raised the total cost curves for all of
the firms. Each of them might find its ultimate position no better,
or perhaps even worse, than the original position, if the effect of
the combined advertising expenditures did not result in the diver-
sion of consumer purchases from alternative kinds of goods to the
products offered by the firms in this particular industry.
There is, obviously, no single set of prices or production and
sales schedules for all of the firms in an industry that "must" pre-
vail at any given time. However, it might be said that there would
be at least a momentary, if perhaps somewhat unstable, "equi-
librium" in the industry concerned if each firm, through a process
of trial and error, had achieved a position in which the manage-
ment felt th^t no further change in its own prices, relative to those
of other firms, and no change in its own advertising outlays or
modifications of its product, was likely to result in a further im-
provement in its own position, in terms of prospective profits, or
security, or prestige, or any other goal that the management might
have in mind.
Evidently such an equilibrium situation, if ever achieved, might
be upset by any number of possible events either inside or outside
the industry. Suppose, for example, that the firms already engaged
in an industry had achieved a situation in which they were all
relatively well satisfied with their respective shares of the total
volume of business, and had no prospect of immediate advantage
through an alteration of their respective price and sales policies.
They might, nevertheless, find their positions threatened or im-
paired by efforts on the part of new firms to enter the industry, or
on the part of already existing firms in other industries to break
into the field. The entry of new firms would tend to attract some
business away from already existing firms. It would therefore
tend to reduce their respective total sales revenue curves, unless
the demand for the type of product involved was increasing at a
sufficiently rapid rate to absorb the output of new firms without
diminishing the sales of the older firms.
If the increase in demand were not sufficient to offset the entry
of new firms, then the effect of that entry would be to cut back the
total sales revenue curves of the firms in the industry and to reduce
their anticipated profits from operations. It is unlikely that all
firms would be equally affected by the force of the competition
76
PRICE STRUCTURES, LEVELS, TRENDS
offered by the newer firms, or that all firms would have similar
total cost conditions.
If the firms, however, were much alike in cost conditions and in
the relative appeal of their respective products, then the tendency
would be for all of them to suffer approximately equal reductions
in profit prospects. On that assumption it could be said that a
new equilibrium would tend to be established when the division
of the total sales in the market had reached the point at which
none of the firms, old or new, could find any adjustment of their
respective prices and outputs that would enable them to more
than break even. In graphic terms, that equilibrium position
would be reached when the total sales revenue curves for each of
the firms were tangent to their respective total cost curves. Such
a situation is depicted graphically in Figure 18, in which total sales
revenue curves and total cost curves are depicted for three firms,
which may be taken as representative of the entire group.
OUTPUT
FIRM A
OUTPUT
FIRM B
OUTPUT
FIRM C
FIGURE 18. GROUP EQUILIBRIUM IN AN INDUSTRY CHARACTERIZED BY CONDITIONS
OF MONOPOLISTIC COMPETITION
In such a situation, all of the firms would be "breaking even"
with total revenues sufficient to cover total costs, but no more. If
so, there would be no further stimulus to the entry of additional
firms into the industry, or for further expansion on the part of
those already in. There is the chance, however, that mistaken
forecasts of market prospects might have led more firms to enter
than were in fact warranted by the demands for the products of
the firms in the industry, or that existing firms might have over-
expanded on the basis of mistaken forecasts. In that event some
firms, or perhaps the entire group, might find themselves unable
to break even at any price or output that they individually might
choose.
PRICE STRUCTURES, LEVELS, TRENDS 77
Under such circumstances the industry as a whole would be
characterized by overcapacity and by losses on current operations.
Some firms might be unable to continue in operation indefinitely
in the face of losses, and others might seek to improve their posi-
tions by diverting their facilities, in part or in whole, to the pro-
duction of some other kind of product not directly competitive
with the products of the firms remaining in the industry. Such a
process of withdrawal from the industry would tend to increase the
shares of the total business obtainable by the firms which remained
and to increase their respective total sales revenue curves once
more. This process presumably would continue until the ma-
jority, if not all, of the remaining firms were at least breaking
even, with total revenues sufficient to cover the total costs of pro-
ducing their respective outputs. When and if none of the remain-
ing firms could foresee any advantage to be obtained by further
changes in their respective prices and outputs, and there were no
incentives to the entry of new firms or the exit of existing firms
from the industry, a position of equilibrium would once more be
established for the industry.
It must be emphasized again that such an equilibrium position
is seldom, if ever, fully attained or maintained over any period of
time, because general economic conditions do not remain static.
Changes in people's tastes and preferences, in their incomes, in
business prospects generally, and in the technology of production,
to name but a few of the relevant circumstances, are constantly
occurring and setting in motion processes of further adaptation on
the part of different firms in any industry and in different indus-
tries. One may think of business firms as being engaged more or
less constantly in making changes in their own price and produc-
tion policies in an effort to adapt themselves to prospective
changes, as they see them. These changes represent tendencies
toward equilibrium. But the processes of adjustment are never
fully completed, and the direction of adjustment may itself be
altered by changes in conditions that lie far beyond the control of
any individual firm, or even of an entire industrial group.
Interfirm price and production relationships under oligopoly
What has been said of monopolistic competition applies likewise
to the case of oligopoly, where the number of rival producers of
similar products is small. But in the latter case strategic considera-
78 PRICE STRUCTURES, LEVELS, TRENDS
tions are more likely to lead the few rival producers to avoid price
competition if at all possible. Where the rival producers are few
in number, a small reduction in price by one firm might result in
an increase in its sales if the other firms did not follow suit. But
the additional customers would be drawn away from a few rivals,
and the cause of their losses in sales would be much more obvious
than if the shift of customers were distributed over a large number
of rivals. The likelihood, therefore, is that countervailing price
adjustments would be made quickly by other firms in order to halt
the shift in customers or to reverse it. Thus the chance of gaining
sales volume at the expense of rival concerns must be, and com-
monly is, heavily discounted. There is also a widespread fear, in
industrial circles, that the initiation of a price reduction by one
firm may touch off a "price war/' with repeated price cuts by each
of the various rivals in a see-saw battle for the available business.
As a consequence, competition in oligopolistic situations is
much more likely to take indirect forms: advertising (where the
products are somewhat differentiated from one another), or the
offering of additional services, generous credit terms, and the like.
All of these tend to affect profit margins by raising total costs rather
than by lowering prices; they will tend to lower profits if they raise
the total cost curve for a given firm more than they raise its total
sales revenue curve. A certain degree of stability or "equilibrium"
might be said to exist in the price structure of an oligopolistic in-
dustry if each of the rival firms had achieved an adjustment of its
own prices, advertising and selling activities, and product modifi-
cation, in comparison with those of other firms, such that no firm
saw a prospect of advantage to itself in undertaking any further
change in its own policies.
As in the previous case of monopolistic competition, it is pos-
sible that such an equilibrium, if attained, might be upset by the
entry of new firms if it appeared that the firms already in the
industry were making substantial profits. But in such situations,
there are frequently serious obstacles to the entry of new firms. In
some instances, a heavy initial investment is necessary to construct
a plant of the size required to achieve a degree of economy of
operation comparable to that of firms already in existence. Very
large risks of loss would therefore face the promoters of any new
firm seeking to enter the field, particularly if it seemed likely that
the firms already in existence might be disposed to fight off the
PRICE STRUCTURES, LEVELS, TRENDS 79
threat of new competition by temporary price reductions. In
other cases, the entry of new firms may be difficult because large
sums would have to be expended in establishing market outlets,
and servicing facilities, and gaining consumer acceptance of the
product, as, for example, in the automobile industry. In still other
cases the product itself, or important processes of production, are
covered by patents held by one or more of the existing firms. In
such cases, a refusal of a license to the prospective newcomer to
utilize the patents may operate as an effective barrier to the entry
of new firms into the industry.
Where such barriers to the entry of new firms do exist, it may
be possible for the firms already in the industry to achieve and
maintain a position of equilibrium among themselves, with each
firm reaping substantial profits from current operations, and with
a considerable measure of security in the continued enjoyment of
those profits. Under such circumstances there is no reason to sup-
pose that the forces of competition, either from within or without,
will necessarily tend to force prices into close approximation to
production costs. Even so, however, the firms in the industry are
"seldom in position to prevent the possible impairment of their
position as a consequence of the development of competition from
other industries.
In the case of oligopoly, as in the case of monopolistic competi-
tion, there is little reason to suppose that a position of equilibrium,
if attained, could in fact persist for any great length of time, be-
cause economic conditions are constantly changing and creating
opportunities and incentives for further adaptation on the part of
the firms concerned. It is more appropriate to think of competi-
tion among rival firms, whether they be few or many, as a continu-
ous process, in which readjustments are made from time to time,
sometimes smoothly and sometimes only in a rather jerky fashion,
as the various firms find modifications in their respective price and
production policies prospectively of advantage to themselves.
Interfirm price and production relationships under pure
competition
Under conditions of pure competition, with a large number ot
producers turning out an identical product and selling it in a
common market, none of the producers is in position to frame a
price policy of his own. He must sell at the prevailing market
80 PRICE STRUCTURES, LEVELS, TRENDS
price if he wishes to sell at all. His planning, therefore, is con-
cerned primarily with forecasting the probable market price at the
time his product will be ready for the market, and deciding what
output would be most profitable for him to produce in the light
of that price forecast.
Inasmuch as the quantity of product actually placed on the mar-
ket depends on the production plans formulated by perhaps many
thousands of separate producers, whose forecasts of probable future
prices may also diverge widely from one another, the actual price
that equates the supply of and demand for the product may turn
out to be either relatively high, in comparison with the unit costs
of production of many producers, or relatively low. In the first
case many, if not all, of the producers may reap substantial profits.
In the second case, many of the producers, if not all, may experi-
ence losses of varying magnitudes.
In a period when the producers in a purely competitive industry
are in general making substantial profits, there will be an incen-
tive for producers already in the field to expand their productive
operations, and also for new producers to enter the industry, either
by shifting over from other products or by establishing new enter-
prises. The net effect will be a tendency to increase the supply of
the commodity in question relative to the demand for it, and
therefore to drive the price downward. Conversely, if the price of
the product is relatively low, and many producers are suffering
losses, there will be an incentive for the existing producers to cur-
tail their operations, if possible, and for some of them to shift their
activities to other industries or to other types of products, if there
is any possibility of utilizing their productive facilities in other
ways. Such shifts of productive facilities, however, are often diffi-
cult to accomplish quickly, and a long period of time may elapse
before such a transfer can be accomplished on a large scale. The
interim period may be one of severe pressure and hardship for the
producers in the industry concerned.
If all producers in a purely competitive industry had substan-
tially similar costs of production, it could be argued that the forces
of competition would tend to drive the market price toward equal-
ity with unit costs of production, that is, toward a position in
which the total revenue and total cost curves of each of the pro-
ducers were tangent to each other, each producer receiving total
revenues approximately equal to the total cost of producing the
PRICE STRUCTURES, LEVELS, TRENDS 81
output of each firm. It would be strange, however, if all of the
producers in the industry had identical costs of production, so that
all would just break even at the same level of market price. Dif-
ferences in the relative positions of different producers may arise
because of differences in the ability of management, in the age and
character of productive equipment, in the ease of access to the
market (reflected in costs of transporting the product to market),
in the availability or quality of raw materials or labor, or in natu-
ral advantages of one sort or another. One wheat farmer or dairy
farmer, for example, may operate under much more advantageous
conditions than another, and be able to produce the product prof-
itably at a price that would be ruinous to another.
If it is possible for firms having higher costs of production than
others to duplicate the facilities of their lower-cost competitors,
there may be a gradual shift in the relative positions of different
firms in terms of profitability. But anything that tends to give a
firm a permanent position of advantage will stand in the way of
such an equalizing process. If some producers owe their advantage
to superiority of location, for example, it may be impossible for
'other firms, no matter how able their managements, to offset
that advantage. Anything, however, that tends to give one firm a
position of permanent advantage will tend to be valued in propor-
tion to the advantage it confers. A good location or superior land
will increase in value if it is found that a firm occupying that site
or using that land can achieve lower variable costs than firms
located elsewhere. A farmer who has very productive land finds
that he could sell his land at a higher price than would be paid for
poorer land in the same locality. If he were willing to retire from
active farm operation, he could rent his land to another farmer at
a comparatively high rental. If he should sell his land at a high
price to another farmer, the latter would find that although the
land was very productive, and that a large crop could be raised
with relatively low variable costs, the interest on the necessary in-
vestment in the land would make his fixed costs of production
relatively high, thereby partially offsetting the advantage of using
the superior land. Or if the original farmer were to rent his land
to another, the rental payment would in the same way tend to off-
set the advantage of comparatively low variable costs of produc-
tion.
This means that from the standpoint of the more favorably sit-
82
PRICE STRUCTURES, LEVELS, TRENDS
uated producers, their advantages in terms of variable costs are
partially canceled out by relatively greater fixed cost elements. As
a consequence, the differences in total costs for well situated pro-
ducers, as compared with those using poorer resources, may be
much less than the differences in their respective variable costs;
and if there were no elements of friction involved in revaluing
advantages of location, the total costs of all producers would be
the same as the total revenues that they respectively received for
the outputs that they produced. In other words, the unit costs of
each of the producers would be the same as the prevailing market
prices, and none of the producers, in an equilibrium situation,
would show a profit spread between total costs and total revenues.
This hypothetical equilibrium situation is depicted graphically
in Figure 19, in which Firm A represents a producer with a supe-
rior location or superior resources, Firm B a producer operating
with resources of average quality, and Firm C a producer operat-
ing with comparatively poor resources. Their respective outputs
differ, but for each firm total costs and total revenues are equal at
the output indicated, and no other output would enable any one
of the firms to break even.
OUTPUT
FIRM A
OUTPUT
FIRM B
OUTPUT
FIRM C
FIGURE 19. GROUP EQUILIBRIUM IN AN INDUSTRY CHARACTERIZED BY CONDITIONS
OF PURE COMPETITION
If the prevailing market price were to decline, all of the firms
would fall short of breaking even. If the price were to fall to the
point where Firm C could not cover its variable costs of produc-
tion, it would be forced to withdraw from production. Firms
A and B would show losses under such circumstances, but they
would not necessarily be forced out of production. However, if
the lower level of market price were expected to persist, a lower
PRICE STRUCTURES, LEVELS, TRENDS 83
valuation would be placed on the possession of specialized re-
sources needed for production. Superior land or location would
be less desirable and would command lower prices or rentals. A
new producer seeking a favorable location would offer a lower
price for its possession, and if he obtained such a location at a
lower price, his fixed costs of production would be correspond-
ingly reduced. That in turn would lower his total costs of pro-
duction, and he might be in position to break even at the lower
level of market price.
This pointthat certain components in total costs of production
for the firm depend on the valuations placed upon specialized re-
sources of different qualitieshas long been recognized by econo-
mists. It is summed up by the traditional statement that high
rentals of land and the costs of other similar resources are not the
cause of high prices but rather a consequence of high prices for
the products concerned. This is, however, but one example of the
interdependence of prices of different kinds of goods and produc-
tive services, an interdependence which in some measure charac-
terizes the entire price structure for all kinds of goods and services.
These relationships, as they apply to the valuation of the agents
of production, will be dealt with in somewhat greater detail in
Chapter 8.
Interindustry price structures
Thus far the discussion of price structures has been concerned
with the relationships linking the activities of firms producing
similar if not identical products, so that they could be loosely
classified as operating in the same industry. But just as no one
firm in an industry can commonly pursue a completely independ-
ent course, so also is it necessary to recognize the fact that indus-
tries themselves are but parts or segments in an even larger struc-
ture. Rarely are the prices or sales of any given type of product
unaffected by changes in the prices and sales of the products of
other industries. The competitive aspect of interindustry substi-
tution was symbolized years ago by the cigarette manufacturer's
advertising slogan "Reach for a Lucky instead of a sweet" and by
the well organized campaign of the dairy industry to prevent the
sale of colored oleomargarine. The prices and sales of lumber are
affected by the prices of other building materials; the prices and
sales of copper are in part determined by the prices and sales of
84 PRICE STRUCTURES, LEVELS, TRENDS
steel, aluminum, and other nonferrous metals, and so on. Even
where products are not capable of serving the same uses, they still
stand in a semicompetitive relationship to each other as rivals for
a place in the budgets of consumers or of industrial users.
In most instances no single firm is in position to determine just
what alternative products of other industries are responsible for
the behavior of the demand for its own product, or for changes in
its own prospective total sales revenue at any given price. All that
the single firm can do is to try to maintain the sales of its own
product either by expending added sums on advertising or product
improvement (if the product is identifiable) or by readjusting
prices if it appears that they have "got out of line" with the pre-
vailing level for alternative products.
Interindustry price structures have a manifold significance be-
cause they embrace not only the "horizontal*' interrelationships of
firms and industries producing different types of finished goods
but also the "vertical" interrelationships of firms and industries
producing commodities at different stages of the over-all process
of production. For example, the price structure of the automo-
bile industry reflects the competition of the various automobile
manufacturers in their attempts to attract the favor of ultimate
users of automobiles at any given time. But automobile prices
may also be compared with the prices of component parts pur-
chased from other firms, with the prices of steel, fabrics, glass, and
other materials used in motor car production, with the wages of
workers employed in automobile manufacturing, and so on. Ob-
viously the prices of semimanufactured goods and raw materials,
of equipment, and of labor, affect the costs of automobile produc-
tion, and therefore are linked with the prices of these "end prod-
ucts" of the industry. Changes in prices at any level of the whole
process of production and distribution will react up and down the
entire chain, resulting either in widened profit margins or in
"squeezes" at various levels, that in turn stimulate further changes
in price and production policies on the part of the firms affected.
Thus the entire economy embraces manifold industrial seg-
ments and segmental price and production structures that are
linked with one another, sometimes very closely and sometimes
only loosely or indirectly. As changes in prices and production
occur in certain segments, horizontal and vertical price disloca-
tions or disparities tend to develop and to force changes in other
PRICE STRUCTURES, LEVELS, TRENDS 85
segments. One of the major problems of industrial and public
economic policy is to find ways and means of bringing about re-
adjustments that will ease the strains and repercussions of such
dislocations.
During the first part of this century, the cotton textile industry
found itself involved in an extensive and prolonged structural
maladjustment that resulted from the rapid development of cot-
ton textile manufacturing in the South. The cotton textile man-
ufacturers of New England found themselves faced with increas-
ingly severe competition from newer southern mills, and many
were ultimately forced to close down because they were unable to
achieve reductions in production costs that would enable them to
survive. Others found it possible to continue in operation by
concentrating on finer goods or specialty products to which their
plants were relatively better adapted than were the facilities and
labor force of the southern mills.
More recently the cotton growers of the South have found
themselves faced by a changing demand for raw cotton because of
the development of the synthetic fibers, paper, and plastic mate-
rials which have come to supply an increasing, though still com-
paratively small, part of the nation's requirements for fiber. As a
consequence, a price for cotton that at one time would have in-
sured very large sales of raw cotton may now be one that would
cause a continuing loss of outlets for cotton because it is relatively
high in comparison with the prices of newer alternative materials.
The point is that price structures that may represent conditions
of comparative equilibrium at one point in time, either within a
given industry or as between industries (in that they do not pro-
vide any immediate incentive to any producer or group of produc-
ers to initiate changes in prices or in output), may and do get "out
of focus" over a period of months or years, as a consequence of
changes of many kinds. Changes in people's tastes and modes of
living, the development of new products and production tech-
niques, changes in the amount of income that people have to
spend, the opening up of new sources of materials, changes in
population and in the distribution of the population as between
different sections of the country, all these and many other cir-
cumstances operate to prevent the achievement or maintenance of
equilibrium. The economy as a whole is dynamic, not static, and
the economic process is one of continuous adaptation.
86 PRICE STRUCTURES, LEVELS, TRENDS
Price Levels and Trends
Changes in relative prices over time
Studies of the prices and production of different commodities
over considerable periods of time show that some are much more
sensitive than others to changes of the sort discussed in the preced-
ing section. There is also no reason to suppose that all industries
would be affected equally by the impact of new products or new
methods of production, or by changes in people's tastes or modes
of living, or by changes in population or in the geographical dis-
tribution of the population. Furthermore, changes in the prices
and production in certain segments of the economy might be off-
set by opposite changes in other segments. Thus, to get an accu-
rate picture of the functioning economy, it is necessary to see
whether the prices and production of certain kinds of commodities
are tending, with any degree of persistence, to rise or fall in com-
parison with others. When such a clear-cut tendency is evident,
one may say that the trend in the prices (or production) of these
commodities is upward or downward. A knowledge of these
trends, supplemented by a careful analysis of the underlying forces
that they reflect, is important to economists, businessmen, public
administrators and lawmakers, and the public at large because it
will provide a better basis for formulating business and govern-
mental policies aimed at avoiding the development of critical
stresses in the economy or relieving stresses that may already have
arisen.
Attention has been focused thus far on the competitive forces
that link firms and industries and give rise to changes in their rela-
tive positions. But the demands for, and prices and sales of, dif-
ferent commodities are also influenced in varying degrees by
changes of a more general sort affecting the economy as a whole.
Over the years, changes in population, in the general level of em-
ployment and spendable income, and in volume of money and
credit in the country (to name but a few of the forces acting over
a broad front) are reflected in the demands for, and prices of, many
different kinds of goods. Some of these changes in basic economic
conditions show a definite cyclical pattern of expansion and de-
cline, and are, indeed, major manifestations of the business cycle.
Other changes show no definite pattern of expansion followed by
PRICE STRUCTURES, LEVELS, TRENDS 87
decline, but continue to operate in the same direction for periods
of time that are not directly related to the level of business ac-
tivity.
Cyclical changes in prices and production
Over the years, changes in the general level of economic activ-
ity, employment, and income, associated with alternating periods
of general prosperity and depression, have had a profound impact
upon the demands for, and prices and sales of, all kinds of com-
modities. In periods of general prosperity and high-level employ-
ment, people, whether wage earners or salaried workers, owners or
managers of business, or creditors or owners of real estate, in gen-
eral have larger incomes than in periods of widespread unemploy-
ment and depression. With these incomes they are in position to
buy and pay for a larger variety and quantity of consumers* goods.
Hence the demands for virtually all kinds of goods, and the ex-
pected total sales revenue curves of business firms in general, tend
to be shifted positively. More goods, under such circumstances,
could be sold at any given price than when the incomes of the
people of the community were smaller. Gains in sales for a par-
ticular firm, under such circumstances, may be obtained without
aggressive competition to attract customers from rival firms.
In periods of general business activity, moreover, business firms
themselves have an incentive to expand their operations, and
hence to increase their purchases of machinery, plant facilities,
and all the other means of providing an increased total output*
Thus the demands for producers' goods, as well as consumers*
goods, tend to be increased in a period of general prosperity.
Conversely, a decline in the general level of economic activity,
as in the downward phase of the business cycle, tends to reduce the
demands for all kinds of goods and services, both at the consumers'
and the producers' level. If people are working short time, or
fearful of losing their jobs entirely, they feel constrained to curtail
their expenditures wherever possible. Thus the demand for any
given firm's product, and its estimated total sales revenue curve,
tend to be shifted negatively. Here again the change in the situ-
ation facing any single firm is not necessarily a consequence of
intensified competition from rival firms; all may be losing sales at
the same time. There is also no assurance that a reduction in the
price of the firm's product would fully arrest the loss in sales, be-
88 PRICE STRUCTURES, LEVELS, TRENDS
cause people are seeking to conserve whatever incomes they have
at their disposal.
In explaining the sales of different commodities, such consider-
ations suggest that, in both a period of expansion and of contrac-
tion, the influence of changes in the incomes of the people in the
community may often be greater than the influence of changes in
the prices of commodities. In other words, the prosperity of a
given firm may be affected in much greater degree by the force of
changes in the general level of economic activity, employment,
and income in the economy than by the competition of its own
immediate business rivals.
The individual business firm, or even all the firms in a sin-
gle industry, however, can do comparatively little to cope with
changes in demand which result from changes in the general level
of employment and income in the entire community. Measures
to cope with such changes must be formulated and put into oper-
ation on an economy-wide basis if they are to be effective. Hence
they fall primarily within the scope of national or governmental
economic policy rather than of individual firm or industry plan-
ning.
Noncyclical forces affecting price levels and production
Many forces affecting the level of prices and production over
broad sectors of the economy, or over the entire economy, are non-
cyclical in character. The growth of the nation's population is
one such force. Changes in the volume of money and credit with
which business is carried on, and, even more important, changes
in governmental fiscal policies and expenditures reflecting the im-
pact of war, are also responsible for major changes in the general
level of prices and production. An adequate consideration of the
working out of these forces, in the light of American experience,
would greatly prolong the present discussion. For the moment it
is sufficient to note that these forces do play a prominent role in
determining the general level of prices and production, and that
the forces themselves lie far outside the control of individual busi-
ness firms or industries. To account for the broad movements of
prices and production, it is necessary to think constantly in terms
of the behavior of the economy as a whole, and to view individual
firms or industries, not as entities functioning by themselves, but
as articulated parts of the larger "macroeconomic" system.
Part Two
ENTERPRISE, FACTOR PRICING,
EMPLOYMENT, AND INCOMES
Chapter 6
PROFIT EXPECTATIONS AND
INCENTIVES OF ENTERPRISE
Nature of Enterprise
Goods and services are not produced for their own sake, but
because it is believed that a demand for them exists or can be
created by skillful sales effort or advertising. Furthermore, goods
and services do not produce themselves. They are brought into
existence only because someone takes the initiative in assembling
the necessary means and directing the processes of production.
Some goods and services are, of course, produced by people for
their own use, as can be seen in the operations of any household
or farm. The activities of governmentfederal, state, and local
also comprise an important segment of our entire economy. But
a major part of the economic activity in the modern economy still
is carried on by business enterprises which undertake to produce
goods to meet the anticipated demands of consumers or other
users of goods and services. Any person or organization undertak-
ing the production of goods or services for sale to others is an
enterpriser, from the bootblack or popcorn vendor to the United
States Steel Corporation or the Tennessee Valley Authority. The
essence of enterprise is the initiation and conduct of economic
activities. It would, however, be rash indeed to suppose that
entrepreneurial decisions made by such diverse enterprisers are all
of equal weight in explaining the behavior of production in the
economy as a whole.
91
92 PROFIT EXPECTATIONS
Dual role of business enterprise
It is significant to note, in this connection, that the business en-
terprise plays a dual role. On the one hand, it is a supplier of the
goods or services that it undertakes to produce, and so appears as
a supplier in the market or markets in which those goods and
services are sold. This phase of the operations of the enterprise
has been analyzed in preceding chapters. But the enterprise is
also an employer of the productive resources and services needed
to turn out the finished product. Thus it appears as a demander
for labor services, raw materials and supplies, and all the other
productive facilities required to turn out its product. Obviously,
any individual firm's demands for these productive resources and
services will be closely linked with the demand for its own par-
ticular product. Very seldom would the firm voluntarily employ
larger quantities of resources than are needed to produce the out-
put of finished goods that is believed to be salable at a profit.
Enterprise as related to employment and income
Inasmuch as the enterprise is in position to exercise the initia-
tive in determining the extent of its own productive operations,
and hence the amounts of the various resources employed, the
employing firm's demands are significantly related to the incomes
that are received by those who provide resources and services for
use in production. The wage earner's income depends largely
upon the wage rate at which he is employed and on the number of
hours he works per week; thus he looks to his employer as the
immediate source of the income he receives. A change in wage
rates or in the amount of employment offered him will directly
affect the amount of his income. And the same thing is true,
although somewhat more indirectly, of those who obtain incomes
by virtue of the ownership of property of one kind or another.
Thus, in any discussion of the circumstances that tend to deter-
mine the prices paid for the use of productive services and re-
sources, the extent to which they are employed, and the incomes
received by those who provide or own them, it is necessary to start
with an analysis of the factors that influence entrepreneurial deci-
sions with respect to production. This chapter, therefore, is de-
voted to a discussion of the incentives that influence the decisions
of enterprisers, large or small, with respect to production and
employment.
INCENTIVES OF ENTERPRISE 93
The Dominant Role of Expectations
Expectations as determinants of production plans
At this point it is necessary to emphasize once again the signifi-
cant role that the expectations of business enterprisers play in
determining their plans with respect to production and employ-
ment. Expectations are important because, with few exceptions,
days, weeks, or perhaps months must elapse before the production
of goods or services can be completed and the sale of the finished
product to consumers or other users accomplished. Consumers'
goods to be sold for the Christmas trade must be produced and in
the hands of wholesalers or retailers by early fall; the body design
of next year's car must have been selected, and the necessary dies
and fixtures put into production, many months before the new
model appears on the streets.
Thus, production budgets must be drawn up, commitments
made for raw materials, supplies, and equipment, and large ex-
penses incurred in the production of the initial run of product
weeks or perhaps months before the acceptance of the product by
the public can be ascertained. Normally, the firm will seek to
maintain some degree of flexibility in its operations. But there is
no escape from the necessity of making extensive commitments
in advance, based on forecasts or estimates of the future demand
for the finished product, as well as of the probable costs of produc-
tion, with allowances made for many contingencies that may arise
as production plans are carried into execution.
Expected or ex ante returns versus realized or ex post returns
A distinction must thus be drawn between the planning or
budgeting aspect of business enterprise, which involves the mak-
ing of plans for a subsequent operational period (perhaps three
months, six months, or a year) and the accounting aspect of the
enterprise, which involves a recapitulation of the results of these
operations at the end of the operational period. A corresponding
distinction must be made between the expected or anticipated
earnings or profits of business enterprise, on the basis of which
policies are formulated and plans made, and the realized earnings
or profits of enterprise as determined by the accountants after the
results are all in.
The plans determine how many goods or services will be pro-
94 PROFIT EXPECTATIONS
duced and what quantities of resources will be employed. As the
processes of production and sale progress, the actual results may
be quite different from what was expected when the original plans
and commitments were made. At the end of the year, or the
quarter, or any other conventional accounting period, it may be
found that actual sales revenues for the period were either greater
or less than had been expected, and also that production costs
actually incurred were greater or less than had been anticipated.
What remains as earnings for the enterprise (the excess of total
sales revenue over total costs incurred) therefore may exceed or
fall short of the original expectations.
By that time, however, labor and other productive resources
have already been employed, and in general paid for, and the
goods or services have been produced and sold. There is no way
of going back, on the basis of hindsight, and changing what has
already been done. Therefore, the profits or earnings that are
actually realized have no direct significance in determining the
production, employment, and pricing policies of the enterprise.
For example, an aircraft manufacturing firm might have found, at
the end of 1945, that it had made large profits on its production
of military aircraft during that year. But that would provide no
basis for planning for an equally large or larger production of
such aircraft for 1946, when presumably government requirements
for planes would be drastically reduced.
It is now common in economic literature to refer to expected
or anticipated profits, on the basis of which plans are made, as
ex ante profits (profits as viewed before the fact) and to refer to
actually realized or accounting profits as ex post profits (profits as
viewed after the fact). The following discussion is concerned with
profit expectations or anticipations, that is, earnings or profits
ex ante. The latter part of the chapter will deal in some detail
with the calculations by which actually realized earnings or profits
are determined ex post, and with the disposition that may be
made of such earnings among the various groups who have claims
against those earnings.
Realizations of one period as an element conditioning future
prospects
It must be recognized, of course, that the results of past opera-
tions may condition what the business enterprise can do in the
INCENTIVES OF ENTERPRISE 95
future. For example, a firm that has shown a long record of prof-
itable operation in the past may have ample resources at its dis-
posal and find little difficulty in obtaining additional funds, if
needed, to carry out its plans for the future. A new firm, on the
other hand, or a firm that has experienced severe losses in the
past, may encounter serious difficulties in seeking to attract re-
sources with which to carry on production, even though the pros-
pects for profitable operation in the future are regarded as bright
by those at the helm of the enterprise. Granting all this, it is still
true that the decisions of those responsible for the conduct of the
enterprise will be guided by their own views or forecasts of the
future, and that they will be unlikely to make commitments for
future production, regardless of the resources that could be com-
manded, unless there is a prospect that the operation will be
profitable.
It is possible that, in forecasting the future, those responsible for
the conduct of the enterprise may simply assume that the condi-
tions affecting the operations of the firm are unlikely to change
radically and that future returns are likely to be about the same
as were those realized in the past. That may or may not be a
rational forecast, but if it is made, then it will condition the deci-
sions that must be made now in order to keep production going
at the same level.
If there is an expectation of increased demand for the product
of the firm, and therefore of increased total sales revenues, an in-
centive exists for making such adjustments in production plans,
and in the employment of productive resources, as seem most
likely to afford the maximum gain to the enterprise. Or, if there
is a prospect of increased production costs, a corresponding re-
adjustment of production and employment plans, and perhaps
prices, will appear to be in order. Conversely, if there is an ex-
pectation of diminished demand for the product, or of alterations
in costs, there will be a basis for altering the plans of the firm for
future production.
The time span of expectations as related to planning
Obviously the future stretches on to eternity, and no business
firm would seek to plan once and for all for such an indefinite
span of time. Actually there are great differences in the period
of time that must be contemplated by business management with
96 PROFIT EXPECTATIONS
respect to different parts of its planning problem. Production
plans and commitments can be varied, within the limits of exist-
ing plant capacity, on comparatively short notice. Production
schedules may be adjusted quarter by quarter, or month by month,
or sometimes even day by day, depending on the amount of no-
tice required to vary the procurement of raw materials and labor.
The decision to install additional machines, or to erect new build-
ings, or to develop a new sales organization involves much longer
forecasts, covering a few years or perhaps two or three decades.
Thus a much greater degree of uncertainty and risk of potential
loss affects certain business decisions than affects others, because
they involve longer spans of time, within which unpredictable
changes of conditions may occur.
Profit Expectations as Contrasted with Other Incentives
to Enterprise
How precisely can future prospects be evaluated?
In recent years, it has frequently been charged that economic
analysis is based on the assumption that business activity is moti-
vated exclusively by the desire for profit, and that an unrealistic
degree of emphasis is placed on the maximization of profit pros-
pects. In the first place, it is said that conventional economic
analysis assumes that businessmen know far more than they actu-
ally do about the demands for their products and their costs of
production, and that, in fact, business decisions rest on far less
precise calculations than would be supposed from a study of a
textbook on economics.
An effort has been made in this book to indicate that business
decisions are necessarily based on estimates of prospective de-
mands and costs, which may or may not be accurate. Those esti-
mates may be thought of in terms of probabilities, with respect to
which a considerable margin of error in estimation may be in-
volved. It is clear, also, that a businessman's estimate of what is
likely to happen in the future is often swayed by the views of his
friends or associates, by what he reads in the newspapers or in
trade journals, by his political convictions, or by the prevailing
tone of optimism or pessimism in the community. But in the last
analysis it is what a man thinks that influences his action, even
though later events may prove that his forecast or estimate was
INCENTIVES OF ENTERPRISE 97
wrong. Thus, by recognizing the element of fallibility in human
judgment, it is possible to escape at least a part of the weight of
this first charge.
The significance of nonpecuniary motives
A second point in the charge against conventional economic
analysis is that it puts exclusive stress on the desire to maximize
profits and ignores other incentives that may have great impor-
tance in determining the plans and undertakings of business en-
terprise. These other incentives or motives may differ widely.
For example, certain prominent business leaders and others have
stressed the ideas of "business as a profession" and the public re-
sponsibilities of business enterprise. In times of war or emer-
gency also, patriotic considerations may exercise a powerful influ-
ence on business decisions. But at the same time the position of
self-styled "hard-headed" businessmen must be recalled. These
men take the attitude that they are not in business for their health,
that no one else will pay their bills, and that in the last analysis
the acid test of any proposition is whether or not it will make
money. Even the most altruistic business leader is unlikely to
embark deliberately upon a venture that promises to result in loss
if, by any legitimate alternative, that loss could be avoided.
In other quarters stress has been placed on such incentives as
the desire for security for the enterprise or the protection of the
capital position of the enterprise. The effort to achieve security
may lead to the development of policies designed to protect the
position of the firm in its field against the encroachment of rivals,
but not necessarily designed to exploit all opportunities for gain.
Or, alternatively, the desire for power or prestige may induce con-
tinued expansion of large firms, even though there is no clear evi-
dence to support a belief that such expansion would carry with it
commensurate gains in earnings.
Long-term versus short-term gains, and strategic considerations
in business policy
It must be noted that there may be a difference between maxi-
mizing immediate profit expectations and maximizing the profit
expectations of the firm for a longer period in the future. Strate-
gic considerations that concern the position of the firm for many
years to come, both in relation to its business rivals and in relation
98 PROFIT EXPECTATIONS
to its sales prospects and its structure of production costs, may also
play a significant role in the formulation of policy.
This point is perhaps illustrated by the history of the automo-
bile industry in the years following World War II, when the ma-
jor manufacturers refrained from raising new car prices and
boosting manufacturing profits to the full extent that the pent-up
demand for automobiles would have permitted. By adopting a
more moderate policy, the automobile manufacturers escaped a
part of the resentment on the part of car buyers that might have
been directed at them had they exploited current opportunities
for profit to the hilt, and most of the opprobrium was directed to
the "gray-market profiteers" who "gouged'* the buying public. It
is also possible that the automobile manufacturers held within
narrower limits the price reductions that might subsequently have
to be made to maintain the salability of their products. They
may also have limited to some extent the increase in wages de-
manded by their employees, and so kept down the future level of
production costs.
Granting that to place exclusive emphasis upon the maximiza-
tion of profit prospects may give an erroneous impression of the
factors that govern entrepreneurial decisions, it may be said that
profit expectations represent only one of many considerations play-
ing upon the plans and commitments of enterprise. But no busi-
ness firm can expect to remain long in existence if it is consist-
ently unable to obtain, in revenue from the sale of its product, an
amount sufficient to meet the obligations incurred in production.
In general, a firm's price, production, and employment policies
will necessarily be formulated with an eye to the avoidance of
losses, if that is humanly possible, whether or not those policies
are intended to wring every last penny of profit from the conduct
of the firm's operations. Moreover, few business enterprises would
regard the showing of a handsome profit from operations as an
unmitigated calamity.
Expectations, Risk Assumption, and Profits
Assumption of risk as an element in enterprise
Whatever the complex of motives that may influence present
business decisions, the fact remains that in order to carry on oper-
ations at all, present commitments must be made commensurate
INCENTIVES OF ENTERPRISE 99
with the magnitude of the projected operations. In making these
commitments, a risk is necessarily assumed that the conditions
that emerge with the passage of time may be quite different from
those that are now forecast, and that the results may be either
much more favorable or much less favorable than are now an-
ticipated.
Obviously, there will be no complaint if the returns are unex-
pectedly good; but what if they are bad? The incentive to take
this risk exists because the only way by which the enterprise can
be put in position to reap the hoped-for gain is to assume the risk;
"nothing ventured, nothing won." The larger the possible gain,
generally speaking, the greater will be the willingness to assume
the risk. And, conversely, the greater the apparent chance of loss
if things go poorly, the greater will be the prospective chance of
gain needed to induce the assumption of that risk.
Are profits a reward for risk- taking?
This sort of analysis has often led to the conclusion that "profit"
is a "reward" for risk-taking, which, in turn, is necessary if the
processes of production are to go on. The difficulty with such a
view is that the profits that are important from the standpoint of
incentives are ex ante profits, that is, profit anticipations before
the fact, and that these anticipations have little connection with
the realized profits, or profits ex post. The risks that are impor-
tant are expected hazards and not those adverse events which may
or may not in fact occur. Indeed, one may say that realized prof-
its tend to be large if anticipated risks or hazards do not material-
ize, and vice versa.
The case of monopoly profits
Furthermore, difficulties beset an explanation of profits as a re-
ward for risk-taking when one comes to grips with the problem of
monopoly profits, or gains that may result from policies designed
to exclude potential rivals from the market. In such a case, the
monopolistic firm, by following out policies designed to assure it-
self of a preferred market position, may greatly reduce the risks
which it faces. Yet that does not necessarily reduce either its
profit expectations or its profits actually realized. What can be
said in such a case as to the significance of risk as an element re-
lated to profits?
100 PROFIT EXPECTATIONS
A way out of this difficulty may be found by reexamining the
relation of risk assumption to profit anticipations. Business en-
terprisers assume risks (up to a certain limit) in order to put them-
selves in position to cash in on profit opportunities as they see
them; they do not go out deliberately to assume risks for their
own sake. If they believed that they faced no risks at all, their
enthusiasm would doubtless be even greater. But at any given
time, the risks involved in making present commitments, even in
the same industry, are not the same in the eyes of all potential
enterprisers. For the firm already established in the field, the
risks attaching to present commitments are likely to appear much
less grave than the risks as appraised by a newcomer or by those
who are considering an attempt to enter the field. And if the
firm or firms already in the field are large or very aggressive, other
firms, new or old, that might be competent to enter the field, may
be deterred by fears that an attempt to do so will be met by re-
taliatory action on the part of those already "in/* The history of
American industry is strewn with the records of firms that tried
to crash their way in and failed.
Thus, the risks of possible loss, as appraised by would-be com-
petitors, bulk much larger than do the risks of already established
firms and serve as a deterrent to entry. By holding down the ex-
tent of competition faced by those already in, the risks that the
latter must assume are correspondingly reduced and their profit
prospects thereby protected. Handsome realized profits and gen-
erous profit prospects for firms operating in protected markets are
to be explained thus; not in terms of the prospective risks that
they themselves must assume, but in terms of the large risks that
would have to be assumed by anyone else who sought to challenge
their position risks that may in fact prevent new rivals from
appearing at all.
The assumption of risk, then, represents the stake that must be
put up to participate in the game, and if some of the players can
control the deal of the cards, they may stand to gain more than if
they did not, with little chance that their hands will be low on
the show-down.
Profit expectations, not profits realized, the key to enterprise
A further point may be made with respect to the significance of
profits as an incentive to economic activity, namely, that though
INCENTIVES OF ENTERPRISE 101
profit expectations are essential as a stimulus to the initiation and
continued conduct of business operations, it is not necessary that
profits actually realized from such operations exceed the losses of
those whose expectations are disappointed. It has been said that
the amount spent over the centuries in prospecting for gold ex-
ceeds the value of the gold taken out of the ground by those who
struck pay dirt. And in every successful sweepstakes the amounts
expended by hopeful gamblers exceed the value of the prizes dis-
tributed. Yet the clear recognition of these facts does not deter
the hopeful venturer who believes that in his own individual case
the gamble will pay off. What is important is the prospect of
possible gain which lures men on, not the post-mortem compari-
son of realized gains and losses for the entire group.
Questions of Public Interest and Public Policy
Opportunities for gain that are not associated with public
benefit
A final point in the consideration of profits is that the opportu-
nities for gain that present themselves to businessmen may or may
not be associated with activities that result in general social advan-
tage. Our system of private enterprise is based on the assumption
that, on the whole, profit opportunities will be associated with the
production of goods and services that are desired by the people of
the community. It is assumed that profits will accrue as a result
of the skillful forecasting of people's demands for those goods and
services and the mobilization and effective utilization of the hu-
man and material resources and services needed to turn them out.
However, as Thorstein Veblen and others have pointed out, there
is no necessary connection between making goods and making
money, and many of our problems of public policy arise from the
fact that such a disparity does exist. In so far as opportunities
exist for obtaining enhanced gains by restricting production or
raising artificial barriers to potential competition, there is a basis
for conflict between the interest of the particular enterprise or in-
dustrial group and the general public interest.
What if expectations of gain are insufficient to insure full
employment?
Even where opportunities for the exploitation of monopolistic
advantages are slight, problems of general public concern still
102 PROFIT EXPECTATIONS
arise as a consequence of the fact that profit opportunities do not
present themselves as a steadily burning light, producing a con-
stant stimulus to economic activity. On the contrary, individual
profit expectations are subject to drastic fluctuations in response
to changes in the general level of economic activity and income.
To a certain extent, profit expectations are self-realizing, in the
sense that when profit expectations are high, business firms are
generally motivated to expand their activities, with concomitantly
increased demands for productive goods and services. These de-
mands in turn contribute to an expansion of the aggregate demand
for all kinds of goods and services and a higher level of employ-
ment and incomes, which help to "make good" the opportunities
of disposing of the products of industry at a profit. Conversely,
when general business prospects are worsening, most individual
enterprises are prudentially inclined to cut back production and
to reduce, if not eliminate, plans for expansion. But such cut-
backs in the employment of labor and other resources carry with
them, reduced outpayments of income and therefore reduce the
aggregate amounts available for expenditure on the purchase of
goods and services. Thus, sales and sales revenues decline, and
profit realizations also tend to decline, or to be replaced by losses.
As a consequence, a major problem of public policy in the mod-
ern economy is to devise ways of offsetting the effects of fluctua-
tions in the profit anticipations of private enterprise in the aggre-
gate, and to find means of maintaining the level of production and
income for the economy as a whole at the highest level permitted
by the available resources and technical knowledge in the commu-
nity. This is the central problem of macroeconomics, the analy-
sis of the functioning of the economy as a whole.
Realized Profits of Enterprise: the Economic and the
Accounting Viewpoints
The foregoing pages were concerned with the significance of
profit expectations as an incentive to enterprise. But what of the
profits (or losses) that may actually accrue as the production plans
of enterprise are carried into execution? How are the operating
results of the enterprise determined, and how are the gains or
losses from current operations apportioned among those who have
an interest in the enterprise?
INCENTIVES OF ENTERPRISE 103
In approaching this analysis, it is important to keep in mind
that there is a difference between realized profits as viewed from
the standpoint of economic analysis, and realized profits or earn-
ings as customarily viewed from the standpoint of the accountant
or the business firm itself.
Economic analysis of realized profits
In carrying on its operations, the business firm must purchase
raw materials, hire labor, and rent or own land, buildings, and
machinery in amounts sufficient to carry on current productive
operations. For those resources or services that can be purchased
from day to day, the firm must make immediate current outlays in
order to carry on production. Costs of administration and super-
vision, and also selling costs, may be partly variable with output,
and partly fixed. In the case of plant and other durable produc-
tive facilities owned by the enterprise itself, the calculated amounts
allowed for or imputed to their use during a given period of time
constitute fixed costs of production, from the standpoint of eco-
nomic analysis, although they do not necessarily involve any im-
mediate cash expenditures. These calculated costs or allowances
include depreciation and a "return" (equivalent to the going rate
of interest) on the investment in fixed plant and equipment as well
as on inventories of goods in process. From the economic point of
view, taxes paid to various governmental units, except those levied
on profits, are also regarded as costs. If the revenues from the sale
of the product are more than sufficient to cover variable costs and
fixed costs, as calculated, the firm will show a profit.
Accounting analysis of operational results
From the accounting point of view, the various items indicated
above are broken down in a somewhat different way. The gross
profit of the enterprise is the difference between total current reve-
nue, from the sale of the firm's product, and the direct cost of pro-
ducing the goods sold. This cost includes expenditures for raw
materials, labor, and similar items. Certain other items listed in
the preceding section are commonly classed as "expenses" and de-
ducted from gross profit to determine the net income of the enter-
prise. These items include administrative and selling expenses,
interest on borrowed funds, taxes (except corporate income taxes),
and also an allowance for depreciation to compensate for that part
104 PROFIT EXPECTATIONS
of the service life of the plant and other durable productive facili-
ties which is estimated to have been used up in the process of cur-
rent production. The allowance for depreciation is a calculated
expense and not a cash outlay, but if an allowance were not made
for it, the result would be an overstatement of the apparent earn-
ings on current operation.
It should be noted that although depreciation is regarded as a
part of fixed cost in the economic sense, it is not the only element
included, because the concept of fixed cost in the economic sense
includes also an allowance of at least a minimum return (equiva-
lent to the going rate of interest) on the investment in the durable
assets used. But, in figuring the cost of goods sold, the accountant
does not include any allowance of a return on investment in pro-
ductive plant as a cost. It follows, therefore, that the accounting
concept of gross profit includes sums which, from the economic
point of view, are treated as costs.
Certain additional items of expense, associated with the sale of
the product and with the general administration of the business,
are customarily deducted from the gross profit of the enterprise in
determining its net profit from operations. Even net profit from
operations, however, includes certain items that from an economic
point of view are regarded as costs. These include taxes payable
by the enterprise (except corporate income taxes) and net interest
payable to others as a consequence of either short-term or long-
term borrowing. What remains after these items are deducted is
referred to as net income (before corporate income taxes), that is,
income accruing to the enterprise from its operations. This is the
amount that is available (after payment of corporate income taxes)
for distribution to the stockholders of a corporation, or for with-
drawal by the proprietor or partners of an unincorporated enter-
prise.
Even the net income, in the accounting sense, does not fully cor-
respond to realized profits in the economic sense, because it does
not seek to differentiate between that part of the earnings which
represents a return on the investment (equivalent to the interest
that might have been obtained had the investment funds been
loaned to others) and the part that represents a return attributable
to the undertaking of whatever venture was involved in current
production. With this latter component of earnings profit, in the
economic sense, is primarily associated.
INCENTIVES OF ENTERPRISE
105
Income statements from the economic and accounting
viewpoints
A numerical illustration may help to clarify the comparison of
the economic and accounting viewpoints. Suppose that a busi-
ness firm utilizes a building and equipment valued at $1,000,000.
Depreciation on the fixed plant and equipment is calculated to be
10 per cent per year, or $100,000. If the amount invested in the
plant facilities had been loaned at interest, an annual income of
perhaps $40,000 in interest might have been obtained (correspond-
ing to a 4 per cent interest rate on long-term loans). Thus the use
TABLE 6
INCOME ACCOUNTS FROM THE ECONOMIC AND ACCOUNTING VIEWPOINTS
Economic Viewpoint
A ccoun ting Viewpoin t
Total sales revenue (net) $500,000
Less: variable costs
Labor $100,000
Materials 140,000
Administration and
sales* 15,000
Interest (short term). 5,000
260,000
240,000
Less: fixed costs
Administration and
sales* 45,000
Depreciation 100,000
Taxes 45,000
Interest on investment 40,000
Total sales revenue (net) $500,000
Less: cost of sales
Labor $100,000
Materials 140,000
Depreciation 100,000
Gross profit
340,000
160,000
230,000
Profit on operations $10,000
Less: selling expenses
Administration, ad-
vertising, sales sal-
aries, etc.** 20,000
Less: general expenses
Administration and
office expenses * * . 40,000
Net profit from operations
Less:
Taxes 45,000
Interest 5,000
60,000
100,000
Net income
50,000
$50,000
'Assuming that one-fourth of administrative and selling costs are variable with output and that three-
fourths are not.
* Assuming that nonmanufacturing expenses are divided about one-third for selling and two-thirds
for general administration.
106 PROFIT EXPECTATIONS
of the plant and equipment involves a fixed cost, in the economic
sense, of $140,000. Taxes of various kinds, except corporate in-
come taxes, amount to another $45,000. Other costs of produc-
tion include $140,000 paid for raw materials, $100,000 for labor,
and $60,000 for administrative and selling expenses. In addition,
$5,000 is payable as interest on short-term credits extended to the
firm by suppliers of materials or by banks. The total amount re-
ceived from the sale of the finished product is $500,000. Note how
this situation would appear if presented in the form of an income
statement, first in terms of customary economic analysis, and sec-
ond, in terms of customary accounting procedures.
Reconciliation of economic and accounting viewpoints
The difference between the "profit on operations," as computed
in the left-hand part of the table, and "net income,' 1 as computed
on the right, arises because the $40,000 of "imputed** interest on
investment in plant and equipment was included as a part of the
fixed cost of production in the income account from the economic
point of view, but was not included as a cost or expense in the
accounting analysis. The deduction of this amount from the net
income as shown in the right-hand section of the table would
leave a remainder corresponding to the $10,000 shown as profit on
operations from the economic viewpoint.
One may be tempted to inquire what purpose is served by dif-
ferentiating between profits in the economic sense and net income
as calculated by the accountant, particularly since the figures re-
ported by business enterprises almost invariably relate to net in-
come. One reason for making such a distinction, and deducting
imputed interest on investment from net income, is that unless
this is done, differences in the financial structures of different firms
may give rise to misleading impressions of their relative profit-
ability.
Suppose, for example, that the firm whose operations were sum-
marized in Table 6 had obtained half of the funds invested in
plant and equipment by selling $500,000 worth of bonds bearing
4 per cent interest per year, involving an annual interest payment
of $20,000, and that the remaining $500,000 had been provided
by the stockholders. In that case, the income account for the firm,
from the accounting viewpoint, would be the same as in Table 6,
down to and including the computation of net profit from opera-
INCENTIVES OF ENTERPRISE
107
tions. From there on, however, the allocations from net profit
would be different, as indicated in Table 7.
TABLE 7
ALLOCATION OF NET PROFIT FROM OPERATIONS, WITH AND WITHOUT BONDED DEBT
Without Bonded Debt
With Bonded Debt
Net profit from operations $100,000
Interest (short term).$ 5,000
Taxes 45,000
50,000
Net profit from operations $100,000
Interest (short term).$ 5,000
Bond interest 20,000
Taxes 45,000
Net income $50,000
70,000
Net income $30,000
It is thus apparent that unless allowance is made for imputed
interest on the investment of the owners of the enterprise the
operating results of the firm that had no bonded debt would seem
to be better than those of the firm that had a bond issue outstand-
ing, although in fact the results might be precisely equivalent.
The Distribution of the Earnings of Enterprise
In the foregoing discussion it was apparently implied that the
net income of the enterprise accrues to the stockholders. How-
ever, it is by no means always true that the entire net income re-
maining after payment of corporate income taxes is distributed as
dividends to the stockholders; indeed, in many cases it is not.
Dividend disbursements versus retained earnings
The directors of a corporation are empowered to determine
what part of net income, after corporate income taxes, shall be dis-
tributed as dividends, and what part shall be retained as undistrib-
uted profits or corporate surplus and reinvested in the business.
To be sure, the directors are normally elected by the stockholders
and so are presumably amenable to their wishes. But since, in
the modern corporation, directors are often elected by a small
minority of the whole group, in some instances they constitute a
virtually self-perpetuating body. Thus it often happens that they,
with the active management, can exercise very nearly a free hand
in determining just how the earnings of the enterprise shall be
distributed.
108
PROFIT EXPECTATIONS
It follows that there is no necessary correspondence between the
net income of any specific enterprise (or of all the business enter-
prises in the economy) and the amounts distributed as dividends
to stockholders in any given year, or over a period of years. Many
corporations follow a policy of maintaining a relatively steady
rate of dividends from year to year, despite fluctuations in earn-
ings, by appropriating a part of earnings to surplus in good years,
and drawing against surplus to maintain dividend payments in
poor years. Other corporations regularly appropriate to surplus
each year a significant share of earnings, utilizing these as a means
of financing business expansion. The magnitude of the share of
earnings retained as undistributed profits, as compared with divi-
dends paid out, is indicated, for the United States as a whole, by
the figures in Table 8.
TABLE 8
DISPOSITION OF CORPORATE PROFITS, 1929-1948
(Millions of Dollars)
Tear
Corporate
Profits*
Inventory
Valuation
Adjustment
Profits
Before
Taxes
Corporate
Income
Tax
Profits
After
7 axes
Divi-
dends
Undistrib-
uted
Profits
1929
10,290
472
9,818
1,398
8,420
5,823
2,597
1930
6,563
3,260
3,303
848
2,455
5,500
-3,045
1931
1,631
2,414
- 783
500
-1,283
4,098
-5,381
1932
-1,995
1,047
-3,042
382
-3,424
2,574
-5,998
1933
-1,981
-2,143
162
524
- 362
2,066
-2,428
1934
1,098
- 625
1,723
746
977
2,596
-1,619
1935
2,997
- 227
3,224
965
2,259
2,872
- 613
1936
4,946
- 738
5,684
1,411
4,273
4,557
- 284
1937
6,166
- 31
6,197
1,512
4,685
4,693
- 8
1938
4,292
963
3,329
1,040
2,289
3,195
- 906
1939
5,753
- 714
6,467
1,462
5,005
3,796
1,209
1940
9,177
- 148
9,325
2,878
6,447
4,049
2,398
1941
14,615
-2,617
17,232
7,846
9,386
4,465
4,921
1942
19,894
-1,204
21,098
11,665
9,433
4,297
5,136
1943
24,279
- 773
25,052
14,406
10,646
4,493
6,153
1944
24,046
- 287
24,333
13,525
10,808
4,680
6,128
1945
19,153
- 564
19,717
11,215
8,502
4,699
3,803
1946
18,331
-5,229
23,560
9,620
13,940
5,808
8,132
1947
25,615
-5,987
31,602
12,511
19,091
7,018
12,073
1948
32,623
-2,170
34,793
13,619
21,174
7,932
13,242
* Corporate profits and inventory valuation adjustment figures reflect estimates of changes in the value
of inventories that are not fully reflected in stated corporate profits.
Source: U. S. Department oi Commerce. National Income Supplement to Survey of Current Business, July.
1949, Table 1, page 10. J 7
INCENTIVES OF ENTERPRISE 109
From these figures it is apparent that the amounts paid out in
dividends to their stockholders by American business corporations
have fluctuated less, from year to year, than have net incomes. As
a consequence, the incomes received by stockholders as a group
have been more stable than have business earnings (though not
necessarily more stable than the incomes of any other economic
groups in the community). Also it is apparent that over the span
of years covered by these figures the amounts retained out of cor-
porate earnings as corporate surplus (undistributed profits) have
considerably exceeded the amounts by which surplus has been re-
duced in poor years to maintain dividend payments. Thus, in the
nine years (1930-1939) covering the period of the great depression,
the aggregate reduction in undistributed profits amounted to ap-
proximately twenty billion dollars, whereas, in the subsequent
nine years, the additions to undistributed profits aggregated very
nearly forty-six billions. This, then, affords an indication of the
magnitude of the amounts retained as corporate savings and hence
available for the financing of corporation expansion without un-
dertaking the offering of new securities to the public.
Obviously, the share of earnings retained by corporations is not
paid out in personal incomes to the stockholders, and hence is not
available to them either for current consumption or for direct per-
sonal savings. Earnings retained by the business enterprise are
not, of course, lost so far as the stockholders are concerned. The
stockholder has an undivided interest or equity in all of the assets
of the corporation, including those acquired by reinvestment of
surplus, and the market value of his stock is likely to rise as the
enterprise expands and prospective earnings improve. Neverthe-
less, there is no way in which he can realize on earnings that have
not been distributed as dividends, except by selling his stock to
someone else for a higher price. There is also no necessary corre-
spondence between changes in the market value of the stock and
the amount of undistributed earnings plowed back into the busi-
ness. Thus, a stockholder who sells out his stock may obtain a
"capital gain" either greater or smaller in amount than the amount
of earnings retained for reinvestment. 1
i Under the Federal Income Tax law a part of long-term capital gains is taxable
as income.
110 PROFIT EXPECTATIONS
Diversion of earnings
Furthermore, where a corporation is subject to management
control, as may be the case when stock ownership is widely dis-
tributed among small owners, it may be possible for a small group
closely connected with management to divert, by one device or
another, a part of the true earnings of the corporation to them-
selves. One such technique is for a few individuals to set up
another enterprise to perform certain types of service (manage-
ment, financing, construction, or distribution) for a major corpora-
tion which they control, and to set fees or prices for such services
at relatively high levels. Payments of these padded prices or fees
then appear as contractual costs on the books of the main corpora-
tion, and hence operate to dilute the apparent earnings of the
latter.
In still other cases the directors of a corporation have approved
the payment of unusually large salaries to key management per-
sonnel, or bonuses or other rewards that supposedly compensate
exceptional contributions by these individuals to the business of
the corporation. Inasmuch as definite standards for the measure-
ment of such contributions are lacking, there may be wide differ-
ences of opinion concerning the actual worth of the services
performed. Still another device by which the allocation of the
earnings of the business corporation may be affected is the institu-
tion of pension plans providing retirement income for executive
personnel.
Such practices may offend the traditional view that the manage-
ment of a corporation stands in a position of trusteeship for the
stockholders as the legal owners of the corporation, and the as-
sumption that the owners have a rightful and legal interest in all
earnings resulting from the activity of the enterprise. They also
raise serious questions as to the economic functions or activities
with which profits are connected.
Obviously the effect of such practices is to blur the distinction
between personal service incomes and proprietary incomes. They
emphasize the difficulty of associating the receipt of "profits" with
the performance of any unique "function" in the conduct of eco-
nomic activity.
Chapter 7
PRODUCTION, EMPLOYMENT, AND
INCOME
Production Plans of Enterprise as Determinants of
Employment and Income
For the individual firm and for business enterprises generally,
the current state of business expectations plays a dominant role in
the formulation of pricing, production, and employment policies.
On the basis of the expected receipts from the sale of the product,
the enterprise undertakes to pay the wages of the labor force em-
ployed, the rental for property owned by others and used in pro-
duction, interest on funds advanced by others, and the bills for
materials, supplies, power, transportation, and all the other items
needed to carry on production. The firm must also pay taxes to
federal, state, and local governments, and make provision for the
depreciation of physical equipment owned by the enterprise itself.
If there is an expectation that, after all of these expenses have been
met, something will remain as profit for the enterprise, an incentive
will exist to put the production plans into execution. An incen-
tive to continue production will also exist, even if there is a
prospect that loss will ensue, provided it appears that an even
greater loss would result if production were halted or curtailed.
Upon the plans made by individual business firms and by busi-
ness enterprises as a whole depends the extent to which the differ-
ent kinds of productive factors are employed at any given time in
the private enterprise segment of the economy, that is, in non-
governmental activities. On those decisions, likewise, depend the
amounts that are paid out in the form of wages, expenditures for
ill
112 PRODUCTION, EMPLOYMENT, AND INCOME
materials, supplies and components, rentals, interest, and the like.
Thus, the incomes received by different economic groups in the
community directly reflect the magnitude of the production plans
of business enterprises, and they rise or fall as those plans call for
an expansion or contraction of the production schedules for all
enterprises taken collectively. If the receipts from the sale of all
finished goods exceed the aggregate costs involved in their produc-
tion, a gain will be recorded for the enterprises concerned. If
total receipts fall short of covering all costs, a loss will be recorded/
reflecting a negative return to the enterprises concerned.
Before going on to the discussion of the problems associated,
with the formulation of the employment policy of a particular
firm, it will be helpful to consider further the over-all picture of
the connections between production, employment, and income for
the economy as a whole. This consideration is desirable be-
cause the general level of business activity and income plays a
major role in determining what the particular employer is able to
do in formulating his own policy.
Measurement of Production and Income for the
Whole Economy
In recent years the National Income Division of the United
States Department of Commerce has formulated several important
and related measures to reflect the level of economic activity in the
United States and to show the way in which the income arising out
of this activity is apportioned or allocated to different economic
groups. If one knows something about these methods of measure-
ment and the magnitudes of the incomes received by various eco-
nomic groups from year to year, he is in better position to analyze
the operation of the economy both in terms of its over-all behavior
and of the behavior of different industries or enterprises within
industries.
Gross national product
To reflect the general level of economic activity, the National
Income Division has published estimates of the gross national
product of the country for each year from 1929 to the present.
The gross national product purports to represent the value of all
PRODUCTION, EMPLOYMENT, AND INCOME 113
finished goods and services produced in the course of a year, the
value being estimated in terms of market prices.
It is necessary to express the total production of the economy in
terms of value rather than physical units because there is no way
of adding together the automobiles, loaves of bread, phonograph
records, shoes, suits of clothes, and all the other kind of goods pro-
duced, so as to get a sensible total figure, except by converting
them all to common terms, such as dollar prices.
In estimating the gross national product, an allowance is made
for the value of goods and services produced, even though they
may never actually be sold, as, for example, foodstuffs produced
and consumed on the farm. Certain types of service are not in-
cluded, such as the service that a man performs for himself in
shaving or mowing the lawn, or the activities of a housewife in her
own home, because of the difficulty of attaching any definite mone-
tary value to such services. But an allowance is made for govern-
mental services, although many of them are not sold and are diffi-
cult to evaluate. Governmental services and activities are valued
in terms of what they cost, that is, in terms of the total expendi-
tures made by governmental units for salaries or wages to govern-
ment employees and for purchases of materials and supplies.
The gross national product could be estimated theoretically in
either of two ways: (1) by summing up the values of all finished
goods and services produced in the course of a year, or (2) by sum-
ming up the values added to goods and services by business units
(and governmental agencies) at each stage of production. If the
value of the products (both finished goods and raw materials or
semifinished goods) turned out by all the business units of the
country in the course of a year were added up directly, a great deal
of double counting would occur and the total volume of produc-
tion would be overstated. For example, if the value of all the coal,
all the iron ore, all the steel, and all the automobiles produced in
a year were added together, the coal and iron ore used in produc-
ing steel would be counted for the third or fourth time in the
value of the automobiles produced. If, however, the summary
figures include only the value of finished goods produced and
ready for final sale to consumers or to other users for use rather
than resale, then the double counting is eliminated.
The alternative way of viewing the gross national product is to
114 PRODUCTION, EMPLOYMENT, AND INCOME
regard it as summing up the value added in manufacturing or
processing activities by the different enterprises of the economy.
If, for each business firm or unit, the amounts paid to other busi-
ness firms for raw or semifinished materials, supplies, or nonper-
sonal services are deducted from the sales value of the product
turned out, the remainder represents the value added in manu-
facturing or processing by that firm. For example, if the amounts
paid by an automobile manufacturer for steel, parts, and other
components and services supplied by other firms are subtracted
from the value of the finished cars produced, the difference repre-
sents the gross product of the automobile firm. It is then possible
to sum up the values added at different stages of production, with-
out double counting, and so arrive at a total figure for the gross
national product, providing that amounts representing the values
added by governmental activities are also included.
In actual practice, not all of the information is available that
would be needed to determine the gross national product accord-
ing to either of the approaches outlined above. The figures pub-
lished by the National Income Division represent the most accurate
estimates that can be made with the available data, several differ-
ent sources or techniques often being used in arriving at particular
items that enter into the total.
Net national product
Turning out the goods and services that constitute the gross
national product of the economy in any given year involves not
only the use of manpower but also the employment of a tremen-
dous mass of productive plant and equipment built up over past
decades. Although much of that equipment is durable, still its
use in production involves depreciation, which must be provided
for or offset if the productive capacity of industry is to be main-
tained for the future. Moreover, at the beginning of any year
there are large stocks of unfinished goods in process with which to
start out. If the inventories of such goods are smaller at the end
of the year than at the beginning, then again the potential output
of the succeeding year may be impaired. Therefore, to get a more
accurate picture of the real productive activity that has occurred
during the year, it is necessary to make an allowance for the de-
preciation of productive equipment and for any reduction in in-
ventories that may have occurred. This allowance is referred to as
PRODUCTION, EMPLOYMENT, AND INCOME 115
a capital consumption allowance. When it is subtracted from the
value of the gross national product, the remainder is termed the
net national product.
National income
The net national product may be regarded as representing cur-
rent production in the economy as a whole during the year, valued
at market prices or their equivalent. The value of the net national
product, in turn, must be allocated in various ways. Business en-
terprises are obligated to pay taxes of various kinds to different
governmental units if they are to do business. These taxes repre-
sent a claim against the value of the goods produced that, from a
legal standpoint, takes priority over other claims. Therefore, in-
direct business taxes (which in practice include all taxes except
corporate income taxes and personal income taxes) are treated as
the first deduction from, or allocation of, the net national product.
The remainder is referred to as the national income, or net na-
tional product valued at factor cost.
The significance of the term national income is that it repre-
sents the aggregate value attached to the services performed by the
various groups participating in productive activities during the
course of the year, and hence constitutes the basis of their claims to
income. It also represents the "factor cost" of producing the goods
and services turned out during the year, including wages and other
compensation of labor, interest paid or payable to those who have
advanced funds for use in production, rentals paid or payable to
individual owners of property, and the earnings (or losses) of enter-
prise in the aggregate. In the statistics published by the Depart-
ment of Commerce, the national income is allocated to five major
categories: (1) compensation of employees, (2) rental income of
persons, (3) net interest, (4) income of unincorporated enterprises,
and (5) corporate profits. It should be noted in passing that none
of these income categories represents "profits" in the strict eco-
nomic sense of the term. Instead, they represent mixed types of
incomes.
Personal income
The national income comprises the claims of the various eco-
nomic groups to "shares" in the current national product. There
are, however, some differences between these claims and the
116 PRODUCTION, EMPLOYMENT, AND INCOME
amounts of income actually received by individuals as personal
income. It is not necessary for present purposes to list all the
adjustments that must be made in order to reconcile the estimated
national income with the personal income actually received by
individuals, but the major items may be indicated briefly.
Compensation of employees, for example, as figured in national
income, includes not only wages paid to employees but also sums
paid over by employers as contributions to social security funds.
Inasmuch as the employees will ultimately benefit by these con-
tributions, they are regarded as compensation, even though they
do not appear in the pay envelope.
Similarly, corporate income taxes paid to the government are
regarded as coming out of the earnings of enterprise, to which the
stockholders have a claim. If a corporation does not pay out all its
earnings (after payment of corporate income taxes) as dividends
to its stockholders, the undistributed profits do not appear as
personal income to the stockholders, although they are included in
the figures for national income. On the other hand, in a year
when the earnings of business are poor, a corporation may pay
dividends in excess of its earnings, drawing on previously accumu-
lated surpluses or undistributed profits to do so. Such dividend
payments out of surplus will be reflected in personal income for
the years in which paid, but not in estimated national income,
because they do not arise out of current economic activity.
Amounts paid out as social security benefits, or as aid to de-
pendent persons, also appear as personal income but not as a part
of national income. The National Income Division does not trea^
interest paid on the government debt, incurred largely to finance
the war, as arising in connection with current production, anc
hence does not include it as a part of national income. It does,
however, include such interest in estimating personal income.
Disposable income
Even after personal income for the economy as a whole has been
estimated, it is necessary to deduct personal income taxes before
arriving, finally, at a figure which indicates the total amount that
the people of the economy can dispose of according to their own
wishes. It is this final remainder, referred to as disposable income,
which people may spend on goods or services, or give away, or save.
It is this disposable income, therefore, that is of primary signifi-
PRODUCTION, EMPLOYMENT, AND INCOME 117
cance in dealing with the demands of people for different kinds of
consumers' goods and services, because the amount of disposable
income determines how much they can buy.
Statistics of Production and Income, 1929-1948
The various steps by which the value of the goods and services
produced during a year may be broken down into significant com-
ponent parts have now been traced. But a much better picture of
what it all means may be obtained by looking at the actual sum-
mary figures compiled by the National Income Division for the
past two decades. Table 9 includes the figures for the gross na-
tional product, net national product, national income, personal
TABLE 9
NATIONAL PRODUCT, INC OME, AND EMPLOYMENT IN THE UNITED STATES,
1929-1948
(In billions of dollars; millions of persons)
Year
Gross
National
Product
Net
National
Product
National
Income
Personal
Income
Disposable
Income
Employ-
ment
Unem-
ployment
1929
103.8
95.0
87.4
85.1
82.5
47.6
1.6
1930
90.9
82.1
75.0
76.2
73.7
45.5
4.3
1931
75.9
67.6
58.9
64.8
63.0
42.4
8.0
1932
58.3
50.7
41.7
49.3
47.8
38.9
12.1
1933
55.8
48.5
39.6
46.6
45.2
38.8
12.8
1934
64.9
57.7
48.6
53.2
51.6
40.9
11.3
1935
72.2
64.8
56.8
59.9
58.0
42.3
10.6
1936
82.5
74.8
64.7
68.4
66.1
44.4
9.0
1937
90.2
82.2
73.6
74.0
71.1
46.3
7.7
1938
84.7
76.7
67.4
68.3
65.5
44.2
10.4
1939
91.3
83.2
72.5
72.6
70.2
45.8
9.5
1940
101.4
93.0
81.3
78.3
75.7
47.5
8.1
1941
126.4
117.1
103.8
95.3
92.0
50.4
5.6
1942
161.6
151.6
137.1
122.7
116.7
53.8
2.7
1943
194.4
183.7
169.7
150.3
132.4
54.5
1.1
1944
213.7
201.8
183.8
165.9
147.0
54.0
.7
1945
215.2
202.8
182.7
171.9
151.1
52.8
1.0
1946
212.6
200.7
179.6
176.9
158.1
55.3
2.3
1947
235.7
222.0
201.7
193.5
172.0
58.0
2.1
1948
262.4
246.7
226.2
211.9
190.8
59.4
2.1
Sources: U. S. Department of Commerce, National Income Supplement to Survey of Current Business, July,
1949, Tables 3 and 4, pages 10-11; U. S. Department of Labor, Handbook of Labor Statistics, 1947 edition
{Bulletin 916), Table A-12, page 36; The Economic Report of the President to Congress, January 7, 1949, Table
C-7, page 105.
118 PRODUCTION, EMPLOYMENT, AND INCOME
income, and disposable income, and also, to provide a different
type of indicator of the level of economic activity, the number of
persons gainfully employed in the United States for each of the
years covered. Table 10 repeats the national income figures and
shows the break-down of the national income into the five major
categories to which it is allocated.
TABLE 10
ALLOCATION OF NATIONAL INCOME IN THE UNITED STATES BY DISTRIBUTIVE SHARES,
1929-1948
(In billions of dollars)
Year
National
Income
Compen-
sation of
Employees
Rental
Incomes of
Persons
Proprietor-
ship In-
comes*
Net Interest
Received by
Persons
Corporate
Income
Before Tax*
1929
87.4
50.8
5.8
13.9
6.5
10.3
1930
75.0
46.5
4.8
11.0
6.2
6.6
1931
58.9
39.5
3.6
8.2
5.9
1.6
1932
41.7
30.8
2.5
4.9
5.4
-2.0
1933
39.6
29.3
2.0
5.2
5.0
-2.0
1934
48.6
34.1
2.1
6.6
4.8
1.1
1935
56.8
37.1
2.3
9.9
4.5
3.0
1936
64.7
42.7
2.7
9.9
4.5
4.9
1937
73.6
47.7
3.1
12.2
4.4
6.2
1938
67.4
44.7
3.3
10.8
4.3
4.3
1939
72.5
47.8
3.5
11.3
4.2
5.8
1940
81.3
51.8
3.6
12.7
4.1
9.2
1941
103.8
64.3
4.3
16.5
4.1
14.6
1942
137.1
84.9
5.4
23.0
3.9
19.9
1943
169.7
109.2
6.1
26.7
3.6
24.3
1944
183.8
121.2
6.5
29.0
3.1
24.0
1945
182.7
123.0
6.3
31.2
3.0
19.2
1946
179.6
117.0
6.2
35.0
3.0
18.3
1947
201.7
127.6
6.5
38.5
3.4
25.6
1948
226.2
140.3
6.6
42.8
3.8
32.6
* Including inventory valuation adjustment.
Source: U. S. Department of Commerce, Motional Income Supplement to Survey of Current Business. July,
1949, Table 1, page 10.
Fluctuations in Production, Employment, and Income
The figures presented in Table 9 spotlight the drastic fluctua-
tions that have occurred over the years in the general level of
economic activity, employment, and income. Between 1929 and
1933 the gross national product declined more than 40 per cent,
PRODUCTION, EMPLOYMENT, AND INCOME 119
from almost $104 billion to $56 billion, and national income de-
clined similarly, from about $87 billion to less than $40 billion.
Not until after the outbreak of World War II did the level of
economic activity, as reflected in the gross national product figures,
surpass the 1929 level, nor did the national income exceed the
1929 level in any of the intervening years.
In the succeeding years, however, the unprecedented require-
ments of World War II were accompanied by a rise in both gross
national product and national income to levels previously regarded
as unattainable, and after the end of the war both continued to
rise. A part of this gain can be regarded as a nominal, rather than
as a real, increase in production and income, inasmuch as prices
rose during the war and even more after its close. Nevertheless,
allowing for the increase in prices, there was a substantial gain in
the volume of goods and services actually produced, as compared
with prewar production, and a corresponding rise in the "real"
value of the national income.
Here emerges one of the most significant and important prob-
lems posed for economic analysis. Why is it that the American
economy as a whole displays such variability in its performance?
Why can it at times reach very high levels of activity, with the
production of a veritable flood of goods and services, and a high
level of income for the people of the community, and at other
times decline into a prolonged depression, with low production,,
unemployment, and scanty income? The question is one of vital
and direct concern to everyone in the economy, because, as can be
seen from the figures on the distribution of the national income*
every class in the community is affected in very large degree by
changes in the general level of economic activity and income.
When production expands, employment and incomes expand con-
currently. When production declines, employment and incomes
fall off, and the well-being of the entire community is reduced.
The Distribution of National Income
In considering the figures on the distribution of the national
income, in Table 10, it must be remembered that they stand for
types of income and that any given individual may derive personal
income not only in wages or salary but also by virtue of property
ownership.
120 PRODUCTION, EMPLOYMENT, AND INCOME
By type of income
Furthermore, the category of compensation of employees covers
remuneration for all types of personal services, from those of the
scrubwoman in the office building to those of the president of a
giant corporation, or from those of the movie extra to those of the
highest-paid star. Similarly, the incomes of unincorporated enter-
prises include incomes ranging from that of the poorest share-
cropper to that of a partner in a highly lucrative law firm or
brokerage business or that of a prominent medical practitioner.
Thus, relatively little significance attaches to the calculation of the
average wage or salary received by the "gainfully employed" per-
sons in the country, because the personal incomes of people vary
widely above and below the average.
By size of income
A better picture of what the national income means in terms of
the living standards and well-being of the people of the country
may be gained by examining the distribution of the national in-
come among different income groups or brackets. Table 1 1 pre-
sents the data on the distribution of income in the United States
for two different years, 1935-1936 and 1947, according to size of
TABLE 11
SHARES OF TOTAL MONEY INCOME RECEIVED BY EACH TENTH OF THE NATION'S CON-
SUMER UNITS, 1935-1936 AND 1947
Consumer
1935-1936
1947
Units
Ranked by
Size of
Range of
Per Cent of
Range of
Per Cent of
Income
Incomes
Total Monty
Incomes
Total Money
Received
Income
Received
Income
Top tenth
$2,600 and up
36.2
$5,700 and up
33.0
Ninth
1,925- 2,600
14.5
4,200- 5,700
15.
Eighth
1,540- 1,925
11.5
3,500- 4,200
12.
Seventh
1,275- 1,540
9.3
3,000- 3,500
10.
Sixth
1,070- 1,275
7.5
2,550- 3,000
9.
Fifth
880- 1,070
6.6
2,100- 2,550
7.
Fourth
720- 880
5.5
1,700- 2,100
6.
Third
545- 720
4.3
1,200- 1,700
4.
Second
340- 545
2.9
750- 1,200
3.
Lowest tenth
Under $340
1.7
Under $750
1.
Sources: National Resources Committee, Consumer Inconus in the United States t 1938, Table IB, page 95;
2 ederal Reserve Bulletin, June, 1948, page 653.
PRODUCTION, EMPLOYMENT, AND INCOME 121
income. The income-receiving units (families or single individ-
uals) are arranged in ten groups or deciles, each representing 10
per cent of the entire number, and these deciles are ranked from
top to bottom according to the size of income. Thus, the top decile
includes those income-receiving units that had the highest in-
comes; the bottom decile includes the tenth of the entire group
that received the lowest incomes, and so on.
The first year, 1935-1936, is representative of the period of the
great depression, and the second represents the postwar era of
high employment, production, and income.
Relative stability in the distribution of income
One fact stands out at a glance at these figures. Although the
total national income increased nearly four times between 1935-
1936 and 1947, the percentage of total national income received by
each group changed very little, although the aggregate amount
received by each group did rise.
The striking fact that emerges from such a comparison is that,
despite great changes in the total national income, the distribution
pattern changed very little. Whether the national income was
large or small, nearly half of the total was received by the upper
two-tenths of all income recipients. And in neither year did the
lowest tenth receive as much as 2 per cent of the total national
income.
Inequality of income
The figures shown in Table 1 1 indicate that the distribution of
income in the United States is far from equal and that there is
little tendency for the inequalities to be diminished by an expan-
sion of production and employment and the attainment of a high
level of national income. To a certain extent, the persistence of
differences in income may be explained in terms of the typical
progression of the individual or family from a relatively low in-
come in the days of struggle to get established to a more comfort-
able position in years of maturity. Thus in any given year the
newcomers to the ranks of those gainfully employed would account
for a part of the lower-income groups. But this is only a part of
the explanation, and a very considerable part of the working popu-
lation has little prospect of lifting itself out of the bottom 10 or 20
per cent of income recipients.
122 PRODUCTION, EMPLOYMENT, AND INCOME
What significance attaches to this fact of unequal distribution of
income, apart from ethical, sociological, or psychological questions
that might be raised? To this query no complete answer can be
attempted at this point. Certain important implications, however,
do warrant emphasis, particularly those having to do with the use
that people at different income levels are disposed to make of the
income they receive.
Inequality of income as related to use of income
In the use of disposable income (after payment of personal in-
come taxes) the two alternatives open to people are (1) expenditure
on current consumption and (2) personal saving, whether repre-
sented by the accumulation of bank deposits, the purchase of in-
surance, the purchase of a home, or the purchase of securities.
Although the modern income tax takes a much larger slice out of
large incomes than out of smaller incomes, it merely reduces, but
does not eliminate, the differences in disposable income from one
level to another.
Studies of the use made of income at different income levels
clearly indicate that at the lower end of the income scale all dis-
posable income is expended on current family living and even
more. That is, consumption expenditures, for the group as a
whole, absorb more than current income, the deficiency being
made good by aid received from other sources. As the income
level increases, total expenditures on consumption increase, but
the percentage of income that is spent on consumption decreases
and the percentage that is saved increases. Thus it was estimated
that in 1935-1936 the income groups receiving $20,000 per year or
more in income paid out about one-seventh of the total income
received in personal income taxes and in gifts to others, spent a
little more than one-third on current consumption, and saved a
little more than one-half. In the $5,000 to $10,000 bracket, nearly
two-thirds of income received was spent on consumption, a little
less than a third was saved, and the remainder went for gifts and
taxes. In the $2,000 to $2,500 bracket, nearly seven-eighths of in-
come was spent, less than a tenth was saved, and about 4 per cent
went for gifts and taxes.
This does not necessarily mean that receivers of low incomes are
improvident and unwilling to exercise the virtues of thrift and
frugality. It merely means that virtually all of the income re-
PRODUCTION, EMPLOYMENT, AND INCOME 123
ceived has to be expended in keeping the wolf beyond the thresh-
old. At the same time, it is clear that a very large part of all
individual savings are made by people in the middle and upper
income brackets, and that a much smaller proportion of income in
those brackets is expended on current consumers' goods and serv-
ices. With larger incomes, it becomes increasingly possible to set
aside a part of current income for saving without a drastic impair-
ment of living standards. Thus it appears that the amount of
personal saving is closely related to the level of income and tends
to vary as the level of income varies.
Propensity to consume and propensity to save
In recent years it has become customary in economic literature
to use the term consumption junction to describe the relation-
ship between the size of income and the amount spent on con-
sumption, both for individuals and for the economy as a whole.
Studies of the amounts spent from year to year on consumers 1
goods in relation to the national income for the corresponding
years have indicated that the higher the level of income the smaller
the percentage of income spent and the larger the percentage
saved. Thus the total amount spent for consumption in any given
year, and also the total amount saved, tends to be determined by,
or is a "function of," the total amount of income received.
The average propensity to consume at any given level of income
is represented by the percentage of total income that would be
spent for consumption purposes at that level of income. The
average propensity to save } conversely, is represented by the per-
centage of total income that would be saved at that level of income.
Suppose that total income is increased or decreased. The change
in income will carry with it changes in the total amounts spent for
consumption and utilized for savings. The ratio of the change in
consumption to the change in income with which it is associated is
referred to as the marginal propensity to consume. Correspond-
ingly, the ratio of the change in savings to the change in income
with which it is associated is referred to as the marginal propensity
to save.
As an example, assume that, at a given level of national income,
the people as a whole were spending 80 per cent of their incomes
for consumption and saving 20 per cent. The average propensity
to consume, under such circumstances, would be 0.8 and the aver-
124 PRODUCTION, EMPLOYMENT, AND INCOME
age propensity to save would be 0.2. Suppose, however, that if
income were to increase the people as a whole would divide addi-
tional income between spending and saving in the proportions of
75 per cent and 25 per cent. In other words, seventy-five cents
out of an additional dollar of income would be spent, and twenty-
five cents would be saved. In that event, the marginal propensity
to consume would be 0.75 and the marginal propensity to save
would be 0.25. In general, the larger the income, the further
short of total income do expenditures for consumption fall, and
the larger becomes the amount representing personal savings.
Significance of the level and distribution of income
The level and distribution of income in the community are
factors of major importance for business enterprisers because they
determine the character and extent of the demands of consumers
for all kinds of goods and services. A producer of luxury goods is
interested in knowing how many people fall in the income bracket
for- which his wares are designed. A bond salesman would have
slim pickings among the sharecroppers of the cotton belt or the
migratory laborers in the sugar-beet, potato, or vegetable-canning
sections of the country. The mass-production industry, on the
other hand, is directly concerned with the amount of income en-
joyed by the vast bulk of the population, because that will affect
the demands for its products.
From the standpoint of the economy as a whole, the facts of
income level and distribution are also important, because they
bear directly on the determination of the aggregate demand of the
community for all kinds of goods and services as well as the quan-
tity of savings for which people are seeking acceptable forms of
investment.
That part of income which is spent on consumers' goods and
services is obviously converted directly into demand for the output
of industry. As and if the savings of individuals, together with
business earnings retained as undistributed profits, are utilized to
finance the purchase of machinery, tools, and equipment to make
possible a further expansion of production, then the savings of the
community, just as much as the sums expended on current con-
sumption, are converted into demands for goods and services of
the appropriate kinds, and hence afford a stimulus to economic
activity.
PRODUCTION, EMPLOYMENT, AND INCOME 125
That is not, however, always the case, because the existence of
outlets for savings depends on the state of business expectations
for the future. Only if business leaders, individually and collec-
tively, believe that the prospects for the future are good will there
be an incentive to seek funds for purposes of expansion by offering
new securities to prospective investors. Lacking such prospects,
business enterprises will offer restricted opportunities for the in-
vestment of savings. As a consequence, current savings will not be
translated immediately into demands for goods and services, but
will tend to accumulate in idle funds or bank balances.
It is with this general problem of the interrelationships of in-
come, consumption, savings, investment, production, and employ-
ment that the remainder of this book is primarily concerned. But
in order to understand the behavior of the economy as a whole it
is necessary to see how these interrelated factors present them-
selves to and influence the policies of the responsible managers of
business enterprises through which the economic activities of the
community are carried on. Production, employment, and national
income expand when businessmen or enterprisers as a group be-
lieve that they can advantageously expand their respective under-
takings. But those expectations will exist only if there is ground
for believing that, if they do expand their operations, the added
output can be sold at a profit. That means that the consumers or
other users of finished goods and services must have either in hand
or in prospect the means with which to buy the added product.
But in general the means for making such purchases will become
available only if employment increases. Thus again it becomes
apparent that production, employment, and income are all in-
extricably linked in the same process.
In an effort to trace through the interwoven strands of this
process, the next two chapters will be devoted to a consideration
of the conditions influencing the production and employment
plans of the individual enterprise and the supply of productive
resources for current use. The latter part of the book will be
concerned with those aspects of the economic process that have to
do with investment by business enterprise, the interrelationships
of savings, investment, interest rates, and property incomes gen-
erally, and the level of production, employment, and income for
the economy as a whole.
Chapter 8
EMPLOYERS 1 DEMAND FOR
PRODUCTIVE FACTORS
The Problem of Employment from the Standpoint
of the Firm
The preceding chapter dealt with the interrelationships of pro-
duction, employment, and income for the economy as a whole,
both analytically and in terms of the statistics of production and
income for the United States during the two decades 1929-1948.
But the aggregate level of production and income, and the extent
of employment of productive resources, depend on the formula-
tion and execution of production plans by literally millions of
business enterprises, large and small, which organize and carry on
the productive activities of the community.
It is necessary, therefore, to consider the problems of produc-
tion, employment, and income not only from the standpoint of the
economy as a whole, but also from the standpoint of the individual
enterprise faced with the necessity of deciding upon its own pro-
duction, pricing, and employment policies. How much labor
would it be to the advantage of the firm to employ at a given rate
of wages, in the light of the estimated demand for the product of
the firm? Would an increase or decrease in wages tend to alter
significantly the amount of labor employed and the amount of
product turned out? How would an increase or decrease in the
prices of raw materials or components affect the production plans
of the enterprise and the amounts of such resources employed?
Under what circumstances would it be to the advantage of the
126
EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS 127
firm to increase its investment in productive plant facilities and to
substitute machinery for labor? The answers to such questions
will help to round out the consideration of the functioning of
business enterprise, both singly and for the economy as a whole.
Character of Employer's Demand for Productive Factors
It has already been noted that the employing firm plays a dual
role. It is both a supplier of the finished goods it turns out and a
buyer of the resources and services needed for production. The
market conditions faced by the employer as a buyer of productive
resources and services may be quite different from those which
prevail in the market or markets in which the finished goods are
sold. For example, a firm that has something of a monopolistic
position in the sale of the finished product may be only one of
many buyers of certain types of labor or raw materials. On the
other hand, a firm that faces the competition of many rivals in the
sale of the finished product may be the only buyer, or one of a
few rival buyers, of certain resources or services needed for pro-
duction. A manufacturer located in a small town may provide
virtually the only opportunity for employment to skilled me-
chanics or other workers living in that community. A canning
house in a rural locality may offer the only near-by outlet for
farmers specializing in the production of tomatoes, peas, beans, or
small fruits. Moreover, the same employer may find quite differ-
ent market conditions prevailing in each of the several different
markets from which supplies of labor, materials, and components
are obtained. These variant conditions may exercise a very con-
siderable influence on the employer's demands for the various
items required for production.
Employer's demand contrasted with consumer's demand
An employer's demands for productive resources and services
differ in certain significant respects from a consumer's demand for
finished goods and services. The consumer's demands reflect his
own personal tastes, preferences, and spendable income. The
employer's demands, largely impersonal, are derived from the an-
ticipated demand of consumers for the finished product. The
business firm employs productive services and resources, not for
their own sake, but because there is a prospect that the amounts
128 EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS
expended in employing them will be more than returned by the
sale of the finished product. There are, of course, instances in
which an employer feels an obligation to keep the workers em-
ployed even though it might be more advantageous from a profit
standpoint to lay some of them off. Thus it would be wrong to
regard the employer as a mere calculating machine. Neverthe-
less, there are distinct limits within which humanitarian consid-
erations can operate; the firm can seldom run the risk of going
"broke" by keeping its workers employed in producing goods that
cannot be sold for an amount sufficient to cover the costs of cur-
rent operation.
In the remainder of this chapter attention will be concentrated
on the two major elements affecting the particular employer's de-
mands for productive resources or services: (1) the demand for the
finished product, as it affects the quantities of the various re-
sources required for production, and (2) the possibilities of achiev-
ing economies in production by substituting one kind of resource
or 'service for another.
Outlays or expenses versus costs: the unit of calculation
In considering the problems of pricing and production policy
for the firm in earlier chapters it was convenient to work in terms
of units of the finished product that was to be sold. The relations
of prices, total sales revenues, and total costs were analyzed in
terms of quantities of finished product. But in turning to the
position of the firm as an employer or buyer of different kinds of
productive resources or services, it is convenient to shift the basis
of calculation from units of finished product to units of the par-
ticular productive factor immediately under consideration. The
situation of the employing firm presents itself in a different per-
spective, although it is still the same basic situation. But the ques-
tions that arise have a different focus.
Suppose that the employing firm is faced with a demand for an
increase in wages. How much more could the firm afford to pay
in wages without significantly changing the number of men em-
ployed? Here, obviously, the unit in terms of which it is con-
venient to calculate is not a unit of finished product, but the unit
of labor which is the subject of bargaining, whether it be an
hour's labor, a day's labor, or a month's labor. Of course, what
the management of the firm believes it can afford to pay will de-
EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS 129
pend on how much labor is required to turn out a unit of finished
product, and on how many units of finished product can be sold
at a given price; but it is much simpler to shift the basis of calcula-
tion from units of finished product to units of labor employed.
In translating the analysis of the operations of the firm into
terms of employment policy, it is desirable to use some term other
than "cost" to refer to the payment that the employer makes for a
unit of labor (or of any other productive resource or service),
even though a change in the amount so paid will result in a change
in the cost of the finished product. In the ensuing discussion the
words "outlay" or "expense" will be used in referring to the pay-
ments made by the employer for factors of production, whenever
the pricing and employment of those factors are being consid-
ered, and the word "cost" will be employed only when the analysis
refers to calculations in terms of units of finished product.
Suppose, for example, that a firm were employing 8,000 man-
hours of labor at a wage rate of $1.25 per hour, and that, with the
employment of that amount of labor, 24,000 units of product
could be turned out. The total outlay for labor, or the total labor
expense, would be $10,000, and that, of course, would also repre-
sent the total labor cost of producing the 24,000 units of product.
The labor cost per unit of product would be $10,000 divided by
24,000 units of product, or about forty-two cents per unit. The
average outlay per unit of labor employed would be $10,000 di-
vided by 8,000 man-hours, or $1.25 per man-hour. By using the
term "labor cost" only in referring to the cost of labor in turning
out finished product, and by using the terms "labor outlay" or
"labor expense" in referring to the employment of labor, it be-
comes unnecessary to add other terms to indicate which phase of
the employer's activities is under consideration.
Employer's Demand as Related to Demand
for Finished Product
Once an employer has decided how much of the finished prod-
uct to turn out, the amount of labor and other resources needed
to produce that volume of output will be pretty well determined
by the technical conditions of production in the plant. But how
much labor (or how much of any other resource or service) would
it be to the advantage of the employer to utilize if the wage rate
130 EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS
(or the price of any other resource or service) were either higher
or lower? Inasmuch as factor prices have an obvious bearing on
production costs, it is to be expected that variations in wage rates
and in other factor prices would react in some measure upon the
pricing and production policy of the firm, and therefore upon the
amounts of the productive factors employed.
In the discussion of pricing and production policy in Chapter 4,
changes in factor prices were taken into account in the discussion
of the effects of changes in variable costs (see pages 56-58). At
that point, no attempt was made to break down the variable costs
into the different component elements (labor cost, raw-material
cost, and so on). But when one turns to the discussion of the con-
ditions influencing the employment of the various productive fac-
tors, it becomes necessary to try to segregate the effects of changes
in the price of whatever factor is immediately under investigation.
Inasmuch as labor is commonly the productive factor that is most
easily varied in employment, the ensuing discussion will deal with
the employment of labor, but the analysis is broadly applicable to
other factors as well.
If the employer found that it was necessary to pay higher wage
rates for labor than before, that would tend to increase the total
outlay for any given amount of labor, and hence would also raise
the total labor cost of turning out the product. This might very
well alter the quantity of product that would be most profitable,
under given market conditions for the finished product, and hence
would alter the amount of labor that would be employed. Con-
versely, a lower wage rate would tend to reduce the total outlay
for any given quantity of labor, and also the total labor cost of any
specified quantity of product. This in turn might alter the quan-
tity of product that would be most profitable, and hence would
alter the quantity of labor employed.
The extent to which a higher or lower wage rate for labor
would increase or decrease the amount of labor demanded by the
employer will depend on whether the demand for the finished
product is changing at the same time. It is likely, in fact, that at
a time when wage rates for labor are either increasing or decreas-
ing the demands for many kinds of finished goods are also chang-
ing. Indeed, it is the view of many economists, based in part upon
the general statistics of income and employment, that the volume
of employment is much more directly affected by the general level
EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS 131
of income and aggregate demand than by variations in wage rates
for specific groups of workers. It is, nevertheless, important to
get a clear picture of the interrelationship of wage rates and other
factor prices and the pricing and production policy of the individ-
ual employing firm, inasmuch as the initiative in production and
employment lies with the employer in any particular instance.
The problem for consideration at this point, therefore, is to iso-
late the effects of variations in wage rates upon the cost structure
and pricing situation as seen by a given employer at the time when
production plans are being formulated and commitments for labor
and other resources are being made. With a certain estimate or
forecast of the demand for the finished product, the question is to
determine how much labor and other resources it would be advan-
tageous to employ in producing goods or services to meet that
demand, assuming that wage rates were either higher or lower.
The analysis is made difficult by virtue of the fact that in most
cases a change in the output of the individual firm would involve
not only a change in the amount of labor employed in production,
but also a change in the amounts of raw materials and other ele-
ments that go into the finished product. How, then, can the
effects of variations in wage rates upon employment and produc-
tion be segregated?
There are different ways in which such a segregation may be
attempted, for purposes of analysis, but one of the simplest meth-
ods is to subtract from total sales revenue the outlays that must
be made for all the other variable factors of production required
to produce the corresponding output of finished product. If the
employing firm, for example, were a manufacturer of men's cloth-
ing, then the outlays for cloth, trimmings, and other items needed
for the production of finished suits could be subtracted from the
total sales revenue that could be obtained from the sale of a given
number of garments. The remainder could be regarded as the
net total revenue or the total value product obtained by the firm
for the making of the suits in question, in which the labor outlay
would represent the principal variable element. It would then be
possible to analyze the effects of changes in wage rates and in the
employment of labor upon the total expense of making different
numbers of suits, as compared with the net total revenue, or total
value product, obtainable from their sale. Such a comparison
would show the quantity of labor that it would be most profitable
132 EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS
to employ at any given rate of wages, with a given demand for the
finished suits.
This approach may appear to be highly unrealistic, but as a
matter of fact it is very common in compiling statistics of industry
to show the value added in manufacturing, that is, the difference
between the total sales value of the product turned out and the
total cost of raw materials and supplies purchased by the manufac-
turer from outside sources. In the ensuing discussion, therefore,
the total sales revenue for the firm will be taken as equal to the
net amount remaining from the sale of any given quantity of
product, after subtracting raw material and other variable ex-
penses apart from labor. Total fixed expenses, however, will con-
tinue to be treated as a component in total expense of production.
As an illustration of the effects of a change in wage rates upon
total costs of production, and upon the production and employ-
ment policy of the particular firm, it will be convenient to trans-
late the previous analysis of changes in variable costs (as presented
in .Chapter 2, pages 31-32, and in Chapter 4, pages 56-58) into terms
that will emphasize the labor aspect of the situation. This is done
in Figure 20, in which the abscissa scale represents units of labor
employed, in terms of man-hours, and the ordinate scale repre-
sents total labor outlays or expense involved in employing the
corresponding numbers of man-hours. The price radials shown
here represent wage rates per man-hour, and not prices for the fin-
ished product as in previous figures. Thus, if the employer were
to hire 10,000 man-hours of labor at a wage rate of $1.25 per hour,
the total labor outlay for that quantity of labor would be $12,500,
indicated by a point on the $1.25 wage-rate radial directly above
the 10,000-unit point on the abscissa scale. If the employer were
to employ 8,000 man-hours at a wage rate of $1.25, the total labor
outlay for that quantity of labor would be $10,000, indicated by
a point on the $1.25 wage-rate radial directly above the 8,000-unit
point on the abscissa scale. It follows, then, that the wage-rate
radial corresponding to the prevailing rate of wages may be looked
upon as a total outlay curve for labor, reflecting the way in which
the total labor expense would vary as the amount of labor em-
ployed was varied, assuming that the wage rate remained un-
changed. By the same token, a change in* wage rates would carry
with it a corresponding change in the total outlay curve for labor.
To determine how many man-hours of labor it would be to the
EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS 13$
advantage of the firm to employ at a given wage rate, it is neces-
sary to see how changes in the amount of labor employed would
affect the total amount of product that could be turned out, and
also the total value product (as defined above) obtainable from
the sale of the product under current demand conditions.
30,000
25,000
z 20,000
15,000
i 10,000
5.000
30,000
25,000
20,000 >
I
15,0000
I
10,000
5,000
2,000 4,000 6,000 6,000 1O.OOO 12,000 14,000
UNITS OF LABOR
16,000
FIGURE 20. EMPLOYER'S DEMAND FOR LABOR: BASIC CONDITIONS OF EMPLOYMENT
For each of the indicated levels of employment 5,600 8,400
Estimated total output in units of product 17,500 25,000
Estimated total sales revenue $20,000 $24,300
A represents raw materials expense of 5,250 7,500
Giving a total value product of 14,750 16,800
D represents total labor expense of 7,000 10,500
C represents total fixed expense of 5,000 5,000
B represents total expected profit of 2,750 1,300
The first step in picturing this situation is to add another curve
to Figure 20 to indicate the quantities of product that could be
turned out in the plant if various quantities of labor were em-
ployed. This curve may be referred to as the total physical prod-
uct curve, and is labeled TPP in Figure 20. Note that this curve
starts at the origin and slopes upward to the right, rising more
and more sharply as the number of man-hours employed is in-
creased over a certain range, and then "damping-off" or rising less
and less rapidly as still larger numbers of man-hours are employed.
The curvature of the TPP curve reflects the fact that with a very
134 EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS
small amount of labor employed the existing productive facilities
would be undermanned, so that an increased output per man-
hour could be obtained by stepping up employment and produc-
tion. Conversely, the "damping-off ' of the TPP curve toward its
upper end represents the difficulty of obtaining substantial addi-
tions to total product as the utilization of plant facilities ap-
proaches capacity.
To provide a means of estimating the total physical product as-
sociated with any given number of man-hours employed, a second
ordinate scale is included on the right-hand margin of Figure 20
as a measure of total physical product. Thus, for example, a total
output of 12,500 units of product could be turned out if 4,000
man-hours were employed, whereas if 5,600 man-hours were em-
ployed, 17,500 units could be turned out, and 20,000 units of
product could be obtained if 6,400 man-hours were employed.
The basic employment and output figures used in the construc-
tion, of Figure 20 and also the figures for total sales revenue, total
value product, total outlay, total raw materials expense, and total
labor expense are presented in Table 12. These assumed data
TABLE 12
EMPLOYMENT, REVENUE, VALUE PRODUCT, AND EXPENSE DATA FOR FIGURE 20
(1\
(2\
w
w
(5}
W
W
(Q\
\' )
Man-hours
Employed
\*)
Output
Units
Total
Sales
Revenue
Total
Material
Expense
Total
Value
Product
Total
Labor
Expense
(7)
Spread
Total
Fixed
Cost
\ y )
Total
Profit
1,800
2,500
$4,250
$ 750
83,500
$2,250
$1,250
$5,000
-$3,750
2,080
5,000
7,500
1,500
6,000
2,600
3,400
5,000
-1,600
2,485
7,500
10,600
2,250
8,350
3,150
5,200
5,000
200
3,200
10,000
13,450
3,000
10,450
4,000
6,450
5,000
1,450
4,000
12,500
16,000
3,750
12,250
5,000
7,250
5,000
2,250
4,800
15,000
18,150
4,500
13,650
6,000
7,650
5,000
2,650
5,600*
17,500*
20,000*
5,250*
14,750*
7,000*
7,750*
5,000
2,750*
6,400
20,000
21,500
6,000
15,650
8,000
7,500
5,000
2,500
7,320
22,500
23,000
6,750
16,250
9,150
7,100
5,000
2,100
8,400
25,000
24,300
7,500
16,800
10,500
6,300
5,000
1,300
10,360
27,500
25,300
8,250
17,050
12,950
4,100
5,000
-900
13,920
30,000
26,250
9,000
17,250
17,400
-150
5,000
-5,150
* Most profitable level of employment.
Column (5) is equal to Column (3) minus Column (4).
are, incidentally, the same as those underlying the construction of
Figure 10 in Chapter 5. The only difference is that in Figure 20
the data are rearranged in order to put the emphasis on the wage
EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS 135
and employment aspects of the situation. The data on raw-
materials expense assume that the raw material cost per unit of
finished product remains unchanged at thirty cents regardless of
variations in the output of the plant.
In order to obtain a graphic picture of the effect of changes in
the number of man-hours employed, and corresponding changes
in total output (as indicated by the TPP curve), the total sales
revenue curve has been redrafted so as to show the total amount
that would be received from the sale of the product that could
be turned out with any given quantity of labor. Thus, with
8,400 man-hours, a total output of about 24,300 units could be
produced, as indicated by the corresponding point on the TPP
curve. The sale of that output would bring in a total sales reve-
nue of about $25,000. Deducting the $7,500 representing the raw
materials expense for that quantity of product leaves a total value
product of about $16,800, indicated by the corresponding point
on the net total revenue or total value product curve, TVP. At a
wage rate of $1.25 per hour, the total labor outlay for 8,400 man-
hours would amount to $10,500, indicated by the corresponding
point on the total labor outlay curve, TLO. Adding to the total
labor outlay the $5,000 representing total fixed or overhead ex-
pense would give a total outlay (excluding raw-materials expense)
of $15,500. The difference between this total outlay of $15,500
and the $16,800 representing the total value product would con-
stitute the total profit that could be derived from the employment
of 8,400 man-hours in production. In this case, the total profit,
with that volume of employment, would be approximately $1,300.
(See points A, B, C, and D on the graph.)
A larger total profit could, however, be obtained by cutting back
employment to about 5,600 man-hours. With that number of
man-hours employed, total output would be about 17,500 units,
which would give a total sales revenue of about $20,000. The
deduction of $5,250 of raw-materials expense would leave a total
value product (TVP) of $14,750, as against a total outlay of
$12,000, of which $7,000 would represent the total labor expense
in employing 5,600 man-hours at a wage rate of $1.25, and $5,000
would constitute total fixed expense of production. The $2,750
difference between the total value product and the total outlay
would represent the total profit obtainable with that volume of
employment. (See points A, B, C, and D on the graph.)
136 EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS
Note that at this volume of employment the spread between
total value product, as represented by the TVP curve, and total
outlay, as represented by the TO curve, exceeds the spread obtain-
able at any other volume of employment. (See points B on the
graph, for 5,600 man-hours.) This, then, represents the most
profitable volume of employment and production, under the
assumed conditions of demand for the finished product, raw-
materials expense, and wage rate for labor employed. A change
in any one of these elements would alter to some extent the vol-
ume of production that would be most profitable for the firm. As
a consequence, there would be some change in the amount of
labor that it would be most advantageous to utilize in production.
Demand for labor as related to wage rates
Suppose that, with no change in the demand for the product or
in raw-material prices, the prevailing wage rate were to rise or fall.
That would involve a corresponding increase or decrease in the
total outlay for labor if the employment of labor were not changed,
and would therefore decrease or increase the total profit that the
firm could obtain from the sale of any given quantity of product.
In many instances a moderate change in wage rates might have so
small an influence on the profit position of the firm that it would
not be worth while to change the volume of production and the
employment of labor. But if it were believed that a significant
improvement in the position of the firm could be achieved by
altering the production schedule, there would be an incentive to
add to the labor force if the wage rate decreased, or to cut back
on the labor force if the wage rate increased. The demand for
labor on the part of the individual firm represents the quantities
of labor that it would be most advantageous to employ at different
rates of wages, assuming that other conditions remain unchanged.
A graphic illustration of the conditions underlying the demand
of the individual firm for labor is presented in Figure 21. The
construction of this figure is basically the same as that of Figure
20, except that the total physical product curve (TPP) has been
omitted, as unnecessary for further comparisons. The total value
product curve (TVP) is the same as in Figure 20 and repre-
sents the net total sales revenue obtainable from the sale of the
product that could be turned out by employing different quanti-
ties of labor, after deducting the raw-material costs of the product.
EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS 137
In Figure 21, however, a series of wage-rate radials has been added
to represent different possible wage rates, from seventy-five cents
per hour to $4 per hour. Each of these radials may be regarded
as representing not only a given wage rate, but also the total labor
outlay that would be incurred in employing different amounts of
labor at the wage rate indicated.
25,000
Si
2*
20.000
15.000
< 10,000
*l
2 5,000
2,000 4,000
6,000 8,000 10,000 12,000 I4POO
UNITS OF LABOR
16,000
FIGURE 21. EMPLOYER'S DEMAND FOR LABOR AS RELATED TO WAGE RATES
TLO represents the variation in total amount that the employer would find
it profitable to expend on the employment of labor at different wage rates,
with given demand for the finished product, as represented by the total sales
revenue curve, TR.
The profit obtainable with any given volume of employment at
a given wage rate would therefore be determined by deducting the
total fixed cost, $5,000, from the spread between the total value
product curve (TVP) and the appropriate wage-rate radial at
points corresponding to that amount of employment. The most
profitable volume of employment, at any given wage rate, would
be the employment at which the spread between the TVP curve
and the wage-rate radial in question was greatest.
In Figure 21 a series of points has been plotted on the TVP
curve and on the successive wage-rate radials to indicate the
amounts of labor that would afford the maximum profit to the
firm at each of the different wage rates. To facilitate the identifi-
cation of these points, they have been connected by a dotted-line
138 EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS
curve, TLO> which serves to show how the total labor outlay of
the firm would vary, with different wage rates, if production and
employment were adjusted in each case to the maximum profit
position.
At a wage rate of $1.25 per hour, the maximum profit would be
obtained by employing about 5,600 man-hours, with a total value
product, as indicated by the TVP curve, of $14,750, and a total
labor outlay of $7,000, giving a spread of $7,750. Deducting the
$5,000 representing total fixed costs would leave a total profit of
about $2,750.
At a wage rate of $1.50 per hour, the greatest spread between
the TVP curve and the $1.50 wage-rate radial would be obtained
with an employment of about 4,900 man-hours of labor. The
total value product would be about $14,000, and the total labor
outlay about $7,350, giving a spread of about $6,650. Deducting
the $5,000 representing total fixed costs would leave a total profit
of approximately $1,650.
Or if the wage rate were $1 per man-hour, the greatest spread
between the TVP curve and the $1 wage-rate radial would be
obtained with an employment of about 6,000 man-hours. With
that volume of employment, the total value product would be
about $15,300, the total labor outlay about $6,000, the total out-
lay, including fixed costs, about $11,000, and the total profit ap-
proximately $4,300.
Similar comparisons of the total value product curve, TVP,
with the other wage-rate radials give the following approximate
results. At a wage rate of seventy-five cents, the most profitable
amount of employment of labor would be 6,600 man-hours; at
$1.75, about 4,400; at $2.00, about 3,750; at $2.25, about 3,450.
These results may be arranged in the form of a demand sched-
ule for labor, as in Table 13, or plotted graphically in the form of
a demand curve (labeled Z)i), in Figure 22.
It may appear surprising that the amount of labor it would be
advantageous to employ would not increase to a larger degree at
lower wage rates. A major element in the failure of employment
to expand more nearly in proportion to the change in wage rates
is the assumption that the product of the firm is sold under condi-
tions of monopoly or monopolistic competition, so that increased
output could be disposed of only if the price of the finished prod-
EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS 139
TABLE 13
EMPLOYER'S DEMAND SCHEDULE FOR LABOR; EFFECT OF A CHANGE IN DEMAND FOR THE
FINISHED PRODUCT
Wage Rate
per Hour
Man-hours of Labor
Demanded Before
Change in Demand
for Product (Di)
Man-hours of Labor
Demanded After
Change in Demand
for Product (D 2 )
$2.50
2.25
2.00
1.75
1.50
1.25
1.00
.75
3,000
3,350
3,750
4,400
4,900
5,600
6,000
6,600
3,850
4,200
4,700
5,175
6,000
7,200
7,900
8,600
uct were reduced. This has the effect of "damping-off" the total
sales-revenue curve and the derived total value product curve for
labor, as is evidenced in Figures 20 and 21, by the flattening out
of the total value product curve.
2.50
2.00
j
150
z
UJ
H
2 1.00
UJ
o
.50
C
-
\ \
\
\
\
\ \
\\
\
\
\o,
"V
) 2,000 4,000 6,000 8,000 10,000 12,0
UNITS OF LABOR
FIGURE 22. EMPLOYER'S DEMAND FOR LABOR
DI represents the employer's demand for labor under conditions of
demand for the product represented in Figure 21; D 2 , the employer's
demand for labor under conditions of demand for the product
represented in Figure 23.
140 EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS
Effect of a change in demand for the finished product
Suppose that the demand for the finished product of the firm
were to increase. The effect of such a change would be to raise
the total revenue curve, TR, and also the total value product
curve, TVP. The effects of such a change in the demand for the
finished product upon the employer's demand for and employ-
ment of labor are represented graphically in Figure 23. In this
figure, the total value product curve, TVP V is the same as the
TVP curves of Figures 20 and 21, whereas the TVP 2 curve rep-
resents the change in the demand for the product. It is assumed
that raw-material expenses and total fixed costs are unchanged
from the earlier illustration.
25,000
(/>
oc .
20.000
15,000
-JO
<CD 10,000
-I
<
5,000
2,000 4,000
6,000 8,000 10,000 12,000 14,000
UNITS OF LABOR
16,000
FIGURE 23. EMPLOYER'S DEMAND FOR LABOR AS AFFECTED BY CHANGE IN
DEMAND FOR FINISHED PRODUCT
! is the same as the TVP curve of Figure 20 and Figure 21; TLO is the
same as the TLO curve of Figure 21.
By the same procedure as has already been demonstrated, the
most advantageous amounts of labor to be employed at different
possible wage rates have been determined and are indicated by
pairs of points plotted on the TVP 2 curve and the wage-rate
radials. The third column of Table 13 shows the demand sched-
ule of the firm for labor following the shift in demand for the
finished product. A comparison of columns two and three in the
EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS 141
table indicates that the amount of labor that could advantageously
be employed would be greater, at each of the possible wage rates,
as a consequence of the change in the demand for the finished
product.
The figures from column three of Table 13 are plotted in the
form of a demand curve for labor, labeled JD 2 , in Figure 22. A
comparison of the D l and D 2 curves serves to suggest the reaction
of the employer's demand for labor to a change in the demand
for the finished product. It is interesting to note that with figures
which were not hand picked for this particular example, but were
originally employed in Chapters 2 and 4 to illustrate cost condi-
tions and price adjustments, the change in employment which
would tend to follow a shift in demand appears to be greater than
that which would be associated with a comparable proportionate
change in wage rates.
For example, a 20 per cent decline in wage rates, from $1.25 to
$1.00, would make possible an increase in employment from
5,600 man-hours to about 6,000 man-hours, or about 7.2 per cent,
assuming that other conditions, including the demand for the fin-
ished product, remained unchanged. On the other hand, a change
in the demand for the finished product, as represented by the shift
from the TVP 1 curve to the TVP 2 curve, would increase the most
advantageous volume of employment from 5,600 man-hours to
7,200 man-hours, or about 28.5 per cent.
The percentage change in demand may be figured in either of
two ways. First, it may be computed by comparing the total sales
revenue that could be obtained, under the changed demand con-
ditions, from the sale of the same output as would have been
most profitable under the original demand conditions, but at the
higher price made possible by the change in demand. Reference
to Figure 11 in Chapter 4 indicates that under the original de-
mand conditions the 17,500 units of product turned out with
5,600 man-hours of labor would have brought in a total sales
revenue of approximately $20,000^ After the change in demand
occurred, the same output could have been sold at a price that
would bring in a total sales revenue of about $22,750. The in-
crease in total sales revenue, for the same employment and output,
would be about 14 per cent.
i See pages 53-56.
142 EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS
The second way of measuring the change in demand is to see
how much more of the finished product could be sold, after the
shift in demand occurred, if the price of the finished product
were not changed. Reference once more to Figure 11 indicates
that if the price were not changed, consumer purchases of the
product following the shift in demand would be about 26,000
units as compared with 17,500 prior to the shift. Measured in
that way, the change in demand would be about 48.5 per cent.
Even so, the increase in employment associated with the change
in demand would be proportionately greater than the increase in
employment associated with a 20 per cent reduction in wage rates.
It would be rash indeed to generalize from a single example,
particularly when the example itself is hypothetical. However,
the conclusion to which the example leads is in line with the
view, now widely held among students of labor economics, that
changes in wage rates are less significant in their influence upon
employment than are changes in demand associated with changes
in* the general level of income. In summarizing the argument, it
may be said that either a change in demand for the finished prod-
uct or a change in wage rates will tend to change the volume of
employment that would be most profitable for the firm, but that a
change in demand for the finished product is more likely to result
in a substantial change in the volume of employment than is a
moderate change in wage rates.
Application of the analysis to other productive factors
Although the analysis of the individual firm's demand for a
productive factor has thus far been presented in terms of labor,
the same technique might equally well be applied to the analysis
of the demand for any other productive resource or service em-
ployed in production. The demand for raw materials, for exam-
ple, might be derived in the same way: by treating labor expense
as a deduction from total sales revenue, and comparing the re-
mainder with the different total outlays that would be required to
purchase different quantities of raw materials at different raw-
material prices. And in somewhat the same way the demand of
the individual firm for machinery and other productive facilities
at different prices for such equipment might be derived. It
seems scarcely necessary, however, to go on at this point to the
EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS 143
detailed examination of these other cases of the individual em-
ployer's demand for the productive factors.
Market demand schedules for particular factors of production
In some instances, the individual firm is the only buyer of a
particular type of labor or of a particular type of raw material in
a certain community, or perhaps within a comparatively large
region. In that case, the particular employer's demand also con-
stitutes the entire market demand for the service or resource in
question. The telephone company, for example, is virtually the
only employer for certain specialized types of workers. In other
instances, there are only a few employers of certain classes of labor
or purchasers of raw materials within a particular market, as, for
example, the major tobacco manufacturers or the major meat
packers. In that event, strategic considerations may play an influ-
ential role in determining the employment policies of the firms in
question.
In still other cases, the individual employer is only one of many
firms making use of about the same type of labor or material re-
sources. In such instances it is possible to visualize a market
demand schedule which represents the amounts of labor (or of
other resources) that the employers as a group would stand ready
to employ at various possible wage rates (or prices), other things
being equal.
It should be kept in mind that a general change in the demands
for the finished products turned out by the various employers
would tend to carry with it a roughly corresponding shift in their
combined demands for labor and other resources. Also, the larger
the segment of industry that is embraced in the analysis, the
greater is the likelihood that an increase or decrease in the wages
of labor or in the prices of other resources would result in concur-
rent changes in the demands for finished products, brought about
by changes in the incomes received by wage earners and property
owners. It therefore does not follow that for a large segment of
industry a lowering of wage rates, or of the prices of other re-
sources or services, would induce employers to increase employ-
ment even to the degree suggested in the earlier analysis of the
demand of the individual firm. The larger the segment of indus-
try involved, the less is the justification for assuming that "other
144 EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS
things remain equal" when a change in wages or in raw-material
prices is under consideration. In other words, for a large seg-
ment of the economy it is inappropriate to assume that the de-
mand for finished products is "independent" of the incomes paid
out by the employers as a group to those who provide labor serv-
ices or materials for use in production.
Employer's Demand as Affected by Substitution of Factors
It was suggested at the beginning of this chapter that the indi-
vidual employer's demand for any particular resource or service is
influenced not only by the demand for the finished product but
also by the possibility of substituting one resource or service for
another. The possibility of making such substitutions is governed
primarily by the technical conditions of production. In some in-
stances, there is little possibility of varying the amounts of differ-
ent resources or services used in turning out a given quantity of
finished product, whereas in other cases a great deal of flexibility
exists. In making men's suits, for example, the yardage of cloth
needed for each garment is fixed within comparatively narrow
limits. However, there is a greater possibility of substituting ma-
chine work for hand tailoring if an advantage in production can
thereby be obtained.
Generally speaking, the degree of flexibility in substitution is
greater over a period of time than it is at the moment. For ex-
ample, a manufacturer faced by an increase in wage rates might
have little opportunity to substitute labor-saving machinery imme-
diately. But over a period of a few months it might be possible to
install (or even develop) machines that would reduce substantially
the amount of labor required to turn out a given amount of prod-
uct. It would be advantageous to do so if the ultimate effect
would be to reduce the total cost of producing the desired output,
taking into account the cost of maintaining, repairing, and ulti-
mately replacing the machines, as well as the additional fixed costs
resulting from the increase in plant investment.
Substitution as related to changes in relative factor prices
The general theory of substitution may be stated simply. It
will be to the advantage of an employer to substitute one factor for
another, as long as that would tend to reduce the total outlay for
EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS 145
the resource that was being displaced, in greater degree than it
would add to the total outlay for the resource that was being sub-
stituted. In other words, it would pay to substitute labor-saving
machinery for hand labor as long as the total labor outlay was re-
duced more than the total outlay for machine operation was in-
creased.
It should be remembered that seldom does substitution involve
the complete displacement of the factor that is being "econo-
mized." The introduction of labor-saving machinery rarely per-
mits the complete displacement of labor, inasmuch as some labor
is required to operate the machines or to perform supplementary
operations. However, the type of labor required may be different
from that which is displaced. But in any event, it would be ad-
vantageous to continue substituting machinery for labor as long as
the reduction in the total wage bill was greater than the corre-
sponding increase in fixed and maintenance expense, plus the ex-
pense of operating the machines. The process of substitution
would reach its limit when the "saving" in labor expense was just
offset by the increase in other expenses.
What the "saving" in labor expense and the increase in other
expenses will amount to depends (1) on the technical conditions of
production, and (2) on the relative prices of the factors that are
capable of being substituted for each other. Suppose, for exam-
ple, that it was found by experiment that, when a certain amount
of product was being turned out in a given plant, the addition of
100 man-hours of labor to the existing labor force would result in
an increase of 200 units of finished product, with no increase in
the amount of machinery in place. Alternatively, the installation
of an additional machine would permit the same increase in out-
put to be achieved, with no increase in the labor forc6.
Under such circumstances one machine or 100 man-hours of
labor could be regarded as technically the equivalent of each
other. Whether the employer would gain, or lose, or just break
even, by adding a machine and cutting the labor force by 100
man-hours, would depend on the wage rate currently being paid
for labor, as compared with the expense of operating the machine
for the period of time required to turn out 200 additional units of
product. Suppose that the wage rate for labor were $1.25 per hour
and that the fixed and operating expenses chargeable to the ma-
chine for the given period of time were $125. Under those cir-
146 EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS
cumstances, no net gain would be achieved by substituting the
machine for labor, or vice versa.
Suppose that the wage rate were to increase to $1.50 per hour,
and that there were no corresponding increase in machine ex-
pense. It would then be advantageous to substitute the machine
for 100 man-hours of labor, because total labor expense would be
reduced by $150, whereas total machine expense would be in-
creased by only $125 for each machine added. But as the process
of substituting machines for labor continued, the size of the total
labor force would be progressively reduced in comparison with
the number of machines in use.
Eventually a point would be reached beyond which the further
substitution of machines for labor would entail increasing diffi-
culties, because operators would still be needed to man the ma-
chines and to carry through other processes. As the number of
machines was increased, in relation to the labor force, the larger
amount of mechanical equipment in use per worker would tend
to increase the output of product per man-hour employed. As
labor became increasingly "short," in comparison with the amount
of machinery employed, it might be found that a further reduc-
tion of the labor force by 100 man-hours would cut; back the out-
put as much as 240 units. To make up that deficiency it would
now be necessary to add 1.2 machines.
Obviously it would not be possible to add a fraction of a ma-
chine, but machines could be added in the ratio of 6 machines to
500 man-hours of labor displaced. However, the addition of 6
machines would entail an increase of $750 in machine expense, an
amount just equal to the reduction in total labor expense that
would result from cutting back 500 man-hours at a wage rate of
$1.50 per hour. The process of substitution would therefore
reach its limit when it had run far enough to equalize the saving
in labor expense and the addition to machine expense. Clearly,
the greater the increase in wages, the further the process of substi-
tution could go before reaching the economic limit.
A decrease in wages, conversely, would open opportunities for
substitution in the opposite direction. However, the process of
substitution resembles a chemical reaction that is only partially
reversible. If an employer has once expanded plant facilities by
installing additional durable mechanical equipment, the invest-
ment could be liquidated only by reselling the machinery. But
EMPLOYERS' DEMAND FOR PRODUCTIVE FACTORS 147
conditions are not always favorable for the disposition of used
equipment. Thus, once machinery has been substituted tor labor,
a considerable decline in wages might occur without stimulating
a reverse process of substitution.
The preceding analysis of substitution may be stated in some-
what more technical economic terms, as follows. It would be to
the advantage of an employer to substitute factor A for factor B
until the additional physical product resulting from the employ-
ment of an additional unit of A stands in the same ratio to the
reduction in physical product that would result from the elimina-
tion of a unit of B, as does the outlay for a unit of A to the outlay
for a unit of B. 2 Expressed symbolically, the limit to the substi-
tution of A for B is reached when
Increase in total product
Increase in amount of A Price per unit of A
Decrease in total product Price per unit of B
Decrease in amount of B
The left-hand member of such an equation represents the margi-
nal rate of substitution of A for B, and the right-hand member
expresses the price ratio of the substitutable factors. This formu-
lation of the principle of substitution is valid, assuming that the
prices of the factors are not directly affected by the amounts in
which they are employed by the particular employer. In cases
where a change in the amount of a factor employed by a given firm
would tend to push the price of that factor up or down, it is neces-
sary to replace the right-hand member of the equation with a term
that will reflect the change in total outlay for each of the factors
as their employment is varied.
There is no very simple way of illustrating graphically the step-
by-step process of substitution. However, a glance back to the
discussion of the effects of an expansion of plant investment in
Chapter 2 and in Chapter 4 (pages 29-35 and 56-61) will help
to picture the way in which the substitution of machinery for
labor may alter cost conditions for the employer and also the out-
put and employment levels at which the profit position of the firm
would be maximized. In the illustration employed in Chapter 4,
2 Assuming that the change in the amount of a factor employed is small, the
ratio of the change in output to the change in the amount of that factor employed
is commonly referred to as the marginal physical product of that factor.
148 EMPLOYERS' DEMAND FOR PRODUCTIVE FACT
the expansion of plant investment, on the comparatively lar;
assumed there, was found to be dependent not only upon
crease in the prices of the variable factors of production, I
upon an increase in the demand for the finished product,
been possible to substitute machinery for labor in smaller '
some substitution might have been profitable even withou
crease in the demand for the finished product.
Very often, however, the piecemeal substitution of machi
labor is impracticable; an entire process must be change
from one method to another if significant results are to
tained. And where the process of substitution is "lumpy,"
be possible for the wage rate for labor, or the price of an
factor, to change considerably before substitution becom
nomically practicable. Once the critical point is reachec
ever, an extensive substitution may occur. The possibility
substitution may provide an upper limit or ceiling beyond
a change in wage rates (or in the price of any other factor
ntft go without resulting in a drastic change in the amount
factor employed. Within that limit, changes in wage rate
other factor prices might have comparatively little effect o
employment, assuming that the demand for the finished j
remained about the same.
Chapter 9
SUPPLY OF PRODUCTIVE FACTORS
General Considerations Relating to Supply
Differences in degree of control over supply
In turning from the analysis of the employer's demand for pro-
ductive resources and services to the investigation of the supply
side of the markets for such productive factors, several points
should be kept in mind. The first point is that there are marked
differences in the degree to which the supplies of different types
or kinds of productive factors are controlled by the suppliers.
For example, a manufacturer of women's hosiery might find that
there was only one source of the particular type of yarn (such as
Nylon) that he wished to use, that there were few firms supplying
machinery of the types required in his plant, that there was only
one public utility company from which he could purchase his
power, and that the available labor force was organized under the
banners of the Full-fashioned Hosiery Workers' union. Under
such circumstances, the supply of each of the major factors needed
for production would be subject to a considerable degree of con-
trol. In other cases, however, the employer has alternative sources
of supply for some if not all of the factors that he needs, and thus
the degree of control over supply is smaller.
Where there is a considerable degree of control over supply, the
pricing of the corresponding factors may involve a process of two-
sided bargaining, or the individual employer may find the price set
on a take-it-or-leave-it basis by the suppliers. Where the alterna-
tive sources of supply are more numerous, the prices of the corre-
sponding factors of production are more likely to be set by the play
149
150 SUPPLY OF PRODUCTIVE FACTORS
of competitive market forces and to fluctuate more readily in re-
sponse to changes in employment conditions.
Differences in the responsiveness of supply
A second point to be kept in mind is that there are marked
differences in the responsiveness of different factors of production
to changes in the prices paid for their use, and that responsiveness
of supply over a period of time may be greater than at the moment.
At a certain time, the offering of a considerably higher wage for a
given type of labor might not attract many additional workers,
particularly in a period of reasonably full employment in the lo-
cality. However, some additional workers might be drawn away
from other employers; some people, including housewives and
younger or older people not normally employed, might be induced
to take jobs; and some workers might find it worth while to move
from other localities. Thus, given time, an increase in wages
offered may elicit a larger increase in the labor force than could
be obtained immediately.
In other cases, the supply of productive resources may be un-
responsive to the offer of increased factor prices, even in the long
pull. The classic example of unresponsiveness is found in the case
of certain types of land, notably urban land. An increase in the
price offered for land on which to build houses or commercial
buildings or factories can have virtually no effect upon the amount
of land of suitable kinds available, because there is no way in
which additional land of the desired type can be brought into exist-
ence, except, occasionally, where swamp areas or the shores of
rivers and bays can be filled in. To be sure, the needs for addi-
tional space may be met by pushing out the fringes of towns and
cities, but for many purposes (particularly commercial uses), such
outlying sites are not the full equivalent of sites in the centers of
commercial activity. For industrial use, access to transportation
facilities, power, and other advantages give some locations desira-
ble characteristics that cannot be fully duplicated elsewhere. Even
for residential purposes, some land equally desirable in terms of
accessibility to light, air, and pleasant surroundings may involve
transportation difficulties or other disadvantages that, from the
standpoint of the prospective home owner or tenant, make it in-
ferior in attractiveness to other locations. Over the years, changes
in methods of transportation, in industrial technology, and in the
SUPPLY OF PRODUCTIVE FACTORS 151
tastes of people may cause substantial changes in the relative de-
sirability of different locations for residential, industrial, and com*
mercial purposes, but such changes can seldom be brought about
by the efforts of any individual or small group in the business:
community. It is in this sense, then, that the supply of land uses
must be classified as relatively unresponsive to changes in the
prices offered for land use.
Differences in the urgency of need for current income
A third point to be kept in mind is that there may be great
differences in the importance attached to current income by those
who are in position to supply resources or services for use in cur-
rent production and, therefore, in the minimum terms on which
such resources or services will be made available. The individual"
worker, for example, is usually directly dependent on his job for
income with which to meet current living expenses and seldom has
other resources on which he can fall back if he should be laid off.
Even with unemployment insurance or union out-of-work benefits,,
or the aid of relatives or friends or of charitable agencies, the alter-
native to employment is ordinarily an immediate impairment of
the living standard of his family. Moreover, days lost in idleness
can never be recovered. Hence the worker is usually under con-
siderable pressure to accept employment on such terms as are
offered to him.
There is also a direct connection between the wage rate at which
the worker is employed and the standard of living that his family
can maintain. With a given amount of employment, a higher wage
rate means more money in the pay envelope and the ability to buy
more goods and services, if the prices of those goods and services do
not rise proportionately at the same time. Conversely, a lower
rate of wages, with a given amount of employment, means pressure
on the worker's standard of living. In other words, the wage rate
and the amount of employment jointly determine the personal
income of the worker, and the amount of labor supplied at the
wage rate reflects the willingness of workers to work at that wage
in return for the standard of living that it makes possible.
The prices paid for resources or services other than labor are
often just as directly translated into personal incomes as are the
wages of labor. The owner of a house or small apartment building
may look to that building for a major part of his or her personal"
152 SUPPLY OF PRODUCTIVE FACTORS
income and be largely dependent on that income for the main-
tenance of a standard of living. Failure to rent the property may
entail an irrecoverable loss of the income that might have been
obtained from its current use. Strong pressure may therefore exist
to take whatever may be offered in the way of current income for
the use of the property, if the alternative is to receive no income
at all.
It is impossible, therefore, to draw a sharp line of distinction
between personal service incomes and property incomes on the
basis of the urgency of need for current income, and the degree of
pressure that there may be to accept relatively unfavorable terms
rather than risk the chance of receiving nothing at all. However,
property incomes are for most people supplementary to other
sources of personal income, whereas wage incomes are usually the
primary reliance of industrial and other workers. Thus the pres-
sures upon the latter to sell their services for what they will bring
at the moment are likely to be greater than the pressure upon
property owners to accept low returns, rather than nothing, under
currently unfavorable conditions.
Labor Services and Labor Organization
Supply of labor in the absence of organization
Where workers are not organized, the supply of labor services
will tend to reflect the varying degrees of pressure on different
members of the group to exchange their services for money wages
and all that those wages represent in terms of things needed for
family living. If the wage rate offered by a particular employer
or employers were quite low, the number of workers willing to
work on those terms might be small. Alternative employment
opportunities, indignant refusal to take less than the work was
"worth," optimistic belief that something better could be found
later or somewhere else, or the ability to turn to others for aid,
would determine for each individual the minimum wage rate at
which he would continue on the job. It would be surprising,
indeed, if this minimum were the same for the whole group of
workers.
At progressively higher wage rates, then, the number of workers
offering their services would become larger, other things being
equal. This situation is described technically by the statement
SUPPLY OF PRODUCTIVE FACTORS 153
that at a given time and under given conditions the supply curve
for labor tends to be positively sloped: the higher the wage offered,
the larger the number of people who would be willing to work.
To this general statement, however, there are possible excep-
tions or qualifications. Under certain circumstances, the offering
of higher wages (beyond some critical level) might tend to reduce
rather than increase the total number of man-hours of labor service
made available. If wages are comparatively high, a worker may
feel that he could meet the needs for family living by working
fewer hours and devoting the rest of his time to leisure occupa-
tions. Or the larger take-home pay of the head of the family may
make it possible for the wife or other members of the family to
withdraw from full-time or part-time employment. Conversely, a
decline in wages may compel the wife or other members of the
family group to seek employment in order to supplement the wage
income of the head of the family. In such a case, the supply curve
for labor would tend to be negatively sloped, at least over a certain
range of wages; that is, the higher the wage offered, the smaller the
total amount of labor time made available to employers, and vice
versa.
It may be granted that for any individual a point would be
reached beyond which the appeal of additional income would be
outweighed by the pull of alternative leisure-time activities. But
it is also apparent that different people differ greatly in their needs
for money income, and therefore in the degree to which they
would prefer leisure to the additional income that could be de-
rived from working up to or beyond the full normal working day
or week at a higher wage rate. Moreover, the conditions of mod-
ern industrial employment are such that the individual worker is
usually not altogether free to decide how many hours he will work
per day or per week. He has to conform to the usual practice of
the establishment, except, perhaps, for occasional lapses into ab-
senteeism. Thus, those who would prefer to increase their leisure-
time activities, if wage rates were comparatively high, are likely to
be more than offset by the inclusion of additional recruits to the
labor force who are attracted by the offer of good pay.
Experience has also indicated that most workers are willing to
work longer hours, within reason, when the additional hours are
paid for at overtime rates. This would lend support to the as-
sumption that in general the supply curve for labor is positively
154 SUPPLY OF PRODUCTIVE FACTORS
sloped. At a given time and in a given locality, the supply of a
certain class of labor may be relatively unresponsive; that is, a
rather substantial increase or decrease in wage rates might not
result in a very large change in the number of workers available
for employment. Over a longer period of time, which would per-
mit the attraction of workers from other localities or the training
of new workers, the responsiveness of the labor supply might be
considerably greater.
Labor not a single homogeneous factor
In speaking of the supply of labor, it must be remembered that
there are many different types and classifications of labor employed
in different occupations, and also that workers are relatively im-
mobile, both geographically and occupationally. Even in the
United States, with a deeply rooted tradition of migration in the
quest of economic opportunity, many people are reluctant to pull
up stakes, and leave friends and familiar surroundings behind, in
the hope of finding a better job somewhere else. Furthermore,
different occupations require different skills and training; and a
worker who has attained experience in one occupation may stick
with it, even though employment conditions are not particularly
good, because in any other occupation he would have to start over
again as an unskilled worker. Seniority rights, pension rights, and
other vested interests attaching to particular employments also
operate as barriers to the shifting of workers from one firm to an-
other in the same industry, or from one occupation to another.
Such obstructions to the shifting of workers from firm to firm,
from locality to locality, and from occupation to occupation, sub-
divide the labor force of the country into a vast number of geo-
graphically and occupationally separated labor markets. A skilled
machinist or textile worker in New England is primarily interested
in the employment conditions in that area, and only indirectly in
the conditions prevailing in the South or on the Pacific Coast. By
the same token, the New England machine-tool manufacturer or
textile mill operator is more interested in the local labor supply
than in the employment conditions prevailing elsewhere in the
country. It is necessary, therefore, to think in terms of relatively
localized and occupationally specialized labor markets, rather than
in terms of a great single labor market for the country as a whole.
It is possible for wages and employment conditions for a particu-
SUPPLY OF PRODUCTIVE FACTORS 155
lar class of workers in a given labor market to change considerably,
in comparison with those prevailing for other types of labor in the
same community, or in comparison with those prevailing for the
same class of workers in other communities, before there is any
marked tendency on the part of the workers to shift occupations or
to move to other communities. The greater the geographical or
occupational obstructions to movement, the greater are the relative
shifts in wages and employment conditions that may occur before
equalizing processes are set in motion.
Trade unionism and collective bargaining
The progressive expansion of trade unionism under modern in-
dustrial conditions has tended to increase the barriers to the trans-
ference of workers from one industry or occupation to another,
particularly where union contracts with employers specify union
membership as a condition of employment or establish preference
for union members in adding to the working force. Seniority rules
applicable to promotion and to retention of workers in lay-offs also
tend to increase the rigidity of occupational lines, and therefore
to reduce the "lateral mobility" of labor.
An avowed object of union organization has been to substitute
collective bargaining for individual bargaining on wages and other
conditions of employment. This clearly brings the supply side of
the labor market under some degree of unified or group control.
It normally precludes the acceptance, by the individual worker, of
employment on terms which he might, as an individual, be willing
to accept as an alternative to no employment at all. Common
union procedure is to bargain with employers for a minimum rate
of pay, either per hour or on a piece-work basis, and to bring pres-
sure to bear upon individual workers not to accept terms that
undercut the union scale. This practice has the effect of cutting
off the supply curve of labor at the lower end and putting a floor
under the minimum rate, even though some workers might be
willing to work for less if that were necessary in order to secure
employment. It should be noted that there have been many in-
stances in the past in which the workers in a plant, without any
formal organization at all, have utilized the pressure of group opin-
ion and interest to prevent individual workers from undercutting
what the group regarded as a fair standard of remuneration and
performance on the job. There may thus be some element of col-
156 SUPPLY OF PRODUCTIVE FACTORS
lective action on the supply side of a particular labor market, even
where there is no formal collective bargaining procedure, and in
the absence of union organization itself.
The wage policies of American unions have been based in the
past largely on a bargaining approach, which has assumed that
within comparatively wide limits an increase or decrease in wages
would not greatly alter the amount of labor that an individual
employer (or an entire industry) could afford to hire. Demands
for increased wages have often been coupled, in the past, with the
contention that the profit position of the firm was such as to per-
mit the payment of higher wages, without necessarily increasing
the price of the finished product. As a practical matter, unions
have been successful in pushing up wage rates by collective bar-
gaining chiefly in periods of expanding economic activity in which
the demands for finished products are increasing. Under such
circumstances, increases in wage rates have not typically resulted
in a decline in employment. Conversely, periods of wage reduc-
tions have in general been periods of declining business activity
and employment, in which the demands for finished goods are
decreasing. And in such periods, even drastic reductions in wages
have been unavailing to prevent deep cuts in employment. It is
on the basis of such pragmatic experience as this, rather than on
any formal economic analysis, that the traditional union wage
policy was formulated. It is interesting to note that the tradi-
tional union view that wage rates are not the major factor deter-
mining the volume of employment is not far out of line with the
inference that may be drawn from the analysis of derived demand
in Chapter 8.
Union leaders have also commonly buttressed their demands for
increased wages with the contention that, unless the purchasing
power in the hands of wage earners (who constitute the bulk of the
consumers of the country) is progressively increased, it will be im-
possible to dispose of all the goods and services that can be pro-
duced under modern industrial conditions. This view, which
dates back long before the modern formulation of national income
analysis, has certain elements in common with the latter. In both,
a minor rather than a major role is assigned to wage rates among
the various factors tending to determine the general level of pro-
duction and employment. In both, great stress is placed upon the
SUPPLY OF PRODUCTIVE FACTORS 157
role of aggregate demand for the products of industry, which in
turn depends on the amount of disposable income in the hands of
consumers. But, as will be seen in later chapters, the national
income and production analysis does not necessarily support the
conclusion that the way to stimulate increased production, employ-
ment, and income is to start with a general increase in wages.
It would probably be conceded (off the record) by thoughtful
union leaders that there is some upper limit beyond which the
wages of a certain class of workers could not be raised, by collective
bargaining or otherwise, without causing a substantial curtailment
of employment. If only a part of an industry were unionized, and
the products of union and nonunion firms were sold in the same
or closely connected markets, an attempt to establish substantially
higher wage rates in the unionized plants than prevailed in non-
union shops would put the union employers at a competitive dis-
advantage. Inability of the United Mine Workers to extend their
organization into the southern coal fields led to the virtual col-
lapse of the union in the late 1920's, as northern coal operators,
theretofore covered by union contracts, broke away in an effort to
realign their wage rates with those of the nonunion competitive
areas. Ability to make the union organization coextensive with
the area of competitive production is essential if the union is to
follow a strong wage policy.
Even with strong union organization over the area of competi-
tive production, it is possible that the wage rate could be pushed
to the point where increased costs and curtailed sales would cause
a cut-back in employment. In other cases, a practical limit to the
upward movement of wages might be set by the increasing advan-
tage to be gained by substituting labor-saving machinery, or mak-
ing other changes in production methods. The policies of many
unions, however, are directly or indirectly aimed at limiting the
possibility of such substitution. Union rules or contract provi-
sions, defining the union's jurisdiction over certain classes of work,
restrict substitution by preventing the transfer of part of the work
to other classes of employees not covered by the union. Many
unions have in the past developed and enforced policies designed
to minimize the advantage that the employer could derive from
the introduction of machinery to do part of the work that was done
before by union members. Such policies include the insistence
158 SUPPLY OF PRODUCTIVE FACTORS
that workers employed in operating machines be paid at rates that
absorb a substantial part of the advantage of substituting the
machine.
The ability of the union to enforce such policies depends on
\vhether the employer still requires the services of the workers be-
longing to the union in some parts of the productive process to
which the machine is not adapted. If some skilled work is neces-
sary, the union may still be in a sufficiently good strategic position
to insist on the policy of handicapping the machine, because it is
in position to withdraw the services of its members as a group if
the employer fails to come to terms. Unless the employer is in
position to dispense entirely with the services of workers of the
type covered by the union, he may be faced with an all-or-nothing
alternative, which would preclude the partial substitution of ma-
chinery for some of the work done by members of the union.
Pricing of labor services
As already indicated, the conditions surrounding the pricing of
different types of labor service are extremely varied, reflecting dif-
ferences from one labor market to another, differences in the
number of employers competing for labor in the same or in closely
related markets and in the degree of organization that prevails both
on the demand side and on the supply side of the particular labor
market. Seldom, however, do conditions approaching those of
pure competition prevail. In some cases, the initiative in wage
determination lies with the employer or group of employers, as in
cases where the employer sets the hiring rate at whatever level
appears necessary to obtain labor in the amount required to im-
plement current production schedules. In other cases, the union
may establish a minimum rate below which its members are not
permitted to seek employment, thereby taking the initiative in
setting the going rate of wages.
In labor markets in which wage rates and other terms of employ-
ment are established by collective bargaining, there is likely to be
a range of possible wage rates between an upper limit, established
in the minds of the employers by their appraisal of current and
prospective demands for the finished products they turn out, and
a lower limit representing the minimum that the union would
voluntarily accept in preference to calling a strike. The wage rate
actually agreed upon will normally fall somewhere within this
SUPPLY OF PRODUCTIVE FACTORS 159
range, at a level determined by the relative bargaining strength of
the two sides. Should a settlement fail to be reached by direct
agreement, and a strike eventuate, the ultimate terms will depend
upon the amount of pressure to which each side is subjected by a
work stoppage. For the employer, the stoppage represents a loss
of current production and sales, and a possible impairment of
profit position that may outweigh the effects of a wage increase
upon total costs. For the union, the pressure arises as a conse-
quence of the immediate loss of wage income for the union mem-
bers and the possibility that, if the strike were long drawn out, the
union resources and morale might be dissipated and the strike de-
feated.
Supply of Materials
With respect to raw materials or components required by a pro-
ducer for the production of the finished product, the conditions of
supply are extremely varied. In some instances, the alternative
sources of supply are so numerous, and the total supply so large in
comparison with the amounts used by any single employing firm,
that any desired quantity can be obtained by a given employer
without causing any significant change in price. However, a gen-
eral increase in the amounts demanded by all of the firms using a
particular type of material would tend to result in a substantial
increase in price, as the suppliers approached full employment of
their own facilities and resources and encountered increasing costs
as a consequence of enlarged output.
In many other cases, the producers of particular types of raw
materials or component parts used by other firms are few in num-
ber, and the supply then comes to be characterized by conditions
of oligopoly or monopolistic competition. In that event, as in the
comparable situation with respect to the production of finished
goods, there is no well defined supply schedule or supply curve.
Instead, the quantity which it will be to the advantage of the in-
dividual supplier or suppliers to provide, and the price policy
adopted, will be influenced by the supplier's appraisal of the cur-
rent demand situation for the materials in question. If both
buyers and sellers are few, or if, as is not uncommon, the situation
is one of dealing between a single buying firm and a single supply-
ing firm, the pricing process may be reduced to a matter of bar-
160 SUPPLY OF PRODUCTIVE FACTORS
gaining. The upper limit of the bargaining range would be a
price at which the buyer would find it preferable to curtail pro-
duction to a drastic degree (or even to shut down) or to shift to the
use of substitute materials obtained from other sources. The lower
limit would be a price at which the supplier in turn would find it
preferable to curtail production, or to seek alternative outlets for
its output. The width of the bargaining range would depend on
the availability of alternative sources and outlets to the bargaining
firms and would tend to vary with changes in general business con-
ditions and in the relative prosperity of the firms in question.
This bargaining situation is not unlike that already considered
in the discussion of wage determination under collective bargain-
ing. The chief difference is that effective organization and control
of the supply side of the market for raw materials, and particularly
for semimanufactured items, is often more easily accomplished
than in the case of labor. However, in the case of agricultural
commodities and other basic raw materials that may be produced
by many thousands of small producers, the difficulties of achiev-
ing and maintaining a voluntary control of supply are at least as
formidable as in the case of labor organization.
Supply of Land Use
As already noted, the total quantity of land available for use is
fixed by circumstances beyond human control, and with few ex-
ceptions there is no way of increasing the amount of land of any
particular quality or location. The ownership of land in the
United States, however, is in general widely diffused, and even in
urban areas the control is seldom highly concentrated. The sup-
ply of land use in any locality, therefore, reflects the attitudes of
the various land owners with respect to the disposition of their
holdings at various possible levels of rental. By and large, no
effort or cost is involved in making the land itself available for use
(apart from costs of administration), and if land owned by a par-
ticular individual is withheld for use, it does not produce any
immediate income. It seems reasonable to suppose that different
owners of land of about the same quality and location would dif-
fer somewhat in the urgency of their needs for current property
income, and therefore in the minimum rentals at which they
would be willing to make their property available for use. If so,
SUPPLY OF PRODUCTIVE FACTORS 161
the higher the rental offered, the larger is the quantity of land of
a certain quality and location that would be made available, and
vice versa.
Even in the same locality there are likely to be considerable
differences in the desirability of different tracts of land, from the
standpoint of prospective users, and hence it is more appropriate
to think of the land as a differentiated rather than an homogene-
ous factor of production, with supply conditions in general resem-
bling those of monopolistic competition. And under such condi-
tions of supply, individual owners of land may feel constrained to
withhold land from use at rentals that they would otherwise be
prepared to accept, because they are fearful of "breaking the mar-
ket" and precipitating a competitive scramble that would drive
rentals still lower. In some cases, such prudential considerations
are supplemented or reinforcd by formal organization on the part
of particular groups of land owners through which concerted ac-
tion to maintain rentals is accomplished, even though the conse-
quence of such action may be a larger percentage of vacancy than
would exist if rentals were allowed to gravitate to the "competi-
tive" level.
Supply of Other Durable Productive Facilities
Much of the land used by industrial and commercial enter-
prises, and an even larger percentage of buildings, machinery, and
other durable productive facilities used in production, are owned
by the employing firms themselves. It seems a bit difficult to think
of the firm owning such facilities as supplying itself with their
uses, yet that is virtually what the situation amounts to. If a man-
ufacturing firm has a building equipped with machines, the firm
can make as much or as little use of those facilities as seems advan-
tageous at any given time (up to the limits of the plant capacity).
In purchasing and installing the equipment, the firm made a cer-
tain investment, and the costs associated with that investment,
including the depreciation of the equipment itself, go on without
much reference to the amount of use made of the equipment at
any given time. It will be advantageous to make use of the equip-
ment whenever the value attributable to its use exceeds any addi-
tional costs that would arise if the equipment were used rather
than left idle. Whether the value attributable to the use of the
162 SUPPLY OF PRODUCTIVE FACTORS
existing plant facilities is also sufficient to provide full coverage
for depreciation and a return on the investment will not greatly
affect the decision as to the extent to which it will be used; that
decision hinges on a consideration of the special costs that arise
only if it is used.
If the employing firm finds itself in the position where its exist-
ing facilities are being fully utilized, then the question of plant
expansion arises. An incentive to increase the investment in plant
facilities will exist if it appears that the demand for the finished
product will be sufficient, in the future, to warrant the employ-
ment of additional productive facilities, considering the costs in-
cident to such an expansion. If an expansion is decided upon, the
firm may be thought of as putting itself in position to supply itself
with a larger supply of productive services than was previously
available. If more machines and other equipment were pur-
chased, an additional fixed expense would be involved, as a con-
sequence of the increased investment required, and depreciation
and maintenance expense would also be increased. A compari-
son of these increased expenses, with the value attributed to the
use of the additional facilities during their service life, would help
to determine how far the expansion of plant facilities could be
carried with a reasonable expectation of increased profit for the
firm.
The relationship between the value attributed to the use of
durable productive facilities and the value attached by the em-
ploying firm to the ownership of those facilities themselves will be
explored in greater detail in the following chapter on the valua-
tion of durable productive assets.
Part Three
INVESTMENT
Chapter 10
REAL INVESTMENT AND THE VALUATION
OF DURABLE ASSETS
A Dual Problem of Valuation
In order to carry on business activities at all, an enterprise must
be in position not only to purchase needed raw materials and meet
payroll expenses, but it must also be in possession of durable plant
facilities in at least such amounts as are required by current pro-
duction schedules. Such facilities may in some cases be rented
rather than owned, but in the great majority of cases they are
owned outright by the employing firms.
In the case of such durable productive facilities, a dual prob-
lem arises because they are not exhausted in a single use. If
properly cared for, their service lives may extend over several or
perhaps many years. Thus a building or a machine represents a
whole bundle of potential uses that may be extracted year after
year until it is ultimately worn out or becomes obsolete. By and
large there is no way of obtaining all of these potential uses, or
even a substantial part of them, at one time. There is no way of
putting through a machine today all of the materials that could be
processed on it tomorrow, and the next day, and in all the months
or years to come before it is worn out. It is necessary to wait for
months or years to obtain all the services that the machine is
capable of rendering.
This means that although a machine or any other durable agent
may be regarded as a bundle or series of uses, these uses differ from
one another with respect to their location in time. Some may be
obtained today, some tomorrow, and others at more and more dis-
165
166 REAL INVESTMENT
tant dates in the future, over the entire life span of the agent in
question. Obviously the use that can be made of a machine next
year is of little significance from the standpoint of today's produc-
tive activity, because there is no way of obtaining that use today.
Suppose that a machine has an expected service life of ten years.
If the volume of production in the plant is such as to require the
use of ten machines, there is no way of getting the entire output
produced by using one machine and extracting its entire ten years
of potential usefulness in one year.
Inasmuch as durable agents require time in which to obtain the
full measure of their potential uses, the value that will attach to
the ownership of such an agent will depend not only on the value
of the use that can be made of it at the present time, but also on
the values that are expected to attach to its use in future years, up
to the limit of its service life. Thus the value of a durable agent
itself may be thought of as being equal to the sum of the present
values now imputed to all of the uses that are expected to be de-
rived from it, taking into account their differing location in time.
In other words, two problems of valuation arise in connection
with durable productive agents. The first is that of how much
the use of the agent for a given period of timesay this month or
this year, or next month or next year will be worth at the time it
is rendered. The second problem is that of determining what the
entire expected series of uses is worth now to the employing firm,
because that solution will determine the value of the agent itself.
The first of these two problems was dealt with in Chapter 8; the
second is the subject for consideration in this chapter.
The meaning of real investment
The term real investment is customarily used to designate the
value of physical resources used in production, including both
durable productive facilities and materials and goods in process of
production. The fixed investment of a business enterprise corre-
sponds to the value of the durable plant and machinery which it
owns; the amounts tied up in materials and goods in process rep-
resent the working capital requirements of the firm. When a ma-
chine or a building is first acquired by the enterprise, the real
investment in it will correspond to its purchase price plus costs of
installation. But as the years pass, the real investment represented
by any given piece of durable equipment will gradually decline as
VALUATION OF DURABLE ASSETS 167
its service life passes or as it becomes obsolete. This decline in
real investment is recognized by allowing for depreciation of plant
and equipment as an expense of current operations.
The real investment in the plant as a whole may be maintained
intact by making regular purchases of new productive equipment
to offset the wearing out of units previously installed. If such
new acquisitions are just sufficient to offset the depreciation of
older facilities and equipment, there will be no net real invest-
ment by the firm. If they are more than sufficient to offset depre-
ciation, there will be net real investment or new real investment
on the part of the firm. If they are insufficient to offset depreci-
ation, there will be a net real disinvestment in the enterprise.
In any case, real investment refers to the value of the means of
production owned by the enterprise itself and available for use in
productive operations. This use of the term investment is more
restricted than the common usage of the term to refer to the value
of any kind of a property right, including the ownership of stocks
or bonds or other types of intangible property that people may
purchase or own. There is, of course, a connection between
financial investment in stocks and bonds (representing ownership
of, or claims against, business enterprise) and the real investment
of the enterprise itself in the means of production. The connec-
tion, however, is not immediate or direct, and therefore the con-
sideration of the financial overlay of the productive process will
be deferred to subsequent chapters.
The problem for immediate consideration is to trace in some-
what greater detail the connection between the values attaching to
the use of durable productive resources and the values imputed to
the agents themselves. It would not be to the advantage of a
business firm to make a real investment by purchasing and in-
stalling equipment that did not promise to "pay for itself" by
"returning" the purchase price within a reasonable time. But
what might appear to be a reasonable period of time for a motor
truck may be quite different from the period that seems reason-
able for a factory building or a railroad right of way.
Basic Elements in the Valuation of Durable Agents
A more systematic statement of the problem will help to bring
out the main factors that determine how much a given productive
168 REAL INVESTMENT
agent would be worth to the firm; if it is worth more than its cur-
rent purchase price, plus installation expense, the firm will have
an incentive to purchase it, thereby increasing the real investment
of the firm.
The first factor influencing the value of a durable productive
agent is its expected service life. There is no way of knowing in
advance just how long it can continue to be used in production
before it is worn out or becomes obsolete as a consequence of tech-
nical improvements. It is necessary, therefore, to estimate the
prospective service life under normal conditions of use, recogniz-
ing that the margin of error may sometimes be quite large.
The second factor influencing the value of a durable productive
agent is the value attributed to the use of the machine during each
operational period (whether a month or a year) in which it is used,
throughout its service life. Chapter 8 dealt with the problem of
valuing the current use of the machine. Whether in subsequent
operational periods the value imputed to the use of the machine
will be the same as, or less than, or greater than, the value attrib-
uted to its current use is also uncertain. Here again it is necessary
to operate on the basis of the best forecast or estimate that can be
made at the present time, in the light of the expected trend of
demand for the finished product. That estimate may prove, in
the course of time, to have been either good or bad, but it is the
only basis on which current decisions can be made. If in subse-
quent years the use of the machine proves consistently to be worth
less than had been anticipated, the investment in the machine will
then appear to have been unwise. If the use of the machine in
later years proves to be worth more than had been expected, the
investment in the machine will be more than justified.
The third factor affecting the value of a durable productive
agent is the element of time discount that is reflected in any pres-
ent valuation of the future uses of a productive agent as compared
with the present use. Inasmuch as the element of time discount
enters into every problem of valuation in which time is a factor,
the ensuing analysis is applicable to many other problems, aside
from the valuation of machines or other types of productive equip-
ment, and is extensively developed in connection with the mathe-
matics of finance.
VALUATION OF DURABLE ASSETS 169
Time Discount and Present Worth
Suppose that the management of a business firm is considering
the purchase of a new machine, the service life of which is esti-
mated at ten years, assuming that the plant continues to run about
the same number of hours per week during that period. It is also
estimated that the use of the machine during the current year
would be worth $1,000 after making allowance for necessary main-
tenance and repairs. So far as is now known, there is no reason to
suppose that the value of the machine in any of the later years
would be much more or much less than $1,000 per year. In that
event, the machine may be thought of as affording a return to the
firm of $1,000 each year for ten years. What then would be the
maximum amount that the firm could invest at the present time
in the purchase of the machine? Would it be worth while to in-
vest as much as $10,000 to acquire it? That amount would corre-
spond to the full estimated value of the use that could be made of
the machine during its entire ten-year life. To do so would mean
that the firm was willing to make an immediate outlay of $10,000,
with the expectation of getting back the same sum in a series of
$1,000 installments spread out over the entire ten-year period.
Although it is possible to visualize circumstances under which
that might be done, it would appear that the firm would be in
equally good position if it put ten $1,000 bills in a safe-deposit
box and then took out one bill each year.
As a matter of fact, the firm could do better than that if it were
simply to lend the $10,000 at the going rate of interest on long-
term loans. Suppose, for example, that it were possible to lend
this amount at 5 per cent interest, splitting up the total amount
into ten loans of $1,000 each, the first loan to be repaid at the end
of one year, the second at the end of two years, the third at the
end of three years, and so on. Then on the $1,000 loaned for one
year the firm would receive back $1,050 at the end of the year in
the repayment of principal plus interest. On the $1,000 loaned
for two years the firm would receive $50 in interest at the end of
the first year, and $1,050 in principal and interest at the end of the
second. On the $1,000 loaned for three years the firm would re-
ceive $50 in interest at the end of the first and second years, and
$1,050 in principal and interest at the end of the third year. If
170 REAL INVESTMENT
the interest received each year were also loaned out at the same
rate (that is, compounded), then the $1,000 loaned for two years
would accumulate to $1,102.50 by the end of the second year
(equal to $1,000 in return of principal, plus $50 in interest for the
first year, plus $52.50 representing interest on $1,050 for the sec-
ond year).
If $1,000 loaned now would bring back $1,050 at the end of one
year, or $1,102.50 at the end of two years, then the present worth
of $1,000, which is expected to accrue from the use of a machine
by the end of one year, will be worth less than $1,000 now. Its
present worth (still assuming that funds could be loaned at 5 per
cent) would be reduced, or discounted, in the ratio of + ' -~,
or 0.952. That is, the present worth of $1 ,000 accruing at the end
of the first year would be $1,000 X 0.952, or $952. By the same
token, the present worth of the $1,000 expected to accrue from
the use of the machine during the second year would have a pres-
$1 000
ent worth of $1,000 X ' r $9 7 '
Present-worth tables to be found in any financial handbook
make it unnecessary, as a practical matter, to compute the present
worth of any single future sum or income by the method indicated
above. In Table 14, the column labeled "Present Worth" is taken
from such a tabulation. The first figure in the present-worth col-
umn represents the amount which, if loaned at a 5 per cent inter-
est rate, would bring back $1,000 in return of principal plus inter-
est by the end of one year. Thus the present worth of the use of
the machine during the first year is represented by the first figure
in the first column of Table 14, and the value attributed to the
use of the machine during that year is represented by the $1,000
at the top of column 2. The second figure in column 1, or $907,
represents the present worth of the use of the machine during the
second year, as compared with the $1,000 which the use of the ma-
chine is expected to bring in during that year (indicated by the
$1,000 appearing at the top of column 3). These additional col-
umns are included simply to show the progressively greater dis-
count that attaches at the present time to the returns expected to
flow from the use of the machine in later years, even though, when
those uses are ultimately obtained, they may prove to be worth no
VALUATION OF DURABLE ASSETS
171
less than the uses obtained in earlier years. In other words, the
present worth of expected future uses differs from the present
worth of the current use.
TABLE 14
PRESENT WORTH OF A SERIES OF $1,000 INCOMES RECEIVABLE ANNUALLY OVER A PERIOD
OF TEN YEARS, DISCOUNTED AT FIVE PER CENT
(Figures are in dollars)
Expected value of the income in the year in which it accrues
Present
Worth
1st
2d
3d
4th
5th
6th
7th
8th
9th
Wth
Tear
Tear
Tear
Tear
Year
Year
Year
Year
Tear
Year
952
1,000
907
952
1,000
864
907
952
1,000
823
864
907
952
1,000
784
823
864
907
952
1,000
746
784
823
864
907
952
1,000
711
746
784
823
864
907
952
1,000
677
711
746
784
823
864
907
952
1,000
645
677
711
746
784
823
864
907
952
1,000
614
645
677
711
746
784
823
864
907
952
1,000
7,725
This table is based fundamentally on a compound interest rate of 5 per cent, and may be used either to
calculate the present worth of a given future income or series of incomes, or the future sum to which a given
present amount of money would accumulate in any number of years, up to 10, if that sum were invested in
such a way as to bring in an annual return at a rate of 5 per cent and if the annual return were in turn re-
invested at 5 per cent.
For example, refer to the bottom line of the table. $614 invested at 5 per cent would bring in approxi-
mately $31 (S30.70) in interest at the end of the first year, giving an accumulated total of $645 by that time.
In the second year, 5 per cent interest on $645 would amount to approximately $32 ($32.25), giving an
accumulated total of $677 by the end of the second year. The successive figures in this line, therefore, show
the progressive accumulation, at compound interest, reaching $1,000 by the end of the tenth year. But if
$614 would accumulate to $1,000 in 10 years, at a 5 per cent compound interest rate, then in 10 years one
dollar invested now, at the same rate, would accumulate to $1,000/5614, or approximately $1.63.
The present worth of the entire series of uses expected to flow
from the machine over its ten-year life would be equal to $7,725,
or the sum of the present worths of the ten-year series, as repre-
sented in column 1 of Figure 14. Viewing the situation somewhat
differently, if $952 were loaned at 5 per cent for one year, $907
for two years, $864 for three, $823 for four, and so on, the accu-
mulation of interest would bring the principal of each loan, plus
interest, up to $1,000 by the maturity date of each loan. The first
loan would bring in $1,000 at the end of the first year, the second
would bring in $1,000 at the end of the second year, and so on.
172 REAL INVESTMENT
The total amount loaned at the beginning would be $7,725; the
total amount received back in principal plus interest over the ten-
year period would be $10,000 in a series of $1,000 annual pay-
ments.
Thus, $7,725 represents the maximum amount that the firm
would be willing to pay for the machine in question, if the ex-
pected returns were no more than $1,000 per year for ten years,
and if, as an alternative, the firm could lend that amount at a
5 per cent rate of interest. Conversely, if the firm did not have
the funds already on hand to purchase the machine, $7,725 repre-
sents the maximum amount that it could afford to pay for the
machine if it were necessary to pay as much as 5 per cent interest
on funds borrowed from outside sources. If it were possible to
borrow funds at a rate of interest lower than 5 per cent, then a
larger present sum could be expended, if necessary, in order to
purchase the machine. If funds could be obtained only at a rate
of interest higher than 5 per cent, less than $7,725 could be ex-
pended on the purchase of the machine, assuming, still, that the
expected returns amount to $1,000 per year for ten years.
Demand for durable agents
It is unlikely that all prospective purchasers of the same kind of
machine would assume the same service life as a basis of valua-
tion, or attach the same estimated values to the future uses of the
machine. Nor is it necessarily true that they could all obtain
present funds on the same terms. Differences in any one of these
elements might lead one firm to regard the machine as "worth 1 '
as much as $8,000, and another to consider it worth no more than
$4,000. With the possibility of such variations in the estimates of
the present worth of a particular kind of machine, the demand
schedule for the machines may be thought of as representing the
numbers of machines that would be purchased at a given time by
all of the potential users, at different possible prices. At a high
price, the investment necessary to purchase and install a machine
would exceed its present worth to many prospective employers; at
a lower price, the necessary investment would be less than the
present worth attached to the machine itself by many potential
employers.
Suppose that, under current conditions of demand and supply in
the market for the type of machine considered above, the prevail-
VALUATION OF DURABLE ASSETS 173
ing price was approximately $7,365, or substantially less than the
$7,725 which a machine would be "worth" to the employer in the
preceding example. In that case, a definite gain would accrue to
the firm from the purchase of the machine, because the price
might be as high as $7,725 before it would fully cancel out the
advantage of adding the machine.
"Rate of return over cost" or "efficiency of capital"
By calculations much like those involved in the determination
of the present worth of the machine, it is possible to compute the
"rate of return over cost" or the rate of return on purchase price
that is expected to flow from its use. The problem is to deter-
mine what rate of interest or discount would make the purchase
price of the machine equivalent to the series of returns expected
from it during its service life. Suppose that a machine selling for
$7,365 can be used in such a way as to obtain returns estimated
at $1,000 each year for ten years. At what rate of discount would
the present worth of that series be $7,365? (From the preceding
example it is known that the present worth would be $7,725 with
a 5 per cent discount rate; therefore the discount rate involved in
a present worth of $7,365 would be greater than 5 per cent.)
The problem may be expressed in the form of an equation, in
which the unknown element to be determined is the rate of dis-
count, r. Thus,
, $1*000 , $
(1 + r) ' (1 + r)* T (1 + r) ' ' ' -r (1 + r)"
If the actual calculation were followed through, it would be found
that the value of r is 0.06 or 6 per cent. That is, if the machine
could be purchased for $7,365, and is expected to return $1,000
each year for ten years, then the expected rate of return over cost
is 6 per cent. In present-day economic literature, the rate of re-
turn over cost that is expected to result from the installation of an
additional unit of productive equipment is frequently referred to
as the marginal efficiency of capital. 1
Note that in the previous calculation of the present worth of
the machine to a particular employer it was assumed that the firm
]. M. Keynes, The General Theory of Employment, Interest, and Money,
page 135.
174 REAL INVESTMENT
could lend surplus funds at its disposal in such a way as to obtain
a 5 per cent interest return on those funds. Or, alternatively, if it
needed additional funds to finance the purchase of such a ma-
chine, it could obtain those funds by borrowing from outside
sources at a rate of interest not greater than 5 per cent. On that
basis, the present worth of the machine was fixed at $7,725. But
if the market price of the machine were less than $7,725, a rate of
return Over cost, or marginal efficiency of capital, greater than
5 per cent could be obtained. Thus, a comparison of the rate of
return over cost, or marginal efficiency of capital, with the pre-
vailing rate of interest on borrowed funds, gives a basis for deter-
mining whether a particular expansion of the investment of the
firm in productive facilities would be advantageous or not. The
higher the expected rate of return over cost, in comparison with
the prevailing interest rate, the greater the advantage to be de-
rived from a given expansion of investment.
The Problem of Depreciation and Replacement as Related
to the Rate of Return over Cost
Suppose that the business firm decides to invest $7,365 in a new
machine of the type considered above. Can the entire $1,000 ex-
pected to accrue each year from its use be regarded as net return
on the investment? If it were, the rate of return would appear to
be much more than 6 per cent, because $1,000 is approximately
13.5 per cent of $7,365. But the machine is expected to last only
ten years, and unless during that time provision is made for its re-
placement, the end of the tenth year will see the machine worn
out and the returns from its use will terminate. Therefore, in
estimating the true or net return from the use of the machine each
year, an allowance must be made for its depreciation or loss of
service life during the year. Unless depreciation is recognized as
one of the costs of current operation, the profits of the enterprise
will be overstated; and if the apparent earnings were all distrib-
uted in the form of dividends to the stockholders, a part of their
capital investment would in fact be returned to them in the guise
of current income. It should be remembered, however, that the
making of an allowance for depreciation of plant and equipment
as an expense of current operation does not in itself make provi-
sion for the replacement of that equipment when worn out. It
VALUATION OF DURABLE ASSETS 175
merely insures that the resources of the firm will not be unwit-
tingly dissipated. How and when to replace worn-out or obsolete
productive plant facilities is another question that must be de-
cided as a matter of managerial policy, to be discussed in a little
more detail below.
In computing depreciation expense, different methods are fre-
quently employed by business firms, but a very common method
is the "straight-line" method. This involves estimating the pros-
pective service life of any particular piece of equipment and writ-
ing off a -uniform percentage of the original purchase price each
year, the percentage being based on the length of the expected
service life. In terms of the preceding illustration, the annual
allowance for depreciation expense would be 10 per cent of the
purchase price of the machine, or $736.50. The difference be-
tween the $1,000 which represents the expected value of the use
of the machine during a year, and the $736.50 figured as depreci-
ation expense, or $263.50, would constitute the approximate net
return on the investment in the machine.
Actually such a calculation would understate the real rate of
return on the investment, inasmuch as $736.50, if set aside each
year to provide for the replacement of the machine, would in ten
years equal the purchase price, even though such funds were left
completely idle. In practice, they are usually utilized by the firm
itself to finance piecemeal replacements, or, occasionally, they are
transferred to earmarked funds, called sinking funds, and in-
vested in securities. The latter practice is seldom followed in
making provision for the replacement of specific items of produc-
tive equipment, because ordinarily a firm expects to make a rate
of return on its own operations that is higher than the prevailing
interest rate on loanable funds.
Suppose that it were expected that the over-all rate of earnings
for the enterprise as a whole would average not less than 6 per
cent in future years. In that event, the setting aside of not more
than $559 per year would be sufficient, over a ten-year period, to
provide a lump sum of $7,365 for replacement purposes at the end
of ten years, assuming that the earnings of the amounts so set aside
were credited to the replacement funds (that is, compounded at a
6 per cent rate). The difference between the $559 needed to pro-
vide for replacement and the $1,000 representing the estimated
value of the use of the machine each year, or approximately $441,
176 REAL INVESTMENT
would amount to a 6 per cent rate of return on the $7,365 invested
in the machine. 2
What this all means is that, by regarding a part of the annual
return from the use of a machine as provision for its replacement
when worn out, the amount originally invested in one machine is
ultimately reinvested in another machine to take its place, so that
in effect the $7,365 is permanently invested or kept intact, despite
the fact that any particular machine has a definitely limited service
life.
Changes in the Rate of Return over Cost
or Efficiency of Capital
As noted earlier, the rate of return over cost, or the efficiency of
a piece of productive equipment, depends on the size and duration
of the returns expected to flow in the future from the use of that
piece of equipment in production. It follows that any change in
current .expectations regarding either the probable service life of
a durable productive agent, or the probable returns to be ob-
tained from its use, will alter the rate of return over cost.
Suppose, for example, that the demand for the finished product
turned out by the firm were to increase. That demand would
provide a basis for some expansion of output and would lead to a
fuller utilization of the existing plant facilities. With such in-
creased utilization, the value attributable to the use of the plant
facilities would be increased, thereby tending to increase the ratio
of the returns on such facilities to the original investment in
them. If existing facilities were being used to capacity, and the
increase in demand appeared to be permanent, the returns that
could reasonably be expected to be obtained by purchasing and
installing additional plant facilities would be comparatively high,
in comparison with the cost of such additional facilities, and thus
a demand for them would be stimulated. Even if the plant as a
whole were not being operated to capacity, bottlenecks in certain
processes or operations might exist that could be relieved by add-
ing certain critical pieces of equipment. In that event, the value
2 Reference to a financial handbook will show that if one dollar were set aside
each year, and the interest compounded annually at a rate of 6 per cent, the total
accumulation would amount in ten years to $13.18. Thus, to accumulate $7,365 by
the end of ten years would require the setting aside of $7,365/$13.18, or approxi-
mately $550 each year.
VALUATION OF DURABLE ASSETS 177
attached to the possession and use of such types of equipment
would rise, and the prospective rate of return over cost that could
be obtained by increasing the investment of the firm in those
types of equipment would rise.
Or suppose that the variable costs of production were to in-
creaseas a consequence, perhaps, of an increase in wage rates
and that such an increase could be offset, in part, by the sub-
stitution of labor-saving machinery. In that event, again, the
prospective use-value of the machinery in question would rise,
thereby increasing the rate of return over the cost of such ma-
chines. In other cases, improvements in the machines themselves
may make new equipment superior in productivity to machines
already in use. In that event, the rate of return over cost with
new machines would exceed the rate of return on investment in
existing equipment, unless the prices of new machines exceeded
the prices of older types by sufficient amounts to offset the differ-
ences in productivity.
In any case, the determining factor with respect to new invest-
ment is the prospective ability of new equipment to "pay for it-
self," which means, fundamentally, that the present worth of the
expected future uses, or returns, must exceed the present cost of
acquiring and installing the equipment in question. In every case
the decision on this point must be made on the basis of forecasts
or estimates covering several years, if not many years, in the future.
On the basis of these forecasts, the firm must make present com-
mitments and invest funds in "fixed" forms, taking the risk that
the actual course of events over the years may be quite different
from the forecast. As time passes, the actual events may be more
favorable to the firm than was anticipated, but there is a chance
that they may prove very much less favorable. This, however, is
one of the elements of unavoidable risk that must be faced by the
enterprise, and only to a limited degree can it be insured against.
Suppose that the business firm finds itself faced with a declining
demand for its product, either as a consequence of adverse condi-
tions affecting the particular industry of which it is a part, or as a
phase of a general decline in business activity. In that event the
value attributable to the use of any particular piece of mechanical
equipment, or of all of the plant facilities together, will decline,
thus tending to reduce the rate of return over cost for all existing
equipment. Moreover, in the prevailing atmosphere of uncer-
178 REAL INVESTMENT
tainty, the values of prospective future uses or returns tend to be
discounted more sharply than in periods of prosperity. As a con-
sequence, the rate of return over cost, or the marginal efficiency
of capital, tends to be cut even further.
Under such circumstances, there will be little incentive to in-
vest in new machines, or even to replace existing equipment that
is fully depreciated, except where the use of new machines, in
place of those already in use, would give promise of very substan-
tial economies in production. Thus a decline in the demand for
the finished product of a firm, even though it is not particularly
severe, may lead to an almost complete cessation of the purchase
of equipment even for replacement purposes. This is an impor-
tant part of the explanation of the violent changes in demand for
many kinds of durable producers' goods that occur in the course
of the business cycle, changes that greatly exceed the changes that
are commonly observed in the demands for most kinds of con-
sumers' goods. 3
This chapter has been concerned with the analysis of the fac-
tors influencing the demands of business firms for the various
kinds of durable productive agents needed to carry on production.
In order to purchase and install additional machines and other
equipment, or to construct additional buildings for use in produc-
tion, current funds will, of course, be required. Thus, a demand
for additional productive equipment will also involve a demand
for additional funds with which to finance the expansion. In
some instances, such funds may already be available to the firm in
the form of retained earnings, or undistributed profits, that have
been held in liquid form. In other cases, new financing will be
necessary in order to carry through a proposed program of expan-
sion. The following chapter will deal at somewhat greater length
with the ways in which a firm may undertake to finance an expan-
sion of its real investment, and the chapters following that will
undertake an analysis of the conditions affecting the supply of
funds for purposes of real investment.
s This relationship, in which fluctuations in demand at one level are accompanied
by wider fluctuations in the demand at other levels in the productive process, is
commonly described by the term acceleration principle.
Chapter 11
DEMAND FOR INVESTMENT FUNDS
Methods of Financing New Real Investment
There are three principal ways in which funds may be obtained
by a business enterprise to finance an expansion of its operations.
These are: (1) the reinvestment of past earnings of the enterprise
itself, accumulated in the form of undistributed profits, (2) the
sale of new securities (bonds or stocks) to the investing public, and
(3) borrowing from banks or other lending agencies, public or
private.
Where earnings on past operations have been retained by the
enterprise in liquid form, that is, in the form of cash balances in
banks or temporarily invested in securities, these funds may be
utilized, at the discretion of the directors and management, to
finance an expansion of real investment. A certain amount of
increase in real investment is also likely to occur as sums corre-
sponding to depreciation allowances are utilized to make replace-
ments of equipment that is retired. This is possible because
conservative business practice tends toward an overstatement of
depreciation, and therefore the writing off of asset values more
rapidly than their actual service lives expire. But where funds
already at the disposal of the firm are insufficient to finance the
proposed expansion, additional funds must be sought from out-
side sources, either by borrowing from banks and other lending
agencies, or by selling new securities to private investors or to
insurance companies, investment trusts, and other agencies through
which the funds of private individuals are brought together for
investment.
179
180 DEMAND FOR INVESTMENT FUNDS
TABLE 15
SOURCES AND USES OF CORPORATE FUNDS, 1947 AND 1948 *
(Billions of dollars)
Uses 1947 1948
Plant and equipment outlays 15.0 17.2
Inventories (changes in book value) 7.2 5.4
Changes in customer receivables 5.9 2.5
Other current assets 0.1
Total uses 28.0 25.1
Sources
(a) Internal
Retained profits and depletion allowances 10.6 11.6
Depreciation allowances 4.5 4.9
Reduction in cash and U. S. securities 3 1
Subtotal 15.4 16.5
(I?) External
Change in trade debt 2.6 1.0
Change in Federal income tax liability 2.4 1.1
Change in other current liabilities 7
Change in bank loans 2.6 1.1
Change in mortgages 8 .8
Net new issues:
Bonds 3.1 4.7
Stocks 1.3 1.2
Subtotal 13.5 9.9
Total sources 28.9 26.4
Discrepancy (uses less sources) 9 1.3
* Excludes banks and insurance companies.
** Less than 50 million dollars.
Source: Midyear Economic Report of the President, July, 1949, p. 117.
Sources and uses of funds
A rough idea of the relative importance of different sources of
funds for business use may be obtained by glancing at the figures
in Table 15, which show the principal sources and uses of cor-
porate funds for the two years 1947 and 1948. Although these
figures do not cover certain segments of the economy, such as
agriculture, in which the bulk of production is carried on by un-
incorporated enterprises, they nevertheless represent a very large
part of the operation of the entire economy.
In considering the uses of funds it must be remembered that
DEMAND FOR INVESTMENT FUNDS 181
plant and equipment outlays (which represent sums expended on
durable productive assets) include both replacement of existing
assets and new investment. In 1947, for example, such expendi-
tures amounted to about 15 billion dollars in gross amount. But
in the lower part of the table it appears that in that year depre-
ciation allowances amounted to about 4.5 billion. The differ-
ence, or about 10.5 billion dollars, would therefore represent the
approximate amount of new real investment in the form of addi-
tions to fixed plant and equipment.
Changes in the book values of inventories indicate the expan-
sion of the volume of goods in process of production and distri-
bution, together with changes in their prices, and thus represent
an increase in investment, but of a current rather than a fixed
character. Changes in customer receivables reflect an expansion
of credit extended to customers in connection with the sale of the
product. They are largely offset by changes in trade debt and
bank loans representing credit extended by outside sources to cor-
porate enterprises, as indicated by the corresponding items listed
as sources of funds in the lower part of the table.
As to the sources of funds, it is noteworthy that in 1947 retained
or undistributed profits amounted to 10.6 billion dollars, depre-
ciation allowances to 4.5 billions, and new issues of securities to
4.4 billions, giving a total of about 19.5 billion dollars available
from those three sources for the financing of replacement of exist-
ing plant, the construction of new plant facilities, and the expan-
sion of the volume of goods and services in process of production.
From these figures it is apparent that, at least in a period of
prosperity such as existed during and after the war, internal
sources of funds were much more significant, in relation to new
real investment in productive facilities, than was the offering of
new securities to the general investing public. It is important to
keep that point in mind in any consideration of the problems of
industrial expansion and investment, because it indicates that
to a very considerable extent enterprises have achieved independ-
ence of the securities markets as a source of funds. This is not by
any means a new development, because many large corporations
have been built up mainly by "plowing in earnings" rather than
by selling new issues of securities in order to raise capital. The
Ford organization is but one notable example of such a process of
expansion from within.
182 DEMAND FOR INVESTMENT FUNDS
Expansion Financed by Retention of Earnings
Where the directors and management of a business enterprise
consistently follow the policy of retaining a substantial part of the
earnings from current operations, that policy is normally based on
the existence of opportunities within the organization itself of
putting the funds so retained to profitable use. If there were lit-
tle prospect that an expansion of its operations would improve the
position of the firm, there would appear to be little reason for
failing to distribute virtually all of the earnings in the form of
current dividends. The expected improvement in the position
of the firm may, however, take the form of an increased security of
its position in relation to existing or potential rivals, rather than
of an increase in profits. Thus, funds arising out of the retention
of earnings may be utilized to acquire an interest in other firms
in the same or related industries, or in industries that provide
outlets for the products of the firm. In some instances, industrial
corporations primarily engaged in one industry have built up
rather widely diversified investments in quite different industries,
so that a significant part of their incomes is drawn from varied
sources and a greater degree of stability of income is achieved by
the spreading of risks. Such firms may in time come to have
many of the characteristics of an investment trust.
If, however, retained earnings are accumulated chiefly with
the intention of reinvesting them in an expansion of the firm's
own primary operations, the amount of earnings retained will be
governed by the prospective possibilities of using them to finance
the expansion of productive plant facilities, either to increase total
output or to achieve further economies in production. If the cor-
poration is closely held, that is, controlled by a small group of
people whose interests are closely identified with the corporation
itself, a very large percentage of current earnings may be retained.
If the ownership of the corporation is widely diffused, a decision
to pay very small dividends out of substantial earnings might re-
sult in complaints from the stockholders that would jeopardize
the public relations of the firm with the investing public and
render it difficult to attract additional investment funds from out-
side sources should a public offering of new securities be necessary
at some later date.
DEMAND FOR INVESTMENT FUNDS 183
Public Offerings of New Securities
If a business firm lacks sufficient current funds in the form of
retained earnings and other internal funds to finance a contem-
plated expansion, it is necessary to look to outside sources for
financing. Such funds may be obtained either by borrowing from
banks and similar lending agencies, or by selling new issues of
securities to the general investing public. If the latter alternative
is chosen, a further decision must be made as to the type of secu-
rities to be offered. The choice of offering a new issue of stock or
a new issue of bonds will be governed by a wide variety of con-
siderations, involving the already existing financial structure of
the corporation, the stability or instability of its earnings, and the
tastes and preferences of the investing public.
An important outlet for new issues of securities under modern
conditions is found among "institutional" investing agencies in-
surance companies, savings banks, investment trusts, and the like
which commonly have large sums in the form of reserves for
which income-yielding forms of investment are sought. Many
such agencies operate under legal specifications as to the types of
securities that are eligible for purchase, and these specifications
must often be taken into account by a business firm in deciding
what types of securities to offer. Consideration must also be
given to the expenses involved in "floating" a new issue of stocks
as compared with a new issue of bonds, that is, the fees and other
charges representing the returns to the investment banks or other
organizations that handle the distribution and sale of the new
issue. The effects of the changes in the financial structure of the
enterprise that will attend a new issue of stocks as compared with
a new issue of bonds must likewise be appraised in terms of their
probable impact on th$ interests of the various groups of man-
agement, stockholders, and others intimately concerned with the
affairs of the firm.
Borrowing through the sale of long-term bonds
Suppose, for purposes of illustration, that a business firm is now
operating a plant in which the fixed investment amounts to ap-
proximately $1,000,000, and that its financial structure is very sim-
ple, represented by common stock having a value, at par, of
184 DEMAND FOR INVESTMENT FUNDS
$1,000,000, with no bonded debt outstanding. (These figures cor-
respond with those assumed in Tables 6 and 7 in Chapter 6.) Sup-
pose also that, as a consequence of an increase in the demand for
the product of the firm, it is estimated that the net profit from
operations of the firm could be increased by at least $9,000 a year
if the output of product were increased to meet the increased de-
mand. But to achieve that increase in output it would be neces-
sary to install additional machinery at a cost of approximately
$150,000. Such liquid funds as the firm has at its disposal are
needed to finance additional purchases of raw materials and for
other current purposes, so that, if the expansion is to be under-
taken, additional funds must be obtained from outside sources.
Assume, to begin with, that it is prepared to finance the expan-
sion by offering a $150,000 bond issue to the public.
Whether the proposed expansion would be to the interest of
the firm would depend on the rate of interest that would have to
be offered in order to induce prospective investors to purchase the
bond issue. The higher the contractual rate of interest that must
be offered, the smaller the advantage of the expansion to the en-
terprise; the lower the rate, the greater the advantage, other things
remaining equal. It would appear that 6 per cent would be the
maximum rate that could be offered, because at a 6 per cent rate
the bond interest on an issue of $150,000 in bonds would amount
to $9,000 per year, and would entirely eat up the expected in-
crease in net profits. If the bonds could be sold at a 4 per cent
rate, the annual bond interest would amount to $6,000, leaving an
annual gain to the corporation of $3,000 in additional net income.
In that event the bond issue would appear to be advantageous.
However, in considering the advisability of financing such an
expansion of investment by issuing bonds, it must be remembered
that the bond issue involves a contractual obligation to pay the
stipulated bond interest each year, regardless of the size of the
actual earnings of the enterprise. As the years go by, the actual
earnings resulting from operations may be either greater or less
than was anticipated when the expansion was undertaken and the
interest obligations assumed. If they are better than was antici-
pated, the net income will be unexpectedly large. If they are
worse, what remains as net income may be smaller than had the
expansion not been undertaken and the burden of fixed interest
charges taken on. And if at any time the firm is unable to meet
DEMAND FOR INVESTMENT FUNDS 185
its interest obligations to its bondholders (or other creditors), it
may be forced into receivership or bankruptcy.
Thus, the firm that undertakes to finance a prospectively profit-
able expansion by selling fixed interest obligations takes the risk
that the expected gains may not materialize, and that the conse-
quence may be disastrous for the firm. How serious that risk may
be depends on the magnitude of the variations in earnings that
may occur from year to year as a consequence of changes in the
demand for the product of the firm, and also upon the proportion
of its capital that is obtained by borrowing on a fixed interest
basis, as compared with investment that does not carry fixed in-
come obligations. Also, the higher the rate of interest that must
be offered in order to sell bonds, the larger is the burden of fixed
charges in proportion to the prospective earnings.
It seems reasonable to conclude, therefore, that with given
prospects of returns from additional real investment, the demands
of business firms for additional funds on long-term loan would
tend to be greater at low rates of interest than at high. This may
be expressed by saying that the demand curve for long-term in-
vestment funds is negatively sloped. But at the same time it also
seems clear, from experience, that changes in expectations of fu-
ture returns from additional investment play a considerably larger
role than do changes in interest rates in determining the amounts
of new funds sought by business enterprises on long-term loan.
Changes in business prospects can swiftly raise or lower the an-
ticipated rate of return over cost or marginal efficiency of addi-
tional real investment, producing drastic changes or shifts in the
demand for long-term investment funds.
Financing through the sale of stock
Some of the hazards inherent in long-term financing through
the sale of bonds may be avoided if funds are obtained through the
sale of "equities," that is, stock or other securities that do not in-
volve fixed contractual income payments to the investors. The
owner of a share of stock has merely a claim to a share in such
earnings as the corporation may make from year to year, and
there is no maturity date at which the amount originally invested
must be repaid to the stockholder. If the funds to finance the
expansion are obtained through the sale of stock, a failure of the
expected returns from an expansion of investment to be fully
186 DEMAND FOR INVESTMENT FUNDS
realized, or a temporary dip in earnings, would not involve the
possibility of receivership or bankruptcy for the firm.
The corporation which offers a new issue of stock for sale in the
market may easily be seen as demanding additional investment
funds, but what is given in return for the funds obtained is far less
definite than the promise of an annual interest payment plus the
return of the principal at some future date. What the investor re-
ceives, in exchange for his money, is a claim to a certain propor-
tionate share in the distribution of the earnings of the enterprise,
and in the distribution of its assets should its affairs be wound up
and its property liquidated. It is thus more difficult in the case
of "equity" financing to picture the demand for funds in terms of
the amounts of such funds that an enterprise would seek to obtain
at different possible "prices" for funds, because these "prices" are
more or less indeterminate.
One way of visualizing the situation, however, is to think of the
dilution of earnings (and possibly of control) resulting from the
issuance of additional stock as representing the "price" involved
in obtaining additional investment funds through the sale of stock.
The amount of dilution will depend on the price at which new
stock can be sold to the investing public, because that will deter-
mine how many shares must be issued and sold in order to raise a
given amount of new investment funds.
Suppose, as in the preceding example, that a corporation with
$1,000,000 in stock already oustanding is contemplating an expan-
sion requiring $150,000 in additional investment funds. Suppose
also that the stock has a par value of $50 per share, that there are
20,000 shares outstanding, and that the stock is selling currently
at about par. If it were possible to sell additional stock at a price
that approximated the par value, then an offering of 3,000 addi-
tional shares would suffice. In that event the new issue would
reduce by slightly less than one-sixth the proportionate interest
in the corporation represented by a single share of stock, from
1/20,000 to 1/23,000. As a consequence of the new issue, any
stockholder's participation in the earnings of the enterprise would
be proportionately smaller than before. 1
This does not mean that the value of a share of stock, or the cor-
poration's assets per share, would necessarily be reduced, because
i Usually new stock must be offered to existing stockholders, pro rata, so that they
can protect themselves against such a dilution of their interests, if they so desire.
DEMAND FOR INVESTMENT FUNDS 187
the assets of the corporation would be increased as a consequence
of the new investment. Nor would it mean that the earnings per
share would be reduced, because the additional investment is ex-
pected to result in an increase in earnings in future years. There
would be little incentive to undertake the expansion if that ex-
pectation did not exist. If earnings were expected to increase in
direct proportion to the increase in stock outstanding, the original
stockholders would be neither better nor worse off than before, in
terms of earnings and dividends. If earnings were expected to
increase more than in proportion to the increase in stock outstand-
ing, the original stockholders would stand to gain, because pros-
pective earnings per share would increase. The worst that could
happen, from the standpoint of the original stockholders, would
be that the additional investment would fail to bring forth any
increase in earnings, as compared with what they might have been
had the expansion not been undertaken. In that event, the
earnings of the corporation, per share, would be about one-sixth
less than had the expansion not occurred.
The other aspect of new financing through the sale of stock is
the dilution of control that may accompany an increase in the
number of shares of stock outstanding. If the new issue carried
voting rights, the share in control of the corporation represented
by any given block of stock would be reduced. But the dilution
of control could be avoided by issuing nonvoting stock, since many
investors, particularly small buyers, are uninterested in control be-
cause they feel that they would be powerless to influence the direc-
tion of the corporation even if they had the voting privilege. And
even though the voting privilege does attach to all outstanding
stock, if the stock is widely held by comparatively small owners, it
is in fact very difficult for any group outside the management and
interests affiliated with it to capture control. Thus the possibility
of dilution of control may, or may not, exercise an influence on
the decision regarding the type of securities to offer, and indeed,,
the decision whether or not to undertake an expansion program.
The extent of dilution of earnings and control will depend on
the price at which the new issue of stock can be sold. Suppose
that, instead of being able to sell a new issue at a price of $50 a
share, the firm could obtain only $40 per share. In that event,
3,750 shares instead of 3,000 would have to be sold in order to
raise $150,000 in additional investment funds. Obviously, the
188 DEMAND FOR INVESTMENT FUNDS
degree of dilution of earnings would be somewhat greater in that
case than if the additional stock could be sold for $50 per share.
The lower the price at which additional shares could be sold, the
greater the number that would have to be issued to raise a given
amount of new funds, and therefore the greater the amount of
dilution of earnings and control. The higher the price, the less
the degree of dilution.
Trading on the equity
If the expansion of real investment in the enterprise is expected
to result in a sustained increase in earnings, in excess of the rate of
interest that would have to be offered in order to sell a new bond
issue, the original stockholders would stand to gain by having the
expansion financed in that way rather than through the sale of
additional stock. If the additional investment were expected to
produce earnings at a rate of 6 per cent, and the necessary bonds
could be sold on a 4 per cent basis, then the earnings in excess of
4 per cent bond interest would be added to net income and would
more than proportionately increase the amounts available for dis-
tribution as dividends or for the accumulation of surplus.
This practice of financing a corporation's investment in part by
the sale of bonds is known as trading on the equity. However, it
involves the risk that in bad years earnings would be insufficient
to meet bond interest, and that a series of bad years would result
in insolvency and the partial or complete loss of the stockholders'
interest in the enterprise. Thus, trading on the equity is a safe
expedient only if carried to a limited degree, so that the fixed
charges do not exceed the minimum earnings that could be ob-
tained on the operations of the enterprise as a whole under the
least favorable conditions possible.
Borrowing from banks
Borrowing from commercial banks represents an alternative
source of either short-term or long-term funds. The considera-
tions involved in bank borrowing are not greatly different, from
the standpoint of the enterprise itself, from those involved in the
sale of long-term bonds. There are, indeed, significant differences
between the lending operations of the commercial banks and those
of other institutional or private investors, but those differences
will be dealt with in Chapter 13 on the supply of investment funds.
DEMAND FOR INVESTMENT FUNDS 189
Demand for Investment Funds and the State of Business
Expectations
From what has been said it should be clear that the demands of
business enterprises for funds with which to finance new real in-
vestment are largely determined by the state of business expecta-
tions at the time the new investment is under consideration.
These expectations immediately concern the future prospects of
the enterprise, both as to the demand for the product and the an-
ticipated sales revenue, on the one hand, and the level of produc-
tion costs on the other. The state of expectations is largely condi-
tioned by the prospective trend of activity for the economy as a
whole, because few businesses are immune to changes in the level
of demand and of costs accompanying changes in the aggregate
amounts of income received by the people of the economy during
the course of the business cycle.
Nor are individual business enterprisers' own judgments as to
the future arrived at in isolation. On the contrary, they are influ-
enced, consciously or unconsciously, by the tone of pessimism or
optimism pervading the business community at the time. If other
businessmen are forecasting the future in gloomy terms, it would
be a hardy enterpriser indeed who would not be influenced in
some degree by the attitude of friends and associates.
Thus, decisions to undertake new investment, and the associ-
ated financing, although made in terms of individual enterprise,
still tend to fall into a rather definite pattern of cyclical change
over time, and to be bunched in periods of rising general business
activity. If the general level of activity in the economy is rising,
brighter forecasts of future earnings prospects lead increasing num-
bers of firms to undertake expansion. At the same time, brighter
expectations for the future, as seen by prospective investors, dimin-
ish some of the hazards of security ownership, so that larger sums
are available for the financing of increased real investment.
In a period of declining general business activity, conversely,
there are poorer prospects of earnings for business enterprises in
general, and for most individual business undertakings. Indeed,
fear of prospective losses may replace anticipations of future gains.
Under such circumstances, there is little or no incentive to under-
take additional real investment, no matter how low the interest
190 DEMAND FOR INVESTMENT FUNDS
rate might be. Instead, the firm might be able to improve its
position if it could liquidate a part of its already existing invest-
ment and concurrently reduce its obligations to others. Thus,
apart from instances in which some additional investment is nec-
essary in order to keep the firm going at all (and so salvage some
part of its undertakings), there is little incentive to seek additional
investment funds.
In line with the preceding analysis, studies of the behavior of
investment during the course of the business cycle indicate that
new investment, and new offerings of securities, tend to rise
sharply in periods of expanding general business activity and to
decline sharply in periods of business decline. This cyclical pat-
tern in investment is itself an important factor, acting and react-
ing with the rise and fall in production and employment over a
period of years.
Chapter 12
FINANCIAL INVESTMENT AND
TRADING IN SECURITIES
Financial Investment as Viewed by Private Investors: the
Financial Overlay of the Productive Process
As indicated at an earlier point, real investment involves the
expenditure of current funds by business enterprise for the ac-
quisition of the means of production required to execute produc-
tion plans, these means including not only durable plant facilities
but also raw materials, components, and services essential to pro-
duction. Funds for real investment may arise out of earnings of
previous productive activities, or may be obtained by borrowing
from banks or from the sale of new corporate securities or other
types of property rights. The essential point is that under mod-
ern industrial conditions, with a large part of economic activity
carried on under the corporate form, an increasingly complex
financial overlay of various kinds of intangible property rights has
come to be superimposed on the productive structure of the
economy.
For the most part, the opportunities for investment that people
find open are opportunities to purchase bonds or stocks or other
kinds of property rights, through which they may share in the
earnings of enterprise, rather than opportunities to invest directly
in the means of production themselves. Only where a person de-
cides to set up in business for himself, or in partnership with a
few other people, is he likely to be the direct legal owner of the
means of production used in turning out the product. If he elects
to purchase a few shares of stock in the Pennsylvania Railroad, he
191
192 FINANCIAL INVESTMENT
does not thereby become the owner of a few hundred feet of track,
or of a small wayside station building, or of a part of some spe-
cific locomotive or box car. What he owns is simply a proportion-
ate share of the entire enterprise, which carries with it the right
to participate in the earnings of the company and to cast votes, if
he wishes, in proportion to the number of shares that he owns,
in the election of the directors of the corporation.
The person who invests his funds in the purchase of the bonds
or stock of a large business corporation may know and care little
or nothing about the operations of the enterprise, or of the char-
acter of the real investment that it has made. What he is pri-
marily concerned with is the income that can be obtained by vir-
tue of his ownership of the bonds or the stock. The operations
of the enterprise are significant to him only as they affect the size
and certainty of that income. The development of modern in-
dustrial organization, therefore, has separated the process of finan-
cial investment on the part of individual private investors from
the process of real investment in the means of production as car-
ried on by corporate enterprise. As a consequence, there is no
necessary correspondence between the amounts that private in-
vestors may wish to invest in intangible property rights at any
-given time and the amounts that business enterprises require to
finance contemplated new real investment in productive facilities.
This fact that there is no close linkage between the amounts that
investors may seek to invest and the amounts that business enter-
prises require for the financing of their production plans is of
crucial importance in analyzing the behavior of the economy as a
As a matter of fact, a decision, on the part of an individual, to
invest funds in the purchase of some shares of stock or some bonds,
may involve no new real investment at all, but result merely in an
interchange of liquid funds and property rights as between indi-
viduals. A person who decides to buy a few shares of American
Telephone fc Telegraph Company stock usually cares very little
-whether the shares in question were previously owned by someone
else or are newly issued. But in the first case, the money that he
invests is simply transferred to the previous owner of the shares
and is available to that person for whatever use he may wish to
make of the funds. No additional funds are, by such a trans-
TRADING IN SECURITIES 193
action, made available to A. T. & T. for use in building a new
long-distance line or a new telephone exchange. In other words,
trading in already outstanding securities involves a financial invest-
ment by the buyer of securities that is matched by a corresponding
financial disinvestment on the part of the seller, with no direct
effect on real investment at all. Only where an individual makes
a financial investment in newly issued securities are additional
funds made available for use by business enterprise in financing
new real investment.
This does not mean that trading in already outstanding securi-
ties has no significance in relation to the financing of new real in-
vestment; the significance is indirect. A business firm which seeks
funds for purposes of expansion by offering new issues of securi-
ties must face the fact that these offerings will be taken by the
investing public only if they appear to be as attractive as other
already outstanding issues. The price at which a new issue of
stock can be sold, and the interest rate offered on a new issue of
bonds, will be determined by the prices at which comparable
stocks are currently selling in the securities markets and the rates
of return obtainable by investors who buy already outstanding
bonds. It follows that in order to understand the conditions that
affect the supply of new investment funds for use by business en-
terprise it is necessary to analyze the forces influencing the evalua-
tion of securities and similar property rights, either new or old,
by the investing public.
Individual Valuation of Investment Opportunities
Any current funds that a person has at his disposal, and that he
does not choose to expend on the purchase of current goods and
services, constitute personal savings. Such funds may be held in
the form of money or in the form of bank balances; in either case
they are classified as liquid funds. But funds held in that form
do not bring in any income. Therefore, there is an incentive to
the holder of such funds to exchange them (except for such
amounts as may be kept to meet unforeseen contingencies or to
cover ordinary expenditures until the next pay check comes in)
for some form of income-yielding investment. Such investment
may be represented by the purchase of a house that can provide its
194 FINANCIAL INVESTMENT
owner with a rental income, by the taking out of life insurance, by
the making of an interest-bearing loan to someone else, or by the
purchase of securities of one kind or another.
The choice of the form of investment will be governed in part
by the amount of funds that the person has at his disposal, by his
preferences for one type of investment as compared with another,
and by the size of the expected income and his degree of confi-
dence that the promised income will in fact be forthcoming in the
future. Some people prefer to put their money in real estate or in
mortgage loans because they can keep an eye on the property that
they own, or against which they have a claim. Others, feeling that
they would rather leave the problems of investment management
to a life insurance company, a savings bank, or an investment trust,
turn their money over to such institutions for investment. Still
others have sufficient funds and sufficient confidence in themselves
to venture into the purchase of corporate bonds or stock.
The question facing any individual prospective investor, in trv-
ing to "decide whether to tie up his funds in a particular form of
investment, is how much the ownership of that particular kind of
property rightwhether a share of stock, a bond, or a piece of real
estateis worth to him. If its value to him as a prospective source
of income is greater than, or at least equal to, its current purchase
price, he will have an incentive to invest in it, assuming, of course,
that no more attractive alternative investment opportunity is in
sight. But what is the basis of his present valuation of a particular
property right or form of investment?
This problem is similar in character to the one already dealt
with in Chapter 10 in connection with the valuation of durable
assets by a business firm. A share of stock or a bond (or any other
comparable property right) may be looked upon as a source of a
series of annual incomes stretching out over years to come. There
is no way of obtaining at the present time the incomes that are
expected to accrue five years hence or in any other future year;
they must be "waited for." Also, in the case of a share of stock,
and many other kinds of property rights, there is no assurance of
the size of the income to be obtained in future years, because that
will depend on the course of subsequent events. The dividends
received by a stockholder may be large or small; there is a chance
that none at all will accrue, or that the enterprise may "go
broke." Thus the prospective investor must forecast as best he
TRADING IN SECURITIES 195
can the income prospects associated with the ownership of any par-
ticular stock or other property right. In the case of a bond, the
annual income is fixed by the terms of the contract, and in most
cases a definite maturity date is set at which the principal is to be
repaid. Even so, some chance of loss may attach to the ownership
of a bond, for the issuing firm may fall on evil days and be unable
to make good on its obligations.
Given the investor's best guess as to the probable size and dura-
tion of the future incomes represented by the ownership of a share
of stock or a bond or some other property right, the questions are:
What is the present worth of that series of prospective incomes to
him? What is the maximum amount of current funds that he
would be willing to part with in order to obtain the right to re-
ceive those incomes? What is his maximum demand price for the
property right under consideration?
Time discount and the present worth of property rights
The basis of the answer to these questions is the same as in the
ise of the valuation of a durable productive agent, except that the
calculations are likely to be a great deal less precise. The present
worth of any particular property right to an individual prospective
investor will depend upon, or reflect, the rate at which he dis-
counts prospective future incomes. Generally speaking, people do
not regard the right to receive a given sum of money income at
some future date as the full equivalent of the same amount of
money immediately in hand. Thus, a person is unlikely to be
willing to exchange $1,000 of funds now at his disposal for the
promise of someone else to return $1,000 to him at the end of
three or five or ten years, even though he has full confidence that
the promise will be fulfilled. (There may, of course, be certain
circumstances under which he would do so.) In general, however>
the individual can be induced to part with current funds only if
there is a prospect of receiving back a larger sum at some future
date. The difference between the present sum and the future sum
to be returned represents a source of gain to the holder of present
funds and provides the inducement to part with liquidity. The
difference may also be regarded as representing the degree to
which the future repayment is discounted in estimating its present
worth, and that degree of discount may be expressed as a rate of
time discount.
196 FINANCIAL INVESTMENT
Time preference and time discount
People differ greatly in the extent to which they discount future
incomes, and for many different reasons. One explanation often
given is that, if a person invests present funds in exchange for the
right to receive a series of future incomes, he gives up the possi-
bility of spending those funds on goods and services that he might
enjoy right now. Instead, he postpones the satisfactions that
might be obtained from current goods and services to the more or
less distant future dates when the receipt of the incomes will again
put him in position to purchase desired goods and services. Inas-
much as the satisfactions obtainable from goods and services in
future years are not immediately present in the foreground of con-
sciousness, they tend to be undervalued or discounted in compari-
son with present satisfactions. And similarly, the sums to be re-
ceived in the future, with which such goods and services could be
purchased, are valued less than the same sums in the present. If
this explanation is valid, the individual would be willing to pur-
chase the right to receive a given series of future incomes only at a
price that involved a discount of the future incomes for which he
would have to "wait/' Or, stated somewhat differently, he would
give up present funds only if he were offered a premium or addi-
tional payment to compensate for waiting and postponing con-
sumption to a later time. Such explanations of time discount are
often referred to as time preference or impatience theories, and
the anticipated incomes are described as the expected "rewards"
for "waiting."
Although there is undoubtedly a great deal of substance to such
explanations of people's attitudes, they do not fit all possible cases.
Indeed, they collide with the fact that the great bulk of investment
in business enterprise is made by people in upper and middle in-
come brackets, where the funds devoted to investment may not cut
substantially into current consumption. Furthermore, amounts
received year by year as income from investments, or as the repay-
ment of principal on loans, are more likely to be reinvested than
spent for consumption purposes at the time they are received.
And there appear to be cases in which people would be willing
to forego present consumption and "save" for the future, even
though the sums receivable in the future would not necessarily
exceed the amounts currently saved. Thus, a person who wishes
TRADING IN SECURITIES 197
to assure himself or his family some measure of security in old age
would not necessarily refrain from current saving and investment,,
even though there was no prospect of obtaining any income from
the amounts so saved during the intervening years.
Liquidity preference and time discount
Another approach to the explanation of time discount is based
on the idea of liquidity preference. As long as a prospective in-
vestor holds his funds in the form of cash or bank deposits, he has
the option of disposing of them in many different ways and is free
to use them in whatever way may appear to be most advan-
tageous. Once he decides to invest his funds by purchasing a
share of stock, or a bond, or some other kind of property right, he
no longer has them in liquid form, available for use at a mo-
ment's notice in whatever way may then appear desirable. In-
stead, they are tied up, for a longer or shorter period of time, ia
the ownership of the share of stock, the mortgage loan, the piece
of real estate, the bond, or the life insurance policy. Different
types of investment vary in the length of time for which the in-
vestor's funds are tied up. If invested in short-term loans, they
may be returned within a few months, when the loans mature. If
invested in bonds, they may be returnable in a few years or per-
haps only after a long period, depending on the date of maturity-
If invested in stocks, which represent permanent shares in the
ownership of enterprise, there is no date of maturity, and the re-
sale of the stock therefore represents the only way in which the
investor can get back into the position of holding liquid funds.
A decision to invest, therefore, involves a sacrifice of liquidity
for a longer or shorter period, and the loss of flexibility or strate-
gic initiative that goes with the holding of current funds. It in-
volves the chance that making an investment now will preclude
the making of some alternative investment next week, or next
month, or next year, that would then appear more promising than
the one now chosen. Should the investor decide at some later
date to liquidate his present investment, that is, "get his money
out" of the investment and into the form of liquid funds once
more, he must find someone else who is willing to buy the prop-
erty right from him, giving current or liquid funds in exchange.
There is a chance that he would be unable to sell out at a price as
high as the price he originally paid, and if so, the liquid funds
198 FINANCIAL INVESTMENT
that he could command by liquidation of his investment might be
less than those originally invested. In that event, he would incur
a capital loss on the entire transaction. On the other hand, he
might find that the conditions prevailing at the time he chose to
liquidate were more favorable than when he originally made his
investment. If so, he would obtain a capital gain on the transac-
tion, in addition to whatever income he received in the interim.
The person who has liquid funds at his disposal may be thought
of as weighing two alternatives. The first is to continue to hold
those funds in liquid form, without resulting income but with the
advantage of flexibility of disposal that goes with liquidity. The
second alternative is to invest the funds in property rights that
give a promise of income, but involve a sacrifice of liquidity for
a longer or shorter period and a risk of possible loss of a part of
the funds invested should the course of subsequent events be un-
favorable.
Different forms of investment differ, as already noted, in the
periods of time for which funds are tied up, and also in the risk of
partial loss of capital value should the investor wish to liquidate
his holdings on short notice. For example, the government com-
monly issues large amounts of short-term obligations, payable
within a few months, in connection with its current operations.
These represent a convenient form in which to invest current
funds to earn a small return while maintaining a degree of
liquidity very nearly equal to the holding of cash, inasmuch as
they mature within a short period, and, if necessary, can be sold
even sooner with virtually no risk of loss of capital value. Even
government bonds having comparatively long periods to run be-
fore maturity also have a high degree of liquidity, since the gov-
ernment has undertaken, as a matter of fiscal and monetary policy,
to maintain the prices of such bonds at very near their par value.
As a consequence, funds invested in such securities can be liqui-
dated on short notice with virtually no risk of loss. For other
types of securities, however, a corresponding degree of assurance as
to the liquidating value does not exist, and so a decision to invest
in them involves a greater sacrifice of liquidity.
A person's rate of liquidity preference may be thought of as rep-
resenting the prospective rate of return on a given investment that
would be necessary to induce him to sacrifice liquidity by invest-
ing current funds. Suppose, for example, that he would be will-
TRADING IN SECURITIES 199
ing to lend $1,000 for a year in exchange for a promise of the
return of $1,050 at the end of the year, but would be unwilling to
make the loan in exchange for any smaller future sum. Assuming
that the fulfillment of the promise was amply secured, the $50 in-
terest payment would represent the required inducement to part
with liquidity for the period of a year, and the rate of liquidity
preference would be 5 per cent (i.e., $50/$1,000).
If an investment were under consideration that would involve
tying up funds for a longer period, with a series of incomes pay-
able in the interim, the liquidity preference rate of the individual
investor would determine the maximum amount that he would be
prepared to invest in that form, in exchange for the promised
series of incomes and ultimate return of principal. Suppose that
a bond issue which is to mature in five years, and bearing interest
at a rate of 4 per cent per year, is offered to the investing public.
What is the maximum amount that an investor who has a liquidity
preference rate of 5 per cent would be willing to pay for one of
these bonds having a face or maturity value of $1,000? Such a
bond may be regarded as the equivalent of five annual payments
of $40 each, plus a payment of $1,000 at the end of the fifth year.
Discounted at a rate of 5 per cent per year, this series would have
a present worth of approximately $957 to this individual investor,
and that would be the maximum amount that he would be willing
to invest in the purchase of the bond in question. 1 If he could
buy the bond at any price lower than $957, he would have an in-
ducement to invest, that is, part with liquidity, because the rate of
return which he could get on his investment, at any lower price,
would be greater than his rate of liquidity preference. At any
price higher than $957, however, the inducement to invest would
be insufficient to offset his liquidity preference, and he would not
buy.
i The present worth of this series would be equal to the sum of the following:
$40 $40 $40 $40 $1040
" I n OK\2 "T" /I ftK\3 ~T~ /I fte\4 T~ "
(1.05) ^ (1.05)2 ^ (1.05)3 ^ (1.05)* ^ (1.05)5
This calculation can be short-cut by referring to Table 14 on page 171, which shows
the present worth of $1,000 receivable at the end of each year from one to ten
years, assuming a discount rate of 5 per cent. If $1,000 receivable at the end of one
year is the equivalent of $952 in present funds, then $40 receivable at the end of
40
one year would have a present worth equal to x $952, or $38.08. Figured in
the same way, the present worths of the other items in the series are $36.28, $34.56,
$32.92, and $815.36, giving a total of $957.20.
200 FINANCIAL INVESTMENT
In reality, there are probably few cases in which the individual
consciously thinks in terms of a rate of time discount or a rate of
liquidity preference, particularly where the prospective returns
from property ownership are not definitely assured and therefore
must themselves be estimated or forecast. A decision to invest in
a certain type of property right, or not to invest, is therefore likely
to be made on the basis of optimistic or pessimistic guesses, or the
belief that conditions in the future will not be radically different
from those prevailing in the past, or because friends or associates
or financial advisers have said that it is the thing to do. But in
any case, reluctance to get "tied up" for the future is a factor in-
fluencing judgment and introducing an element of time discount
into the processes of valuation as applied to property rights to
future income.
It must also be remembered that any individual investor's li-
quidity preference is not constant, but is subject to change as a
consequence of changes in his own circumstances and in his feel-
ing of confidence or distrust in the probable trend of future
events. If he feels that a period of general prosperity is ahead, he
will have little fear of a possible loss of capital value should he
find it necessary to liquidate his investment a few months or a few
ye#rs later. But if he takes a gloomy view of the future, the chance
of capital loss on a possible sale of his investment will bulk
larger in his mind, and his preference for holding current funds in
liquid form will be intensified. Thus, for individual investors,
and for investors as a group, changes in liquidity preference rates
may cause drastic fluctuations in their valuations of different kinds
of property rights. This is an important factor in the explanation
of the rise and fall of security prices, real estate prices, and other
types of property rights to income.
Market Valuations of Property Rights
Under modern conditions, the number of people who own
stocks or bonds issued by a single large corporation such as the
United States Steel Corporation or the American Telephone &
Telegraph Company may run into the hundreds of thousands, and
therefore the total value of all corporate securities outstanding
amounts to many billions of dollars. Although there is a marked
concentration of such ownership in a comparatively small per-
TRADING IN SECURITIES 201
centage of the total population, nevertheless, millions of people
derive at least a small part of their incomes from the ownership of
securities.
It is to be expected that there would be differences in the valu-
ations that different people would attach, at any given time, to the
ownership of particular issues of stocks. These differences would
reflect differences in their respective estimates of future income
prospects, or in their rates of liquidity preference, or both. Those
who had either the most optimistic estimates of future income, or
the lowest rates of liquidity preference, would place higher pres-
ent valuations on the ownership of particular property rights than
would people who were less optimistic about future income pros-
pects, or had higher rates of liquidity preference.
Market demand for securities
The market demand for any particular issue of securities say
the common stock of the X.Y.Z. Corporation may be thought of
as representing the number of shares of that stock that existing and
potential investors would be willing to hold (in preference to
equivalent amounts of current funds) at different possible prices,
other things being equal. Suppose that there were 50,000 shares
of X.Y.Z. stock outstanding. Some people might be willing to pay
as much as $150 per share to acquire such stock, if that were nec-
essary; or, if they were already owners of X.Y.Z. stock, they would
prefer to hold on to it at any price below $150 per share. In
either case, the individuals in question would regard the owner-
ship of the stock as preferable to the possession of $150 in liquid
funds. Other people, however, might attach lower valuations to
the ownership of X.Y.Z. stock, in comparison with the possession
of liquid funds or other types of property ownership.
The market demand situation for X.Y.Z. stock, as it stands at a
given moment of time, may be represented graphically as in Fig-
ure 24. In this figure, the ordinate scale represents possible prices
for X.Y.Z. stock, while the abscissa scale indicates the numbers of
shares that would be held by investors at each of the possible
prices. The plotted curve labeled D shows how many shares
would be held at each possible price in the range from $170 per
share down to $90 per share.
Inasmuch as all outstanding shares of stock must be held by
someone, the current market price of the stock would have to be
202
FINANCIAL INVESTMENT
such that the entire 50,000 shares would voluntarily be held by
people who regarded the stock as worth at least as much as, or
more than, the amount of current funds that could be obtained
by disposing of the stock at the market price. An inspection of the
demand curve D v in Figure 24, will show that at any price above
$110 per share fewer than 50,000 shares would be held voluntarily
by the investing public. Thus, if the price were above $110, ef-
forts on the part of some existing stockholders to dispose of their
shares for money would tend to force the price downward. If
the price were below $110, the amount of stock that would be re-
tained by already existing stockholders, plus the shares that would-
be owners were willing to buy, would exceed the total number of
shares outstanding. The price therefore would tend to be forced
upward. At a price of $1 10, all outstanding shares would be vol-
untarily held by investors; the total demand would be just equal
to the available number of shares.
250
CO
200
o
5 150
$
100
50
10,000
20,OOO 30,000 4O,000 50,000
SHARES
0,
60,000
FIGURE 24. MARKET DEMAND FOR SHARES OF STOCK OF THE X.Y.Z.
CORPORATION
Suppose, now, that the prospects of X.Y.Z. Corporation were to
improve, perhaps as a consequence of an increase in the demand
for its product or some technological development that promised
to reduce its costs of operation. Such prospects would warrant an
expectation of increased earnings in years to come, and therefore
TRADING IN SECURITIES 203
a likelihood of increased dividends to its stockholders. With such
anticipation of increased income, existing and potential stockhold-
ers would regard the ownership of X.Y.Z. stock as the equivalent
of a larger number of dollars in current liquid funds than before.
This would tend to cause a positive shift in the demand for the
stock, which is represented by the second demand curve, D v in-
Figure 24. Assuming that there were no change in the total num-
ber of shares outstanding, the price at which the 50,000 shares
would be held in preference to current funds would be increased
to $125 per share.
Conversely, a deterioration in the prospects of the X.Y.Z. Cor-
poration, as appraised by existing or potential investors, would
result in a negative shift in demand, and the price of the stock
would tend to fall.
It should be noted that changes or shifts in the demand for
stock ownership will reflect not only changes in the appraisals of
future income prospects for the enterprise, but also changes in
liquidity preference on the part of the investors. A decline in the
rate of liquidity preference would tend to increase the demand for
ownership, whereas a rise in liquidity preference would tend to
decrease the demand for ownership.
Rate of yield on market price
A change in the market price of a share of stock or a bond will
cause an inverse change in the yield or ratio of income to market
value, assuming that the income in terms of dollars does not
change at the same time. Suppose that, when the stock of the
X.Y.Z. Corporation was selling at $110, the current dividends de-
clared amounted to $6.60 per share. Then the rate of yield, or
rate of return calculated at market price, would be $6.60/$110, or
6 per cent. When the stock was selling at a price of $125, the
annual dividend rate would have to be $7.50 per share to main-
tain a 6 per cent rate of yield on market value. If the dividend
rate did not increase, but remained at $6.60 per year, then a rise
in the market price of the stock to $125 would cut the rate of yield
from 6 per cent to 5.28 per cent ($6.60/$125 == .0528).
A rise in the market price of stocks tends to reduce the rate of
yield if the dividend rate remains unchanged. If dividends de-
cline, the rate of yield will decline if stock prices do not decline
correspondingly. If stock prices decline more than proportion-
204 FINANCIAL INVESTMENT
ately to dividends, yields will increase. If stock prices decline less
than proportionately to dividends, yields will decrease.
In the case of a bond, the amount of interest payable per year is
usually fixed at a certain percentage of the face value or principal
of the bond. Thus, a $1,000, 6 per cent bond requires the pay-
ment of $60 annually in interest. Although certain minor correc-
tions are necessary if the maturity date of a bond is only a few
years distant, the yield on a bond (as contrasted with the con-
tractual interest rate) would be greater than 6 per cent if the bond
were currently selling below par, that is, for less than $1,000. The
yield would be less than 6 per cent if the bond were currently
selling above par.
A calculation of the rates of yield on different types of securities
provides a good indicator of the terms on which investors are cur-
rently willing to invest, that is, to hold property rights to income
rather than the liquid funds that could be obtained by selling
them out at prevailing market prices. This is essentially what is
meant when it is said that a person has decided to liquidate his
investment: he prefers to hold liquid funds rather than claims to
income when the current (or prospective) yield on the securities
is insufficient to offset his desire to hold liquid funds. Thus, the
rate of yield may be taken as at least a rough indicator of the
prevailing rate of liquidity preference at any given time.
Changes in relative prices of different issues and types of
securities
That people's attitudes are subject to rapid and sometimes al-
most inexplicable changes is indicated by the sharp fluctuations in
security prices (and in the prices of other kinds of property) that
have occurred over the years. Judgments and decisions are seldom
made in dispassionate isolation, but are inevitably swayed by
the actions of other people and by the rumors, tips, and "senti-
ment" of the market. Periods of optimism and pessimism succeed
each other and are reflected in sharp changes in the generally pre-
vailing rate of liquidity preference. A rise in security prices may
itself lead to a more optimistic appraisal of future income pros-
pects and generate increased confidence. That, in turn, may tend
to reduce the rate of liquidity preference and bring about a fur-
ther shift in the demand for securities in a sort of cumulative
process. Conversely, a fall in security prices may inspire more
TRADING IN SECURITIES 205
pessimistic appraisals of income prospects and, at the same time,
cause a sharp increase in liquidity preference rates, because own-
ers fear that if they hold on, and are forced to sell out later, they
may experience more serious capital losses than if they were to
liquidate now. Thus, a downward cumulative process of falling
prices, increased desire to liquidate, and further decline in prices,
may be set in motion.
Great changes in the market prices and yields of securities are
predominantly connected with changes in the general level of
business activity which affect, or appear to be likely to affect, the
profitability of enterprise. Such changes reflect the shifting pref-
erence of people as between the holding of liquid funds and
the making of long-term commitments. There are also marked
changes in the types of securities that people prefer to hold in
times of changing business conditions.
When business activity is improving and general prosperity pre-
vails, the earnings of business enterprises are for the most part
good and income prospects are bright. Under such conditions,
many people are eager to purchase (or hold) stocks, because they
anticipate increases in dividend disbursements to stockholders.
They are relatively less eager to purchase (or hold) bonds on which
the incomes are contractually fixed. As a consequence, bond
prices tend to decline in comparison with stock prices, as many in-
vestors seek to liquidate their holdings of bonds and transfer the
proceeds to investment in stocks. The rise in stock prices, in re-
sponse to the buying pressure, has the effect of reducing the rate
of yield on stocks (that is, the ratio of current dividends to current
stock prices). In a period of intense speculative activity in the
securities market, it is possible for the current rate of yield on
stocks to fall to very low levels, although such a situation can
seldom be maintained for any great length of time. Such a period
is likely to be brought to an end by a sudden collapse of stock
prices, as it becomes increasingly apparent that future earnings are
unlikely to rise enough to give a rate of yield in line with the nor-
mal range of liquidity preference rates.
In a period of declining business activity, and dimming pros-
pects of business earnings and dividends, the reverse process tends
to occur. Then, the more assured though more modest income of
the bondholder appears much more enticing to many investors.
They are inclined to try to liquidate their holdings of stock and to
206 FINANCIAL INVESTMENT
transfer the proceeds to investment in bonds. Under the pressure
of liquidation stock prices decline, while the rush to buy bonds
tends to force their prices upward relative to those of stocks.
Such a shift of emphasis from bonds to stocks or vice versa is
only one example of a shifting preference with respect to invest-
ment. Other types of property rights similarly vary in attractive-
ness in comparison with one another in periods of changing busi-
ness conditions. The repercussions of such shifts, as well as of the
scramble to get out of long-term investment entirely and into
liquid holdings, are felt throughout the entire economic system.
Chapter 13
SUPPLY OF INVESTMENT FUNDS
New Issues of Securities and the Supply of Investment Funds
Terms on which new issues can be sold
From the standpoint of the individual investor, it is usually a
matter of little concern whether the shares of stock or bonds that
he buys are acquired from some other investor or are a part of a
new offering to finance an expansion of real investment. He will
be inclined to purchase newly offered stocks or bonds at prices that
are in line with the prices of already outstanding issues with com-
parable prospects of income and security. Thus a corporation
which proposes to offer a new issue of stock will be guided by the
prices at which its already outstanding shares are being traded in
the market. A firm contemplating a new issue of bonds must
determine the size of the issue, the contractual rate of interest of-
fered, and the offering price, in the light of the current market
prices of comparable bonds and the rates of yield on such bonds.
If there is a probability that the new financing will improve the
future earnings of an enterprise, the mere announcement of the
new offering may increase the demand for its already outstanding
shares as well as the salability of the new. If a firm were to put
out a large issue of bonds, which would have the effect of increas-
ing its fixed charges, owners of already outstanding stock might
feel less confidence in its ability to maintain future dividends. If
so, they would be less willing to hold stocks than before, and stock
prices would decline. Thus, an intricate interaction is likely to
arise as a consequence of the impact of a new financing program
upon the market for already existing securities.
207
208 SUPPLY OF INVESTMENT FUNDS
Personal savings and financial investment
It was explained in the preceding chapter that the decision of
an individual to invest current funds at his disposal will result in
the provision of additional funds for real investment only if they
are used to buy newly issued securities or other property rights in
newly constructed means of production. Otherwise, the transac-
tion is merely a transfer of property ownership and cash holdings
as between individuals.
The amount of current funds that can be devoted by individ-
uals to the purchase of new securities and other new property
rights will depend on the volume of personal savings, that is, the
amounts of personal income that people do not choose to utilize
for consumption expenditures. There is, however, no necessary
correspondence between the amount that any individual may elect
to save out of his income and the amount that he will choose to
invest in securities, because liquidity considerations may lead him
to hold a part or all of his current savings in the form of cash or
bank balances. This means that only in a very broad limiting
sense can it be said that the supply of investment funds by private
investors is governed by the amount of savings or the incentives
that people have for saving. Of more direct significance, in rela-
tion to the supply of investment funds, is the state of liquidity
preference on the part of the investing public, and the relative
optimism or pessimism of current appraisals of business prospects
for the future.
Actually, the amount of personal savings, out of which new
financial investment may be made, is itself largely dependent on
the general level of production and income in the economy. The
higher the general level of production and income, the larger is
the aggregate amount of savings likely to be, and therefore the
potential supply of funds to finance new real investment. But if
these potential investment funds are to be converted into real in-
vestment, the potential investors must have a sufficient induce-
ment to invest to overcome their preference for liquidity. Other-
wise they will attempt to hold their savings in idle cash or bank
balances, awaiting the appearance of better opportunities for finan-
cial investment.
Although this discussion has been framed largely in terms of
personal savings and financial investment by individual private
SUPPLY OF INVESTMENT FUNDS 209
investors, the situation is not greatly different in the case of such
"institutional" investors as life insurance companies, savings banks,
and investment trusts, through which the savings of countless indi-
viduals are brought together for purposes of investment. The cur-
rent funds placed at the disposal of such agencies for investment
tend to vary with the level of national production, employment,
and income, and their problem is to find forms of income-yielding
investment that will combine income with a minimum risk of capi-
tal loss should liquidation of a part of their holdings prove neces-
sary at any time. Legal standards or specifications established by
law limit to some extent the types of investment that may be
selected, and thus tend to channel the financial investments of
such institutions more narrowly than is true of private financial
investment in general.
The situation of the life insurance companies presents certain
unusual characteristics, in that the volume of current funds for
investment is a reflection of the total number of policies in force
and the gradually increasing life expectancy of the population.
<That is, the amount paid in each year in premiums is determined
by the sales of policies over the past generation, and hence does
not fluctuate greatly with changes in general business conditions,
except as policyholders may find themselves compelled to lapse
policies in periods of acute economic distress. At the same time,
the gradually increasing life expectancy of policyholders means
that the reserves of the life insurance companies have increased
more than proportionately. Thus the funds available for invest-
ment by such companies have increased progressively, and have
shown less variation, in response to changes in general business
conditions, than have other sources of investment funds.
For savings to be translated into financial investment, either by
private individual or institutional investment, the potential in-
vestors must have an incentive to part with liquidity; otherwise,
they will seek to hold the funds in idle cash or bank balances
awaiting the arrival of more favorable opportunities for invest-
ment. If they fail to find such opportunities, the accumulating
idle balances will not be converted immediately into demands for
additional investment goods with which to expand productive
plant and equipment. Under such circumstances, business enter-
prises in general will not be able to dispose of all the goods and
services that could be produced with the manpower and resources
210 SUPPLY OF INVESTMENT FUNDS
available. Cutbacks in production will occur, and the amount of
employment and total income for the economy as a whole will be
reduced. The decline in total income will tend to reduce the
savings of the community more than total consumption* This
downward process will continue until the amount of savings that
is made out of current income is in line with the current de-
mands of business enterprise for funds to be utilized for real in-
vestment.
This analysis may be summarized by saying that the funds avail-
able for financial investment (that is, the savings of the commu-
nity) come from the income resulting from economic activity and
that, as the level of economic activity rises or falls, the volume of
current savings increases or decreases very greatly. But savings
constitute only a potential supply of investment funds. They are
converted into actual supply of investment funds for use by enter-
prise only if the prospects of obtaining additional income through
investment are sufficiently attractive to overcome liquidity prefer*
ence. And income prospects, in turn, depend on the prospects of
enterprise. If business prospects as appraised by business man-
agements are poor, the offerings of new securities to prospective
investors may fall short of the volume that would be necessary to
absorb the total quantity of savings. But the holders of those
savings tend to hold them idle rather than to spend them for pur-
poses of consumption, because they still hope that opportunities
for advantageous investment will crop up later. Any tendency for
holdings of idle balances to increase will, however, touch off a
process of curtailment of production and declining employment
and income. People whose incomes are reduced will find that
they are unable to maintain their savings as planned, and there-
fore the decline in income will force a reduction in savings, and in
the supply of investment funds, until the supply is in alignment
with the demands of business enterprise for funds with which to
finance real investment.
Bank Credit as a Source of Investment Funds
The foregoing discussion was confined to the supply of invest-
ment funds by private investors through the exchange of savings
out of income for holdings of new securities. But business firms
that desire additional funds for real investment are not limited to
SUPPLY OF INVESTMENT FUNDS 211
such funds as may be made available by private investors through
the purchase of new securities. As a supplement to or as an alter-
native to the offering of new securities to the public, business en-
terprises may seek to obtain funds for additional real investment
by borrowing from banks. Although traditionally most borrow-
ing from banks was on a short-term basis, a greatly increased per-
centage of bank credit has come in recent years to take the form
of longer-term loans to business and to government.
Creation of credit by the banking system
One very significant point stands out in connection with bank
loans as a source of investment funds: the banking system of the
country possesses the power of creating the liquid funds that are
made available for investment. This is a power not possessed by
any other group apart from the government itself.
When a commercial bank makes a loan to an individual or a
business firm, it merely increases its deposit accounts (liabilities)
by an amount corresponding to the amount of the loan, and at the
same time it increases its own investments (assets) by the amount
of the note or other obligation received from the borrower. To
be sure, an individual bank may experience a drain on its reserves
as the borrower draws against the newly created deposit, but that
drain is largely offset, for the banking system as a whole, because
sums drawn by a given borrower are redeposited by those to whom
he makes payments. Bank reserves for many years have run con-
siderably above the minimum percentages specified by law, and if
an individual bank or the banking system as a whole should ex-
perience a drain on reserves which threatened to cut them below
the legal minimum, additional reserve funds could be obtained by
borrowing from the Federal Reserve Banks or by other methods
that are outlined in a later section of this chapter.
This means that the banks as a whole are in position to increase,
within very wide limits, the total quantity of liquid funds (repre-
sented by bank deposits) available for the financing of real invest-
ment, without involving any prior saving on the part of the com-
munity. An individual who decides to invest can do so only as
a consequence of saving, that is, foregoing the alternative of ex-
pending funds on consumers 1 goods and services. The creation of
bank credit, however, results in an increase in the quantity of
liquid funds available for real investment without requiring any
212 SUPPLY OF INVESTMENT FUNDS
reduction in current expenditures by the people of the commu-
nity for current consumers' goods and services. Only if the econ-
omy as a whole is operating close to the level of full employment
of labor and resources does this general statement fail to hold, as
will be seen at a later point.
Limits to the expansion of bank credit
If it is true that the creation of bank credit can make additional
funds available for financing current real investment, without ne-
cessitating any current saving at the expense of current consump-
tion, a practical question arises: What limits are there to the
expansion of the supply of investment funds through the creation
of bank credit, as compared with the other sources of such funds?
If saving, in the sense of earmarking funds for investment rather
than expenditure for current consumption, is not necessary in the
case of bank-created credit, this element of "cost" or "sacrifice" is
not involved in the supply of current investment funds from that
source. Hence, one of the factors that may help to explain the
limits of supply of funds from other sources is lacking. Certain
costs, of course, are involved in the making and administering of
bank loans, but the cost of making bank loans to business enter-
prises has been estimated at no more than 2 per cent, whereas the
interest rates charged on such transactions are commonly substan-
tially higher. Is there any explanation of the failure of interest
rates on bank loans to fall to a level closely corresponding to the
administrative costs of handling different types of loans, or for the
failure of bank loans to expand up to limits set by full-employment
conditions?
To these questions there are no easy answers, and the answers
themselves do not necessarily afford a justification of existing prac-
tice. One part of the answer is that interest rates on bank loans,
like most other prices, are influenced by a variety of institutional
circumstances, conventions, and quasi-monopolistic conditions.
Interest rates, like many other prices, display a considerable de-
gree of "stickiness" or inflexibility in the face of changing condi-
tions over time. Interest rates on certain classes of loans remain
virtually constant from year to year because they are the rates that
everyone is used to. Moreover, banks, like many other enter-
prises, are influenced by the possibility that a reduction in price
(in this case the interest rate) might result in an increase in the
SUPPLY OF INVESTMENT FUNDS 213
total volume of loans that could be made, but not necessarily in
the total expected profit. The anticipated profit would depend
on the difference between total revenue received in the form of
interest and the total cost of making and administering a larger
total volume of loans. For example, if the interest rate on a cer-
tain type of loan were reduced from 4 per cent to 3 per cent, the
total volume of loans would have to expand by one-third to bring
in the same total revenue as could be obtained on a 4 per cent
basis, and would have to expand still more to afford the same total
dollar profit.
In considering interest rates on bank loans, it must be remem-
bered that banks serve not just one group of potential borrowers
but several, and that different rates of interest are commonly
charged on different classes of loans. Comparatively high rates are
common on personal loans to individuals to finance the purchase
of automobiles and other consumers' durable goods. Lower rates
may be charged on collateral loans to individual borrowers and
business customers, and on mortgage loans to finance real estate
transactions. Still lower rates prevail on loans to government,
represented by the purchase of long-term government bonds or
short-term government issues having maturities of less than a year.
On the short-term government issues, the interest rate is com-
monly very low, running in the neighborhood of 1 per cent per
year.
Studies of the structure of interest rates on bank loans indicate
that the size of the loan is one of the major factors accounting for
differences in interest rates. The cost of making and administer-
ing personal loans to individuals, in amounts ranging up to a few
hundred dollars, often repayable on an instalment basis, will ob-
viously bulk up larger than the cost of lending the same total
amount in a few large blocks to large business customers.
Apart from the cost of making and administering loans, other
deterrents to an indefinite expansion of bank loans do, of course,
exist. As loans are expanded, bank reserves are reduced in pro-
portion to legal requirements as provided by law, and banks may
be forced to borrow from the Federal Reserve Banks to replenish
their reserves. The interest payable on such rediscounts will pro-
vide some deterrent to indefinite expansion by increasing the cost
of the loans to the banks. Although this type of limit on the ex-
pansion of bank credit was originally expected to be an important
214 SUPPLY OF INVESTMENT FUNDS
device for controlling the total volume of bank credit, it has
proved in practice to be much less significant than other forces
influencing the volume of bank loans outstanding. On the whole,
the reserves of the banking system of the country have been large
enough, with a few exceptions, to permit a further expansion of
loans without reducing the reserve percentages to the minimum
legal requirements.
Concern over the security of the loans made (that is, over the
assurance that repayment of loans will be made when due) pro-
vides a certain limit to the expansion of loans. For while there is
possibly no limit to the sums that businessmen and individuals
would be ready to borrow if interest rates were very low, and if
repayment could be postponed for a very long period of time,
there are definite limits to the amounts that they can borrow and
utilize in ways that will permit repayment within definitely lim-
ited periods of time. The responsible bank official's appraisal of
the borrower's ability to repay will influence his decision as to the
making of a proposed loan and the amount of the loan to be
granted. Furthermore, the estimate of the borrower's ability to
make such repayment will reflect the prevailing state of business
expectations. In periods of expanding business activity and gen-
eral prosperity, there will be less risk of loss on loans, and hence a
greater willingness to make loans, than in a period of declining
activity and depression.
Thus, something akin to liquidity preference influences the de-
cisions of responsible banking officials. The sum total of credit
which the banks as a whole stand prepared to extend to the com-
munity tends to fluctuate with the general level of business activ-
ity, even though that credit is not itself dependent on savings and
does not involve in itself any real cost of creation, apart from costs
of administration and supervision.
The Special Case of Bank Credit Extended to Government
Bank loans to the federal government stand in a category by
themselves for two reasons. First, there is virtually no risk of de-
fault in interest payment and in repayment of principal by the
government. Hence there is no direct prudential limit to the
amount of credit that could be placed at the disposal of the gov-
ernment. Second, bank loans to the government differ from loans
SUPPLY OF INVESTMENT FUNDS 215
to other customers in that for all practical purposes the borrower
(the government), rather than the banks, can determine how much
credit is to be created and loaned to it. This follows because the
federal government itself, through the operations of the Treasury
and the Federal Reserve System, can at will increase (or decrease)
the amount of reserves available to the banks, and hence the
amount of credit that the banks can create.
During World War II, for example, the Federal Reserve Banks
stood ready to purchase from the banks any quantity of govern-
ment bonds that the banks wished to sell, at a virtually guaran-
teed price. This meant that the banks could safely purchase gov-
ernment bonds, paying for them by crediting the government's
deposit accounts in the banks with the purchase price of the
bonds. Against these deposits the government could draw as
needed to make payments for war materials, or to government per-
sonnel, or for other purposes. If, as a consequence of such with-
drawals from the government's deposit accounts, an individual
bank found its reserves were being depleted, it could rebuild its
reserves to the required legal level by selling to its Federal Reserve
Bank a part of the bonds it had already bought. Since the bank's
required reserves were only a fraction (say 20 per cent) of its de-
posit liabilities, it could increase its investments in government
bonds, and hence its earning assets, by a multiple of those resold
to the Federal Reserve Bank.
The volume of bank-created credit available to the government
was therefore determined, not by reference to the amount of sav-
ing being made in the community, or by prudential considerations
on the part of bank officials, but by the requirements for funds
and the financial policy of the government itself. During the course
of World War II, bank holdings of government bonds came for
the first time to constitute the major element in the earning assets
(loans and investments) of the banking system, far outstripping
loans to individuals and private business enterprises.
Increasing importance of government debt in the entire
structure of financial investment
The rise of government borrowing to a position overshadowing
all other financial transactions of the community has brought
about a veritable revolution in the banking system, and, indeed, in
the financial mechanism of the entire economy. With very large
216 SUPPLY OF INVESTMENT FUNDS
holdings of government bonds in the hands of the commercal
banks funds that could be converted into additional reserves by
sale to the Federal Reserve Banks or on the open market the
banks could, if they desired, expand their loans to private indus-
try in very large amount without incurring any limit attributable
to lack of reserves. The issues of national monetary and economic
policy that are presented by such a situation must, however, be
considered in an even broader context than they are considered in
this chapter.
One very real question that arises is whether there is economic
justification for the payment of interest on loans made to the
government by the banks, as compared with loans made by indi-
viduals. Inasmuch as the making of such loans to government is
virtually free of risk of loss, and the basis for the creation of the
credits involved is provided by the government itself through its
operation of the Treasury and the Federal Reserve System, the
payment of interest is not a necessary condition for the obtaining
of the loan. No essentially different results would follow if the
government were itself to create the additional means of payment
by an outright printing of money. The chief objections to the
latter procedure lie in the vague fears of the community that an
open resort to the printing press is somehow dangerous and un-
sound, perhaps because it is "too easy" and "likely to lead to infla-
tion," that is, rising money prices for goods and services. But the
conditions under which rising money prices for goods and services
are likely to follow an increase in the volume of means of payment'
are conditions of full employment. Under such conditions it
makes little difference whether the increase in the means of pay-
ment results from the operation of the printing press or the more
conventional operations of the banking system.
Chapter 14
SAVINGS, PROPERTY INCOMES,
INVESTMENT, AND EMPLOYMENT
It has been seen, in previous chapters, that new real investment
and an expansion of economic activities may be financed in a num-
ber of ways, including (1) the reinvestment of earnings by business
enterprises, (2) the sale of new securities to the investing public,
and (3) the creation of bank credit in the form of short-term or
long-term borrowing from commercial banks. By the same token,
an excess of governmental expenditures over current tax receipts
may be covered by "deficit financing" through the sale of addi-
tional government securities to the general public or the banking
system.
Where expansion is financed out of undistributed earnings of
enterprise, the liquid funds so utilized constitute business savings
as contrasted with private personal savings. When expansion is
financed through the sale of new securities to the general public,
financial investment by the general public results in the conver-
sion of savings into real investment by business enterprise. The
amount of real investment possible might therefore appear to be
limited by the amount of liquid funds at the disposal of the poten-
tial investors, that is, by the aggregate amount of their savings.
But as a practical matter, the amounts of such funds directly re-
flect the level of economic activity and income, and vary as the
level of economic activity and income rises or falls. Also in an
economy that, like the United States, has a relatively high level of
productivity, the amounts that tend to be saved at high levels
of economic activity and income may considerably exceed the
amounts required to meet the real investment demands of en-
217
218 SAVINGS, PROPERTY INCOMES
terprise. Thus, in reality, the limits to the expansion of economic
activity have seldom been set by a lack of sufficient funds to carry
through plans for industrial expansion. Except under conditions
of full employment, the possibility of creating additional funds
through the operation of the banking system has meant that means
could be made available for expansion, either on the part of in-
dustry or government, or both, even if business savings and private
personal savings should be insufficient to meet all current de-
mands for funds.
If it be assumed that economic forces tend to push production
and income up to full employment levels, then it would follow
that the amount of expansion in economic activity from year to
year would be governed by the amount of savings available for in-
vestment in the means of production required to turn out larger
quantities of goods and services. On that basis, a critical impor-
tance would attach to the amount of saving as a factor governing
the rate of expansion of economic activity in the community, and
to the incentives that people had for saving a part of their current
income rather than expending income on current consumption.
Traditionally it has been assumed that the hope of obtaining a
property income from invested savings is a primary incentive to
saving, although by no means the only determinant of the amount
of saving. 1 If the interest rate be regarded as representative of
property incomes in general, then, to the extent that the prospect
of obtaining a larger interest return would result in larger savings,
and a prospect of a smaller return would result in diminished sav-
ings, the interest rate would assume a strategic role in fixing the
rate at which economic expansion could occur. It is essentially
on such a basis as this that the traditional emphasis on the virtue
and economic merit of thrift was grounded.
But if an economy is not operating at full employment, and
shows little tendency toward expansion as a consequence of forces
generated within the system itself, then the situation is quite dif-
ferent. In that event, the limitations to expansion do not lie in
the lack of resources with which to achieve a higher level of pro-
duction and income. Rather they lie in a lack of profit opportu-
nities sufficient to call into use even the full amounts of productive
1 In the Soviet economy, real investment is dependent only to a slight degree on
private personal saving, and even in the "private enterprise" economy, as already
seen, the amount of saving is largely determined by forces beyond individual control.
INVESTMENT, EMPLOYMENT 219
resources already available for use. Under such circumstances,
which correspond roughly to the situation in the United States
during the decade of the 1930's, the crux of the economic problem
is not to obtain sufficient savings to implement an expansion of
production, employment, and income. Rather it is to find suffi-
cient opportunities for real investment to absorb the savings that
would tend to be made by individuals and business enterprises at
a high level of economic activity and income.
Such a situation presents a sharp contrast to the traditional
analysis of the relationships linking savings, property incomes, pro-
duction, employment, and the level of income for the community
as a whole. Inasmuch as current thinking is still much influenced
by the traditional analysis, it is important to subject the latter to
close investigation, to see in what respects it falls short as an ex-
planation of the economic process. Such an appraisal is impor-
tant not merely to make economic analysis itself a more appropri-
ate explanation of the facts of modern economic experience. A
more important reason is that if the traditional analysis is accepted
as valid, the measures that would appear appropriate to cope with
widespread unemployment would differ greatly from those advo-
cated by adherents to the more recent economic analysis. If eco-
nomic analysis is to be used as a guide on important matters of
public policy, it is imperative that it be subjected to searching and
critical examination.
The Traditional Analysis of Savings, Interest, Investment,
and Employment
The traditional analysis was based essentially on a line of rea-
soning which is summed up in the "Law of Markets" as formu-
lated by J. B. Say, a French economist of the early nineteenth
century. The fundamental proposition in this "law" was that
"supply creates its own demand," or, stated somewhat differently,
that it is impossible for a general overproduction or "glut" of
commodities and services to exist. The general argument may be
summarized briefly as follows.
The fundamental reason for carrying on economic activity is to
obtain the goods and services that people need to meet their de-
sires. Presumably no one in his right mind would expend time,
energy, and resources in producing goods and services that would
220 SAVINGS, PROPERTY INCOMES
afford him insufficient satisfactions to compensate for the sacri-
fices required for production. It was assumed that human wants
are indefinitely expansible, and always greater than could be sat-
isfied by the manpower and physical resources available for pro-
duction. Coaches-and-four and liveried retainers, or even a
4 'chicken in every pot" for everyone, seemed far beyond the flight
of even the most fervent imagination. Therefore, goods and serv-
ices in general would always be scarce in comparison with the de-
sires of people, and would always have a definite positive value to
the people of the community, even though accident might occa-
sionally result in a temporary excess of some particular com-
modity.
The fact of exchange was not believed to make any essential dif-
ference for the argument. Any person who specialized in the pro-
duction of one commodity or service did so expecting to obtain,
from its sale in the market, the means with which to purchase, in
the market, goods and services that he himself desired. Only by
providing some salable commodity or service could he obtain an
income. With that income he became, in turn, a demander for
products turned out by others. With what he paid for goods and
services purchased from them, they in turn became demanders of
still other goods and services. Thus, supply was conceived to be
the counterpart of demand, and in the aggregate the goods and
services supplied to the market were necessarily equal to, and the
same as, the goods and services demanded.
With an inexhaustible reservoir of desires, far beyond the
capacity of existing resources to satisfy, there would always be op-
portunities to dispose of additional goods (assuming that the char-
acter of people's desires was properly forecast), provided the addi-
tional means for their production could be created by building
more factories, producing more machinery, and extending the use
of fields, forests, and mines. But to free existing resources for
diversion into the creation of additional real investment goods, it
would be necessary to induce some people to refrain from current
consumption of a part of current income, that is, to save. Other-
wise the expansion of productive capacity would be impossible.
Here, therefore, is to be found the basis of the traditional analy-
sis of the relations between saving, investment, interest (as repre-
sentative of property incomes in general), and the expansion of
productive activity in the economy.
INVESTMENT, EMPLOYMENT 221
Specifically, so long as the physical means of production remain
scarce, in comparison with the uses that can be made of them in
producing goods and services that people want, a scarcity value
will attach to the uses of such means of production. That use-
value will in turn provide the basis of a property income to those
who own the means of production, and will permit the payment of
interest (or its equivalent) to people who are willing to make their
savings available for real investment. There will be an incentive
to people to save, as long as the return, in interest or its equiva-
lent, is sufficient to compensate the savers for the necessary sacri-
fice of current consumption. According to this view, the process
of expansion in production would continue until the prices that
people in general were willing to pay for goods and services were
just sufficient to cover the labor and other costs of production.
Included as an element in cost would be the payment of interest,
or its equivalent, at a rate that would just induce the amount of
saving necessary to keep production rolling.
As the volume of production increased from year to year, the
scarcity of the means of production might be reduced, relative to
the desires of people for goods and services for which those means
were used. If this happened, the rate of interest would tend to
decline. But it would not decline to zero, because if it did, the
owners of property presumably would have no incentive to keep
up productive plant. The lower limit to which the rate of inter-
est could decline would be reached when it provided merely a
sufficient incentive to keep people from attempting to consume
not merely their current income from other sources, but also to
"eat up" their past savings as well, by withdrawing from industry
more than the earnings on current operations. This could be
done, for example, by failing to make full provision for deprecia-
tion, and depleting "capital" by using the funds so released to
cover interest or dividend payments or other entrepreneurial
withdrawals.
The prospect of being able to obtain an income through prop-
erty ownership was thought of as the "price" or "reward" for sav-
ing, the effect of which was to reduce the relative scarcity of the
means of production. The higher the rate of interest, the greater
would be the incentive to save. The lower the rate of interest, the
less the incentive to save would be. But so long as any scarcity of
productive means remained, a positive value would attach to the
222 SAVINGS, PROPERTY INCOMES
use of such means, and therefore a source of property incomes
would exist.
In the traditional view, the interest rate was significant not only
as a factor determining how fast and how far the expansion of pro-
duction in general could go (by virtue of its function as an induce-
ment to saving), but it was also thought of as a part of the general
structure of prices. It therefore was a factor influencing the lines
along which the productive activities of the economy would be
directed.
Expanding industries would require additional funds to finance
the expansion. To obtain such funds, they would have to com-
pete with one another for the limited funds available by offering
the best possible returns to prospective investors. If the products
of one firm were in great demand, it would be in position to at-
tract additional funds by offering higher returns to the investing
public than could other firms whose products were not in such
keen demand. Investment funds derived from savings would tend
to flow into enterprises where prospects for future expansion were
brightest, and not into others whose prospects, though perhaps
good, were still less alluring.
In other words, the interest rate was conceived of as allocating
or rationing a limited flow of savings for expansion purposes in
ways that seemed economically most advantageous, considering the
demands of the people of the economy for finished goods and
services. As long as the total amount of savings at any given time
was insufficient to meet all possible demands for real investment
purposes, the interest rate would serve as a useful and indeed nec-
essary device to ration the available savings among competing
channels of investment.
Traditional analysis based on assumption of full employment
A major deficiency of the traditional analysis was that it was
based on the assumption that normally the economy operates un-
der conditions of full employment. It assumed that, except for
temporary lapses, all existing physical means of production would
be employed either in producing consumers' goods or in con-
structing plant facilities, machinery, and other things required for
a further expansion of production. Savings out of current income
would not reduce the demand for goods and services in the aggre-
gate, because as they were invested they would be translated into
INVESTMENT, EMPLOYMENT 223
demands for labor, raw materials, and equipment to erect build-
ings and construct machinery.
As time went on, the rate of interest obtainable from invest-
ment might decline; but as long as savers realized that possibility,
they would presumably readjust the amounts they sought to save,
in comparison with the amounts they spent on consumption. And
as the production of goods and services expanded, their prices
would tend to be readjusted in comparison with the wage incomes
of workers and the declining rate of interest and other property
incomes, so that all goods and services that could be produced
could still be purchased with the money incomes that people re-
ceived, in one way or another, from productive activities.
The traditional analysis did not overlook the fact that the crea-
tion of bank credit could make funds available for the expansion
of real investment without any direct saving on the part of the
banks or their owners. But if the economy were already operating
at full capacity, the creation of additional liquid funds or means
of payment would simply result in the bidding up of the prices of
those types of labor, raw materials, and equipment that could be
used for the production either of consumers' goods or of invest-
ment goods. These increases in certain prices would force people
whose incomes or means of payment were not increased to cut
down on their current consumption, thus providing the "real"
savings that corresponded with the increase in bank credit and the
associated increase in real investment. Such savings are often re-
ferred to as forced savings. It may be noted parenthetically that
in this case the people who cut down on consumption, and thus
"saved," would not thereby become owners of claims to future
property income. However, they might ultimately be compen-
sated by a subsequent increase in real income as a consequence of
a lowering of the prices of consumers' goods, as and when the vol-
ume of production was increased by virtue of the expansion of
productive capacity.
The Problem of Chronic Unemployment
The body of traditional economic analysis, as outlined above,
may appear reasonably appropriate for an economy operating un-
der conditions of full employment, or for one whose current pro-
ductive capacity is barely adequate to meet the minimal living
224 SAVINGS, PROPERTY INCOMES
requirements of its people. But it fails to provide an adequate
explanation of the experience of modern industrialized economies,
including the United States, which have suffered prolonged periods
of deep depression and unemployment, both of labor and of physi-
cal productive resources, such as prevailed during the 1930's. Nor
does experience seem to lend confirmation to the traditional views
as to the relations among saving, investment, and the interest rate
the latter being used as a symbol of property incomes in general.
Take first the view that saving, in the sense of foregoing present
consumption, is necessary to permit the diversion of labor and
other resources from the production of consumers' goods to the
production of additional investment goods. That is clearly not
the case if the point of departure is a situation in which a sub-
stantial part of the labor force and already existing productive
facilities are idle. All that is then necessary, in order to create
additional productive plant and facilities, is to put the idle re-
sources to work. That need involve no curtailment of current
consumption at all. What is required is the existence of some in-
centive to put the process of expansion in motion.
The difficulty is that few business enterprises, in such a period,
can foresee any possibility of additional returns, to be gained by
carrying out an expansion of their own undertakings, that are
commensurate with the risks they would assume in seeking addi-
tional funds to finance the expansion. They may concede that if
all the firms in the country were to increase production and em-
ployment simultaneously, the increased wages and other outpay-
ments involved would increase consumers* purchases of goods and
services in general. But still no one of them is in position to gam-
ble on its own share in the possible increased aggregate demand.
And inasmuch as the initiative in expansion has to be taken by
individual firms, the tendency is for each one to wait and see what
happens. The stimulus to expansion may therefore have to come
from some outside source.
Or turn to the role of interest as a stimulus to saving, and the
assumption that there is a direct relationship between the expected
or anticipated rate of return on financial investment and the
amounts that people are willing to save out of current income. As
noted in preceding chapters, studies of saving in modern commu-
nities indicate that the bulk of current personal savings is made by
INVESTMENT, EMPLOYMENT 225
upper and middle income groups at comparatively little sacrifice
of living standards, and that a considerable proportion of all sav-
ing is accomplished by corporate rather than individual decision.
Likewise it can be argued, with some support from experience,
that many people would tend to save more out of current incomes
if interest rates were low than if they were high. If interest rates
are low, a person who wishes to accumulate a certain life insurance
estate, or an annuity of a certain size for his retirement, must and
commonly does pay larger current premiums than would be
needed if the rate of interest accumulation were high.
It also seems very clear, from the record of experience in the
past few decades, that the total amount of saving in any given
year is much more affected by the general level of economic activ-
ity and income than by the interest rate. In years of general busi-
ness prosperity, incomes in all brackets tend to be higher than in
years of low business activity. As people's incomes increase, they
tend to save a larger part of those incomes than when incomes are
low. Living standards tend to fluctuate less than incomes, and
savings tend to take up the slack, without much reference to the
interest rate.
It may be argued that if people had no expectation that their
savings could be used in such a way as to add to their incomes in
the future, some of them, at least, would give up the attempt to
save and instead would consume their incomes "up to the hilt."
But even so, the person who this year received a larger income
than he had previously enjoyed might still feel a prudential urge
to lay part of it aside, even though he had no assurance that next
year, or five years later, or ten years later, he would find himself
in command of a larger sum of liquid funds.
In any event, it is clear that the amounts that people will volun-
tarily seek to save out of current income are much more directly
influenced by the ups and downs of general business activity and
income than by the interest rate. That is the fact that is of major
economic significance for the American economy of today, because
those sums that are saved out of current income are not directly
spent on consumption, and do not immediately constitute de-
mands for goods and services. Even when invested, in the finan-
cial sense, they do not become converted into demands for current
goods or services until they are invested in a real sense, largely by
226 SAVINGS, PROPERTY INCOMES
business enterprise or, increasingly, by governmental agencies, in
raw materials and the use of labor, to expand the productive ca-
pacity and activities of the economy.
But there is no necessary reason to suppose that the amounts
people choose to save out of current income will be precisely the
same as the amounts that business enterprises would wish to in-
vest, in the light of current business prospects. If people at a
given time should attempt to save out of current incomes larger
amounts than are called for by the business community's plans for
real investment, consumers' purchases of goods and services, plus
business purchases for purposes of expansion, would tend to fall
short of the total volume of goods and services that could be pro-
duced with the already available resources. This would tend to
depress business prospects and induce a cutback in total produc-
tion and employment, and therefore a reduction in the total
amount paid out by business firms in the form of wages, rents, in-
terest, and profits. It would mean, in effect, a reduction in the
total amount of income received by the people of the community.
As aggregate income declined, people would be in poorer position
to save, because more of their incomes would be needed to main-
tain living standards. As incomes declined, savings would decline
more than proportionately, until a level was reached at which the
total amount of saving (both individual and corporate) was in line
with the amounts required for real investment to maintain that
level of economic activity. The minimum level to which eco-
nomic activity could sink, except for short periods, would be one
at which there was no net saving for the economy as a whole. At
that point, total production would suffice merely to cover current
consumption and the replacement of productive facilities worn
out during the year. For the United States, however, that level of
production and income would involve unemployment for millions
of workers and for many billions of dollars' worth of productive
equipment.
Finding outlets for savings, and incentives to expansion
One of the major economic problems of the modern economic
community such as the United States has been to find outlets for
savings in excess of the outlets provided by the demands of private
enterprise for funds for real investment. As the wealth of the
community increases, the opportunities for real investment that
INVESTMENT, EMPLOYMENT 227
remain unexploited may involve expectations of smaller, or more
remote, or more problematical returns. There may be slighter
chances of gains to be achieved from such investment, in com-
parison with the obligations that would have to be assumed to
obtain additional funds from the investing public.
It may be argued that if this prospect were recognized by would-
be investors they would either save less or would voluntarily accept
lower and lower property incomes. In the latter case, the interest
rate and comparable rates of property income would decline, in
comparison with the marginal efficiency of capital, and therefore
continued expansion would be possible. But under modern con-
ditions the processes of private individual saving and financial in-
vestment are largely divorced from the processes of real invest-
ment, and, as has been seen, the volume of savings is influenced by
factors that have only indirect connection with the business com-
munity's appraisals of the opportunities for further expansion in
the future. And instead of accepting as inevitable a low return
on the financial investment of their savings, those who save tend
to prefer to hold savings in liquid forms (as cash or bank deposits)
for considerable periods in hope that more favorable opportuni-
ties for investment may arise later. In other words, liquidity pref-
erence rates tend to remain higher than the marginal efficiency of
capital, and hence the whole economic process bogs down.
Inasmuch as risk of possible capital loss constitutes one of the
elements in liquidity preference, one way of breaking the impasse
is to offer savers an outlet for savings in which the risk element is
negligible, although the prospective rate of return may be corre-
spondingly lower. Government securities present one avenue of
comparatively riskless financial investment, and prospective in-
vestors may be willing to exchange liquid holdings for the owner-
ship of such claims when other forms of investment are relatively
unattractive. The sale of such securities then affords a means of
mobilizing savings and putting them to use in financing activities
that private business enterprises cannot or will not undertake,
either because the prospective returns are too uncertain, or be-
cause there is no way of making the venture pay off in a private
profit sense. For example, the proceeds of a government bond
issue may be utilized to construct a highway, new school buildings,
public recreational projects, a flood control system, an expansion
of military installations, or the construction of naval craft. Any
228 SAVINGS, PROPERTY INCOMES
one of these may be of obvious advantage to the community either
in terms of additional services rendered or the promotion of secu-
rity. But it would be difficult, if not impossible, for any private
venture to organize the operation in such a way as to obtain a
return on the investment that would enable it to raise the neces-
sary funds by selling stock or bonds to the general investing public.
The view that government is in position to provide outlets for
saving, to make good any deficiency in the demands of private en-
terprise for funds with which to finance real investment, is based
on the point that governmental activities are undertaken, not on
the expectation that they will result in a gain or profit to the gov-
ernment, but for purposes that are conceived to be of general so-
cial advantage. The test of the propriety or advantage of a gov-
ernmental activity is not whether it can be made to pay, but what
it can add to the well-being and security of the people of the com-
munity. Thus the opportunities for making advantageous use of
funds through governmental channels do not expand or contract
in response to changes in the general level of economic activity
and in business expectations as do the opportunities for real in-
vestment by private enterprise. Furthermore, an expansion of
governmental activities and expenditures may not only help to
maintain outlets for investment funds and employment of labor
and resources, but such an expansion may in fact result in a more
than proportionate increase in the aggregate production and in-
come of the economy. It has been estimated, on the basis of ex-
perience, that the over-all effect of an increase in governmental
expenditures in a period of widespread unemployment may be to
raise the general level of production and income by as much two
or three times the amount of the increase in governmental ex-
penditures. This does not mean, however, that an increase in real
investment by private enterprise would not have a similar multi-
plier effect. But in a period of unemployment the opportunities
for real investment as seen by private business firms are limited,
and hence a basis for a large expansion of private real investment
is lacking.
One problem faced in attempting to use an expansion of govern-
mental expenditures as a means of raising the level of production,
employment, and income in a period of depression is to find chan-
nels for such expenditures that will not cause a further deteriora-
tion of the incentives to private real investment. For example, a
INVESTMENT, EMPLOYMENT 229
decision on the part of the government to build a new hydro-
electric power plant might involve a large increase in real invest-
ment in the area concerned, but it might also arouse fears of "gov-
ernment competition" in many business groups and perhaps put a
damper on their own plans for possible expansion. In that event,
an increase in real investment through governmental channels
might be offset in part at least by a decrease in private plans for
real investment. It is largely for this reason, and to escape the
organized opposition to "government competition" with private
enterprise, that governmental expenditures to promote employ-
ment have been largely directed toward public works of a non-
competitive character, including the construction of highways,
schools, public buildings, recreational facilities, and, most impor-
tant of all, military installations and equipment. The field of
housing, in which is to be found a tremendous outlet for addi-
tional real investment that could contribute to the well-being of
the people of the community, has been a battleground because it
is a field in which an expansion of governmental activities might
react adversely upon the business prospects for a large and very
vocal group of already existing property owners.
If the difficulties of reaching and maintaining a high level of
production, employment, and income appear to grow out of a dis-
crepancy between the amounts that tend to be saved out of high
levels of income, on the one hand, and the amounts needed to
implement business plans for real investment on the other, the
question arises whether the impasse could not be surmounted by
reducing the amounts of saving and concurrently increasing total
expenditures for consumption. This sounds a good bit like heresy
and a repudiation of the traditional belief in the virtues of pru-
dence and thrift. But the practice of thrift, like other types of
behavior, can be overdone. Furthermore, what may be to the in-
terest of any single individual may, or may not, be to the interest
of the community as a whole.
It has been argued, particularly in labor circles, that increased
wages for labor would tend to increase the share of the total na-
tional income received by those groups in the community most
likely to expend additional income for purposes of consumption.
If the problem is one of excess savings, a reduction in property
incomes, falling chiefly on groups receiving larger incomes, would
tend to reduce savings and so bring them more nearly into line
230 SAVINGS, PROPERTY INCOMES
with the amounts called for by business plans for real investment.
If so, the increase in wages would have beneficial rather than
harmful results, from the standpoint of the economy as a whole.
One objection to such an approach is that the proportion of
labor costs to total costs varies considerably from industry to in-
dustry, and therefore the impact of a general advance in wages
would differ greatly from industry to industry. Although the
increased labor income would increase aggregate expenditures for
all kinds of goods and services, the increases in demand for the
products of different industries would not necessarily correspond
to, or offset, the effects of the wage increases. Thus, the effect of
such a change on the plans of business enterprises for further real
investment would be varied, and to a considerable extent un-
predictable.
An alternative approach to the control of savings would call for
the use of the income tax for that purpose. By taking a still larger
slice out of the higher income brackets, which account for the bulk
of savings, and reducing rates in the lower brackets, or relieving
them entirely from such taxation, disposable income would be in-
creased for those groups most likely to expend additional income
on consumption. Many students of fiscal policy, however, believe
that the possibilities of manipulating the structure of income tax
rates in this direction have been pretty well explored, and that
further changes of this sort alone would not suffice to cope with
the basic difficulty.
Some students of the problem, however, have advocated the es-
tablishment of a flexible system of personal and corporate income
tax rates, under which changes in tax rates could be initiated by
executive authority, subject to review by Congress at periodic in-
tervals. In the event of a threatened downturn in economic activ-
ity, tax rates could be cut immediately, within limits, thereby in-
creasing the disposable income in the hands of individuals. This
would tend to stimulate consumption, and therefore lend support
to aggregate demand. Conversely, an increase in tax rates in a
period of relatively full employment would reduce disposable in-
comes and put a damper on consumption. That would help to
reduce the upward pressure on prices in a period when produc-
tive facilities were being strained to produce the goods and serv-
ices that people wished to buy, and so would restrict the tendency
toward inflation.
INVESTMENT, EMPLOYMENT 231
In general, the view that the way to achieve economic stability
is to reduce savings to bring them into alignment with opportuni-
ties for real private investment may be thought of as a defeatist
approach. It would imply that no way could be found to organ-
ize the economy in such a way as to convert manpower, technologi-
cal knowledge, and resources into a further, or a more rapid,
increase in the living standard of the people, whether that living
standard be thought of in terms of goods and services bought and
sold in the market place, or also in terms of public improvements
and services.
Whatever one's views as to the most feasible line of attack, the
fact remains that the major domestic economic question facing the
United States in recent times has been how to achieve and main-
tain a high level of production, employment, and income. It is
clear that, contrary to the traditional view, the economic system
does not inherently tend toward full employment. Instead, it may
continue to operate for long periods of time with millions of work-
ers able and willing to work, but unable to find jobs, and with
great aggregations of productive plant and equipment idle or
operative only a few hours per week.
Such idleness means the irretrievable loss of potential output of
goods and services that people would gladly consume if they could
get the jobs and income necessary to enable them to buy. We
have seen the phenomenon of poverty in the face of potential
plenty, if not abundance. From such a paradoxical situation the
United States escaped during the 1940's as a consequence of the
drive for production unleashed by the demands of modern war-
fare. The problem of the decades to come is to find ways of
making the demands of peacetime use equally effective in releas-
ing the incentives to full production and employment, and thereby
avoiding a future retrogression. In comparison with this problem,
most of our other economic concerns are of the second or lower
order, because the ability of our existing economic system to sur-
vive, both domestically and internationally, is likely to depend on
OUT ability to solve this paramount problem.
INDEX
Acceleration principle, 178n
Advertising:
and total costs, 74-75
brand, 14
competitive, 65
counter-advertising, 65
price and production policy, 62-65
pricing as related to (chart), 62
to increase sales, 74
Agricultural Adjustment Administra-
tion, 39
Agricultural commodities and volun-
tary control of supply, 160
Allowance for depreciation, 104 (see
also Depreciation)
Antitrust laws and basing point sys-
tem, 44
Assets, earning, 215
Automobile industry, 16, 98
Bank credit:
as a source of investment funds, 210-
216
available to government, 215-216
borrower's ability to repay, 214
creation of, 211-216
for expansion of production, 223
limits to expansion of, 212-214
liquid funds, 211
long-term loans, 211-216
Bank loans, interest on, 212-214
Bargaining:
and supply of materials, 160
collective, 155-158
Base price, 44
Bonds:
amount of interest on, 195, 204
corporate, 194
financing through use of, 183-185
government, 198, 215, 216, 227-229
maturity of, 195
new issues, 207
prices of, compared to stock prices,
205-206
purchase of, 192-193
sources of income, 194-195
trading of the equity, 188
Borrowing:
from banks, 188
through the sale of bonds, 183-185
Brand advertising, 14
Break-even chart, 26, 49, 54, 57, 59, 63,
67, 74
Budgeting, consumer, 7
Business cycles:
and consumer demand, 10
investments, 189-190
national income, 119
Buyers, potential and price, 4
By-products, 35
Capital:
consumption allowance, 114-115
efficiency of, 173-174, 176-178
gain and loss in investments, 198
marginal efficiency of, 173-174, 178,
227
233
234
INDEX
Charts, break-even, 26, 49, 54, 57, 59,
63, 67, 74
Collateral loans, 213
Collective bargaining, 155-158
Commodities:
and price, 3-4, 7
frequency of purchase, 4
staple, 38-39
supply schedules for, 17
Comparison shopping, 40
Competition:
monopolistic, definition of, 16
and land, 161
and price setting, 43
and raw materials, 159-160
and supply, 17-18
price, 44
pure, definition of, 14-15
and price structure, 79-83
and prices, 14-15, 37-38, 65-69
and supply, 17-19
market supply curve, 69
Constant costs and enlargement of
plant, 61
Consumer:
acceptance and brand names, 14
attitudes, effect on demand, 3
methods of determining, 11
budgeting, 7
demand, attitudes affecting, 3
estimated, 8 (see also Demand)
Consumer Incomes in the United
States, 120n
Consumer purchases, 4
Consumption function, 123
Control, voluntary, of supply, 160
Convenience goods, 40
Cooperative marketing organizations,
39
Corporate enterprises, growth of, due
to price competition, 45
Corporate funds, sources and uses, 180-
181 (table), 180
income taxes, 116
Corporate profits (table), 108
surplus, 108
Costs:
allocations, 35
alternative, 20
and output, 20
average, 26-28
constant, 61
curves, 23, 48-64
definition of, 19-20
affected by:
increases in factor prices, 32
increases in raw material prices, 31
increases in wage rates, 31
plant expansion, 29-31
fixed, 21-25, 30, 132
and plant expansion, 29
definition of, 21
joint, 36
labor, 21
money, 20-21
of multiple products, 35
opportunity, 20
out-of-pocket, 22
production, 13, 20-21
and supply, 19-20
prospective, 18
real, 20
variable, 21-30
definition of, 21
total curves, 23-25 (see also Break-
even charts)
Cotton textile industry, 85
"Damping-off" of curves, 134, 139
Decisions, business, motives in, 47
Decreasing costs to scale, 61
Deficit financing, 217
Demand:
and employer's demand, 127-128
changes in, 10-11
changes in income, 10
curve (chart), 5, 6
definition of, 3, 5
estimated consumer, 8
estimates of, 11
prospective, 16
rates of, 4
responsiveness of, 6-7, 11, 13
schedule of, 4 (table), 5
particular factors of production,
143-144
shifts in, 10-11
unresponsiveness of, 7 (sec also Con-
sumer demand)
Depreciation:
and replacement of durable assets,
174-176
of plant facilities, 23, 104
straight-line method of computing,
175
Durable assets:
demand for, 172-173
depreciation and replacement as re-
lated to rate of return over cost,
174-176
elements in valuation of, 167
marginal efficiency of capital, 173-174
methods of financing, 178
present worth of, 167-172
problem of valuation of, 165-166
INDEX
235
Durable assets (cont.):
rate of return over cost of, 173-174
changes in, 176-178
sinking funds, 175
time discount, 168-172
value of use of machines, 167-168
Durable goods, prices, 41
Earnings, diversion of, 110
retention of, 182
Economic and accounting viewpoints
in income statements, 105-107
Economic Report of the President to
Congress, January 1, 1949, The,
H7n
Economics of Industrial Management,
The, 48n
Employees, compensation of, 116, 118
Employer:
amount of labor necessary, 130-136
and strikes, 159
demand for increase in wages, 128-
129
employment policy, 129
expense, definition of, 129
expenses versus costs, 128-129
obligation to workers, 128
outlay, definition of, 129
problem of employment, 126-127
Employer's demand:
and consumer's demand, 127-128
and market demand, 143
as affected by substition of factors,
144
as related to demand for finished
product, 129-136
change in, for finished product, 141-
142
character of, for production factors,
126-144
for labor's basic conditions of em-
ployment, 133-136
schedule for labor, 138-144
wage rates and amount of labor,
130-139
Employment:
and investment, 217-231
and production, 111-112
national (table), 117
necessity for full, 231
traditional analysis of, 219-223
volume of, in relation to income
and demand, 130-131
Enterprise:
as related to employment and in-
come, 92
definition of, 91
distribution of earnings, 107-109
diversion of earnings, 110
dual role of, 92
incentives of, 93-110
nature of, 90-92
profit expectations, 96-102
risk in, 98-99
Enterpriser, definition of, 91
Equilibrium, group, under pure com-
petition, 82
Equilibrium level of prices, 37-38,
75-77
Expenditures curve, 7-10, 12, (chart),
8, 12
Expense, definition of, 129
Factor prices and production costs, 130
Fair Trade laws, 14, 40
Federal Farm Board, 39
Federal Reserve System, 213, 215, 216
guarantees price of government
bonds, 215
regulates bank reserves, 215
Financial investment and real invest-
ment, 167
and securities, 191-206
Financial overlay, 167
Financing:
through sale of bonds, 183-185
through sale of stock, 185-188
Finished goods and services, 112-113
Finished product, change in demand
for, 140-142, 178
Fiscal policy, 230
Fixed expenses, total, 132
Fixed investment, 166-167
Forced savings, 223
Forecasting, business activity, 11
demand, 12-13
income, 12
Fortune (periodical), 48n
General Theory of Employment, In-
terest and Money, The, 173n
Goods, convenience, 40
Government bonds:
as earning assets, 215-216
debt and fiscal policies, 215-217
liquidity of, 198
loans, interest on, 216
securities for financial investment,
227
spending to raise level of produc-
tion, 228-229
Gray-market profiteers, 98
236
INDEX
H
Housing, source for real investment,
229
Incentives, 93-110
Income:
aggregate, 226
and production, 111-125
changes in, as affecting demand, 10
consumer, 120n
corporate, 118
differences in urgency of current,
151-152
disposable, 116, 122, 230
distribution of, 124-125
gross national product, 112-114
high, necessity for, 231
individual expenditure of, 4
inequality of, 121-123, (table), 120
level and distribution of, 124-125
national, 115, 117-119, (table), 117
allocation of, 118
distribution of, 119-125
net national product, 114-115
personal, 115-117, 152
social security, 116
property, 152, 221-222
proprietorship, 118
rental, 118
tax, flexible levies, 230
use of, 122-123
wage, 152
Increasing costs to scale, 61
Individual bargaining and trade union-
ism, 155
Individual supplier and prices, 19
Industrial management:
break -even charts in, 48
techniques, 26
Industry, price structures, 83-85
Inequality of income, 121-123
Inflation, 216, 230
In-line pricing, 40
Insurance companies, investments of,
209
Interest:
and expansion of production, 222
received by persons, 118
traditional analysis of, 219-223
Investment:
and employment, 217-231
financial and real, 166-167
meaning of, 197-198
real, 166-167
traditional analysis of, 219-223
Investment funds:
bank credit as source of, 210-216
borrowing through sale of long-term
bonds, 183-185
business expectations, 189-190
demand for, 179-190
financing through sale of stock, 185-
188
internal source of, 181
limited by law, 209
public offering of new securities, 183
retention of earnings, 182
supply of:
bank credit, 210-216
creation of credit by banks, 211-
216
life insurance companies, 209
liquid funds, 211
personal savings, 208
state of liquidity preference on,
208
vary with production, employment
and income, 209
trading on the equity, 188
Investment management, 194
Joint products, 35
Keynes, J. M., 173n
Labor:
costs, 21, 129
demand curve, 138, 140-142, (chart),
140
demand for and wage rates, 136-139,
(chart) 137, 139
employment of, 130
expense, 129, 132
lateral mobility of, 155
lay-off, 21-22
not a single homogeneous factor,
154-155
outlay, 129, 131
unit of, 128
wage rates, 229-230
Labor organization:
collective bargaining, 155-158
trade unionism, 155-158
Labor services:
in absence of organization, 152-154
pricing of, 158-159
Labor supply:
in absence of organization, 152
types and classifications of labor in,
154-155
Labor union contracts; premium rate
for third shift, 32
INDEX
237
Land:
available supply of, 160-161
ownership of, 160-161
rentals of and high prices, 83
supply of, 151
Law of Markets, 219
Licenses, patent, 45
Life insurance companies and supply
of investment funds, 209-210
Liquid funds, 193
created by banks, 211
Liquidity preference in securities, 197-
200, 214
of government bonds, 198
Living standards:
and national income, 120
fluctuations of, 225
Loans:
bank interest on, 212-214
collateral for, 213
security for, 214
M
Machines, demand schedule for, 172,
(see also Durable assets)
Macroeconomics, 102
Man-hours and total output, 133-136
Marginal cost and revenue, 52
Marginal efficiency of capital, 173-174,
178, 227
Marginal physical product, 147
Mark -downs, 41
Market demand for securities, 201-206
Market-determined prices, 37-38
Market forces and price level, 19
Market forms, 15
Market research studies, 11
and product demand, 71
Markets:
monopolistic competition, 15-16
oligopoly, 15-16
pure competition, 14-15
pure monopoly, 15
Market situations, types of, 15
Market-supply curve in pure competi-
tion, 69
Mark-ups, 40-41
Materials, raw, purchase of, 12
Materials, supply of, 159-160
Midyear Economic Report of the Presi-
dent, July, 1949, 180n
Modern Industry (periodical), 48n
Monetary policy, 216
Money costs, 20
Monopolies and prices, 42
Monopolistic competition:
and land, 161
price changes, 72
price structures, 72-79
production policy, 72-79
supply of materials under, 159-160
Monopoly, 16
pine, 15
Mortgage loans, 194, 213
N
National income, 119-124
allocation of (table), 118
National Income Division (U.S. Dept.
of Commerce), 112, 114, 117
National Income Supplement to Survey
of Current Business, 117n, 118n
National Resources Committee, 120n
Net profit from operations, 104
Nomograph, 8-9 (chart), 8
Oligopoly:
and interfirm prices and production,
77-79
definition of, 15
equilibrium in, 78-79
price changes, 72
price competition, 78
supplies of raw materials, 159-160
Opinion polls, 11
Outlay, definition of, 129
Out-of-pocket costs, 22
Output (see Production)
Overhead expense, distribution of 35
Overlay, financial, 167
P
Patents and price selling, 45
Personal loans, 213
Physical product, total, 133-134
Physical product curve, total, 133
Planning horizon in profit, 47
Plant expansion, 58-61, 162, 178
Plant facilities:
depreciation of, 161-162
replacement of, 175
use of, 161-162
Poverty, 231
Present worth of durable assets, 168-
172
Present-worth (tables), 170-171
Price(s):
administered, 40-42
by negotiation, 41
conventional, 40
in-line, 40, 41
loss leader, 41
mark-up, 40-41
price-lining, 41
retail, 40
238
INDEX
Price(s) (con*.):
agreements, 45
and consumer demand, 3, 4-15
and quality, 14
and transportation costs, 44
base, 44
bottom bracket, 41
changes in and consumer demand, 11
competition, 18, 45
competitive, 38-39
cutting, 44
delivered-price basis, 44
demand curve, 5-6
determinants, 22
determination, 46
equilibrium level, 37-38
flexible, 38
formulation of policies, 16, 19, 28,
47-69
break-even chart, 48-57
change in costs, 56-61
change in demand, 53-56
changes in technology, 61-62
effects of advertising, 62-65
marginal cost and marginal reve-
nue, 52-53
monopolistic competition, 72-77
production and supply under pure
competition, 65-69
industry, 41
leadership in setting, 43
levels and trends, 80-88
changes in process, 86-87
cyclical changes in and produc-
tion, 87-88
determinants of, 19
lining, 41
market determined, 37-38
of product and consumer demand,
12
organizational influences in, 42-43
patent licenses and, 45
pools, 45
reduction and responsiveness of de-
mand, 6-7, 10
retail, 40-41
schedules, 75
setting limitations on, 13-14, 17, 18
shading, 44
stabilized, 39
structures:
interindustry, 83-85
under monopolistic competition,
72-79
under pure competition, 79-83
support, 39
under monopolistic competition, 18
under pure competition, 18
war, 43, 78
Production:
and income, 117-118
costs of:
and supply, 19-20
average, 26-28
consumer demand, 13
factor prices, 130
fixed, 21-35
money, 20-21
variable, 21-27
determinant of employment and in-
come, 111-112
expansion of, 28-29, 32-33
formulation of policies, 19-28, 47-69
based on consumer demand, 12
break-even chart, 48-57
change in costs, 56-61
change in demand, 53-56
changes in technology, 61-62
effects of advertising, 62-65
marginal cost and revenue, 52-53
under monopolistic competition,
72-77
under pure competition, 65-69
gross national, 112-114
high, necessity for, 231
level of, raised by government
spending, 228-229
net national, 114-115
schedule, 75, 96
Productive factors, supply of, 149-162
Profit(s):
accounting analysis of operational
results, 103-104
and man-hours, 135
definition of, 94
economic analysis of, 103
expectations of, 93-110
and full employment, 101-102
anticipated versus realized earn-
ings, 93-94
budgeting aspects versus account-
ing, 93
incentives of enterprise, 96-102
key to enterprise, 100-101
long-term versus short-term gains,
97-98
nonpecuniary motives, 97
past record and future prospects,
94-95
time span, 95-96
maximum, 47, 52, 96, 97-98
monopoly, 99-100
prospective, 13
public interest, 101
realized, 102-113
risk-taking, 99
INDEX
239
Profit(s) (cont.):
undistributed and retained earnings,
178
Propensity to consume, 123-124
to save, 123-124
Property rights:
definition of, 167
market valuations of, 200-206
present worth, 195
time discount, 195
Public utilities and joint costs, 36
Public works, 229
Purchases:
habitual, 4
individual, 4
Quantity and demand curve, 5-6
Rate of return over cost, 174, 177-178
Rautenstrauch, Walter, 26, 48n
Raw materials, demand for, 142-143
Real estate, 194
Real investment:
and financial investment, 167
definition of, 166-167
funds for, 191-193
in housing, 229
maintained, 167
methods of financing, 179-180
types of financing, 179-180
Reserves, required, 213-215
Retail prices, 40
mark-up, 40
Risk in enterprise, 98-99
Sales revenue:
and price, 18
change in demand, 50
curve, 7-10, 48-60, 62-64, 73, 135
(chart), 8, 12
overhead expense, 35
schedules, 75
total, 132
volume and price, 18
Savings:
aggregate, 208
amount of, controlled by income tax,
230
analysis of, 219-222
and consumption, 123, 125
and real private investment, 231
forced, 223
individual, 123, 217, 218, 229-230
definition of, 193
outlets for, 226-231
traditional analysis of, 219-225
real, 223
Say, J. B., 219
Securities:
contractual rate of interest, 207
fluctuation in, 204-206
government, 215-216, 227-229
impatience theories, 196
liquidation of investment, 204
ottering price, 207
property rights, 195, 200-206
public offerings of, 183
rates of yield, 207
rewards for waiting, 196
short-term obligations, 198
size of issue, 207
time discount and liquidity prefer-
ence, 197-200
time preference, 196
Selling below cost, 41
Shares of total money income, 120
Shopping, comparison, 40
Sinking funds, 175
Stability in distribution of income, 121
Standard of living, 120, 123, 225
and wage rates, 151-152
Steel industry, 16
and price setting, 44
Stocks:
changes in demand for, 203
definition of, 186
dilution of control, 187
financing through sale of, 185-188
purchase of, 192-193
rate of yield on market price, 203-
204
source of incomes, 194
value of, 186-187
Strikes, 158-159
Substitution:
marginal rate of, 147
process of, 147-148
theory of, 144-148
Supplier, individual and prices, 19
Supply:
and current income, 151-152
controlled by supplier, 149
curve and pure competition, 69
definition of, 17
productive factors, 149-162
responsiveness of labor force, 150-151
schedules, 17
subject to control, 149-150
voluntary control of, 160
Taxes:
corporate, flexible levies, 250
240
INDEX
Taxes (cont.):
income, flexible levies, 230
Tax rate, increase in time of full em-
ployment, 230
Technology, changes in, 61-62
Thrift, excess, 229
Time discount:
liquidity preference, 197-200
value of durable agent, 168-172
Time-jointness, 36
Time preference of invested funds,
196-197
Total expenditures curve, 7-10, 12,
(chart), 8, 12
Total physical product curve, 133
Total sales revenue curve, 7-10, 12-13,
14 (chart), 8, 12
Trade associations and price setting, 44
Trade unionism:
and collective bargaining, 155-158
and individual bargaining, 155
and introduction of new machinery,
157
and strikes, 159
and wage policies, 156
seniority rights, 154, 155
U
Unemployment, chronic, problem of,
223-226
insurance, 151
Unionism (see Trade unionism)
United Mine Workers, 157
United States Department of Com-
merce, 112, 115
United States Steel Corporation, 44
Valuation, problem of, 165-166
Value added in manufacturing, 132
Value product, total, 131, 137-138
Veblen, Thorstein, 101
Villers, Raymond, 48n
W
Wage rates:
and standard of living, 151-152
and trade unionism, 156
and volume of employment, 156
as related to demand for labor, 136-
139
disposable income, 156-157
effect and pricing situation, 131
effect upon cost structure, 131
general level of income, 142
labor supply, 136-139, 153-154
(charts), 137-139
minimum, 155, 158
segregation of effects of variations
in, 131
to increase consumption, 229
World War II, and the Federal Reserve
System, 215
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