Chapter II

, and it was a striking feature of the diagrams which we employed to illustrate the argument. We shall do well to cultivate a lively sense of this symmetry, for it will frequently save us from ignoring factors which have a vital bearing on the problems we are considering. We should never leave an important feature of demand without turning to see whether it has a counterpart on the supply side, though indeed we may not always find one. In the last chapter we examined the relation between utility and price, and found that the true relation was between the price and what we termed the marginal utility. Corresponding to utility on the demand side is cost of production on the supply side. The question should thus at once suggest itself--"Can we speak appropriately of the marginal cost of production, and will this serve to make clear the relation between cost and price?" To answer these questions, let us take one of the instances in which we found that price could not be explained satisfactorily by the bare phrase "cost of production."

An important feature of the coal industry, which recent events have brought into sharp prominence, is the great diversity of conditions between different coalfields and different collieries. We speak of rich seams and poor seams, of fertile and unfertile mines, and we are aware that the costs of raising coal to the surface differ very widely in accordance with these diverse natural conditions. Nor must we confine our attention to the cost price at the pit-head. If we wish to speak of cost of production as a factor determining price, we must use the term in a broad sense to include the transport and other charges necessary to bring the coal to market.

In this respect also one coalfield differs greatly from another. Some are well situated close to a large market, or within easy reach of the seaboard; others must incur very heavy transport charges to bring their coal to any considerable centre of consumption. These varying conditions lead, as we well know, to great variations in the financial prosperity of different colliery concerns. In Great Britain, under the abnormal conditions which prevailed during the war, and subsequently, these variations were so huge as to constitute a most formidable embarrassment and to contribute, more perhaps than any other single factor, to the unrest and instability by which the industry has been afflicted. But they are always with us, if usually upon a more modest scale.

What, then, is the normal relation between price and cost in the case of coal? Should we direct our attention to the average costs over the whole industry, or the costs incurred by the richer and better situated mines, or, lastly, that of the poorer and worse situated? Now, as things are, it is clear enough that no concern will continue indefinitely producing at a loss. It may do so for a time, rather than close down altogether, hoping to recoup itself later when the market has taken a more favorable turn. But, in the long run, taking good years with bad, it must expect to obtain receipts sufficient not only to cover its necessary expenditure, but to provide also a reasonable profit on the capital employed. Of course, once the capital has been sunk and embodied in plant and buildings, which are of little use for any other purpose, a business may continue for many years, with a rate of profit far below what it had anticipated. But plant and buildings gradually wear out, and need to be replaced; the course of technical improvement calls continually for fresh capital outlay, which a business in a bad way is reluctant to undertake. The tendency, therefore, when profits rule low over a considerable period, is for the plant to fall gradually into disrepair and obsolescence, and finally for the business to disappear. We can thus include an ordinary rate of profit under the head of cost of production, and say with substantial accuracy that for no business can this cost for long exceed the price if the business is to continue to exist. If then the relatively poor and badly situated mines are to be worked, the price of coal, taking good years together with bad, must cover the costs at which these mines can produce. If the price rules lower than this, sooner or later they will close down, and we will be left with a smaller number of mines, among which great variations of conditions will still prevail. Once more, the price must cover the cost incurred by the least profitable of these remaining mines, unless their number is still further to be diminished. Thus we can conceive of a "margin of production" which will shift backwards to more profitable or forwards to include less profitable mines, according as the demand for coal contracts or expands. But, wherever this margin may be, there is no escaping the conclusion that it is the cost of production of the "marginal mines," of those that is to say which it is only just worth while to work, to which the price of coal will approximate.

It follows that there is no real connection between price and cost of production throughout the industry as a whole. It follows incidentally that those concerns which can market their coal at an appreciably lower cost than the marginal concerns, are likely to reap more than an ordinary rate of profit, though royalties may absorb part of the excess.

§2. _The Various Aspects of Marginal Cost_. This relation cuts much deeper than the particular system under which the mines are at present owned and worked. If, for instance, we supposed that the various mines were amalgamated together in a few giant concerns, each of which comprised some of the richer and some of the poorer mines, the preceding argument would need to be recast in form, but its substance would be unaffected. For though a great coal trust could in a sense _afford_ to sell at a price lower than the marginal cost, setting its losses on the poorer against its gains on the better pits, is it likely it would do so? Why should it dissipate its profits in this way? It is clearly more reasonable to suppose that it would close down the poorer pits (unless it could advance the price of coal), and thereby maintain its profits at a higher figure. If, indeed, the mines were nationalized the deliberate policy might be pursued of selling coal at a price which left the industry no more than self-supporting as a whole. Some coal might thus be sold at less than its cost price, and the selling price would conform roughly to the _average_ cost. But such a policy, though in special circumstances it might be justified, would represent a very dangerous principle, which could not be applied widely without the most serious results. Nothing could be more fatal to any enterprise, whether it be in the hands of an individual, a joint-stock company, a State department, or a Guild, than that the management should content themselves with results which in the lump seem satisfactory, and regard losses here or there with an indifferent eye. That way lies stagnation, waste, progressive inefficiency and ultimate disaster. To inquire searchingly into every nook and cranny of the business, to construct, as it were, for each part a separate balance-sheet of profit and loss, to expand in those directions where further development promises good results, and to curtail activity where loss is already evident, is the very essence of good management. Here, it will be observed, we are using language very similar to that in which we described the principles which govern a business man's expenditure. The resemblance is inevitable and significant, for we are dealing here with what is essentially another aspect of the same thing. The object is to secure that nowhere does expenditure fail to yield a commensurate return. This we express, when we consider a business in its aspect as a consumer, by saying that its consumption of anything will not be carried beyond the point at which the marginal utility exceeds the price it will have to pay. When we consider it as a producer, we say that its production of anything will not be carried beyond the point at which the marginal cost exceeds the price it will obtain.

§3. _The Dangers of Ignoring the Margin_. This at least is the general rule. A business may decide deliberately to sell part of its output below cost, because, for instance, this will serve as an advertisement, bring it connections, and enable it to obtain a larger profit at a later date, or immediately on other portions of its sales. In so acting, it recognizes that the price obtained for a thing may be an inadequate measure of the real return it yields. In the same way, though for different reasons, a nationalized coal industry might conceivably be justified in selling some coal below cost price, because, let us say, it held that the price which the immediate purchasers were willing to pay was an inadequate measure of the utility of coal to the community as a whole. But in all such cases it is essential to be very clear as to what exactly you are doing; so that you may be at least moderately clear as to whether the policy is well advised. It may be sound enough to lose on the swings and make good this loss on the roundabouts, but only if your loss on the swings _helps_ you to a larger profit on the roundabouts. If you would get the same return on the roundabouts in any case, it would be better to cut the swings out altogether. So, if you are directing the policy of a nationalized coal industry, and decide to make a loss on a portion of your sales, you will need to know that the indirect benefit which the community will derive from this particular part of your coal output is worth the loss which you incur. You will certainly come to grief, if you pursue a vague ideal of lumping all results together, and regarding a profit somewhere as a sufficient excuse or a positive reason for making a loss elsewhere.

It is quite true that in big undertakings, where there are large standing charges, and where the organization possesses some of the characteristics of an integral whole, it is not easy to measure accurately the specific costs which should be assigned to any

## particular portion of the output. But this difficulty is one of the

most serious weaknesses of large undertakings; precise detailed measurement is the great prophylactic of business efficiency, and, where it is lacking the bacilli of waste will enter in and multiply. So clearly is this recognized, that the development of large scale business has led to the evolution of new methods of accountancy, designed to make detailed mensuration possible. We have most of us heard of them vaguely under such names as "comparative costings," but too few of us appreciate their full significance. It is hardly too much to say that the issue as to whether the size of the typical business unit will continue to become larger and larger, or whether it has already overshot the point of maximum efficiency will turn largely upon the capacity of accountancy to supply large and complex undertakings with more accurate instruments of detailed financial measurement.

§4. _A Misinterpretation_. The price, then, of a commodity tends roughly to equal its marginal cost of production; and this marginal cost (in perfect symmetry with what we observed as regards marginal utility), may be conceived as applying either to the marginal producer or to the marginal output of any producer. In the former aspect it is open to a misinterpretation, against which it will be well to guard. Some advocates of socialism have argued, as one of the counts in their indictment of the present industrial system, that the price of a commodity is determined by the cost at which the least efficient concern in the industry can produce. They say, in effect, "Under the present competitive regime, you have to pay for everything you buy a price which far exceeds the necessary cost to a concern which is managed with ordinary ability. For, as economic theory has shown, it is the cost of the _marginal_ concern, i.e. the concern managed by the most incompetent, and half-witted fellow in the trade; it is the cost incurred by him, together with a profit on his capital, that the price has got to cover. The producer of no more than average capacity is therefore making out of you a surplus profit, which would be quite unnecessary in any well-arranged society." Such an argument is a gross caricature of the marginal conception. The half-witted incompetent will, as we know well enough, speedily disappear under the stress of competition, and his place will be taken by more efficient men. There is an essential difference between him and the "marginal coal mine" of which we spoke above. For the probabilities are that of the coal resources, whose existence is clearly known, the more fertile and better situated parts will already be in process of exploitation; and there is not likely, therefore, to be a supply of substantially better seams which can be substituted for the worst of those in actual use. There _is_ likely, on the other hand, to be available a supply of decent business capacity which can be substituted for the most inefficient of existing business men. The marginal concern, in other words, must be conceived as that working under the least advantageous conditions in respect of the assistance it derives from the strictly limited resources of nature, but under average conditions as regards managerial capacity and human qualities in general. Thus in agriculture we can speak of a marginal farm, which we should conceive as the least fertile and worst situated farm which it is just worth while to cultivate (of which more will be said when we come to the phenomenon of rent), but we must assume it to be cultivated by a farmer of average ability.

§5. _Some Consequences of a Higher Price Level_. The foregoing controversy will be of service to us, if it makes clear the manner and the spirit in which the marginal conception should be handled. It should be regarded not as a rigid formula which we can apply to diverse problems without considering the special features they present, but rather as a signpost which will enable us to find our way, a compass by which we may steer between the shoals of triviality and sophistry to the crux of any problem with which we have to deal. Let us illustrate its practical uses by an example which is of great interest and far-reaching practical importance at the present day. As has been already observed, the war has left behind it in all countries a great and almost certainly permanent increase in nominal purchasing power. Since the armistice prices have moved upwards and downwards with unprecedented violence; and it would be very rash to prophesy the precise level at which they will ultimately settle (using that word with considerable relativity). But, for reasons for which the reader is referred to Volume II in this series, it is safe enough to say that the general level of post-war will greatly exceed that of pre-war prices. Now this will apply not only to consumers' goods like milk and clothes, or to raw materials like pig-iron and cotton, but in very much the same degree to things like factories and machinery. Things of this last type are sometimes called "capital goods," because it is in them that a large part of the capital of a business is embodied. Now the fact that it will cost much more than it did before the war to construct fresh capital goods, has a significance which very few people appreciate. An existing factory cost, let us say, $500,000 to build and equip with machinery before the war. To construct a similar factory to-day would cost, let us assume (it is probably a moderate assumption) $1,000,000. Suppose 10 per cent to be the gross profit that is necessary to attract capital to the particular industry. Then it will not pay to construct this new factory unless the trade prospects point to the probability of a profit of about $100,000 per annum. But if the old factory is equally well managed, it too should be able to earn this $100,000, which upon the capital actually sunk would represent a rate of 20 per cent. The particular figures given are, of course, purely illustrative; the conclusion to which they point is that, if new enterprises are to be undertaken, pre-war enterprises are likely to yield a rate of profit, on their fixed capital at least, increased in rough proportion to the price-level. Of course, in years when trade is bad, the factory which dates from pre-war times will not earn a profit of this kind, it may very likely make an actual loss. At those times it is very certain that few new factories will be erected. But it is difficult to reconcile a condition of trade activity, in which the constructional industries are busily employed, with a rate of profit to pre-war businesses on the fixed part of their capital of a lesser order of magnitude than has been indicated. It makes no difference, it should be observed, whether we suppose the new enterprises to take the form of starting of new concerns or extending old ones; in neither case will they be undertaken, unless there is reason to expect an adequate return on the capital which they require at post-war constructional prices. High profits (taking always good years together with bad) on capital sunk before the war in buildings and machinery are thus a likely consequence of an increase in the price-level.

This fact is, indeed, the counterpart or complement of another phenomenon with which we are more familiar. While prices are actually rising, profits, as we have come to recognize, necessarily rule high, because every trader or manufacturer is constantly in the position of selling at a higher price-level, stock which he purchased, or goods made from materials which he purchased at a lower level. He thus acquires an abnormal profit on his circulating capital, which is essentially similar to the profit on fixed capital, which we have just examined. The difference is that the former profit is crowded into the years when prices are actually on the increase, and thus is very noticeable indeed; while the latter profit continues to accrue in smaller instalments after prices have settled down, as it were, at the higher level, and is not exhausted until the buildings and machinery have become obsolete. But the two profits are essentially similar, and in the long run should be commensurate. In the one case, stock can be sold for a large profit, because it cannot be replaced except at a higher price; in the other case, plant and buildings yield a higher income because _they_ cannot be replaced except at a higher price. Indeed, if the owners choose, the plant and building can, like the stock, be sold at their appreciated value, as has been widely done by the owners of cotton mills in Great Britain since the armistice.

There is nothing in these considerations that should surprise us, or even shock our moral sense. For what they have indicated is an increase of money profits in rough proportion to the price-level, so that the aggregate profits will represent about as much real income as before.[1] The conclusion therefore amounts to no more than this, that you cannot alter fundamentally the distribution of wealth between labor and capital by merely inflating the currency, or otherwise juggling with the price-level. And this is only what we should expect, if there are any laws of distribution of sufficient importance and permanence to justify the many volumes which have been devoted to them.

[Footnote 1: Assuming that the rate of interest has remained unaltered. In fact it has greatly increased since pre-war days, and this points to a still further increase of money profits, and an increase in the real income which they represent. See