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On Competition as Determining Cost

( Originally Published Early 1900's )

IT is a current opinion that prices are necessarily kept down to nearly their lowest limit wherever free competition is permitted. The reason is briefly this : If the dealers in a commodity do not sell it at the lowest paying price, others will step in and offer the same commodity at a lower price, and thus draw away all the custom from those whose charges are too high.

This proposition is sufficiently near the truth in the wholesale trade of the country, and with respect to those necessaries of life which are produced and sold independently by great numbers of persons. In this case business success depends entirely upon the producer and jobber being able to sell at the lowest possible price. It is less true in the retail markets, and may fail entirely in special cases. We shall now analyze the principal cases in which it fails. Take first the general principle as we may conceive it exemplified by an example. A city dealer sells cloth at one dollar per yard which has cost him eighty cents per yard. We may suppose this cost to include all the expenses of business and loss upon waste material, thus making the net profit twenty cents a yard. It occurs to the dealer to inquire whether by lowering his price to ninety-five cents a yard he will get custom enough to make good the diminution in the rate of profit. To effect this result his sales must increase by at least one third, otherwise the diminution of profit on each yard from twenty to fifteen cents would not be compensated. Now if, when he thus lowers his price, he could make everybody know that fact, and could satisfy the public that it was a real diminution in price and not merely the substitution of a poorer article, he would succeed.

But in the majority of cases the cloth will be purchased only occasionally, and in such small quantities that it will not be worth while for the man's customers to make a special investigation in order to learn about the diminution of price. Consequently it may well happen that his sales would not be increased by one third, and lie would then lose by his attempt to sell at a lower price.

The less important the commodity, that is, the smaller the amount of money any one expends for it annually, the less likely it is to be sold at the lowest possible price. It is not worth any one's while to change his grocer because some other grocer sells pepper or mustard ten per cent cheaper. Even in the case of such staples as tea and coffee, it is so difficult to ascertain the quality before trial that the customer finds it a very difficult problem to determine who it is that really sells at the lowest price, taking quality into account.

In such cases, however, there is a tendency analogous to competition which does tend to lower prices by giving an advantage in the long-run to him who sells the cheapest. Sup-pose two persons appear in business, one of whom goes on the principle of exacting the highest price from his customers that he can profitably command, while another sells as low as he can, perhaps from mere conscientious motives. The first may make the largest profits in one year and for several years, but the fact that the second is a more economical dealer to purchase from will gradually become known to a larger and larger section of the community, so that lie may ultimately have the most profitable business. Moreover, the very state of things which makes this access of custom so slow will make it permanent. A large body of customers having become permanently satisfied with his dealings will not take the trouble to investigate whether some one else may not serve them a trifle cheaper, and thus lie may be on the sure road to fortune. The general fact thus illustrated is this : If the question which suggests itself to the retailer's mind is, What are the most profitable prices for me to charge these individual customers for this article ? the answer may be very different from what it will be if he asks himself what price will in the long-run best serve to give him a permanent and enduring trade.

Cases of Prices not determined by Competition. We have in the three preceding chapters laid down and illustrated the law that if the price is above the normal one at which supply and demand are. balanced, the supply will exceed the demand, and there will be in the case of a commodity a continually increasing accumulation which cannot be disposed of. There are, however, large classes of services in which the equilibrium will be brought about in a somewhat different way. A price may be fixed either by law or custom for certain personal services. If this price is below the normal one, a sufficient number of people cannot be found to render the services, and there will be an unsupplied demand. If the fixed price is above the normal one, and if there is no monopoly, the supply will exceed the demand.

Carriage-fares afford one case in point. It is so difficult to satisfactorily fix the price of a drive in a carriage by bargaining between the passenger and the driver, that in nearly all civilized cities a tariff of prices is fixed by the municipal authorities. In cities where this tariff is low, passengers will frequently find it difficult to secure carriages, because it will not pay the owners to keep more carriages than there is constant employment for. 'When it is above the normal price the number of carriages to be had will exceed those which are necessary to carry all the passengers demanding them at the fixed rate. The result will be that a certain proportion of the carriages will stand idle a large part of the time. In this case the competition is not a competition as regards price, but a competition to secure a passenger at a fixed price. It is a fact continually lost sight of that this competition is just as effective in bringing the compensation of each individual driver to the lowest limit as would be a competition in the matter of prices. No permanent gain can accrue to individual drivers by having the tariff raised, unless they can at the same time keep out competition. If free competition is allowed, additional carriages will be bought, more men will go into the business, the profits will be divided among a larger number, and this process will continue until the individual profits of each driver are reduced to the lowest point at which he is willing to remain in the business.

Another case is afforded by the sale of newspapers. As a general rule the price at which any newspaper is sold remains unchanged through all the vicissitudes of supply and demand for long periods of time. The equilibrium is then kept up by publishers accommodating their supply to the demand, in creasing or diminishing it according as there is more or less matter of public interest in the paper sold.

If the prices of all journals were fixed by law, custom, or mutual agreement, the competition would be entirely in respect to quality. That paper would get the largest circulation which most pleased its subscribers. The result would be that more and more labor and expense would be devoted to its production, and by this competition the profits would again be brought to their lowest limit.

Cases where Competition is Difficult. In the preceding cases we have supposed the service to be such that it can be easily rendered, and that great numbers of people can en-gage independently in rendering it. But in recent times a large and important class of services have sprung up, in which the amount of wealth and organizing ability required to render them is so great that a temporary monopoly may be established, though none is legalized. Then this monopoly may be rendered permanent, or at least may be continued through many years, by skilful management. Such a case is seen in the telegraph system of the United States. When a single company possesses the only line between two cities, or over a certain region of country, it can fix its own price for messages. It may find it profitable to keep this price far above the normal rate, rather than to enlarge its facilities, so that a great number of messages can be sent at a low rate. If a competing company is proposed, its promoters may foresee that, at the low prices to which competition would lead, it would be unable to make a profit. It may therefore stay out of the competition long after the business would be sufficient to give it a paying profit, were they secure against a fall in prices. During all this period of doubt and uncertainty the first company has the field to itself. Suppose at last a competing company to build a new line, and to take messages at a low rate ; if this low rate is not as profitable as a higher one would be, the two companies may combine in some way, or the more wealthy may buy out the poorer one, so that the monopoly shall still be kept up. The whole history of telegraph companies in the United States has been of this character. It is supposed that great numbers of small companies have been established for the sole purpose of being bought out by more powerful rivals, in order that the latter might continue their temporary monopoly.

It will be seen that the only cases in which individual pro-fits can be kept permanently above their normal minimum is that in which some monopoly is owned by the producer. This monopoly may be one of individual skill, knowledge of business, or the possession of some natural agent.

Competition among Business Managers. We have seen, in treating of labor, what an almost infinite variety there is in the employments which men engage in for pay. The natural endowments of men by which they are qualified for one or another employment also differ in an important degree. Considered in their effects, these differences in capacities are enormously greater than they appear when considered in them-selves. To illustrate what we mean, consider the difference between the captain of a great steamship and one of the sailors. They differ very slightly in bodily structure, and the sailor has the same general mental qualities as the captain. He speaks the same language, and there are a great many things which he knows how to do better than the captain does. The superiority of the captain consists in this, that he knows how to navigate and direct the ship, while the sailor does not. This is a very small difference in itself. But, small as it is, it makes all the difference between conveying the ship safely to port and losing a million of dollars and a thousand lives by wrecking her.

We have now to show how the law of supply and demand operates in consequence of these great diversities in natural and acquired capacities. The question is, what cause determines the rate of compensation in any particular employment, or the in-come which a man can gain in any business. To avoid wandering through a wilderness of different occupations, let us take as examples the various operations necessary to the production of shirts. We shall then suppose a person to have his choice between becoming a field-hand, a planter engaged in raising cotton, a cotton-broker, an operative, a manager of a cotton-mill, a dealer in cotton cloth, a manufacturer of shirts, or a shirt-dealer.

If these different occupations could be equally well pursued by all men, it is evident that the most agreeable would be preferred. The occupations of planter, manager, and broker are more agreeable than that of the operative, and the latter is more agreeable than that of the field-hand. Hence there would be more competition in the first three occupations than in the two last, and the field-hand would gain the highest income among all engaged in producing shirts. But we know that this is not the case. The reason is obvious. The number of people who are qualified to become brokers, managers, and merchants is very small, while the large majority of men are born capable of being trained for the position of field-hand. Were it not for this great diversity in natural capacities, we should have the singular result that the occupations we now consider the lowest would be best paid.

To fix the ideas, let us suppose the number of people who are required to supply shirts to the population of New York City to be as follows :

1,000 field-hands, 50 planters, 10 cotton-brokers, 2,000 operatives, 5 managers of factories, 100 shirt-dealers.

Suppose, however, that instead of the number of persons qualified to perform these functions in the best manner being in the same proportion, they are in some such proportion as this :

10,000 field-hands, 40 planters, 5 brokers, 10,000 operatives, 3 managers of factories, 1,000 shirt-dealers.

We see that there is a comparative scarcity in the number of persons qualified as planters, brokers, and managers. To understand exactly what this signifies, we must remember that, when we speak of the number being thus limited, we do not mean that only this number could by hook or by crook follow these occupations. What we mean is that the number who can fill them in the most advantageous manner is thus limited, and that, in consequence of this, they can in a certain sense defy competition.

To show what the result of this is, let us compare two cotton-brokers who at first sight may seem to be about equal in ability. But one is not a good judge of cotton, does not know what farmers are most to Be relied on, does not know exactly what kind of cotton will bring the highest price, cannot well judge what the state of the market will be next year, and does not know the cheapest way of getting his cotton to the manufacturer. The other broker knows all these things. The skilful broker then outbids the other with the most honest farmers, buys the best kind of cotton, especially that kind of cotton which in a few months is going to rise in price, has his stock well housed, and gets it to the manufacturer at a cheap route, and by a line of railway which is reliable in its management. The poorer broker outbids his keener neighbor with another class of farmers, buys cotton which is going to fall in price, finds that it is not of the quality which he expected, learns when too late that somebody has cheated him by putting stones inside the bales, has a lot of cotton damaged by getting wet, pays more for transportation to the manufacturer, and finds he has to sell it at a lower price because the market is glutted with that particular kind of cotton. At the end of the year he may find that he has made just $5 as the result of the year's business, while his more skilful neighbor may find that he has made $50,000.

The same principle holds true in the management of the factory. The poor manager buys the wrong kind of cotton at the wrong time, does not know how to mix it properly, gets it wasted, finds his machinery getting out of order, cannot make his operatives work together in the most advantageous manner, and does not know the right time to sell. If there were no other manager who could do better than he, he would still be able to live. But there may be a single competitor who will know how to arrange these matters by avoiding all waste and having all the operations conducted in the most advantageous manner. He will sell his goods at so low a rate as to drive his competitors out of business, and at the same time make a fortune for himself. Whether the breadstuffs and other products which are every year brought from the far West to the Atlantic seaboard shall cost $100,000,000 or only $80,000,000 for transportation depends entirely upon the skill of a few dozen railway managers. The managers who can bring them for $80,000,000 will drive the others out of business and make $20,000,000 profit for their companies.

38. All these cases of special skill in business management are examples of a graduated monopoly of the same kind as that in the ownership of the soil. Let us imagine ourselves able to measure and record the business ability of every man in the country. The result would be of this general nature : that a dozen men might be ranked in the highest class, a score or two in a class a shade below, a hundred in a third class, several hundred in a fourth class, and so on. Since there is more business than can be transacted by the half-dozen highest classes on this scale, it follows that the latter will be able to command or gain by their services an income proportionate to their superiority over the lowest class that can make a living. These incomes will be gained by such wise management that the inevitable waste of material and labor shall be reduced to a mini-mum, and that the product shall be what consumers most want.

The principle involved can be seen in another case. Let us imagine that among a tribe of savages one man has learned to make first-class fire-arms and excellent gunpowder. His fellows see how he does it, and they find that they can also make a kind of gunpowder and of fire-arms. But, through want of knowledge, what they make is so poor in quality that they can seldom get near enough to an animal to shoot it. The skilful man understands the chemistry of the subject so well that with his gunpowder and arms a buffalo can be shot before the animal sees the huntsman. Then the skilful man could, without injuring his fellows, charge for his services the whole advantage which he gave them. He could, perhaps, if the tribe was a thousand strong, charge for is powder and guns one half of all the game killed with them, and the rest of the tribe would find it more advantageous to pay this price than to use the best weapons they could themselves make. Morever, this bargain would not be to their disadvantage, since the skilful man could never command more from them than the value of the advantage he afforded.

AT a first glance the term " cost of production " may seem perfectly definite and precise in meaning. When, in accordance with universal practice, it is measured by money, it signifies the value of the labor and money which the producer must expend in order that an article may be produced. If for each yard of a certain kind of cotton the owner of a factory is obliged to pay out a certain sum of money for labor, materials, repairs, interest, etc., then the cost of production is said to be that sum per yard. When the cotton is sold, the excess of money received after paying all expenses connected with the sale is called profits, and is supposed to be the share received by the owners of the factory as the result of the skill, enter-prise, and capital which they have invested in the work. If we trace out what the factory pays, we find it to be divisible into wages and cost of material. But the materials which are purchased cost labor, and this labor has to receive its wages from the proceeds of the sale. Following the process backward step by step, it was found that everything paid for the manufactured product might be divided into three parts, namely :

I. Rent which was received by the owners of the soil from which the original materials were obtained.

II. Wages paid for labor expended in production.

When the manufacturer sells the product he must get both these items back again with a surplus, else he cannot continue business. The surplus is his share of the money received, and is called his profit. Thus we have a third element in the price of the product, namely

III. Profits, or the share of the gross amounts realized which constitute the gains of the manufacturer or employer of labor.

This was the theory of the leading economists a generation or two ago. But it fails to satisfy the requirements of the present time. It is now seen that rent and payment for any monopolized elements of production should be included in the same class. Hence if we are to consider rent as part of such cost, we should also include everything that the owners of mines, the organizers of labor, and the possessors of material limited in supply can command over and above the ordinary wages of labor. Again, the profits of the manufacturer are really his compensation for the skill and capital which he in-vests in his enterprise. In so far as they are gains made by the use of his organizing powers they are products of his labor, and therefore may be considered as wages when that term is used in its most extended sense (II. 34). That portion which represents profit upon the capital invested should be considered as interest on capital. Thus profits are divisible into the two parts wages, or gains by labor, and interest on capital.

It is unnecessary to develop the subject from this point of view, because without greater precision the classification can serve no useful purpose. To show the difficulties in the way of a rule for estimating cost of production which shall suit every case, let us suppose the possessor of a valuable bed of iron ore who has in his employ a chemist and an engineer, each possessing extraordinary skill in conducting the processes necessary to the smelting and casting of the iron which comes from his bed. Now, the way he would estimate the cost of producing iron is this : " This bed of iron is of great value ; I should have to pay two hundred thousand dollars for it" (perhaps he did pay two hundred thousand to get it). " The annual interest on this money is ten thousand dollars. I have to pay salaries of ten thousand dollars each to two scientific experts ; an equal salary to a business assistant, whose services are of great value. I also have to pay great sums for the use of certain patents in the manufacture of steel. Moreover, my own organizing ability and knowledge of the business are of great vaine. Since they will on the average enable me to gain a large sum per annum, forty thousand dollars or more, I there-fore estimate them at that figure." Adding up all these items, he will obtain the cost of production per ton of the various kinds of iron which he turns out.

A little consideration will show us that this cost of production will, in practice and in the long-run, mean very nearly the same thing. as the price he can get for his iron. For if, during along series of years, he can command a price very much above the ordinary cost of production, it must be because he possesses a monopoly of some kind, either in the quality of his ore, the skill of his assistants, or his own knowledge and organizing abilities. Whatever this monopoly consists in, it will be valuable in proportion to the gains it enables him to secure, and its use will therefore be charged to cost of production. Nor can we stop him from doing this. He may sell out to another man all his monopolies except his own knowledge and skill, and may sell him the product of that knowledge and skill in so far as they are embodied in the organization of the work, for a sum proportioned to the gains of the establishment. Then, since the buyer has had to pay so great a sum of money, it is quite reasonable that he shall include all these items for which he has had to pay in the cost of production.

There is, however, another sense in which we should make an entirely different estimate. It might be claimed that it cost a man nothing to use his own faculties or to manage his own capital. If his machinery would wear out as fast in standing idle as when running, we might say that it cost him nothing to run his machinery. So it costs the land-holder nothing to rent his land. The iron ore still under ground, though it may have been sold for millions of dollars, has never cost anybody anything except the trouble of finding it. The original discoverer got a grant of it from the government; he sold his rights to some one else; the buyer sold them again, and thus they passed from hand to hand, increasing in value as the richness of the ore became known. But this increase of value cost nobody anything more than the labor of learning the value of the ore.

We may thus form a new conception of cost of production by not counting as such cost anything except the labor which lias been actually devoted by men to the production, and valuing this labor by the same standard that we value other kinds of labor. In making this new estimate we leave out of consideration everything that is paid for monopolies of any kind. We therefore take from the cost the rent of land, the money paid for the. bounties of nature, the high salaries of skilled employees, and the gains which the owners make by their special skill. To distinguish this diminished cost of production from the one already described, we shall call it net cost.

It is now necessary to have some criterion for determining what we shall consider the net cost. Such a criterion is afforded by economic science, and may be arrived at as follows: Let us suppose the price of a commodity to gradually and continually fall from month to month and from year to year, with no hope of its ever again rising. A first approximation to the net cost of production to any individual producer, whether a person or a company, would then be the price at which the producer would abandon business entirely.

A little reflection will show that this is a legitimate definition from the second point of view just outlined. For no per-son or company can or will go on producing indefinitely at a loss. He may do so temporarily, hoping for prices to be higher in the future. But if they are never to be any higher, which is the case we have supposed, then the producer will immediately stop when he ceases to gain.

It is evident that this stopping-point may be far below what is estimated as cost of production by the first method. In the first place, the millions of dollars which the unfortunate owner paid for the mine do not count at all. His mine is worth to him just what he can make out of it ; and it makes no difference, so far as his interests at the present time are concerned, whether he got it for nothing or paid a million dollars for it. If he can make any money out of it he will, and if he cannot he will give it up. In the next place, as he finds his profits diminishing, he will have to inform his skilled assistants and manager that they must either submit to a reduction of their wages or allow the establisment to go out of business. The result will be the reduction of all wages to the lowest point which will suffice to retain the services of the different grades of employés. If these employés are able to use their special skill in other pursuits with equal advantage, they will soon seek for such pursuits. But it is one of the marks of monopolized skill that it cannot generally be employed advantageously in many directions. The skilled employés of all grades would therefore have to submit to a greater or less reduction. Finally, if the owner or company themselves cannot advantageously change their capital, which, as a matter of fact, they may find to be the case, they will have to be satisfied as long as they are making a fair living.

Let the reader not forget the object of this criterion for determining net cost of production. We are not showing that under any probable or conceivable circumstances would the possessors of skill and capital be thus reduced to what would seem to them penury. We are supposing an ideal state of things: one in which the possessors of monopolies would be unable to command more than if they did not possess them. We are trying to divide what is commonly called cost of production into two parts : the value of special monopolies, and what is really paid for non-monopolized labor and services. We eliminate the monopolized elements by supposing the price to diminish until those elements cease to be of special value to their owner, at least in the particular direction in which they are used. Then we have the net cost of production as it would be were the most skilful business managers and other possessors of monopolized elements brought down to the general level of their fellowmen of the same class.

The elements which enter into net cost of production as thus defined are :

I. Wages, measured on the lowest scale for which any of the persons concerned would be willing to continue work.

II. Interest on capital invested in the work.

III. Taxes, insurance, and other miscellaneous items incidental to production.

Whatever the producer receives for his products above the net cost of production thus defined may properly be considered as his profit. It includes the gains of himself and his immediate employés arising from their special skill, the interest on whatever money he may have sunk in the enterprise and be unable to command again, by sale or otherwise, as well as the gains from monopolies of every kind. No one knows, and no one can estimate with precision, what the profits are in any special case. We know by experience that there are certain products the prices of which are subject to great fluctuations from year to year. We also know that there are certain establishments which continue in operation through a period of years at the lowest price, without any positive hope that prices will be higher in the immediate future. If prices do finally rise, it cannot be supposed that the net cost of production rises in anything like the same proportion. We may therefore fairly suppose that when prices are high the producers are gaining a profit not necessarily equal to the whole increase of price, but certainly equal to an important fraction of it.

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