This section is from the "Economics In Two Volumes: Volume I. Economic Principles" book, by Frank A. Fetter. Also available from Amazon: Economic
§ 6. Meanings of cost. The profit in enterprise results from the surplus of sales (receipts) over costs (expenses). Few words are more often heard in business than cost, or with more varied shades of meaning.
In a general sense cost always means something given up, parted with, paid, to get something else. Often this outlay takes the form of pain, fatigue, or irksomeness of labor, tho this is a psychic cost, better termed sacrifice. Thus it is said: he got it at the cost of tireless effort; it cost him his health. When the worker who is free to determine the length of his working day stops work, he reveals that his valuation of his labor just at that point is greater than the valuation of the product that will come from further labor - the one negative and the other positive in the balance. Psychic cost thus rises to the level of more or less conscious estimation at certain points and, like psychic income, has its part in many ways in the choices made by individuals. It is not, however, the objective measure of cost in the transactions of trade.
In another sense cost is applied to any objective good or any gratification which could have been chosen, but which was given up when another choice was made. This is alternative cost, called by some, opportunity cost. It is an option relinquished. One may stay at home and read a book or go on a picnic; the pleasure of reading a book will cost the pleasure of the picnic. A good dress may cost a vacation that must be given up for it. In this sense, each thing is a cost of every other thing that might be chosen in the place of it, tho the alternative cost thought of is usually the most important excluded option. Alternative cost, like psychic cost, is individual, and is significant at the moment of choice but is not the measure in which business outlay is expressed.
The sense in which cost is mostly used in business in the common phrase "cost of production" is money cost. It expresses not the pain of the laborer in doing the work, not the sacrifice of the owner of the capital in saving the money, but merely the sum of money paid out by the producer. Costs, proceeds, and profits are all in business practice reckoned in terms of money. The enterpriser invests in order to realize profits. Enterprise is investment, the putting of capital into concrete forms of wealth; and it is in turn the sale of wealth, a process which might be called divestment. The realization of profit means getting out a total sum of capital greater than was put into the business. Capital is thrown into the melting pot, and is taken out crystallized into new forms of wealth which may or may not bear a greater price than the costs. The price of the products depends on the valuations of possible purchasers. The customers may be foolish men with unwholesome desires, and profit-making may result from pandering to their vices; but in any case the enterpriser finds himself limited by this condition: to gain a profit he must produce a surplus of value (as judged by his customers) between costs and selling price.4
§ 7. Superficial view of costs and prices. It is well after this discussion of costs to consider their relation (as a more fundamental problem of theory) to prices and values. The business man, as such, is rarely interested in this question. He knows that many influences unite to determine the cost of the factors he buys, but they are distant; he cannot influence them, and in the single stage of his production his costs seem to fix the price of his products. In some purchases, however, and on the stock exchange, a remarkable power of noting and analyzing the more distant influences is displayed. But in general a superficial view of value is taken in business; it does not pay to do otherwise. The active investor simply takes the price of various factors as he finds them, and seeks to combine them and to sell them when and where he can reap a profit. Yet if he is asked, "What determines the prices of goods? he probably replies, "They are fixed by cost-of-production."5 This is the way it appears from the enterpriser's point of view as he is deciding whether to extend or contract his production and sales, whether to raise or lower his prices.
§ 8. Costs adjusted to prices of products. But costs vary from one establishment to another. No matter what any particular enterpriser's costs may be, the price of the goods is determined by the bidding of buyers and sellers in the market. If any one is so situated that he can regularly get more than cost on any unit, he attributes the gain to whatever agent gives the advantage, - to his patents, his land, his own ability, - and thereafter he adds more to costs on that account. In this case we see plainly that the value (or price) of the factors (that is, the cost) is being marked up (or down) according to the price of the products, and not vice versa.
4 Compare note on value vs. utility of labor in ch. 19.
5 Economists long took that proposition as sound, and tried to build upon it a scientific explanation of prices and values as they are. It always has been recognized that there are difficulties in such an explanation. We shall not enter into the controversy, but briefly indicate the point of view we now take.
The rule must be reversed also in the case of many large classes of goods. Some things that can not be multiplied or reproduced, such as autographs, old violins, old paintings, diamonds, bring prices that are not dependent on the cost of production. The same is true of great numbers of natural resources, including all lands taken in a state of nature, whether agricultural, mineral, residential, or commercial. That leaves still to be explained the relation of costs to the prices of the great class of goods which are grown by the art of man, e.g., grain, cotton, cattle, etc., and manufactured, e.g., tools, machines, cloth, etc. Now it is noticeable that every one of these objects has a cost just because it happens to be looked at just when it is in the enterpriser's hands at an intermediate stage of its production. The cost rule applies only to factors that have been bought at a price, and the total cost is simply the sum of the prices of the factors. But how did the factors, the various qualities of labor, the materials, use of agents, etc., get their price? That question has been answered in earlier chapters: from the value of the expected product, or uses. The business enterpriser is a middleman, buying to sell again, and his costs determine whether or not he can make a profit, but they do not determine the prices of the products. Rather they are seen to be determined by the prices, when a broad enough view of the situation is taken.
§ 9. A single factor of a single product. The tracing of the value of goods through intermediate products to direct enjoyable goods, and finally to the source of value in psychic income, gives the genealogy of value. After the goods enter into the channels of commerce and are once bought and sold, they bear a cost to the owner. In the one direction we seek the "ultimate agent," or factor, the natural agents and laborers; in the other direction we seek "the ultimate products" or ultimate uses. A single product having a single factor shows most clearly the reflection of value directly from the product. (See Figure 43.) The discovery of a mineral spring or of a good quality of building-stone on worthless land, will cause a value to attach at once to the agent. "When a great singer like Ade-lina Patti commands several thousand dollars for each appearance in concert, the value of the music in the minds of delighted hearers is transmitted to the salary of the singer. Her salary is not determined by cost, but it becomes a cost to the enterpriser who employs her and undertakes a concert tour.