This section is from the "Elementary Principles of Economics" book, by Richard T. Ely and George Ray Wicker. Also available from Amazon: Elementary Principles Of Economics: Together With A Short Sketch Of Economic History
The value of this third class of goods is due to precisely the same cause that lies back of the value of all goods, namely, utility under a condition of scarcity. But it is commonly said that with these freely reproducible goods, cost of production determines value. It is true that the price of these goods is not far from their expenses of production. It is easy to see why: If any article is selling for $5 when the expense of producing it is only $1, many persons will turn to the manufacture of this article, the supply is increased, and the price falls to something like $1. But what determines the expenses of production ? Why cannot a baker, for example, sell bread for much less than five cents a loaf ? To say that he must pay a certain price for flour among other things, is merely to put the difficulty one step farther off. Why will all those who immediately or remotely help to make the flour not work for less ? There are two possible answers: They might in some cases prefer to be idle rather than work for less, or they might feel that they were sacrificing the opportunity of making something else for which there are equally urgent wants. Here we have the fundamental sense in which cost of production limits the supply of an article: It is either because of the pain of further work or abstinence, or because by making one article there is sacrificed the opportunity of making another. The supply of snow-shovellers is limited partly because some boys prefer to coast rather than to work, and partly because other boys who are willing to work find that there is opportunity of earning more by ministering to the wants of other people than those who have snow to shovel.
Back of the expenses for labor, raw material, etc., which the business man has in mind when he speaks of cost of production, lie these real sacrifices of production. The exact connection between the two is not always easy to trace, and in studying many problems in business it is sufficient to pay attention only to the expenses of production. In the remainder of this chapter we shall use the term " cost of production " in this sense.
In discussing the conditions governing the supply of freely reproducible commodities, many writers distinguish three classes, as follows: (a) those that can be increased in quantity without proportionate increase in cost; (6) those that can be increased at a proportionate cost; and (c) those that can be increased in quantity only by a more than proportionate increase of cost. The difference may be briefly expressed by saying that production in the first case conforms to the law of increasing returns or diminishing costs; in the second case, to the law of proportionate returns; in the third case, to the law of diminishing returns or increasing costs.
It is to be questioned whether there is any industry in which the law of increasing returns operates indefinitely or until the whole market is supplied. It may be true of transportation or other natural monopolies, although it is doubtful. But there is a competitive field in which it clearly does not operate without limit. In agriculture, manufactures, and commerce there is at first an increasing return, possibly for a time a constant return, and then a diminishing return as the establishment grows in size. Sooner or later the point of maximum efficiency is reached, and then the law of increasing costs begins to operate. It is clear that in agriculture that limit is reached rather quickly, while a textile factory can reach a large size before the point of maximum efficiency is reached. If it were not for this limited operation of the law of increasing returns, we should have present the conditions for a growth of monopoly over the entire industrial field, inasmuch as the largest producers could undersell all others.
Marginal Costs Explained. In the industrial world, as it is constituted, the actual costs of production are not the same for all units of supply, no matter whether the supply be large or small. Thus, in the case of agriculture, some farmers have more fertile or better situated farms than others. In manufactures, the same difference obtains though in a much slighter degree. Some entrepreneurs are better organizers than others; some have better situations with reference to the raw materials or to the market, etc. The costs being thus different, what are the costs which determine value on the side of supply? It cannot be the least cost or the average cost, for in either case a large part of the product would be sold for less than its cost. It follows that the determining costs are the greatest, or as we may call them, the marginal costs of producing that supply which will be in equilibrium with the existing demand.
The " Frictional Elements " Considered. In order that there might be perfect competition, it would be necessary that every producer should always know and seek his own economic interest; that he should be able to throw his labor, his capital, and his land from one occupation to another or to no occupation at all at a moment's notice, and without that loss which the vis inertia of business actually occasions in such cases. From the fact that these conditions are only imperfectly realized, it results that the prices of commodities day by day, or, as they are called, the market prices, fluctuate according to the importance of the frictional elements present, as well as with changes in the state of demand and changes in the costs of production.
But the market price of competitive goods is kept from violent fluctuations by the fact that competition is also present, and that so far as the competition is free and complete it is working to produce harmony between demand and supply, between marginal utility and marginal cost, between producer and consumer.