Principles of Economics by Alfred Marshall (1890)
1. The first difficulty to be cleared up in our study of normal values, is the nature of the motives which govern the investment of resources for a distant return. It will be well to begin by watching the action of a person who neither buys what he wants nor sells what he makes, but works on his own behalf; and who therefore balances the, efforts and sacrifices which he makes on the one hand against the pleasures which he expects to derive from their fruit on the other, without the intervention of any money payments at all.
Let us then take the case of a man who builds a house for himself on land, and of materials, which nature supplies gratis; and who makes his implements as he goes, the labour of making them being counted as part of the labour of building the house. He would have to estimate the efforts required for building on any proposed plan; and to allow almost instinctively an amount increasing in geometrical proportion (a sort of compound interest) for the period that would elapse between each effort and the time when the house would be ready for his use. The utility of the house to him when finished would have to compensate him not only for the efforts, but for the waitings. (1)
If the two motives, one deterring, the other impelling, seemed equally balanced, he would be on the margin of doubt. Probably the gain would much more than outweigh the "real" cost with regard to some part of the house. But as he turned over more and more ambitious plans, he would at last find the advantages of any further extension balanced by the efforts and waitings required for making it; and that extension of the building would be on the outer limit, or margin of profitableness of the investment of his capital.
There would probably be several ways of building parts of the house; some parts for instance might almost equally well be built of wood or of rough stones: the investment of capital on each plan for each part of the accommodation would be compared with the advantages offered thereby, and each would be pushed forward till the outer limit or margin of profitableness had been reached. Thus there would be a great many margins of profitableness: one corresponding to each kind of plan on which each kind of accommodation might be provided.
2. This illustration may serve to keep before us the way in which the efforts and sacrifices which are the real cost of production of a thing, underlie the expenses which are its money cost. But, as has just been remarked, the modern business man commonly takes the payments which he has to make, whether for wages or raw material, as he finds them; without staying to inquire how far they are an accurate measure of the efforts and sacrifices to which they correspond. His expenditure is generally made piece-meal; and the longer he expects to wait for the fruit of any outlay, the richer must that fruit be in order to compensate him. The anticipated fruit may not be certain; and in that case he will have to allow for the risk of failure. After making that allowance, the fruit of the outlay must be expected to exceed the outlay itself by an amount which, independently of his own remuneration, increases at compound interest in proportion to the time of waiting. (2) Under this head are to be entered the heavy expenses, direct and indirect, which every business must incur in building up its connection.
For brevity we may speak of any element of outlay (allowance being made for the remuneration of the undertaker himself) when increased by compound interest in this way, as accumulated; just as we used the term discounted to represent the present value of a future gratification. Each element of outlay has then to be accumulated for the time which will elapse between its being incurred and its bearing fruit; and the aggregate of these accumulated elements is the total outlay involved in the enterprise. The balance between efforts and the satisfactions resulting from them may be made up to any day that is found convenient. But whatever day is chosen, one simple rule must be followed: — Every element whether an effort or a satisfaction, which dates from a time anterior to that day, must have compound interest for the interval accumulated upon it: and every element, which dates from a time posterior to that day, must have compound interest for the interval discounted from it. If the day be anterior to the beginning of the enterprise, then every element must be discounted. But if, as is usual in such cases, the day be that when the efforts are finished, and the house is ready for use; then the efforts must carry compound interest up to that day, and the satisfactions must all be discounted back to that day.
Waiting is an element of cost as truly as effort is, and it is entered in the cost when accumulated: it is therefore of course not counted separately. Similarly, on the converse side, whatever money or command over satisfaction "comes in" at any time is part of the income of that time: if the time is before the day for which accounts are balanced up, then it must be accumulated up to that day; if after it must be discounted back. If, instead of being converted to immediate enjoyment, it is used as a stored up source of future income, that later income must not be counted as an additional return to the investment. (3)
If the enterprise were, say, to dig out a dock-basin on a contract, the payment for which would be made without fail when the work was finished; and if the plant used in the work might be taken to be worn out in the process, and valueless at the end of it; then the enterprise would be just remunerative if this aggregate of outlays, accumulated up to the period of payment, were just equal to that payment.
But, as a rule, the proceeds of the sales come in gradually. and we must suppose a balance-sheet struck, looking both backwards and forwards. Looking backwards we should sum up the net outlays, and add in accumulated compound interest on each element of outlay. Looking forwards we should sum up all net incomings, and from the value of each subtract compound interest for the period during which it would be deferred. The aggregate of the net incomings so discounted would be balanced against the aggregate of the accumulated outlays: and if the two were just equal, the business would be just remunerative. In calculating the outgoings the head of the business must reckon in the value of his own work. (4)
3. At the beginning of his undertaking, and at every successive stage, the alert business man strives so to modify his arrangements as to obtain better results with a given expenditure, or equal results with a less expenditure. In other words, he ceaselessly applies the principle of substitution, with the purpose of increasing his profits; and, in so doing, he seldom fails to increase the total efficiency of work, the total power over nature which man derives from organization and knowledge.
Every locality has incidents of its own which affect in various ways the methods of arrangement of every class of business that is carried on in it: and even in the same place and the same trade no two persons pursuing the same aims will adopt exactly the same routes. The tendency to variation is a chief cause of progress; and the abler are the undertakers in any trade the greater will this tendency be. In some trades, as for instance cotton-spinning, the possible variations are confined within narrow limits; no one can hold his own at all who does not use machinery, and very nearly the latest machinery, for every part of the work. But in others, as for instance in some branches of the wood and metal trades, in farming, and in shopkeeping, there can be great variations. For instance, of two manufacturers in the same trade, one will perhaps have a larger wages bill and the other heavier charges on account of machinery; of two retail dealers one will have a larger capital locked up in stock and the other will spend more on advertisements and other means of building up the immaterial capital of a profitable trade connection. And in minor details the variations are numberless.
Each man's actions are influenced by his special opportunities and resources, as well as by his temperament and his associations: but each, taking account of his own means, will push the investment of capital in his business in each several direction until what appears in his judgment to be the outer limit, or margin, of profitableness is reached; that is, until there seems to him no good reason for thinking that the gains resulting from any further investment in that particular direction would compensate him for his outlay. The margin of profitableness, even in regard to one and the same branch or sub-branch of industry, is not to be regarded as a mere point on any one fixed line of possible investment; but as a boundary line of irregular shape cutting one after another every possible line of investment.
4. This principle of substitution is closely connected with, and is indeed partly based on, that tendency to a diminishing rate of return from any excessive application of resources or of energies in any given direction, which is in accordance with general experience. It is thus linked up with the broad tendency of a diminishing return to increased applications of capital and labour to land in old countries which plays a prominent part in classical economics. And it is so closely akin to the principle of the diminution of marginal utility that results in general from increased expenditure, that some applications of the two principles are almost identical. It has already been observed that new methods of production bring into existence new commodities, or lower the price of old commodities so as to bring them within the reach of increased numbers of consumers: that on the other hand changes in the methods and volume of consumption cause new developments of production, and new distribution of the resources of production: and that though some methods of consumption which contribute most to man's higher life, do little if anything towards furthering the production of material wealth, yet production and consumption are intimately correlated. (5) But now we are to consider more in detail how the distribution of the resources of production between different industrial undertakings is the counterpart and reflex of the distribution of the consumers' purchases between different classes of commodities. (6)
Let us revert to the primitive housewife, who having "a limited number of hanks of yarn from the year's shearing, considers all the domestic wants for clothing and tries to distribute the yarn between them in such a way as to contribUte as much as possible to the family well-being. She will think she has failed if, when it is done, she has reason to regret that she did not apply more to making, say, socks, and less to vests. But if, on the other hand, she hit on the right points to stop at, then she made just so many socks and vests that she got an equal amount of good out of the last bundle of yarn that she applied to socks, and the last she applied to vests." (7) If it happened that two ways of making a vest were open to her, which were equally satisfactory as regards results, but of which one, while using up a little more yarn, involved a little less trouble than the other; then her problems would be typical of those of the larger business world. They would include first decisions as to the relative urgency of various ends; secondly, decisions as to the relative advantages of various means of attaining each end; thirdly, decisions, based on these two sets of decisions, as to the margin up to which she could most profitably carry the application of each means towards each end.
These three classes of decisions have to be taken on a larger scale by the business man, who has more complex balancings and adjustments to make before reaching each decision. (8) Let us take an illustration from the building trade. Set us watch the operations of a "speculative builder" in the honourable sense of the term: that is, a man who sets out to erect honest buildings in anticipation of general demand; who bears the penalty of any error in his judgment; and who, if his judgment is approved by events, benefits the community as well as himself. Let him be considering whether to erect dwelling houses, or warehouses, or factories or shops. He is trained to form at once a fairly good opinion as to the method of working most suitable for each class of building, and to make a rough estimate of its cost. He estimates the cost of various sites adapted for each class of building: and he reckons in the price that he would have to pay for any site as a part of his capital expenditure, just as he does the expense to which he would be put for laying foundations in it, and so on. He brings this estimate of cost into relation with his estimate of the price he is likely to get for any given building, together with its site. If he can find no case in which the demand price exceeds his outlays by enough to yield him a good profit, with some margin against risks, he may remain idle. Or he may possibly build at some risk in order to keep his most trusty workmen together, and to find some occupation for his plant and his salaried assistance: but more on this later on.
Suppose him now to have decided that (say) villa residences of a certain type, erected on a plot of ground which he can buy, are likely to yield him a good profit. The main end to be sought being thus settled, he sets himself to study more carefully the means by which it is to be obtained, and, in connection with that study, to consider possible modifications in the details of his plans.
Given the general character of the houses to be built, he will have to consider in what proportions to use various materials-brick, stone, steel, cement, plaster, wood, etc., with a view to obtaining the result which will contribute most, in proportion to its cost, to the efficiency of the house in gratifying the artistic taste of purchasers and in ministering to their comfort. In thus deciding what is the best distribution of his resources between various commodities, he is dealing with substantially the same problem as the primitive housewife, who has to consider the most economic distribution of her yarn between the various needs of her household.
Like her, he has to reflect that the yield of benefit which any particular use gave would be relatively large up to a certain point, and would then gradually diminish. Like her, he has so to distribute his resources that they have the same marginal utility in each use: he has to weigh the loss that would result from taking away a little expenditure here, with the gain that would result from adding a little there. In effect both of them work on lines similar to those which guide the farmer in so adjusting the application of his capital and labour to land, that no field is stinted of extra cultivation to which it would have given a generous return, and none receives so great an expenditure as to call into strong activity the tendency to diminishing return in agriculture. (9)
Thus it is that the alert business man, as has just been said, "pushes the investment of capital in his business in each several direction until what appears in his judgment to be the outer limit, or margin, of profitableness is reached; that is, until there seems to him no good reason for thinking that the gains resulting from any further investment in that particular direction would compensate him for his outlay." He never assumes that roundabout methods will be remunerative in the long run. But he is always on the look out for roundabout methods that promise to be more effective in proportion to their cost than direct methods: and he adopts the best of them, if it lies within his means.
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5. Some technical terms relating to costs may be considered here. When investing his capital in providing the means of carrying on an undertaking, the business man looks to being recouped by the price obtained for its various products; and he expects to be able under normal conditions to charge for each of them a sufficient price; that is, one which will not only cover the special, direct, or prime cost, but also bear its proper share of the general expenses of the business; and these we may call its general, or supplementary cost. These two elements together make its total cost.
There are great variations in the usage of the term Prime cost in business. But it is taken here in a narrow sense. Supplementary costs are taken to include standing charges on account of the durable plant in which much of the capital of the business has been invested, and also the salaries of the upper employees: for the charges to which the business is put on account of their salaries cannot generally be adapted quickly to changes in the amount of work there is for them to do. There remains nothing but the (money) cost of the raw material used in making the commodity and the wages of that part of the labour spent on it which is paid by the hour or the piece and the extra wear-and-tear of plant. This is the special cost which a manufacturer has in view, when his works are not fully employed, and he is calculating the lowest price at which it will be worth his while to accept an order, irrespectively of any effect that his action may have in spoiling the market for future orders, and trade being slack at the time. But in fact he must as a rule take account of this effect: the price at which it is just worth his while to produce, even when trade is slack, is in practice generally a good deal above this prime cost, as we shall see later on. (10)
6. Supplementary costs must generally be covered by the selling price to some considerable extent in the short run. And they must be completely covered by it in the long run; for, if they are not, production will be checked. Supplementary costs are of many different kinds; and some of them differ only in degree from prime costs. For instance, if an engineering firm is in doubt whether to accept an order at a rather low price for a certain locomotive, the absolute prime costs include the value of the raw material and the wages of the artisans and labourers employed on the locomotive. But there is no clear rule as to the salaried staff: for, if work is slack, they will probably have some time on their hands; and their salaries will therefore commonly be classed among general or supplementary costs. The line of division is however often blurred over. For instance, foremen and other trusted artisans are seldom dismissed merely because of a temporary scarcity of work; and therefore an occasional order may be taken to fill up idle time, even though its price does not cover their salaries and wages. That is they may not be regarded as prime costs in such a case. But, of course the staff in the office can be in some measure adjusted to variations in the work of the firm by leaving vacancies unfilled and even by weeding out inefficient men during slack times; and by getting extra help or putting out some of the work in busy times.
If we pass from such tasks to larger and longer tasks, as for instance the working out a contract to deliver a great number of locomotives gradually over a period of several years, then most of the office work done in connection with that order must be regarded as special for it: for if it had been declined and nothing else taken in its place, the expenses under the head of salaries could have been reduced almost to a proportionate extent.
The case is much stronger when we consider a fairly steady market for any class of staple manufactures extending over a long time. For then the outlay incurred for installing specialized skill and organization, the permanent office staff, and the durable plant of the workshops can all be regarded as part of the costs necessary for the process of production. That outlay will be increased up to a margin at which the branch of manufacture seems in danger of growing too fast for its market.
In the next chapter the argument of Chapter III and of this chapter is continued. It is shown in more detail how those costs which most powerfully act on supply and therefore on price, are limited to a narrow and arbitrary group in the case of a single contract for, say, a locomotive; but are much fuller, and correspond much more truly to the broad features of industrial economy in the case of a continuous supply to a fairly steady general market: the influence of cost of production on value does not show itself clearly except in relatively long periods; and it is to be estimated with regard to a whole process of production rather than a particular locomotive, or a particular parcel of goods. And a similar study is made in Chapters VIII-X of variations in the character of those prime and supplementary costs which consist of charges for interest (or profits) on investments in agents of production, according as the periods of the market under consideration are long or short.
Meanwhile it may be noticed that the distinction between prime and supplementary costs operates in every phase of civilization, though it is not likely to attract much attention except in a capitalistic phase. Robinson Crusoe had to do only with real costs and real satisfactions: and an old-fashioned peasant family, which bought little and sold little, arranged its investments of present "effort and waiting" for future benefits on nearly the same lines. But, if either were doubting whether it was worth while to take a light ladder on a trip to gather wild fruits, the prime costs alone would be weighed against the expected benefits: and yet the ladder would not have been made, unless it had been expected to render sufficient service in the aggregate of many little tasks, to remunerate the cost of making it. In the long run it had to repay its total costs, supplementary as well as prime.
Even the modern employer has to look at his own labour as a real cost in the first instance. He may think that a certain enterprise is likely to yield a surplus of money incomings over money outgoings (after proper allowances for risks and for discountings of future happenings); but that the surplus will amount to less than the money equivalent of the trouble and worry that the enterprise will cause to himself: and, in that case, he will avoid it. (11)
1. For he might have applied these efforts, or efforts equivalent to them, to producing immediate gratifications; and if he deliberately chose the deferred gratifications, it would be because, even after allowing for the disadvantages of waiting, he regarded them as outweighing the earlier gratifications which he could have substituted for them. The motive force then tending to deter him from building the house would be his estimate of the aggregate of these efforts, the evil or discommodity of each being increased in geometrical proportion (a sort of compound interest) according to the corresponding interval of waiting. The motive on the other hand impelling him to build it, would be expectation of the satisfaction which he would have from the house when completed; and that again might be resolved into the aggregate of many satisfactions more or less remote, and more or less certain, which he expected to derive from its use. If he thought that this aggregate of discounted values of satisfactions that it would afford him, would be more than a recompense to him for all the efforts and waitings which he had undergone, he would decide to build. (See III, v, section 3, IV, VII, section 8 and Note XIII in the Mathematical Appendix.)
2. We may, if we choose, regard the price of the business undertaker's own work as part of the original outlay, and reckon compound interest on it together with the rest. Or we may substitute for compound interest a sort of "compound profit." The two courses are not strictly convertible: and at a later stage we shall find that in certain cases the first is to be preferred, and in others the second.
3. In the aggregate the income from the saving will in the ordinary course be larger in amount than the saving by the amount of the interest that is the reward of saving. But, as it will be turned to account in enjoyment later than the original saving could have been, it will be discounted for a longer period (or accumulated for a shorter); and if entered in the balance sheet of the investment in place of the original saving, it would stand for exactly the same sum. (Both the original income which was saved and the subsequent income earned by it are assessed to income tax; on grounds similar to those which make it expedient to levy a larger income tax from the industrious than from the lazy man.) The main argument of this section is expressed mathematically in Note XIII.
4. Almost every trade has its own difficulties and its own customs connected with the task of valuing the capital that has been invested in a business, and of allowing for the depreciation which that capital has undergone from wear-and-tear, from the influence of the elements, from new inventions, and from changes in the course of trade. These two last causes may temporarily raise the value of some kinds of fixed capital, at the same time that they are lowering that of others. And people whose minds are cast in different moulds, or whose interests in the matter point in different directions, will often differ widely on the question what part of the expenditure required for adapting buildings and plant to changing conditions of trade, may be regarded as an investment of new capital; and what ought to be set down as charges incurred to balance depreciation, and treated as expedenditure deducted from the current receipts, before determining the net profits of true income earned by the business. These difficulties, and the consequent differences of opinion, are greatest of all with regard to the investment of capital in building up a business connection, and the proper method of appraising the goodwill of a business, or its value "as a going concern." On the whole of this subject see Matheson's Depreciation of Factories and their Valuation.
Another group of difficulties arises from changes in the general purchasing Power of money. If that has fallen, or, in other words, if there has been a rise of general prices, the value of a factory may appear to have risen when it has really remained stationary. Confusions arising from this source introduce greater errors into estimates of the real profitableness of different classes of business than would at first sight appear probable. But all questions of this kind must be deferred till we have discussed the theory of money.
6. The substance of part of this section was placed in VI, i, section 7 in earlier editions. But it seems to be needed here in preparation for the central chapters of Book V.
8. The remainder of this section goes very much on the lines of the earlier half of Note XIV in the Mathematical Appendix; which may be read in connection with it. The subject is one in which the language of the differential calculusnot its reasonings — are specially helpful to clear thought: but the main outlines can be presented in ordinary language.
9. See above III, iii section 1; and the footnote on pp. 156-7.
10. Especially in V, IX, "There are many systems of Prime Cost in vogue... we take Prime Cost to mean, as in fact the words imply, only the original or direct cost of production; and while in some trades it may be a matter of convenience to include in the cost of production a proportion of indirect expenses, and a charge for depreciation on plant and buildings, in no case should it comprise interest on capital or profit." (Garcke and Fells, Factory Accounts, ch. i.)
11. The Supplementary costs, which the owner of a factory expects to be able to add to the prime costs of its products, are the source of the quasi-rents which it will yield to him. If they come up to his expectation, then his business so far yields good profits: if they fall much short of it, his business tends to go to the bad. But this statement bears only on long-period problems of value: and in that connection the difference between Prime and Supplementary costs has no special significance. The importance of the distinction between them is confined to shortperiod problems.