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ginal revenue lines are higher on the diagram. Since marginal costs rise
with increased output (after an initially falling phase), it follows that when,
with a given cost picture, the intersection of the marginal revenue and
marginal cost curves occurs at higher values of marginal revenue (due to
an upward shift of both AR and MR), this intersection corresponds to a
greater output volume. The more urgently his product is desired by con-
202 MARKET THEORY AND THE PRICE SYSTEM


sumers, the more willing a producer will be to employ his fixed plant more
intensively.
In the special case where an entrepreneur feels that he faces a perfectly
elastic demand situation (so that he believes himself able to sell any quantity
he pleases at a given price), the average and marginal revenue curves coin-
cide as a horizontal line (at the level of the given price). In this case the
quantity of output that it will pay to produce can be seen simply as given
by the intersection of the price line with the marginal cost curve. When
different possible profitable prices are considered (still assuming perfectly
elastic demand), the marginal cost curve itself now appears as the supply
curve of the firm. For each possible profitable price, the quantity that it
will pay the firm to produce is expressed, for this case, by the corresponding
abscissa of the marginal cost curve.
Our understanding of the way the short-run output decisions of the
individual producer depend on the intensity of the demand for his product
suggests, in addition, the likely immediate consequences for industry supply
of the product, of a change in the intensity of over-all market demand for
it. As the general demand for a particular product grows more intense,
it is likely that each of the entrepreneurs (possessing plants designed for
this product) will discover that the demand and marginal revenue curves
for their respective individual outputs have shifted upwards. Each pro-
ducer will discover that additional units of input promise to add greater
revenue increments than previously. Each will seek to expand output in
the short run so that for the group of producers as a whole, the change in
demand tends to bring about an immediate output expansion with existing
plants. The process whereby the market achieves this kind of short-run
adjustment of supply to changes in demand conditions will be more fully
discussed in the succeeding chapters.

LONG-RUN COSTS AND SUPPLY
When an individual entrepreneur considers the wisdom of entering a
particular industry, his basic decisions will not be governed by the pattern
of short-run costs. From the long-run point of view an entrepreneur must
decide whether or not an output level exists for this product that (when
produced as efficiently as he knows that this output can be produced, and
sold for as high a price as he knows that this output can be sold) promises
net proceeds greater than he knows to be obtainable elsewhere. In estimat-
ing how cheaply various possible levels of output can be produced, the
entrepreneur is in the long run free to consider production in various dif-
ferent sizes of plants. Of course, in taking the long-run view of production,
he will have to include (in the costs of production of any proposed level of
output) the cost of erecting the most appropriately sized plant, as well as
COSTS AND SUPPLY 203


the cost of the variable inputs that will subsequently be required. An
entrepreneur who has already been producing in the industry must also
constantly review his position from the long-run point of view. He must
constantly ask whether some alternative plan of production (of the same
product), possibly with a different size of plant, could not yield him higher
net proceeds (even after considering the foremost advantage of his existing
production set up, namely, the fact that he already has his given plant and
does not have now to incur costs for it, as he would have to do with alterna-
tive production plans). And as his existing plant reaches the end of its life,
the entrepreneur must certainly make his decisions with predominantly long-
run considerations in mind.
In making these long-run decisions, therefore, entrepreneurs will ex-
amine the various proposed levels of output with so-called "long-run" costs
in mind. The relevant cost of producing any proposed output volume,
during each period of time, will now be the sum required for production
when the scale of plant, together with all the inputs, can be selected with
complete freedom out of all possible sizes and combinations (subject only
to the constraint that the resulting cost sum be then the lowest known pos-
sible amount).11 In contemplating any proposed volume of output, during
each period of time, an entrepreneur taking a long-run view will ask whether
a better position might not be secured by producing an output slightly
larger, or slightly smaller, than that proposed. In comparing the proposed
output with one slightly larger, he will compare the relevant marginal cost
with marginal revenue. The marginal cost relevant for the long-run view
is the difference between the aggregate costs of production (of the two vol-
umes of output under consideration) when each of the respective aggregate
costs is that which would result from the use of the plant size selected as
best for the particular volume of output under consideration.12
11 In a real world where entrepreneurs hold expectations concerning the future only
with considerable uncertainty, even this constraint will not necessarily be operative.
The producer may well deliberately construct a plant, even though this plant will result
in higher costs of production for the expected output volume than need be incurred
with a differently constructed plant. He may make this decision simply because the
first plant, while more expensive than the second, has the advantage of being more
adaptable to possible deviations from the expected conditions. Concerning this see
Stigler, G., "Production and Distribution in the Short Run," Journal of Political Economy,
June, 1939.
12 Long-run cost curves are drawn to reflect these considerations. An assertion that
the line LAC in the diagram is a long-run average cost curve amounts to the following
statement. For the level of output expressed by the abscissa of any point on the line,
its ordinate corresponds to the lowest per-unit costs of production possible for the
output when (a) the producer is free to select any size of plant for each output level,
and (b) the costs of production include all expenditures (which an entrepreneur who
starts out without owning any resources must incur in order to produce the output).
Although, once the entrepreneur has built his plant only "variable" costs need be
considered in subsequent decision making, this is of course not the case for long-run
purposes. Prospective costs, from the long-run view are the sum of (a) the "fixed" cost
204 MARKET THEORY AND THE PRICE SYSTEM


The pattern that long-run costs will follow as the entrepreneur considers
a wide range of successively larger volumes of output will depend on the
technological conditions governing the particular kind of production.
Since there is freedom to vary the proportions of all factors used, there
would seem (if we assume long-run divisibility of all factors) to be no room
for the laws of variable proportions to operate. Divisibility of factors would
permit the production of any proposed output with the least-cost combina-
tion of factors. With all factors divisible, this identical proportion of in-
puts, if desired, can be reproduced for the production of any other scale
of output. It follows that (if we retain our temporary assumption of
constant factor prices) any change in the per-unit cost of production, result-
ing from a change in output, must be attributed to the change in scale of
production, not to any change in factor proportions. During a portion of
the preceding chapter the analysis proceeded on the assumption of constant
returns to scale. On this assumption the per-unit long-run costs of produc-
tion would remain unchanged regardless of the scale of output (so long as
factor prices do not change). Any proposed volume of output could then
be produced, in the long-run view, at as low a per-unit cost as any other
volume of output. Long-run marginal cost would be unchanged for all
proposed output changes and would be the same as long-run per-unit cost.
Any increase in intensity of market demand for the product of the industry

of erecting the desired plant and (b) the variable costs appropriate to the selected size
of plant. With respect to a given proposed size of plant, prospective costs per unit of

* r
j


TAC
P·"¯
unit



” ” •



LMC

A Quantit;
0

Figure 9-3
output, from the long-run view, are thus obtained by dividing the sum of these two
cost figures (for each output level possible with the plant) by the corresponding output
quantity. (The cost curve thus derived is thus higher than the corresponding short-run
[variable] average cost curve for this plant size, at each output level, by the quota of
"fixed" cost assigned to a unit of output for that output level.) In the diagram the
line TACX is such a curve (for one size plant); TAC 2 is another. If one were to imagine
such curves to be drawn for each possible size of plant, it is clear that the curve that
cuts the vertical line A A' at the lowest point corresponds to the size of plant most suited
to the production of the output OA; and similarly for all levels of output. AB thus
emerges as the long-run cost per unit for an output volume OA; and the line of long-
run average costs LAC is seen to be the "envelope" of all the TAC curves relevant respectively
to all the various proposed levels of output.
The long-run marginal cost curve is drawn bearing the usual geometrical relationship
to the corresponding average curve. At any given level of output, long-run marginal
cost is equal to the short-run marginal cost for that level of output when the optimum
sized plant for the output is being used.
COSTS AND SUPPLY 205

could result in a larger aggregate supply, without any increase being neces-
sary in the product price.13
Where, however, the required factors of production are only imperfectly
divisible, it will not in general be possible to expand output by simply
increasing the input of each factor in the same proportion. If there is a
particular volume of output for which inputs, by chance, can be combined
in an optimum proportion, a relatively small increase or decrease in out-
put will result, with some inputs indivisible, in a less than optimally propor-
tioned input combination. When an indivisible input is underutilized,
expansion of output will lower per-unit costs. When output has expanded
sufficiently so that optimal proportions are attained, further employment
of additional units of the divisible factors without a corresponding increase
in the input of the indivisible factors (due to this indivisibility) must raise
per-unit costs. Thus, even where production might otherwise yield constant
returns to scale, factor indivisibilities may cause rising or falling long-run
costs.14 In fact, it is possible (and sometimes convenient) to view all de-
partures from constant returns to scale as being in principle the conse-
quences of "indivisibilities."
Whatever the pattern of long-run costs, which the technological condi-
tions of the industry determine, an entrepreneur will formulate his long-run
plans by comparing marginal cost with marginal revenue for each possible
output. If there is no output at which the long-run average costs are fully
balanced by expected average revenue, the entrepreneur will not enter the
industry. Where the demand for his product is sufficiently strong for a
range of outputs to be possible for which average cost is not greater than
13 The long-run average (and marginal) cost curve would thus be a horizontal
straight line passing through the minimum points of all the TAC curves. (Of course,
once a given sized plant has been built, the [short-run] marginal costs will nevertheless
be rising.)
TAC, TAC.
per




O OuonTity


Figure 9-4
14 Many economists (for diverse reasons) have believed that the accompanying diagram
illustrates the typical pattern of long-run costs.


LAC




Quantity

Figure D-5
206 MARKET THEORY AND THE PRICE SYSTEM


average revenue, the entrepreneur will choose to produce that output for
which long-run marginal cost is just balanced by long-run marginal revenue.
When he produces this output volume with the size of plant that minimizes
its costs of production, he is doing the very best that he can.15 Any other
output, no matter how efficiently produced, must yield either a smaller sur-
plus of aggregate revenue over aggregate costs, or even a deficit.
For the special case where an entrepreneur believes the demand for his
product to be perfectly elastic (so that he can sell any volume of output
without lowering the price), he will, attempt, if it pays at all to be in the
industry, to expand output (that is, to build larger and larger plants) so
long as long-run average costs decline (that is, so long as there are increasing
returns to scale). The size of plant that he should erect will be limited
only by eventually rising long-run costs (when he will seek to build a size
of plant for which his long-run marginal costs just balance his product
price).

FACTOR PRICES AND SUPPLY
Cost curves and supply have been analyzed in the preceding sections
on the assumption that the prices of productive factors do not change re-
gardless of the level of output. So long as this assumption was retained, the
only changes in the per-unit costs of production that were possible, as output
increased, were those resulting from the technological conditions governing
production. Thus, in the short run, per-unit costs changed as a result of the
laws of variable proportions, while in the long run, costs depended on re-
turns to scale. It was possible, we found, to make statements concerning
supply (especially for the short run) based solely on these considerations.
But we have already seen that the costs (and therefore the supply) of each
product are governed by a paramount additional economic consideration.
We know that when the output of any one product is expanded, a with-
drawal is required of more and more units of factors away from potential em-
ployment in other branches of production. By the principle of diminishing
marginal utility, therefore, the steady advancement of the margin of output
of any one product involves the simultaneous reduction in importance of

13 It needs to be stressed that long-run cost considerations do not require that the
producer erect a plant of such a size that he use it subsequently at its most efficient level
of utilization. In other words the LAC curve does not necessarily pass through the
minimum points of the TAC curves. All that is necessary is that, for whatever output
level it is decided to produce, a plant of necessary size be erected that minimizes its costs
of production. This may well mean that this plant will then be used at less (or more)
than its optimum level of utilization. This does not matter; the output that would be
yielded by such "optimum" utilization of the plant could be produced more cheaply,
it is likely, by underutilizing or overutilizing a different size of plant. Anyway, the
aim is not to use plants at their most efficient levels of use, but to produce a given
output with its most efficient combination of inputs.
COSTS AND SUPPLY 207


each additional unit of this product, and increase in importance of the
units at the respective margins of output of other products.
This tendency must eventually express itself through the price mechan-
ism. (In the succeeding chapters we will examine more closely hoiv the
market process would tend to make prices reflect such a tendency.) Even-
tually, entrepreneurs in the expanding industry would find on the one hand
that their product has a lower price, and on the other hand that the various
inputs can be bid away from other industries only at higher prices. As a
result of the latter tendency, it is clear, producers will find that the per-unit
costs of producing their product will tend to rise. Producers will attempt
to escape some of the consequences of higher factor prices by altering the
proportions of the various inputs, substituting factors whose prices have not
risen (or which have risen less) in place of the factors whose prices have
risen most. But the rising factor costs will ultimately raise the costs of
production, and this will exert an appreciable effect on supply. The output
for which an entrepreneur finds that marginal revenue is balanced by mar-
ginal cost will be a smaller one, as a result of rising factor costs. With a
given intensity of demand for his product, the entrepreneur will therefore
be prepared to supply only a smaller volume of output to the market.
If the entrepreneur is a relatively important buyer of a particular re-
source, he may find that the price of this input rises directly (and signifi-
cantly) as a result of his own expansion of output and consequent increased
purchases of the input. In such a case his own cost curves will directly
incorporate the rising factor prices. Where the individual entrepreneur
is a relatively unimportant purchaser of a particular input, its price will
not rise appreciably as a result of his output expansion alone. But where
a larger number of entrepreneurs are simultaneously expanding output (as
a result, let us say, of an increase in demand) their competition will even-
tually force up the price of the required inputs.16 In this case an individual
entrepreneur will incorporate the consequences of rising factor prices in his
long-run cost estimates only if he is able to forecast correctly the general ex-
pansion of his industry (and thus the higher prices). Entrepreneurial deci-
sions made subsequent to a rise in factor prices, of course, will take them
fully into account; thus, as the aggregate quantity supplied of the product

10 Where a producer's cost curves rise in consequence o£ an expansion not of his own
output, but of the output of his entire industry, the industry is said to be subject to
external diseconomies. Rising costs come to the producer due to reasons "external" to
his own operations. In theoretical literature attention is also paid to the industry that
enjoys external economies. Here the costs of the individual producer falls as a con-
sequence of expansion of the output of the industry as a whole. External economies
are usually identified with such eíFects o£ expansion as more wide-spread knowledge,
the possible cheapening of factors used, the increased possibilities of economies due to
specialization, and so on.
208 MARKET THEORY AND THE PRICE SYSTEM


increases, the resulting rise in factor prices will very definitely act as a drag
upon further increases in supply.
It is not difficult to understand the various factors that determine the
extent of the price rise of a particular resource consequent to expansion of
production in a particular industry. The more important the industry
(relative to all the industries employing this resource), the more sensitive
the resource price will be to the expansion of the industry. Again, on the
other hand, the more elastic the over-all supply of this resource, the smaller
will be the rise in its price necessary to expand output in one industry
(since a small rise in price will call into production a greater aggregate
supply of the resource, making it unnecessary to withdraw a great deal of
the resource from other industries). The more easily a given resource
can be replaced by other inputs (both in the expanding industry and in the
others), the less rapidly will the industry expansion bring about a rise in
the resource price. A small rise in its price will lead to its substitution by
other inputs. Another consideration indirectly relevant to a rise in input
prices, consequent on expansion of an industry, will be the demand condi-
tions for the other products employing the inputs. The more sensitively
the quantity demanded of the other products shrinks as a result of a rise
in their prices (consequent on increases in factor prices and thus also in
the production costs of these other products), the less sharply will factor
prices rise further as a result of the further growth of the expanding industry.
An analysis of all these determining factors is merely a way of assessing
the actual opportunity cost of withdrawing productive resources from one
use for more extensive employment in a different use. The pricing process
conveys all the relevant information on this score through the extent that
input prices rise. The entrepreneur in the expanding industry considers
this information in assessing his own cost of production for different possible
levels of output. His decision of the quantity of output to supply the
market will then reflect his desire (motivated by the search for profit) to
serve the market most faithfully in the light of (a) the intensity of demand
for his product, and (b) the loss to the market of other potential products
involved in the production of each successive unit of his own product.

SUMMARY
In Chapter 9 the analysis of the forces of supply is continued. Relying
on the principles of production developed in the preceding chapter, the
present chapter examines the way costs of production depend upon the level
of output, and thus how producers make their output decisions.
The economist views cost from the opportunity cost point of view.
(Any portion of a price paid for the use of a factor that does not reflect the
foregone product that the factor could have rendered elsewhere is not a cost
COSTS AND SUPPLY 209


but rent.) From the opportunity cost point of view, the market governs the
supply of any one product by balancing its value against that of the other
products sacrificed through its production. This control is expressed
through the impact of the producer's costs of production. The costs rele-
vant to any particular production decision are those alternatives that, availa-
ble immediately before the decision, were rejected by that decision. Since
in the course of the production of a product it may be necessary to make
successively a number of decisions, it is clear that the "cost of production" of
the product cannot be unambiguously described unless a particular decision
is identified as the focus of attention.
This relativity of costs springs partly from the specificity of the capital
goods used in production. Because the costs incurred for capital goods at
an early stage in production planning cannot subsequently be retrieved
through switching them to other uses, it follows that these sunk costs are not
costs at all from the point of view of subsequent production decisions.
The limited divisibility of capital goods is responsible for the typical
way short-run costs depend upon the level of output. Output changes in-
volve, as a consequence of the laws of returns, therefore, changes in factor
efficiency, and thus in the per-unit cost of output. The resulting pattern
of short-run costs makes it possible to understand the way a producer will
make short-run adjustments in output as a consequence of changes in the
data facing him.
In making decisions for the long run, on the other hand, producers
must consider all prospective costs in a production process. In planning
the size of plant, a producer must consider the way prospective changes in
long-run output affect these over-all costs. Involved in such alterations is
the question of returns to scale, rather than the effect of changes in factor
proportions.
A more complete analysis of producer's decisions must consider, in ad-
dition, the possibility and the consequences of alterations in factor prices.
The impact of such alterations will depend on the size of the producer with
respect to the relevant factor market. The extent of the changes to be ex-
pected in factor prices as a result of the expansion of a given industry
depends on the alternative uses of the factor and the conditions surrounding
the elasticity of the factor's supply.

Suggested Readings
Viner, J., "Cost Curves and Supply Curves," Zeitschrift fur Nationalökonomie
(1931), Reprint in Readings in Price Theory, American Economic Association.
Chamberlin, E. H., The Theory of Monopolistic Competition, 7th Ed., Harvard
University Press, Cambridge, Massachusetts. 1956, Appendix B.
Aíises, L. v., Human Action, Yale University Press, New Haven, Connecticut, 1949,
pp. 336-347, 499-510.
10

Partial Market Processes ” The
Determination oj Product Prices
ana Factor Prices



W E RETURN now to consider the mar-
ket process. In Chapter 7 we considered the kind of market process that
would emerge in the absence of production. We assumed a society nat-
urally endowed with a daily income of consumption goods of various
kinds, and we then followed through the logic governing the emergence of
exchange and prices. For that analysis the only prior theory that was
required was the theory of consumer demand. On the basis of the theory
of the demand of the individual consumer, we were able to work out the
results of the interaction of the activities of numerous individuals for whom
there are no production opportunities. However, in a society where men
are able to further their purposes, not only by consuming what they find
easily available, but also by using their resources to produce other goods,
the market process becomes much more complex. (We have already ob-
tained a bird's-eye view of this process in Chapters 2 and 3.) This process
is based on the actions of individual human beings not only as consumers,
but also as producers and as resource owners. The preceding two chapters
have been devoted to the theory of production and costs, clarifying the
behavior of the individual producer. In this chapter and the next we
follow through the market process in a productive society, taking fuller
account of productive activities and the market phenomena they give rise
to. To a considerable extent we will be able to rely on the analysis of
the simplified market process contained in Chapter 7.
In Chapter 7 each market participant was endowed daily with an
210
MARKET FOR SINGLE PRODUCT 21 1


initial bundle of consumer goods. In our present problem each market
participant is endowed in addition with a bundle of productive resources.
The market presents possibilities for each participant, through exchange,
production, and possibly further exchange, to transform his initial en-
dowment into one that is more desirable from his point of view. The
interaction of all participants in the market generates, as we saw in Chap-
ters 2 and 3, sub-markets where various resources are bought and sold,
and also a great deal of entrepreneurial activity linking the various sub-
markets together through production decisions.
The market process determines (a) the prices and quantities of each
of the resources sold, (b) the quantities of each of the resources used in
each branch of production, and (c) the quantities and prices of each of
the products produced and sold. (We are aware, of course, that any num-
ber of intermediate products may be produced and sold, as well as con-
sumption goods.) This market process consists in the concatenation of
decisions on the part of market participants, decisions to buy and sell
resources, decisions to use resources to produce products, and decisions to
buy and sell products. As such, and as we have already seen, the process
is a single one”all the decisions are to some degree dependant upon all
other decisions, and in turn influence further decisions. Any separate
analysis of part of the whole market process is justified only provisionally
in the expectation that such analysis will throw light on the process in its
entirety. We proceed, therefore, in the present chapter, to consider first
the market process as it directly affects the output and prices of only a
single product. We will then consider how the market process directly
affects the employment and prices of only a single productive factor. The
extension of these preliminary inquiries will then enable us in the next
chapter to view and to analyze the market process as an indivisible unity.


THE MARKET FOR A SINGLE PRODUCT
In analyzing the market for a single product, we are adopting a
"partial" approach. The only variables into whose value we inquire are
those directly pertaining to the product itself, namely, its price, the method
of production and the quantities of different resources used in its produc-
tion, and the quantities produced by different firms. All other market
phenomena are assumed, insofar as they might affect our own product
market, to be "given" and (at least for most of our inquiry) unchanging.
We ignore, for example, any effects upon other prices that might be brought
about by the process of adjustment in the market for our own product and
that might, in return, exert secondary repercussions upon our own market.
Thus, our problem is to explain the course of the market forces affecting
the price, output, and organization of production of our one product.
212 MARKET THEORY AND THE PRICE SYSTEM


We assume prospective consumers to be faced with known and stable
prices that each of the other available products can be bought at. We
assume entrepreneurs to be faced with known and stable prices that each
of the available productive factors can be bought at, as well as with definite,
technologically determined, possible methods of production. We assume
that a large number of entrepreneurs have access to the factors of produc-
tion. Consumers possess, in addition, definite tastes and incomes. We
proceed to spell out the conditions for complete equilibrium in this product
market.
LONG-RUN EQUILIBRIUM
Complete (or "long-run") equilibrium conditions require that a certain
number of firms produce the product, each firm producing a certain quan-
tity, and each firm producing with a certain method of production; that
entrepreneurs sell and consumers buy the product in certain quantities
and for certain prices”all these quantities and prices being such that no
participant or prospective participant in the market should ever find any
reason to alter his actions for the future. As for a definition of the equi-
librium price of the product, we may to a large extent draw upon the
analysis of Chapter 7.1 In equilibrium there can be only a single price
for the product ruling in the market (otherwise entrepreneurs would
eventually discover the discrepancy in prices, and buy the product where
its price is low, and sell it where its price is high, until the discrepancy
should disappear). This price must be such that the quantity of the
product that consumers wish to buy at this price is exactly the same as
the quantity of product that entrepreneurs plan to produce in expectation
of this price. Any other price would mean that, sooner or later, somebody
(producer or prospective consumer) will find that his plans cannot be
executed in the market. Of course, he would have ample reason to alter
his future actions; the market would no longer be in equilibrium.
There are several further relationships implied by these conditions
for the equilibrium price. If the price is to be such that nobody should
see reason to alter his actions for the future, it must inspire, of course, no
entrepreneur in the industry (nor any prospective entrepreneur) to make
any alteration in output volume. This means that equilibrium conditions
require that the relationship between the volume of output, the price of
the product, and the given prices of the various resources make it dis-
advantageous for any entrepreneur to expand production (or to make
plans for eventual expansion of production); but that this relationship
also makes it disadvantageous to cut back production (or to make plans
to cut back production eventually).

iSee pp. 107-116.
MARKET FOR SINGLE PRODUCT 213


This means, first of all, that each entrepreneur must be producing an
output volume for which the aggregate opportunity cost of production is
no greater in the long run than the total revenue obtainable from the sale
of the products; and also that no producer who is not at present producing
the product can see any prospect of producing any quantity of the product
that should yield a revenue greater than the (opportunity) costs of its
production. If these conditions are not satisfied, changes in output will
occur sooner or later. If any producers are incurring losses (that is, if their
long-run opportunity costs of production”the revenue they could acquire
eventually if they transfered their resources to some other branch of pro-
duction”exceed the revenue that they currently receive from their output),
they will sooner or later alter their actions. This might not happen im-
mediately, since many resources may not be transferable, and may thus
involve no immediate opportunity costs (and thus involve no short-run
losses) in their present use. But sooner or later entrepreneurs will retire
from an industry that yields over-all opportunities inferior to those avail-
able in other branches of production. On the other hand, if any outsider
to the industry can perceive prospects of an output that should yield a
revenue in excess of what he could earn elsewhere with the same resources,
he will sooner or later attempt to enter the industry. Neither of these
eventualities is consistent with equilibrium in the product market.
The above required equilibrium relationship means, in addition, that
each entrepreneur will be producing an output volume and facing a de-
mand curve for his product so that the following conditions are satisfied:
(a) the marginal unit produced has added to total revenue an amount ex-
ceeding the corresponding increase in relevant total opportunity costs, and
(b) the next unit that which the entrepreneur just fails to produce would
have added an increment to cost exceeding or equaling what it would add
to revenue. This, we saw in the previous chapter, represents the optimum
volume of output, relevant”mutatis mutandis”for both short- and long-run
decisions. (If potential producers are so numerous that an increase in
output by one of them leaves the price of the product, and hence marginal
revenue, virtually unchanged, it is clear that such an optimum output is
possible only where the relevant marginal costs increase with increases in
output. If marginal costs do not increase with expansion of output, then,
if a certain level of output is selected as satisfactory, still larger outputs
will be still more satisfactory with declining marginal costs, or at least
no less satisfactory with constant marginal costs. Neither of these possi-
bilities is consistent with equilibrium, since there is no good reason why
any entrepreneur should continue producing a given output volume in-
stead of expanding to produce a larger one.)
To sum up, a market for a product will be in complete (long-run)
equilibrium when the following mutually consistent sets of decisions are
214 MARKET THEORY AND THE PRICE SYSTEM


being made. (1) Each entrepreneur is producing (in response to the mar-
ket price) an output whose (long-run and short-run) marginal costs bear
the above described relationship to revenues. (2) Each consumer is de-
sirous of buying, at the same market price, a quantity such that the ag-
gregate thus demanded is exactly what producers are¿ in aggregate,
producing. (3) For each producer the market price is no less than the
average long-run costs of production for his volume of output. (4) No
entrepreneur who is not presently producing can find any possibility of
employing resources in this industry more lucratively than in other indus-
tries. These equilibrium conditions define the scale of plant for each
producer, the levels of plant utilization, the output consumed by each con-
sumer, and the market price.
Assuming a unique pattern of decisions does exist for producers and
consumers that would mesh completely in this way, it can be seen that
perfect knowledge on the part of all market participants would help them
immediately toward achieving equilibrium. The logic employed in Chap-
ter 7 is sufficient to prove that the only price bids and offers made by
prospective buyers and sellers are those that they know will not be disap-
pointed and will not involve the sacrifice of more attractive opportunities.
Acting, according to "static" assumptions, on the expectation that basic
market data will never change, those producers willing to do so will then
undertake long-range planning to achieve (at lowest possible cost of pro-
duction) those outputs that it will pay them to offer to the market at what
they know will be the equilibrium price. No other price can prevail,
they can be assured, because this would call for the conscious adoption,
on the part of some producers or consumers, of plans that they realize
must be disappointed. In this way each producer will have constructed
the "correct" scale of plant and will have hired the "correct" quantities
of other factors necessary to achieve his "correct" share of the "correct"
aggregate output. The point is that the long-run equilibrium price for
the product is the one able to induce entrepreneurs to initiate long-range
plans for the production of exactly that quantity that consumers will be
prepared to buy at the same price. Perfect knowledge would make possible
the precise calculation of this price, and also the realization that no plans
will be made by anyone on the assumption of other prices.
In a subsequent section of this chapter we will proceed with our main
purpose”the analysis of the market process in the single-product market
when knowledge is not perfect. Before this, we will consider two situations
where the market for a single product may be in "incomplete" equilibrium.
These are model situations where the decisions being made are consistent
with each other, and do mesh, but only on the hypothesis that specific
kinds of further decisions (which might otherwise be made) are excluded
from the models. In other words these two situations are such that they
MARKET FOR SINGLE PRODUCT 21 5


would be sel£-perpetuating if certain specified kinds of change are not
allowed to occur in the analysis. In themselves these models of "shorter-
run" equilibria are purely theoretical constructions, but they will prove
helpful in understanding the market process leading to complete, long-run
equilibrium.

SHORT-RUN EQUILIBRIUM IN THE SINGLE-PRODUCT MARKET
For this first case, decisions are needed on the part of producers and
consumers that should be mutually consistent, on the hypothesis that no
changes shall be made in the size or in tlie number of plants where produc-
tion is carried on. We do not have to inquire therefore into the decisions
of producers as to the scale of plant they should employ. For the present
problem these decisions are not variables that we seek "equilibrium" values
for. Along with the prices and quantities available of all the other prod-
ucts, and of factors of production, they are data that are held unchanged for
our analysis, and that form the framework within which our short-run
equilibrium situation is to be constructed.
Such a short-run equilibrium requires that producers produce a certain
output (each with his given scale of plant) and sell it for a certain price,
such that the aggregate output will equal exactly the quantity of product
that consumers would want to buy at this price. (There must be of course
only a single price for the product if the market is to be in any kind of
equilibrium.) The price we seek, then, for the product is the one that
will induce producers to produce in aggregate (with given plant size)
exactly that output that consumers will buy at the price.
The only opportunity costs of production that are relevant to the
short-run model are those incurred for the variable factors used in pro-
duction. The costs incurred in the past for the plant (including any
contractual obligations for the current period incurred for the plant in
the past) are irrelevant, as we have seen in the previous chapter, for
short-run decisions. It will pay an entrepreneur with a given plant to
keep on producing in the short run even though his average revenue is
lower than average long-run costs, so long as average revenue is greater
than average short-run (variable) costs. With this reservation an entre-
preneur will therefore always carry production to the point where the
marginal unit produced just adds to revenue an amount in excess of the
addition to short-run costs.2

2 For the special case where entrepreneurs face perfectly elastic demand curves, the
best output position will be that where the (rising) short-run marginal cost curve
intersects the demand curve. The demand curve indicates for all outputs the (same)
marginal (and also average) revenue. We have seen, therefore, that the short-run
marginal cost curve becomes part of the supply curve of such an entrepreneur. Such an
216 MARKET THEORY AND THE PRICE SYSTEM


For equilibrium, therefore, the following mutually consistent sets of
decisions must be made. (1) Each of the given entrepreneurs is producing
(in response to the market price of the product) an output whose short-run
marginal costs are related to marginal revenues in the manner described.
(2) Each consumer is desirous of buying, at the same market price, a
quantity such that the aggregate thus demanded is equal to the aggregate
output. It will be observed that short-run equilibrium conditions may
still be fulfilled even though entrepreneurs outside the industry perceive
exceptional profit possibilities in this industry. Moreover, short-run equi-
librium may exist even though some entrepreneurs are producing an output
such that the price of the product does not help recoup the "fixed" costs
incurred in the past in setting up the plant. Clearly, this "equilibrium"
might be rapidly disturbed were the hypothetical short-run interdiction
on changes in plant size and number to be lifted. These short-run equi-
librium conditions define the level of utilization by each entrepreneur
of his given plant, the output consumed by each consumer, and the market
price.3
EQUILIBRIUM IN THE SINGLE-PRODUCT MARKET
IN THE VERY SHORT RUN
The second of the hypothetical situations where the market for a
single product may be in incomplete equilibrium is often termed the "very
short run." In the very short run the hypothesis is made that no decisions
shall be made that should increase the available stock of the product. All
available output is the result of past production decisions. (Thus, we
have a situation similar to those analyzed in Chapter 7 where market par-
ticipants found themselves endowed with non-producible commodities.
In the present context, however, we will assume that the producers can
make no personal use whatsoever of their product; their past production
entrepreneur will thus operate so that his marginal cost equals the market price of his
product, as in the diagram. Short-run market equilibrium will require a market price
MC

AVC

-D`



Quont¡ty

Figure 10”j
(a) low enough to enable all the entrepreneurs to achieve this position without some of
them being left with unsold goods and (b) high enough for the entrepreneurs to achieve
this position without resulting in an aggregate output less than what consumers in
aggregate would buy at the price.
3 The reader, as an exercise, may care to convince himself that perfect knowledge
would lead to immediate attainment of short-run equilibrium conditions in a market for
a single good.
MARKET FOR SINGLE PRODUCT 217


decisions were made purely with the intention to sell the output in the
market.)
The conditions for equilibrium in such a market cannot prescribe,
therefore, any limitations for the production decisions of producers, since
these decisions are excluded altogether. The only decisions that are per-
mitted, on, the present hypothesis (and which must be mutually consistent
if equilibrium is to exist), are those of the producers concerning the
quantities of output to sell and the price to ask, and those of the consumers
concerning the quantities to buy and the prices to offer. We continue
to exclude decisions based on pure speculation so that, since producers have
no use personally for their product, it is evident that each of them will
be willing to sell all available units of product, no matter how low the
market price.
It is therefore easy to spell out the conditions for equilibrium in such
a case. The product, as always in equilibrium, must be selling at the
same price throughout the market. The price, once again, must be such
that the quantity of product that consumers, in aggregate, wish to buy
at this price is exactly equal to the quantity that producers wish to sell at
the price. But we have seen that producers will be willing to sell the
entire stock of the product, no matter how low the price. It follows,
therefore, that the equilibrium price must be that at which consumers
will wish to buy exactly the quantity available. The price must be at a
level such that the least eagerly sought-after unit of product that would
be bought at the price will just exhaust the entire stock.
For equilibrium to exist in the very short run, it will be observed,
it is not necessary that price cover any kind of costs. Moreover, since
producers are prepared to sell the entire stock at any price, it follows that
the active determinant of what the equilibrium price should be is ex-
clusively the demand situation.4 The conditions for equilibrium in the
very short run define the output bought by each consumer and the market
price. It has already been proved in Chapter 7 that in such a market,
equilibrium conditions would be immediately fulfilled if all participants
in the market possessed perfect knowledge.

ADJUSTMENT TO CHANGE IN A MARKET
FOR A SINGLE PRODUCT
The relevance of these situations of incomplete equilibrium for the
understanding of the market process (as it takes place in a world without
omniscience) may be grasped by considering the following case. Imagine
4
For a diagram illustrating this case, and for some further discussion, the reader is
referred to the last portion of the Appendix to Ch. 7, especially to the discussion sur-
rounding Fig. 7-7.
21 8 MARKET THEORY AND THE PRICE SYSTEM


a market for a particular product where the decisions of the various par-
ticipants are made according to the following schedule. (1) Once every
five years, a date is set aside on which all entrepreneurs have, if they wish,
the opportunity either (a) to enter the industry by building a plant (for
those entrepreneurs who have not been in the industry during the pre-
ceding five years); or (b) to build a new plant (for those entrepreneurs who
have been in the industry during the preceding five years) in any size they
see fit; or (c) to leave the industry altogether (by closing down their plants
and having no longer to shoulder any fixed charges upon them). (2) On
the first day in each month each owner of a plant decides the daily rate
of production for the month. This decision is made in the light of the price
of the product expected to rule in the market during the month. Once the
decision has been made, it cannot be altered until the following month.
The monthly decision determines for the whole month the quantity of fac-
tors that shall be employed each day, and provides for a steady daily output
that shall be produced each day, before the daily buying and selling activity
commences, ready for sale to the market. (3) Although during the course
of a month a producer has no way of altering the current rate of output
until thefirstof the following month, each producer daily revises his estima-
tion of the current market price for the product. Before the commence-
ment of trading each day, each producer plans the selling offers that he will
make during the day, in the light of his current estimate of market condi-
tions. (4) Before each trading day each consumer makes his estimate of the
market price for the product for that day, and formulates his buying plans
for the day accordingly.
Suppose this market is initially in a state of complete long-run equi-
librium. Each entrepreneur in the industry is operating with a scale of
plant, at a level of utilization, that permits aggregate output to be sold
at the equilibrium price. No entrepreneurs in the industry have any
reason to offer to sell tomorrow for lower prices than today, nor to demand
higher prices. No entrepreneurs have any reason to increase the rate
of output for the following month, nor to decrease it. No entrepreneur
has any reason, when the date for plant alteration arrives, to do anything
except to build the same size plant that he has owned previously. No one
presently outside the industry feels any attraction to enter it, when it will
be possible to do so. No consumers have any reason to alter their buying
plans for the following day. All decisions, therefore, those made by con-
sumers and those made by producers, those made from day to day, those
made from month to month, and those made only once in five years, are
completely consistent with each other. Into this situation introduce now
a sudden, permanent, unexpected increase, occuring one night in the early
part of a month, in the intensity of demand for the product (represented
graphically by a shift to the right of the entire market demand curve).
MARKET FOR SINGLE PRODUCT 21 9

We must inquire into the effects that this change will generate upon the
market activity of all participants, all other relevant factors remaining un-
changed.
It is clear, first of all, that the market is no longer in equilibrium. If
entrepreneurs go to market on the day immediately following the change
in demand with the same selling plans as for the previous days, there will
have been by the end of the day many disappointed consumer plans. Con-
sumers will have come to market with plans to purchase greater quantities
(at previously ruling prices) than before. The daily output, previously
just sufficient to satisfy consumers at the (previous) equilibrium price, is
now insufficient. Some consumers will have discovered that they must
offer higher prices in order to fulfill their plans. Entrepreneurs will dis-
cover that they may expect higher prices and in the succeeding days will
make their selling plans on this expectation, refusing to sell for the pre-
vious low price.5
When the first of the following month is at hand, and producers must
decide on the rate of output of the next month, their estimates of the
product price for the month will have risen from those of the first of the
preceding month. Each entrepreneur will realize that whatever the rate
of output he had been previously satisfied to maintain, he is now able to
improve his position by stepping up the daily output rate for the month.
The first unit of the product, which previously just was not worthwhile to
add to the daily output, for example, now promises to add more to revenue,
should it be produced, than it would add to current costs. The reason
why this unit of output had previously been the first submarginal one was
that its marginal (short-run) cost just exceeded the addition that it brought
about in revenue. Now, however, the entrepreneur can expect a higher
price for the product, one that causes the marginal revenue from this unit,
and also from some further units as well, to exceed the corresponding
short-run marginal costs.6

5 In the diagram SS' represents the perfectly inelastic market supply curve for the
product (appropriate to the very short run); DD represents the initial market demand
Price
D'






0 S Quantity

Figure 10-2
curve for the product; D'D' shows the market demand curve after the change. Clearly,
the equilibrium position of the market has shifted, for the very short run, from the posi-
tion K to the position K'.
6 This may be illustrated diagrammatically for the special case where the entrepreneur
faces a perfectly elastic demand curve. With the original average revenue line AR, the
220 MARKET THEORY AND THE PRICE SYSTEM


Thus even if the market had achieved, by the end of the first month,
"equilibrium" at the new higher price, this is equilibrium only for the
very short run”until entrepreneurs have the opportunity to step up the
rate of output under the new conditions.
When entrepreneurs do increase the daily rate of output, it should
be noticed, the aggregate output might be so much greater than that of
the previous month that the higher price prevailing at the end of the first
month (during which the increase in demand occurred) may be too high.
Consumers eager, after the change in demand, to buy the smaller daily
output available previously at this higher price are not willing to buy
any larger quantity at the same price. Of course, if entrepreneurs had
perfect knowledge they would step-up output exactly enough for the mar-
ginal cost of the output of each producer to fall just short of the correspond-
ing marginal revenue, as determined by the prices aggregate outputs can
be sold at to the consumers. In the absence of perfect knowledge we can
expect months to go past before entrepreneurs, through the pulls and
pushes of market forces, might have completely adjusted their outputs
to the new demand situation. When such adjustment has been completed
the market will be in equilibrium”but only until the date arrives to review
plans for the entire plant for the next five years.
The equilibrium attained in the previous paragraph is, for two reasons,
only a short-run equilibrium. First, entrepreneurs outside the industry
who had previously been deterred from entering the industry may eventu-
ally find it profitable to do so. Since the price attained in the short run
after the increase in demand is higher than before the increase, some of
these entrepreneurs may discover that they can do better here with a cer-
tain combination of resources, than they can do elsewhere. When the
opportunity for entry presents itself, the entrepreneurs will build plants
and swell the daily supply. Second, entrepreneurs who have been pro-
ducing in this industry are now producing daily outputs with plants that
were built years ago on plans that called for only smaller daily outputs.
When the opportunity arrives for an alteration in the size of plant, en-
position L was the best for the producer. As the product price rises, the AR' line is
itself raised. Units to the right of L, previously not worthwhile to produce (because




Quantity

Figure 10-3
MC > MR), have now become worthwhile. The producer's best position has changed
from L to L\
MARKET FOR SINGLE PRODUCT 221


trepreneurs will certainly expand the scale of plant in order to produce
the current larger daily output most economically, if they were to plan
to continue at this rate of output. But in fact the entrepreneurs will not
be seeking at this time a scale of plant most suited for the production of
this current rate of output. Instead, each entrepreneur seeks to produce
most efficiently the output that appears most advantageous under the
possibilities opened up by the very opportunity of altering the scale of
plant. It is likely that the output most advantageous with the old given
plant is not the most advantageous output when the entrepreneur is free
to select any plant size he wishes. The most advantageous output from
the long-run point of view is that which is, when produced in the most
economical scale of plant (for the output), just short of the unit that would
make an addition to the variable costs (using this scale of plant) that just
exceeds the addition which it makes to revenue. Thus, entrepreneurs
will increase the sizes of their plants accordingly.
Once again it may happen that the aggregate daily output that will
be produced, in the new scales of plant, will be greater than the quantity
that can be sold at what had been the short-run equilibrium price. In this
case the market process will lead, during the second five-year period, to a
somewhat lower price than had been in effect at the close of the previous
five-year period. This will mean that entrepreneurs will find that they are
not yet perfectly adjusted, since their plans, in this eventuality, must have
been made in the mistaken expectation that the old short-run equilibrium
price was to continue indefinitely. The situation will thus still not be
one of long-run equilibrium, since at the start of the following five-year
period entrepreneurs will again alter their plant sizes in order to come
closer to their most advantageous production possibilities. In this way
the market process will bring about an adjustment in plant size every five
years. This process of adjustment will cease only when the industry has
once again been restored to long-run equilibrium, under the new demand
conditions.
We have in this section been illustrating the adjustment process of a
single product market in response to one change, with all other relevant
factors remaining unchanged. The market model used in this illustration
was characterized by a very artificial kind of timetable governing the op-
portunities to make decisions. In any real world market we will probably
expect the various kinds of decisions to be made on a far more flexible
schedule, and, especially, we would not expect the decisions of all entre-
preneurs to be made simultaneously, as they were in our hypothetical case.
Thus, in a realistic market the course of adjustment would be far less
even. We would no longer be able to say that, after the occurrence of
a particular change, there is a definite span of time during which only
decisions relevant to equilibrium in the very short run will be made,
222 MARKET THEORY AND THE PRICE SYSTEM


followed by a second definite span during which, in addition, decisions
affecting equilibrium in the short run will be made”free of long-run
decisions until a further definite period of time should have elapsed. Some
producers will be altering the rate of output in their plants in response
to an increase in demand, while other producers are not free to alter their
output at all; still other producers, perhaps, will already be making de-
cisions to increase the scale of plant altogether. Nevertheless, it will still
be generally true, even under these conditions, that some effects of a par-
ticular change will tend to make themselves felt earlier than others; some
effects, perhaps, working themselves out completely only after a very long
time. When it is desired to separate analytically these various effects from
one another, the mental tools to be used are the different abstractions of
incomplete equilibrium that we have been considering.

THE MARKET PROCESS IN A MARKET
FOR A SINGLE PRODUCT
The illustration worked out in the preceding section indicates the way
the market process exerts pressures on the producers of particular products
to make their various levels of decisions consistent with each other and
with those of consumers. We will explore this process further in this
section, still adhering to our assumption that resource prices (along with
all background data) remain unchanged.
If a market is not in equilibrium, we have seen, this must be the result
of ignorance by market participants of relevant market information. The
market process, as always, performs its functions by impressing upon those
making decisions those essential items of knowledge that are sufficient to
guide them to make decisions as if they possessed the complete knowledge
of the underlying facts. Let us assume that the given factor prices are
perfectly known, and that both consumers and producers also know the
current market price of the product. We can ignore, then, possible price
differentials for the product in various areas of the market.
Market disequilibrium, under these assumptions, must mean that the
output of the producers is not consistent with the prevailing market price
of the product. Producers are in aggregate producing either (a) more
than can be sold at the prevailing price, or (b) less than could be sold at
the prevailing price, or (c) they may be producing the precise quantity
that can just be sold at the prevailing price, but are using methods of
production not best suited for production under these price-output con-
ditions.
If producers are producing more than can be sold at the prevailing
price, the disappointments of sellers will force them either to cut back
output or to offer to sell at a lower price. If producers are producing less
MARKET FOR SINGLE PRODUCT 223


than can be sold at the prevailing price, the disappointments of buyers
will force them to offer to buy at a higher price. These adjustments are
not greatly different from those we became familiar with in Chapter 7.
If producers are producing in aggregate the precise quantity that is
just small enough to be sold completely at the prevailing price, but are
not using the "correct" production methods for this output, there are
several distinct cases to be considered. There will in any event be no
direct pressure for the price of the product to be changed. Adjustments
will take place, initially, on the supply side of the market. The initial
absence of full adjustment on the supply side of the market stems, as
always, from ignorance of market conditions. Our analysis of the eco-
nomics of production and costs in earlier chapters suggests the various
kinds of ignorance that may be involved. These kinds of ignorance, and
the respective kinds of corrective adjustments that will be brought about
by market forces, relate closely to the analytical framework within which
we have discussed, in the earlier sections of this chapter, the various pos-
sibilities of incomplete equilibrium.
An individual producer may find that his own daily rate of output is
too large or too small in relation to the product price. He finds that his
marginal cost far exceeds or falls far short of his marginal revenue; thus,
he would be better off with his margin of output drawn back or advanced
to the point where the marginal cost of output is as close as possible to
marginal revenue. This situation can have arisen only because of prior
ignorance on the part of the producer. When he last had the opportunity
to adjust the daily-output volume, he had apparently acted on mistaken as-
sumptions as to the product price to be expected. Since that time market
experience has taught him what the product price is, and hence he dis-
covers that he must adjust his output accordingly, at the earliest oppor-
tunity. Those entrepreneurs who are most speedily informed of the correct
market price are in the position to most rapidly gear their production
decisions for the appropriate output volume. The gradual discovery by
producers of what the current market conditions really are will then set
into motion an adjustment of aggregate output that may in turn generate
a series of price adjustments until there is consistency between consumers'
and producers' decisions. Market agitation will reflect the impact of the
changes in producers' plans in their successive attempts to bring these
plans into consistency with the market.
On the other hand, the discovery by an individual producer that his
output is too large or too small may reflect decisions made on the basis of
incomplete knowledge, not recently, but in the relatively distant past. In
other words, the decisions that an entrepreneur has made most recently,
with respect to the level of plant utilization and the purchase of variable
inputs, may have been made with complete knowledge of all relevant market
224 MARKET THEORY AND THE PRICE SYSTEM


information. The fact that output volume is too large or too small may
be the result of mistaken investment decisions in the distant past, decisions
made when market conditions of the then distant future were incorrectly
perceived. The scale of plant may be too small or too large in relation to
current sale possibilities.7 The gradual discovery by the different producers,
of true market conditions, will lead to a gradual reshuffling of plant sizes.
Some entrepreneurs will build larger plants, some smaller, and some will
close down their plants altogether. During this process aggregate output
will gradually change, and bring in its train gradual movements in the
product price and subsequent further adjustments in plant size and rate of
output. These long-run market forces will be felt less perceptibly in any
one short period, but over the long period will exert overriding influences.
So long as complete long-run equilibrium has not been attained, this kind
of market agitation will continue. The point is that for production to be
completely adjusted both to the tastes and incomes of consumers, and to
the wishes of producers, decisions must be made at numerous different stages,
all of which must be mutually consistent. Lack of consistency in the de-
cisions made at any one level will bring about possible inconsistency at subse-
quent levels of decision making as well. All this leads to change, as the
operation of the market reveals these inconsistencies through the disappoint-
ments suffered in the market by decision makers. The entrepreneur who
made a complete mistake in entering an industry altogether, for example,
will sooner or later discover that his decision to produce at one particular
cost of production is altogether inconsistent with the degree of eagerness
of consumers to buy his product. His losses will eventually force him to
leave the industry.
Thus far we have analyzed the market process in a single product market
on the assumption not only that factor prices were constant, but also that
consumers' tastes and basic buying attitudes were maintained unchanged
throughout the time long-run adjustments were being made. As soon as
one relaxes this assumption, market agitation must at once assume far
more formidable proportions. Even if we continue the assumption of no
change in factor prices and production techniques, and merely allow the
attitudes of consumers to change, it is clear that the picture becomes far
less simple. In making short-run and long-run decisions, producers must
plan not only on the basis of current market data, but also on the basis of
the expected changes in buyer attitudes for a long time to come. The scope
for entrepreneurial activity, based on a superior ability to forecast future
conditions in the market, becomes immediately wider. The pressure of
market forces will now lead the organization of production to be consistent
7 Since we are assuming perfect knowledge and forecasting of factor prices, we do not
take notice here of the possibility that an entrepreneur discovers his plant to be too
large or too small, due purely to the unexpected high or low prices of variable inputs.
MARKET FOR SINGLE FACTOR 225


with the expectations of producers and consumers as to future changes in
attitudes and tastes. Market disequilibrium will now be the result of
(past) imperfect forecasting of (then future) conditions, in addition to
imperfect knowledge of the present.


THE MARKET FOR A SINGLE
FACTOR OF PRODUCTION
Thus far in this chapter we have been examining one special kind of
sub-market”that for a single product”within the market as a whole. We
have seen how market forces would manipulate the decisions of producers
and consumers in such a sub-market, under specified assumptions with re-
spect to the variability of other market phenomena. Prominent among
these restrictive assumptions was our specification that factor prices should
not change throughout the analysis. Our purpose in making this obviously
artificial assumption was deliberately to illustrate the operation of the
market process in a very limited area, as an introduction to the more compli-
cated process to be taken up in the next chapter. In the present section,
for similar reasons, we once again consider the market processes operating in
a severely limited area, which we insulate from the impact of outside market
forces. This time we consider the market for a particular factor of produc-
tion. We will imagine a large number of resource owners endowed by
nature with a daily supply of this factor of production. We will assume,
for the purposes of the analysis, that the prices oi¯ all the products (especially
those in whose production the factor is able to cooperate) are given, known,
and constant. In addition, since we confine our inquiry to the market for
only one factor, we assume that the prices and quantities employed of all
other factors of production are given, known, and constant.8
Our problem is to understand the nature of the market forces that
determine the prices our factor of production is sold at in the market, and
the quantity of it sold to entrepreneurs and employed in the production of
the various products. As before, we will proceed by first spelling out the
conditions for equilibrium in this factor market (indicating how these would
be achieved were knowledge perfect), and thereafter searching for the market
processes that would be set into motion by the absence of equilibrium condi-
tions.
EQUILIBRIUM IN A FACTOR MARKET
For the market for a particular productive factor to be in equilibrium,
it is necessary that no resource owner nor any entrepreneur-buyer or pro-
8 In this discussion, we will not be making explicit reference to a market for a
produced factor of production. This case too. however, can be analyzed on the lines
developed both in the following discussion, and in the preceding sections.
226 MARKET THEORY AND THE PRICE SYSTEM


spective buyer of the resource should have any reason to alter his market
behavior with respect to the factor. The decisions of the resource owners
in aggregate to sell a given quantity of the resource at a given price must
mesh completely with the decisions of entrepreneurs to buy the resource.
Entrepreneurs must plan to buy currently, at a given price, the precise
quantity of the resource that resource owners are planning to sell at that
price. Moreover, the long-range plans of entrepreneurs must also call for
no change in the quantity of the resource that they will employ. (Since we
ignore the possibility of a resource being bought to be stored for future use,
we will consider the purchase by an entrepreneur of a resource as reflecting
a decision to employ that resource in current production.)
Let us consider the alternatives facing both a resource owner and an
entrepreneur-producer when they make their decisions to sell or to buy a
resource. For the resource owner the alternatives are relatively clear-cut.
He finds himself endowed daily with a given quantity of the factor. He can
do one of two things with each unit in his factor supply. He can sell it
in the factor market, or he can keep it for himself for direct consumption.
For example, a man finds that he can supply twelve hours of labor per day.
He can choose between selling all or part of this in the labor market, or
enjoying the whole time for himself as leisure. A landowner can supply
physical space each year to entrepreneurs who may wish to erect plants upon
it, or he may if he wishes retain the land for himself as a private garden.
At any given market price for the resource, a resource owner will sell a
quantity of the factor such that the marginal utility for him of the additional
commodities that he can buy through the sale of the last unit of the factor
is just higher than the marginal utility for him of the factor unit itself. He
will retain for himself that quantity of factor such that the marginal utility
for him of a factor unit that he possesses is just higher than the marginal
utility for him of the additional commodities that he might have acquired
through the sale of one more unit of factor.9 Of course, in contemplating
9 See Ch. 5, p. 63, ftnt. 1. The analysis of consumer demand developed in Chs. 4
and 5 can be used to examine the decisions of the resource owner. In the diagram
any point represents a combination of (1) a laborer's available labor service that he does
not sell (that is, which he consumes as leisure) and (2) a quantity of a commodity a.




Figure 10-4
OA represents the greatest quantity of labor that the laborer can sell in a given time
period. The line AB represents the possible positions that the laborer can take up
assuming him to be interested in consuming only the one commodity a. The slope
MARKET FOR SINGLE FACTOR 227


the sale of a quantity of a resource, a resource owner will seek the highest
price obtainable in the market, so far as he knows.
An entrepreneur who is deliberating on the purchase of a quantity of
factor, faces a rather different set of alternatives. Moreover, he may con-
template such a purchase in the context of decisions on any of several levels,
in each of which a separate set of alternatives will be relevant. An entre-
preneur knows, on our assumptions, the prices of the various products that
he can produce, and he also knows various possible methods of production
available to him. In the long run his problem is to decide what branch
of production he should enter. In the shorter run he must decide how
much of the factor, along with other inputs, he should buy to obtain his
current output goals. In the long run he will choose to enter that branch
of production where his investment promises him the greatest profits. In
making such a decision an entrepreneur commits himself to the purchase of
necessary resources, in long-range preparation for future productive activity.
The particular combination of resources that he will select will be again
one that promises him the greatest net profit advantages. In such a resource
combination, planned correctly from the very beginning, all the factors
that contribute eventually to output will be present (a) in the correct propor-
tions, and (b) in the correct scale. We know, from earlier chapters, what
these two conditions involve. They require first of all that the marginal
increment of product gained in the long run by the additional expenditure
of a given sum of money upon any one factor be approximately equal to
the corresponding marginal increment that would be gained by the addi-
tional expenditure of the same sum upon each of the complementary factors.
They require, moreover, that in the production of any one product, factors
be hired up to the point where the value of the marginal increment of
product corresponding to the last unit of each factor employed be just greater
than the increment in expenditure involved by this unit.10
In making long-range plans, therefore, in the light of the known pro-
ductive possibilities of each of the factors, and of the prices of the factors and
the products, entrepreneurs will commit themselves to the purchase of a
particular factor, only in sharply defined quantities. For each product
produced an entrepreneur will seek to buy a quantity of the factor so that,
in cooperation with other factors, he will have erected the scale of plant

of the line AB reflects the relative prices of labor and of a. The analysis of the quantity
of labor that the laborer will sell can then be continued completely parallel to the
analysis of the consumer in Ch. 5. (Of course, where institutional conditions make it
possible to sell labor only in large units, then the continuous line AB must be replaced
by a series of discrete points. In such cases the marginal unit is large. In extreme
cases the resource owner may not be able to vary the quantity that he sells; he may
be faced with "all-or-nothing" conditions. In this special case, his entire resource
endowment is the relevant marginal "unit.")
10 See Ch. 9, p. 200, ftnt. 10.
228 MARKET THEORY AND THE PRICE SYSTEM


optimally suited to the future daily production of the most desirable volume
of output. This will depend, as we have seen, on the respective marginal
increments of product associated with the various factors. Thus, our
factor will be purchased by the producer of each product, insofar as his
purchase involves long-range preparation for production, so that when
expected productive activity is under way, the volume of output and the
proportion of the various inputs will fulfill the above conditions for opti-
mality.
In addition, an entrepreneur may contemplate purchase of the factor
in making decisions to regulate the current output volume. Here the factor
will be one of the variable inputs to be used in cooperation with the fixed
plant and equipment. If the original long-range plans were well-laid, the
variable factors will be employed in the proportion and on the scale orig-
inally envisaged”and therefore again will be fulfilling the optimality condi-
tions. Once again then the employment of our factor will depend upon
its efficiency at the margin of employment.
However, as a result of current conditions, the best output that should
be maintained with the given plant might be different from that originally
envisaged. In this case it will no longer be true that the variable factors
are now to be purchased so that the optimal relationship between their
prices and their productive efficiency at the margin are to be achieved.
Nevertheless, within the scope of the methods of production possible with
the given plant, the entrepreneur will still seek that bundle of variable
inputs that will minimize the current costs of the selected output volume.
Once again, therefore, a factor will be purchased as part of variable inputs
in a quantity such that the marginal increment of product (defined now
with reference to the given plant) associated with the purchase of the last
unit of it should just exceed its marginal cost to the producer.
We are now in a position to define the conditions for complete equi-
librium in our factor market. As usual, the conditions include the require-
ment of a single price for the factor throughout the market. And, again
as usual, it is necessary that the price of the factor be such that the quantity
of factor, which resource owners wish to sell in aggregate at the ruling price,
is exactly the same as that which entrepreneurs will just be willing to pur-
chase at the price. But the implications of this last requirement for com-
plete equilibrium, which are peculiar to the market for a factor, need to be
spelled out.
The equilibrium price for a productive factor, (prices of products and
of other factors being given) must be such that exactly that quantity of
factor is offered for sale (that is, withheld from personal use) as is demanded
to be bought. The quantity that resource owners will offer for sale at this
price will reflect the fact the marginal utility to the seller of the last unit
to be sold of the factor is just lower than that of the additional commodities
MARKET FOR SINGLE FACTOR 229


that he can buy with the increment in revenue derived through sale of his
factor unit. In other words the equilibrium price is just high enough to
make it worthwhile for the last unit of factor (necessary to complete the
equilibrium quantity) to be sold by that seller who is less eager to part with
this unit than are the other sellers to part with the units they do sell.
(Of course, this marginal seller is also less eager to retain this unit for him-
self than are the other resource owners to retain all the units for themselves
that they do not sell at the ruling price.) The quantity that entrepreneurs
will seek to buy at the equilibrium price must be exactly the same as this
equilibrium quantity. This quantity will be bought by the various pro-
ducers of each of the various products. For complete equilibrium not only
should the current rate of plant utilization be optimally adjusted to the
factor prices, but the scale of plant itself also should be so adjusted. The
aggregate quantity of the factor that is purchased at the equilibrium price
will reflect the fact that the value of marginal increment of product asso-
ciated with the last unit of the factor purchased by each producer (measured
with respect to long-range calculations) is just greater than the increment in
expenditure required for this factor unit. This must be the case for all
producers in all branches of production.
If these conditions are fulfilled, no participant in the factor market
has any reason to make plans to alter his activities in this market, all other
things remaining unchanged.11 No resource owner is disappointed in his
plans, nor is there any more profitable way he could dispose of his resource
endowment. Similarly, no entrepreneur will be disappointed in his plans,
nor will he discover any more profitable methods of production. Since his
long-range and short-run decisions are mutually consistent with each other
and with current market conditions, it follows that any increase or decrease
in the quantity bought of the factor will upset the proportions factors are
combined in, in a manner that can only decrease efficiency. The conditions
for equilibrium define the size of plant used by each producer in the produc-
tion of each product using the particular factor; they define also the current
volume of output for each producer of each product where the factor appears
as one of the variable inputs; they define the price the factor is sold at; 12 and
11 This point occurs, of course, at the intersection of the market demand curve for
the factor and the market supply curve of the factor”where these curves, as usual,
reflect the amounts of factor that would be respectively asked to be bought and offered
for sale at hypothetical given factor prices. The analysis in the text explains how actual
factor prices (like actual commodity prices) emerge from the attitudes reflected in the
relevant supply and demand curves.
!2 A special case is where the equilibrium price of a resource is zero. Such a resource
is a free good that yields its owner no income in the market, and in whose use it is not
necessary to economize. Suppose that market participants are endowed with huge tracts
of fertile land so large that even the employment of all the complementary resources
(such as labor and tools) available to the group cannot bring all the land under cul-
tivation, then clearly no price can be obtained for land; competition among landowners
230 MARKET THEORY AND THE PRICE SYSTEM


they define, for each owner of the resource, the quantity that he will sell.
Once again it is not difficult to see that perfect knowledge on the part
of all participants in the factor market would help them immediately toward
achieving these equilibrium conditions. With all other prices known, with
all possible methods of production known, with the degree to which each
resource owner is eager to retain factors for personal use known, each partici-
pant would know at what price it would be possible for all of them to adjust
their activities so that no disappointments need occur. No entrepreneur
would plan production on the assumption that he will have to offer a price
for the factor any higher than this equilibrium price. He knows that the
lower price is quite sufficiently high to induce the more eager sellers to
supply all that entrepreneurs will demand at this lower price. No resource
owner, in fact, will waste time asking any higher prices, since he knows that
buyers can find all they will want to buy at the lower price. On the other
hand, no resource owner will accept a price for the factor any lower than
the equilibrium price. He knows that the higher price is quite sufficiently
low to attract entrepreneurs to formulate a long-range production plan
calling in aggregate for a quantity of factor that is not less than the entire
factor quantity that resource owners wish to sell at the higher price.
We notice that, as was the case in our analysis of the market for a single
product, it is analytically possible to distinguish cases of incomplete "equi-
librium" in a factor market as well. It is possible, for example, to set up
a model where all decisions to alter the scale of plants are excluded. The
only decisions that producers are free to make, then, are those involving
alteration of "variable" input proportions employed. In such a model it
is possible to talk of "equilibrium" in the factor market, in the sense that
the permitted decisions of both resource owners and entrepreneurs are

would drive down the price to zero. Whenever, in fact, the quantity of a specific factor
is so large that a surplus of it remains after combining it with all the other complementary
versatile factors worthwhile to apply to the branch of production the first factor is spe-
cific to, then the first factor can command no price. As soon as the market demand for
the product (to whose production this factor is specific) increases so much that it be-
comes worthwhile to employ so large a quantity of the complementary factors in its
production as to exhaust the entire available supply of the specific factor, the specific
factor begins to command a price. This price is a rent since the factor is specific; how-
ever, as we see, it is governed by the same analysis that we apply to all prices. Con-
tinued increases in the demand for the product will force up the price of this factor
more than the price of the other factors. Even a moderate increase in the price of the
other factors may suffice to withdraw additional quantities of them from the other
branches of production where they may have been used. But the specific factor is not
used elsewhere in the economy; it commands a rent only because all of it is insufficient
to satisfy the demand for it in production (when free). The perfect inelasticity of its
supply makes its price depend, even more sensitively than that of other resources, on the
price of the product. On the relativity of the terms "specific factor" and "rent," see
p. 187.
MARKET FOR SINGLE FACTOR 231


mutually consistent. Within the range of permitted decisions, there will
be no disappointed plans in such an equilibrium situation. For such a
situation to exist it is necessary that a price for the factor prevail so that
the quantity that resource owners wish to sell at the price exactly equals the
aggregate quantity that producers will wish to employ at the price, with
given plants. This equilibrium price, as before, must be high enough to
provide the power to purchase commodities with a marginal utility just
higher than that of the last factor unit sold, to its seller; the equilibrium
price must also be such as to make the marginal cost of the factor to the
producer, just lower than the value of the marginal increment of product
derived from the employment of the last factor unit bought.

THE MARKET PROCESS IN A MARKET FOR A
SINGLE FACTOR OF PRODUCTION
In the absence of perfect knowledge we may expect factor sales to be
transacted at prices different from the equilibrium price, and production
to be carried on in plants calling for employment of the factors in aggregate
quantities other than that which would be consistent with an equilibrium
price. These buying, selling, and producing activities will result in disap-
pointed plans; the revision of these plans; and a new set of buying, selling,
and producing activities. These changes will constitute the agitation char-
acteristic of all markets that have not yet attained equilibrium. In this
section we sketch the kind of changes that will be generated by the absence
of equilibrium conditions. We will be able to dispense with detailed repeti-
tion of patterns of change that we have become familiar with in Chapter 7
and in the earlier sections of this chapter. We will proceed by considering,
as an illustration, what happens when a factor market initially in equilib-
rium is subjected to a sudden change. We retain our assumption of known
and constant prices of all products and of all other resources.
A factor market is initially in complete equilibrium. Producers have
built plants in the "correct" sizes in the past (so that in aggregate the same
number of new plants each year replace an equal number of old ones with-
out any alterations in sizes) such that the annual aggregate quantity of the
factor purchased by all producers of all products, in response to the market
price of the factor, can be maintained indefinitely if this price continues.
Long-range plans of all producers in all industry call for the employment
of the factor in each industry to the point where its effectiveness per unit
at the margin is just sufficient to justify paying the market price for the last
unit purchased. At the same time resource owners are induced by the
same market price for the factor to sell exactly the amount sought by pro-
ducers at the price; and no resource owner finds himself disappointed in his
232 MARKET THEORY AND THE PRICE SYSTEM


selling plans, nor in any other way under pressure to alter his selling activity.
Into this situation a sudden unexpected permanent change in the basic data
is introduced”in the form of the invention of a new technique for the pro-
duction of several products. The relevance of this invention for the
market for our factor consists in the fact that as a result of this invention the
effectiveness at the margin of our own factor in the production of these
products has been sharply increased. Our task is to investigate the conse-
quences of this change for activity in the factor market.
It is clear that the factor market is no longer in equilibrium. We are
not assuming perfect knowledge in our model, and therefore, as we have
seen, the market prior to the new invention was perfectly adjusted to its
absence: nobody had made plans based on the expectation of the invention.
The plans of producers thus cannot be expected to be maintained indefi-
nitely without change. Sooner or later somebody producing one of the
products that can be produced more efficiently with the new technique will
discover this. He will seek, at the earliest opportunity, to replace the older
methods of production by the newer one. This will involve a reshuffling
of all his variable inputs until he will have achieved (a) what now appears
as the most desirable output level (attainable with the existing plant, that,
while not planned directly for the new technique, cannot be altered in the
short run), and (b) what now appears as the most desirable set of "variable"
input proportions. Under our assumptions as to the constancy of other
prices, the result will be an increase in the quantity this entrepreneur will
seek to buy of our own factor (at least so long as resource owners have not
discovered that they may be able to ask a higher price). As knowledge of
the new technique spreads, it is clear, the old price for the resource ceases
to be an equilibrium price; the aggregate quantity of the factor demanded
exceeds the quantity that resource owners are prepared to sell at the price.
There will be disappointed plans for at least some producers. These disap-
pointments will gradually lead both producers and resource owners to
recognize that higher prices must be offered, and may be confidently asked,
for the resource. The immediate impact of the technological discovery
has thus been an increase in the quantity of this factor employed, together
with a rise in its price. This price rise may be modified by a tendency on
the part of producers who cannot use the new technique to replace our
factor by substitutes as its price begins to rise.
Eventually, further changes may be expected. When entrepreneurs
have the opportunity to revise their long-run plans, they will do so in the
light of the new productive technique and the new higher prices for our
own factor. For each producer, there will now be a different scale of
plant that promises to be the most desirable. A new volume of output
and a new set of long-run input proportions will be selected by each pro-
PARTIAL MARKET PROCESSES 233


ducer in each industry. This will again alter the aggregate annual quan-
tity of the factor sought to be purchased at the previously established new
price for the factor. This may involve a new adjustment in the market
price of the factor. This kind of market agitation will continue for as long
as the factor market has not attained complete equilibrium.

TOWARD THE GENERAL MARKET PROCESS
We have in this chapter considered separately two areas within a mar-
ket system. Wefirstexamined the processes that would be generated within
the market for a single product, which could be imagined as insulated
from the rest of the market. We then examined a similarly insulated
market for a single productive resource. The juxtaposition of these two
cases should have emphasized the artificiality of the assumptions regarding
their "insulation" from the rest of the market. At the same time this
juxtaposition should have suggested the direction that the analysis must
be extended to if it is to provide a glimpse of the concatenation of decisions
running throughout the entire market system. It must have been re-
marked, for example, that when a new invention increased the marginal
effectiveness of one input, with respect to the production of several products,
we might have expected (if released from the assumed constancy in product
prices) a tendency toward a lowering of the prices of these products, with
subsequent further adjustments. We will explore the more general market
process in the following chapter.
At this point we merely pause to recognize that our analysis shows the
way market forces would operate in each limited area of the market, if
each of these areas were insulated from the rest and considered in turn.
When we drop these "insulating" assumptions, it becomes apparent that
for equilibrium to exist in any one area, it is necessary that conditions be
fulfilled that relate directly to other areas. Moreover, it becomes apparent
that in the absence of equilibrium in any one area, the market forces set
into motion will impinge on other areas as well. Agitation in the market,
proceeding from an initiating cause in one area, will take the form of rip-
ples of change moving from one area to another and, of course, initiating
secondary waves of change having an impact also upon the area the agi-
tation originated in. We turn in the next chapter to this more complex
problem.
SUMMARY
Chapter 10 commences the analysis of the way the decisions of both
consumers and producers interact in the market place to determine the

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