title: Studies in the economics of overhead costs.
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MAURICE CLARK PROFESSOR OF POLITICAL ECONOMY AT COLUMBIA UNIVERSITY THE UNIVERSITY OF CHICAGO PRESS CHICAGO, ILLINOIS UBh'i COPYRIGHT 1923 BY THE UNIVERSITY OF CHICAGO ALL RIGHTS RESERVED. PUBLISHED DECEMBER 1923 Fourth Impression October 1931 COMPOSED AND PRINTED BY THE UNIVERSITY OK CHICAGO PRESS CHICAGO, ILLINOIS, U.8.A. AM 0^6 TO MY FATHER PREFACE This volume is a bit of research into the principles of dynamic economics. It is an experiment in a type of economic theory which is largely inductive, which comes to grips with the dynamic movements and the resistances to movement, and the organic interrelations of parts, which make our economic world a dynamic social organism, rather than a static mechanism with an endless uniformity of perpetual motion. It studies the discrepancies between supply and demand; indeed the whole subject of the book might be defined as a study of discrepancies between an ever fluctuating demand and a relatively inelastic fund of pro¬ ductive capacity, resulting in wastes of partial idleness, and many other economic disturbances. Unused capacity is its central theme. This subject, of costs which are not traced to units of output, or do not vary with output, has challenged the author’s scientific interest for years. From being a mere exception to the general laws of value and efficiency it has grown to be a large and impor¬ tant section of economic principles. And now the question seems to be whether it can best function as an autonomous department of economics, or whether the whole body of economic thought must become an “economics of overhead costs” in the sense of being integrally built upon this as a part of its founda¬ tion. In the latter case, the new groundwork would need to include many other equally important and equally fundamental facts of human nature and industry, all of which together would furnish an adequate and convincing background for a picture of the dynamic, organic, and social qualities of our industrial life. The author has sometimes said that a graduate class in economic theory would be a success if the students gained from it a real understanding of the meaning of cost in all its many aspects. He believes that the economist may well study the X PREFACE accountant’s conceptions of cost, since they constitute economic forces which affect the conduct of business and the laws of value and production. But he believes just as strongly that the accountant should know the meaning of cost from the standpoint of disinterested economic science, because it embodies, in a sense, that impossible goal to which his practical devices serve as approximations. Thus one task of this work has been to try to throw the light of these two conceptions upon each other— with what success the reader must determine. A word of explanation may be in order as to why this bit of experimental research in economic theory should appear in a series of “Materials for the Study of Business.” The funda¬ mental reason is twofold. The author of the book believes in carrying theoretical study into the realm of those facts and forces with w r hich business is consciously in contact (as it is often not consciously in contact with the traditional abstract levels of long-run equilibrium) and generalizing upon that great wealth of inductive material which is accumulating at an ever increas¬ ing rate and for which our schools of business are so largely responsible. And the editors of this series believe that a study of the laws of industry from the broadest social standpoint, and from the standpoint of the search for useful truth of whatever color, is a vitally necessary part of business education. And such a testimonial to the practical worth of theoretical study is, to say the least, worth accepting on behalf of theoretical economics. While the book was not originally planned as a commercial text, the material has been used as the basis of a course in which students of the School of Commerce have participated, along with students in the Department of Political Economy. The course has been given three times, the students have contributed valuable data and an invaluable service of criticism and dis¬ cussion, and the professor’s resignation has not yet been requested. In fact, he has been strengthened in the conviction that a course covering this subject-matter fills a very important niche in any university curriculum and he looks to see such courses become fairly numerous in the near future. PREFACE xl The author has tried to put the argument in such form that business men would find it readable, if they were willing to deal with some few unfamiliar terms and to accept the standpoint of a search for the laws of economic efficiency in the large, rather than of that narrow commercial efficiency which breeds the convulsions that sap the strength of business as a whole. Such readers might do well to omit chapter xxiii, dealing with the theory of marginal productivity, but it is the author’s earnest hope that they will find the bulk of the argument worthy of their attention. The subject it deals with, especially the discrep¬ ancies between commercial and community measures of efficiency, is as important as any which is before us today, and the impor¬ tance of the theme may make up for shortcomings in the author’s presentation. Grateful acknowledgments are due to more individuals than can be named. First of all to my wife, whose suggestions have had more value than she would admit, whose probable comments have been constantly in my mind, affecting the form of the entire work, and who has devoted to it an amount of toil which can never be adequately recognized by that too conventionalized reward of the author’s wife, a mention in the Preface. I have also profited by discussions of particular phases of this work with my colleague, Professor Jacob Viner, and my former colleague, Professor F. H. Knight, now of the University of Iowa. Pro¬ fessor J. 0. McKinsey of the School of Commerce and Administra¬ tion of the University of Chicago kindly read and commented on one part of the manuscript. Acknowledgment is also due to the members of the classes who have worked with me over this material, and to the entire group of teachers and students at the University of Chicago, whose spirit of realism and intimate contact with economic facts have furnished a mine of suggestion and a salutary corrective for the overabstract tendencies of the theorist. As for the many writers who have written on one phase or another of this subject, partial acknowledgment is made in the course of the text, though no one can ever know all the influences which have helped form his ideas on any large subject. The Xll PREFACE greatest debt of all is to my father, who started me in this field of inquiry as a graduate student, who has followed my work with a combination of generous interest and wise refraining from inter¬ ference, and to whom this work is dedicated as a very small contribution toward realizing his conception of a dynamic economics. John Maurice Clark Carmel, California August 29, 1923 CONTENTS CHAPTER PAGE I. The Gradual Discovery of Overhead Costs .... i II. The Scope of the Problem.17 III. The General Idea of Cost and Different Classes of Costs. 35 IV. The Laws of Return and Economy, or the Variables Governing Efficiency.70 V. The Laws of Return and Economy, or the Variables Governing Efficiency { Continued ) .86 VI. How and Why Large Plants Bring Economy .... 104 VII. Economies of Combination.135 VIII. Different Kinds of Business Rhythms.149 IX. Different Costs for Different Purposes: An Illustra¬ tive Problem.175 X. What Is a Unit of Business ?.204 XI. Three Methods of Allocating Costs. 216 XII. Functions and Chief Methods of Cost Accounting . . 233 XIII. Railroads and Costs: A Statistical Study .... 258 XIV. Overhead Costs and Railroad Rate Problems ... 281 XV. The Transportation System as a Whole.298 XVI. Public Utilities.318 XVII. Overhead Costs in Other Industries.335 XVIII. Labor as an Overhead Cost.357 XIX. Overhead Costs and the Business Cycle.386 XX, Discrimination in the Modern Market.416 XXI. Cut-Throat Competition and the Public Interest . . 434 XXII. Costs of Government as Overhead Outlays .... 451 XXIII. Overhead Costs and the Laws of Value and Distribu¬ tion . 459 XXIV. Conclusion.480 Index of Authors.489 Index of Subjects . 49 2 • •• 2011 CHAPTER I THE GRADUAL DISCOVERY OF OVERHEAD COSTS SUMMARY Preliminary definition of overhead costs, i—Expenses of production under handicraft and domestic systems, i—Discrimination natural, 2—Growth of the one-price system, 5—Some early references to overhead costs, 5—Machine versus man: how their costs behave, 7—Overhead costs on railroads, 9—Overhead costs in other industries, 11—Hadley’s summary of the problem, 12—The con¬ tribution of cost accounting, 14—Developments in public utilities, 14—Labor as an overhead cost, 15. I. PRELIMINARY DEFINITION OF OVERHEAD COSTS What are “overhead costs”? The term is nowadays much used and variously defined; in fact, it covers an entire fam¬ ily of ideas, but they have one essential thing in common. They refer to [costs that cannot be traced home and attributed to particular units of business in the same direct and obvious way in which, for example, leather can be traced to the shoes that are made from it. And most of the real problems involve one other fact; namely, that an increase or decrease in output does not involve a proportionate increase or decrease in cost. There is a deal of complexity in the attempts that are made to trace the untraceable costs or to assign them on some rational basis, or to discover the true added costs of added business, but at the bottom of most of these complexities lies a fact that is simple. That fact is unused productive capacity, or capacity of which full advantage is not taken. “Idle overhead,” that great industrial sin, is simply the expense side of this unused capacity. Our study of overhead cost will be largely a study of unused powers of production. ] y y / 2 . EXPENSES OF PRODUCTION UNDER HANDICRAFT OR DOMESTIC SYSTEM The entire idea of expenses of production is, in a sense, a rather recent one. The medieval handicraftsman had occasion 2 ECONOMICS OF OVERHEAD COSTS to count the cost of his materials, and the merchant the outlay for his wares, but his own time he did not pay for, and it was not thought of in terms of expense, in the modem business sense. With the coming of the wage system, labor became an expense of production, paid out by the entrepreneur to someone else. More particularly with the domestic system, the employer paid the worker not merely for the latter’s time but also for the use of his tools and of the premises where he worked. The employer’s chief investment was in the materials, so that virtually every element which economists now think of as an expense of production was paid for in such fashion that each item could be directly charged to an item of product. In these very special circumstances, expenses were virtually all traceable directly to units of product, and overhead expenses were virtually non-existent. From the slowness with which economic science has assimilated the facts of overhead expense, one is almost tempted to conclude that its prevalent ideas on expenses of production date back to the domestic system and are not really appropriate to any later stage of industrial development. 3. DISCRIMINATION NATURAL Our system of trade is a surprisingly artificial thing, in that it is built upon habits and conventions which are, many of them, quite recent and which may, many of them, prove to be quite temporary. In the same way our economics may be said to be artificial, in that it is often tempted to regard these customs and conventions as laws of nature. One custom of this sort is the custom of selling goods to all customers at the same price. And akin to it is the economic doctrine that in a competitive market there can be but one price for one commodity at one time, and the further notion that the prices of individual commodities are governed and definitely determined by their individual expenses of production under a competitive system. If one looks at the matter historically, one sees that this has never been an accurate or adequate description of things and that it has been approxi¬ mately true only for a limited period, beginning with the break¬ down of medieval guild restrictions and ending with the growth GRADUAL DISCOVERY OF OVERHEAD COSTS 3 of industries using large fixed capital. And this is but a minute fraction of time in the history of the human race and includes only the brief infancy of industrialism. Even within that period, discrimination in prices has been an ever present fact, and, far from being a violation of any natural economic laws of competition, it is one of the natural forms which competition takes. As for the proposition that under competi¬ tion there can be but one price in a market, in manufacturing industries there is much stronger ground for holding that under competition there must be, chronically or at least intermittently, two different prices in the same market. Without this it would be difficult or impossible for competition to do its supposedly natural work of ironing out profits and bringing prices and expenses of production together. 1 Some commodities are so standardized and are sold in such well-organized markets that differences in price are very nearly eliminated. But even with such commodities as steel and oil there are differences that are important, small though they may be. Discrimination is the natural and universal mode of trade in countries which have not reached a stage of modern industrialism. It prevails everywhere in the Orient and to a less extent in Europe, although the American one-price system is spreading and there are stores in Japan and China where one is informed on entering that this is a one-price store. The information is very much needed, because without it no self-respecting customer would think of paying the price asked and no shopkeeper would have anything but contempt for the customer who did so. The practice of the art of negotiation furnishes the chief interest of the game to traders of this type and it is virtually as old as trading itself. The economics of it is extremely simple. The goods, for the most part, are not definitely standardized. The customer does not know whether he is being charged more or less than the market price, because there is no market price. It is contrary to the ethics of this kind of trading to go around openly pricing goods in several shops. As for the merchant, he knows what 1 This point will be taken up in a later chapter. 4 ECONOMICS OF OVERHEAD COSTS he actually paid for his goods, and he has his living to make. If he sells goods, they must ordinarily bring in more than he actually spent for them, but his need of an income to cover his living expenses goes on whether he makes many sales or few or none. If he could be made to understand the modem economist’s idea of cost as a reward that must be paid in order to secure the service of manager, laborers, shop and wares, he might discover that his own time, or his own subsistence, constitutes an over¬ head cost, chargeable to his entire business but not chargeable to any particular sale. However, not having the advantage of contact with modern economics he continues to carry on his trade without burdening his mind with unnecessary philosophiz¬ ing as to economic reasons for his policy. If a particular customer happens to know the market well, he will generally get lower prices than one who does not, because he will get the full benefit of such competition as exists. Other customers will be more in the position of purchasers dealing with a monopoly. With this system of price discrimination, based upon an un¬ analyzed element of overhead cost, organized economic thinking seems to have been continually at war, at least down to the last quarter of the nineteenth century. Among the ancients the value of a commodity was thought of as an intrinsic thing, so that a transaction was either at the value of the commodity or above or below it, and this lent itself to the idea that if one party gained in a trade the other necessarily lost. In medieval times it was accepted doctrine that all sales should be at a just price and a just price was commonly thought of as that which would furnish an income to the craftsman or trader sufficient to maintain him in a customary and fitting way, suitable to his station in life. It would cover his customary “overhead charges.” It is somewhat doubtful how effective the machinery of regulation was in practice, whether on the part of guilds or of national governments, in controlling the actual levels of prices, but it seems probable that it had considerable effect in preventing isolated transactions from being made at prices far removed from the market. It undoubtedly acted strongly in the direction of a one-price system. GRADUAL DISCOVERY OF OVERHEAD COSTS 5 4. GROWTH OF THE ONE-PRICE SYSTEM Modem trade followed the practice of discrimination, though perhaps spending less time on the maneuvers of negotiation than the merchant of the oriental bazaar. Stores grew in size and the selling was done by hired clerks. The owner could not generally trust either their knowledge of the goods, their shrewd¬ ness, or their devotion to the profits of the business sufficiently to delegate to them the diplomatic responsibilities of old-style bargaining. Prices were marked on the goods, but in cabalistic ciphers, and the salesman’s discretion was guided and limited, but not eliminated. Finally came the now-familiar system of marking goods in plain figures so that customers could tell what the price was without asking the salesman. This prac¬ tically coincided with the development of large-scale retailing and its economies were obvious. It took less time to make a sale and thus enabled more sales to be made, and it required less talent and knowledge of the busi¬ ness on the part of the salesman. Nowadays, in stores that do not stick to one price the price is often still printed in plain figures, and the salesperson will call in the manager if it becomes necessary to accept something lower in order to make a sale. Thus the one-price system means a saving in overhead costs. However, far from bringing overhead costs into prominence it tends to take care of them automatically by apportioning them equally upon all commodities, or at least upon all units of a single commodity. Manufacturers and wholesalers, to be sure, do not generally follow this policy, but their discriminations appear to have been prevailingly regarded as imperfections of the market and exceptions to economic law, rather than as natural phe¬ nomena whose laws are economic in character and demand study by the economist. 5. SOME EARLY REFERENCES TO OVERHEAD COSTS One special case of overhead costs, indeed, was noted by John Stuart Mill under “Some Peculiar Cases of Value.” 1 In the case of joint products, competition tends to bring the entire income of an industry down to cost, but the relative prices of the 1 Principles of Political Economy, Book III, chap. xvi. 6 ECONOMICS OF OVERHEAD COSTS different products are whatever may be needed in order to take them off the market in the same relative amounts in which the joint process turns them out. This case is dismissed in a brief postscript to the general theory of value, and the reader is left to assume that these are the only cases in which cost of pro¬ duction (or custom) 1 is not an adequate explanation of the prices of particular commodities. Under unimpeded competition there cannot be two prices in the same market. “Yet every one knows that there are, almost always, two prices in the same market. Not only are there .... cheap shops and dear shops, but the same shop often sells the same article at different prices to different consumers.” 2 Such prices, Mill said, were the result of custom rather than of competition, and since it is only by virtue of competition that economics can be a science at all, 3 such practices are exceptions to law. Other writers of this period besides John Stuart Mill gave some notice to the facts of overhead cost: notably Torrens, Senior, and Karl Marx. Torrens said, in 1834: It is self-evident that, amid the ebbings and flowings of the markets and the alternate expansions and contractions of demand, occasions will constantly recur in which the manufacturer may employ additional floating capital without employing additional fixed capital, .... if additional quantities of raw material can be worked up without incurring an additional expense for buildings and machinery.« Senior notes that: There are certain expenses upon a mill which go on in the same propor¬ tion whether the mill be running short or full time, as, for instance, rent, rates and taxes, insurance against fire, wages of several permanent servants, deterioration of machinery, with various other charges upon a manufacturing establishment, the proportion of which to profits increases as the production decreases. 5 1 Principles of Political Economy , Book II, chap, iv, sec. 3. 2 Ibid. (Ashley ed.), p. 246. 1 Ibid., Book II, chap, iv, sec. 1. 4 On Wages and Combinations (London, 1834), p. 63. Cited by Carl Marx, Capital , I, 443. 5 Report of Inspectors of Factories , October 31, 1862, p. 19. Cited by Marx, Capital, I, 443. GRADUAL DISCOVERY OF OVERHEAD COSTS 7 The large amount of fixed capital “makes long hours of work desirable,” 1 and with increased use of machinery, “the motives to long hours of work will become greater, as the only means by which a large proportion of fixed capital can be made profitable.” Karl Marx did not fail to note these damaging admissions and use them against the system of private industry. But the effect of overhead cost on hours of labor is not so simple as these writers supposed; witness Lord Leverhulme’s argument that a six-hour day with two shifts is more profitable than one eight-hour shift, if only the overhead costs are heavy enough! Even where plants work all night, this policy is not generally traceable merely to the attempt to economize on overhead. The most characteristic and disturbing features of overhead costs are concerned with other issues and had not yet come into prominence at the time of Marx and J. S. Mill. The Industrial Revolution was so strangely slow in making men aware of what it was doing to them! Yet the substitution of machine for hand labor meant nothing legs than the introduction of a new species of creature, which rapidly became the dominant personality in industry, especially in the actual physical work of manufacture and transportation. Formerly the laborer was the central figure; he worked according to the laws of his being and his tools worked as he required their services. Now the machine is the central figure, and labor follows the laws of the machine’s being and works as it requires his services.^ 6. MACHINE VERSUS MAN: HOW THEIR COSTS BEHAVE Perhaps the fundamental trait of the human laborer is an elastic sort of stability without complete uniformity. He builds on a foundation of habit and custom, yet he seldom or never does things twice exactly alike. He has many and varied capacities, demanding varied activities to develop him into a healthy being and keep him so. He turns naturally from one thing to another; therefore when he does one thing he sacrifices 1 Letters on the Factory Act (London, 1837), pp. 11-13. Cited by Marx in the same passage as the former quotations. 8 ECONOMICS OF OVERHEAD COSTS something else he might be doing. This fact underlies the cost of any one kind of work, or the cost of work in general, as over against leisure and the pursuits and enjoyments which it makes possible. Having learned one way of doing a thing the human worker tries variants on it, sometimes with a purpose and some¬ times aimlessly, but always following the bent of “ monkeying, ” which has put him where he is, at the head of the animal kingdom and has given him his godlike powers of knowing and transform¬ ing the world in which he lives. He is very imperfectly adapted to continuous toil and when he does work he works, now faster and now slower, with an irregular rhythm of which he is himself often unconscious, but which characterizes all organic nature. Espe¬ cially when working for a purely collective end, his ardors, while often strong, appear to be characteristically intermittent and unreliable. As a class, he needs personal incentives to work— rewards for good performance and penalties for bad—more imme¬ diate and substantial than his share in the welfare of the whole industry or the whole community. In many cases, he seems to need the fear of losing his job to make him do his best. And he is, under our social system, a free being, responsible for his own continuous support and that of his family; hence his maintenance is his own burden and not an obligation of industry, except so far as he can exact wages that will cover it. Contrast with this picture that of the machine. A mere piece of property, incapable of maintaining itself; its maintenance falls, therefore, on its owner, as a “ constant cost.” Its work is not affected for better or for worse by the compensation paid for it: it does not need the incentive of a piece-wage system nor the fear of discharge to make its wheels grind with their utmost power and speed. It needs no incentives—only maintenance. Because of this moral superiority the person who furnishes the funds to buy the machine can get his reward as a guaranteed stipend or as a share in the collective earnings of the enterprise, and the machine will do just as good work as under any other system of payment. Yet if this were done to labor, at least in its present stage of development, all but the best laborers would be more or less demoralized and discipline and output would suffer. GRADUAL DISCOVERY OF OVERHEAD COSTS 9 This mechanical slave has absolutely none of labor’s thirst for variety. Uniformity is his passion; continuous operation his religion. He is tireless: his capacity limited only by the hours of the day. And if any of it is not used it is lost: he cannot fill his idle time with side-occupations. Viewed as an animal he is one whose instinctive inheritance prescribes every act of his life. Minor changes in patterns of behavior require a surgical operation; major ones require that he be born again. Hence he yearns to specialize and to turn out indefinitely large quantities of his specialty. ^For all these reasons the machine’s costs behave differently from those of labor and follow different laws. In the first place, they are “overhead costs” in a much more definite sense and in a much more visible way. Secondly—and this is more important —they fall on industry as constant charges instead of being translated into a variable charge proportioned to services rend¬ ered: a system which would leave the individual investor to bear his ultimate burdens in the same way in which the laborer now bears his. \ 7. OVERHEAD COSTS ON RAILROADS However, this fact did not have its full effect until the largest mechanical unit of all—the railroad—had reached maturity and had had its transforming effect on industry, making possible the fullest development of mechanical production in other lines by enabling the output of mammoth plants to find a market. There resulted the struggle for world-markets, cut-throat compe¬ tition, discrimination, the modern forms of the business cycle, and the growth of monopoly. But it was the railroad itself that first brought the notion of overhead costs into real prominence with economists. When railroads were new, their rates were commonly uniform or nearly so, based on weight and distance, and were uniformly high. Soon it was discovered that additional traffic could be carried at little or no additional cost and that reduced rates, if confined to classes of traffic not already moving, would increase the net earnings of the company. Thus classi¬ fication was born and the foundations were laid for cheaper IO ECONOMICS OF OVERHEAD COSTS railroad carriage than would ever have been possible without discrimination. Along with it or after it, however, came many other less innocuous types of discrimination, often without rhyme or reason, and harmful even to the roads that used them. Rate wars and receiverships followed. Shippers at local points saw goods hauled past them to junctions beyond at lower rates than they paid for their shorter hauls, and with simple logic reasoned that if the lower through rate was adequate, the higher local rate was obviously extortionate. Under pressure of contending interests, with the need of justifying practices against attack, the theory underlying discrimination became vocal and explicit, and the world learned that railroads were different from other industries because such a large part of their costs were “con¬ stant” or independent of traffic. Thus the world of economic thought was made aware of a fact which is older than railroads, older than economic science and, far from being a peculiarity of one business or of a group of highly capitalistic businesses, is universal. From the present point of view, the thing that seems more in need of explanation is why economists should have thought that other industries were different from railroads or why they should have thought that they had explained the prices of single goods by showing that they tended, under competition, to cover the expenses of production. So far as railroads were concerned, the chief use made of the notion of overhead costs was to justify discrimination as a general practice, on the ground that added traffic was not responsible for those costs which did not increase as traffic increased, and that in any case it was impossible to determine the proper share of costs traceable to one shipment or one unit of business . 1 Some attempts were made to estimate in figures the relation between traffic and cost; the question being framed in the form: “What percentage of railroad expenses are constant and what percentage variable?” The common conclusion was that about 1 On the other hand, as early as 1850 Dionysius Lardner, in his Railway Econ¬ omy, worked out an elaborate system of allocating overhead costs. GRADUAL DISCOVERY OF OVERHEAD COSTS II half the operating expenses were variable and everything else, including taxes and all return on capital, was constant . 1 As for the fact that increased traffic demanded increased investment of capital in equipment of all sorts, this was recognized in varying degree by different writers, but was never thoroughly harmon¬ ized with the formula of constant and variable cost. The upshot was that the makers of rates were assumed to know their own interests, and while it was clear that no one in or out of the railroad business knew the “variable cost” of any given class of traffic, it was assumed that the facts of cost justified wide discriminations, and the practice of “charging what the traffic will bear” was given the benefit of the doubt so far as cost was concerned. The question of distinguishing fair from unfair discrimination was left to be argued on other grounds. 8 . OVERHEAD COSTS IN OTHER INDUSTRIES It soon became evident that railroads were not the only industry using large fixed capital and subject to the “peculiari¬ ties” of constant and variable costs. It also became evident that discrimination was not the only untoward result of such a condition. Rate wars on the railroads often abolished the regular classifications and brought all rates to a level far below cost. Large companies, railroad and industrial, failed, were reorganized, and continued in business, often more formidable competitors than before. It became evident that economic law did not insure prices that would yield “normal” returns on invested capital, because the capital could not get out if it wanted to, and so had to take whatever it could get. The business cycle had become a recognized part of the order of things, with its recurring periods of excess producing capacity, during which active competition tended to lower prices until even efficient concerns could make little or no return on their investment. “Cut-throat competi¬ tion” was seen to be a natural thing, and it was seen to be equally natural that business should adopt protective measures, whether combinations, pools, gentlemen’s agreements, or a mere senti¬ ment against “spoiling the market .” 2 1 Cf. Ripley, Railroads: Rates and Regulation (1921), chap. ii. 2 Alfred Marshall, Principles of Economics (6th ed.), p. 375. 12 ECONOMICS OF OVERHEAD COSTS 9. hadley’s summary of the problem A. T. Hadley expressed these tendencies with remarkable compactness in the following passage: The investment of fixed capital described in the preceding chapter has wrought much more radical changes in manufactures and transportation than in agriculture. Each producer can extend his output with a gain rather than a loss in economy. If he can increase his sales, there will be only a slight increase— perhaps none at all—in the expense for wages and materials, and a decided decrease in the share of the charges on fixed capital which each unit of product must pay. There is no fixed standard of cost which we can treat as the normal price; for the cost per unit of product depends on the quantity sold, falling as sales increase. , The price which will induce new competitors to enter the field is also much higher than that which will lead old ones to withdraw. No concern will quit competition as long as it can pay an appreciable part of its interest charges. It is better to lose part of your interest on every piece of goods you sell than to lose the whole of it on every piece you do not sell. As long as the price received more than covers the expense for wages and materials, each of the old factories will continue to compete. Even if it changes ownership by foreclosure it will remain in operation. But, on the other hand, no new competitor will be called into being unless the price is high enough to afford a liberal profit, after paying interest, maintenance, and other charges on fixed capital invested under modern methods. Thus prices, instead of constantly tending to gravitate toward an equitable figure, oscillate between two extremes. The rate of production, at figures which give a fair profit, is usually either much larger than the rate of con¬ sumption, or much smaller. In the former case, prices are unremunerative and unjust to the producer; in the latter case, they are oppressive to the consumer. The average price resulting from such fluctuations may per¬ haps be a fair one; but the wide changes of price are disastrous to all parties concerned. .... In some cases the industrial units which are necessary for proper utilization of labor have become so large as to produce actual monopoly. . . . . Even in cases where the necessity for concentrated management is not quite so marked, .... the competition of different concerns always involves a loss, from the need of maintaining too many selling agencies, the expense of unnecessary advertising, and the lack of proper utilization of fixed capital . 1 Here we have an array of problems, primarily relating to the economist’s search for the laws governing normal and market 1 A. T. Hadley, Economics (1896), pp. 151-54. GRADUAL DISCOVERY OF OVERHEAD COSTS 13 price and to the question whether competition is natural and can endure. If monopoly is natural and if competitive price 4 tends to no definite level, much of one’s old economics needs revising. The “cost of production to the marginal producer” no longer governs value, for the most expensive production is practically always being carried on at a loss. 1 And if the “marginal cost” of production means the additional cost of additional output in a plant working at part capacity, it does not cover return on investment and may not cover all of operat¬ ing expenses. The idea that price is governed by marginal cost of production may be reduced to.a tautology; the marginal producer is the producer whose cost of production is equal to the normal price. Alfred Marshall avoided a barren tautology by making his theory hinge on the expenses of production of a “representative firm” which has gained the chief economies of large-scale pro¬ duction. 2 J. B. Clark considered that the force of competition was continually driving prices toward the cost of production of the most efficient concern, at a speed governed by the rapidity with which its processes could be imitated or its own plant could expand, 3 though he also noted the importance of the variable costs of inefficient producers. 4 The goal would never be reached because it was itself in motion. Still more recently, during the world-war, the statistics of costs gathered to guide the work of regulating prices yielded the idea of “bulk-line” cost, so selected that the bulk of representative producers are below it and only a sporadic 10 or 15 per cent are above it. These last may be chronically inefficient, or may have had accidents which render the year in question a peculiarly bad one for them. The figures gathered in the war years do not necessarily represent the law of competitive price in undisturbed times but they represent a type 1 “Cost” is here understood to include interest on all capital invested, in har¬ mony with the usage of the economic theory we are discussing. The various possible meanings of cost will be examined in chap. hi. 2 Marshall, op. cit., esp. p. 343. 3 J. B. Clark, Essentials of Economic Theory , pp. 286-87, and chap, xxi, esp. p. 369. 4 Ibid ., p. 288. 14 ECONOMICS OF OVERHEAD COSTS of study which may give the law a definiteness that is much needed, especially since it became evident that production can continue indefinitely even though “overhead costs” are not covered. 