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Home , Economies of scale

To Allan and Maria-Isabel, for these many years o f valued friendship Profitability, and Economies of Scale

DUDLEY JACKSON First published 1998 by Ashgate Publishing

Reissued 2018 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN 711 ThirdAvenue, New York, NY 10017, USA

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Copyright © Dudley Jackson 1998

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ISBN 13: 978-1-138-33289-8 (hbk) ISBN 13: 978-1-138-33292-8 (pbk) ISBN 13: 978-0-429-44631-3 ( ebk) Contents

List o f Figures vi List o f Tables viii

PART I PRODUCTION

1 The Resource Costs of Production 3

2 The Efficiency Rate of 32

3 The Constant Annual Rental Model 56

4 The Factor Input Frontier 81

PARTII MECHANIZATION

5 Mechanization in Theory 111

6 Mechanization in Practice 144

PART IH ECONOMIES OF SCALE

7 Economies of Scale in Theory 171

8 The Power Rule 211

PART IV COMBINED MECHANIZATION AND ECONOMIES OF SCALE

9 Increasing and Mechanization in Plants 253

10 The Economic Theory of Combined Mechanization and Increasing Returns to Scale 281

Index 317

v List of Figures

1.1 Analytically distinct forces determining the possibilities for efficient production 4 1.2 The basic classification of transactions 10 1.3 Why gross fixed capital final expenditure on total added in a new fixed asset is a measure of the quantity of fixed capital installed 15 1.4 The concept of depreciation 20 1.5 The economic concept of cost 26 2.1 Profit assessment through measures of profitability 51 4.1 Labour form of the productionfunction 99 4.2 Isoquant form of the production function 102 4.3 Unit isoquant (constant returns to scale) 107 5.1 The theory of mechanization: the minimum cost capital-labour ratio is determined by the marginal physical rate of substitution and the factor ratio 119 5.2 The theory of mechanization: minimum unit labour and capital cost is at that capital-labour ratio where marginal rate of substitution is (-)l 125 7.1 Classification scheme for economies of scale and related concepts 172 7.2 The unit isoquant under conditions of full increasing returns to scale 190 7.3 Deriving the returns to scale profit rate function 202 8.1 Classification of variants of the power rule 213

vi 8.2 The power rule (cost-capacity, asset by asset) for three types of equipment 233 9.1 Plant performance by plant size, fully mechanized blast furnace plants 265 10.1 How the efficiency is determined 303

vii List of Tables

1.1 Straight-line depreciation: ‘maintaining wealth intact’ (hypothetical data) 21 2.1 Brick in Establishment B, Illinois, United States, two-week pay-period in 1922 35 2.2 Unit capital requirement and the unit margin in ethylene plants, United Kingdom, 1964 40 3.1 Discounted cash flow and net present value 61 3.2 Required minimum efficiency rates of profit for various financial internal rates of return (or rates of ), r, and various lifetimes of fixed assets, n 74 4.1 Production function in form with relative values; base value = 1.0000 (hypothetical data) 89 4.2 Calculations for production function in index form with relative values; base value =100 (hypothetical data) 91 4.3 Production function in absolute values in three dimensions: as a function of labour and capital inputs: the cross-section production function, twelve plants (hypothetical data) 94 4.4 Production function in absolute values in two dimensions: labour productivity as a function of the capital-labour ratio, or the labour productivity form of the production function (hypothetical data) 97 4.5 Production function in absolute values in two dimensions: unit capital requirement as a function of unit labour requirement, or the unit isoquant form of the production function (hypothetical data) 106

viii 5.1 Capital-intensity of production, unit labour cost, unit capital cost, and unit labour and capital cost combined (hypothetical data) 123 6.1 Some examples of the impact of mechanization, United States, second half of the nineteenth century 146 6.2 Comparison of hand and loading of ore in the Morning Mine (silver-lead-zinc) of the Federal Mining and Smelting Company, Wallace, Idaho, United States, 1936 153 6.3 Mechanization of the woodroom of Establishment A, United States, 1955 157 6.4 Impact of mechanization on unit total cost and on the efficiency rate of profit in the woodroom of Establishment A (data partly hypothetical) 158 6.5 Mechanization and unit labour requirement in cigar-making, United States, 1935-1936 161 6.6 Mechanization and : of cigar according to annual output, 1921 and 1936 165 7.1 Reduction in unit factor input requirements under full increasing returns to scale (hypothetical data) 187 7.2 Unit isoquants for production at different scales of output under a production function with full increasing returns to scale (hypothetical data) 189 7.3 The unit under full increasing returns to scale: unit labour and capital cost combined as a function of the capital-labour ratio (hypothetical data) 193 8.1 Cost and capacity for three types of process equipment (fixed assets) 229 8.2 Increasing returns to scale in process plants: tonnage oxygen, United States, ca. 1948 240 8.3 Increasing returns to scale in brick production plants, United Kingdom, post-War period 246 8.4 Increasing returns to scale in ethylene plants, United Kingdom, 1964 248

IX 8.5 The returns to scale profit rate function in ethylene plants (data partly hypothetical) 250 9.1 Increasing returns to scale in fully mechanized blast furnace plants, United States, 1923-1926 263 9.2 The impact of rebuilding and enlarging the blast furnace of a fully mechanized plant, Plant No. 21 266 9.3 The impact of mechanizing a non-mechanized blast furnace plant, Plant No. 54 271 9.4 The relationship between mechanization and scale of production and the combined impact on unit labour requirement 273 9.5 The impact of mechanization combined with rebuilding and enlarging a blast furnace plant, Plant No. 27 277 10.1 Production possibilities, showing full and partial increasing returns to scale (hypothetical data) 283

x Part I

PRODUCTION

1 The Resource Costs of Production

1.1 Introduction

This book is about the assessment of profitability when is undertaken in either or both mechanizing production and expanding the scale of production to take advantage of economies of scale. This book introduces, and presents the case for, a new concept of profitability assessment, here called the ‘efficiency rate of profit’, to be used in this assessment of profitability. As part of this argument, this book also considers, and resolves, the question of interest as a cost. In , the matter of interest as a cost has not been given the attention it deserves, with the unfortunate consequence that economists are never quite sure whether or how to include interest in the assessment of costs. This book introduces and explains the ‘constant annual rental model’ which provides the requisite conceptual framework for understanding interest as a cost and then shows how the constant annual rental model relates to the efficiency rate of profit. This book also explains fully the meaning of ‘mechanization’ (both theoretically and with real world plant-level data), the meaning o f‘economies of scale’ (ditto), and why, in the real world, mechanization and expansion of the scale of production are often found in a mutually dependent interrelationship where each may necessitate and require the other. This interrelationship is also exemplified with real world plant-level data. This book shows how the phenomenon of combined mechanization and expansion may be analyzed and understood in terms of the efficiency rate of profit and the constant annual rental model. To put die discussion of mechanization and economies of scale into context, Figure 1.1 shows the four distinct forces which together determine the possibilities for efficient production in a plant. Throughout this book we are concerned with the process of production in a ‘plant’, here defined as the fixtures (buildings etc), implements, machinery, and apparatus used in carrying on any production process or part thereof.

3 (state, and practical application, of knowledge) Profitability, Mechanization and Economies o f f Scale o Economies and Mechanization Profitability, Existing technology New technology (equipment Plant scale: may be same sort or different; in terms of designed Equipment physical quantity of generally different) output per period Same sort Different sort

Learning effect: Mechanization (an instance Technological change: same equipment with same of capital-labour substitution): (i) new-plant technological change: technology at same designed different sort of equipment generally different equipment scale of output (same plant); (mechanization) within existing embodying new technology at same improved operating efficiency technology at the same designed scale of output per period designed scale of output per period; in response to (ii) in-plant technological change: changing factor price ratio generally modified equipment embodying improved technology, output per period may be increased Reduces unit labour requirement by modification in same (unaltered) plant as cumulative total output increases Reduces u n it labour Simultaneously reduces unit labour (also reduces unit capital requirement but increases requirement and unit capital requirement requirement) unit capital requirement at same scale of output*

Economies of large-scale Mixed technological change and production: Mixed mechanization and economies of scale economies of scale (perhaps also with same sort of equipment (but bigger) capital-labour substitution) within existing technology at larger designed scale of output per period

Simultaneously reduces unit labour requirem ent and u nit capital requirement for increased scale of output Automation may increase unit capital requirement

Figure 1.1 Analytically distinct forces determining the possibilities for efficient production (‘diagnostic’ characteristics in italics) The Resource Costs o f Production 5

In the first instance in Figure 1.1 we make a division between the existing technology of production and a new technology of production. The word ‘technology’ is not easy to define. The word derives from the Greek word for art or craft. The dictionary definition is ‘the practical arts collectively’, but this is not very enlightening. In the way in which we shall use the word ‘technology’ we mean the state o f knowledge about methods o f doing things and the practical application o f that knowledge including the artefacts through which that knowledge is applied. The two essential elements in the concept of technology are systematic knowledge about, and devices to implement that knowledge in, the processes of production. Under existing technology we make a subdivision between using, in production, the same sort of plant (or equipment) and using a different sort of plant (or equipment), but all within the same technology. In the second instance in Figure 1.1 we make a division as to the ‘scale’ of output of the plant as initially designed and constructed. In this context, the word ‘scale’ has a complex and subtle three-fold meaning. In the first place, the word ‘scale’ means size, with respect both to the quantity of output produced per period and also to the requisite quantity and capacity of inputs. But, in the second place, the word ‘scale’ conveys (and is meant to convey) the notion of a succession or series of steps—in this context, steps in the quantity of output per period with matching steps in the quantity or capacity of inputs. (The idea of a succession or series is what leads to the use of the word ‘scale’ instead of the word ‘size’.) In the third place, the word ‘scale’ carries the implication (and is meant to carry the implication) that the inputs may all be increased in some proportion so as to produce a greater quantity of output per period. Thus we talk of ‘scaling-up production activities’. The scale of output, or quantity of output per period, which a plant is designed to achieve we shall call the ‘designed scale of output’. In terms of designed scale of output, we make in Figure 1.1 only a two-fold division between plants designed to produce (the same type of product) at the same scale of output per period and plants designed to produce (the same type of product) at a larger scale of output per period. (We could have gradually increasing scales of output, with many rows, but the two-fold contrast is sufficient for purposes of explanation.) Thus, along the first row of Figure 1.1 we will have plants all designed, with the requisite inputs, to produce the same quantity of output per period; a 6 Profitability, Mechanization and Economies o f Scale plant in the second row, when contrasted with a plant in the first row, will be designed, from the outset, to produce a larger quantity of the (same type of) output per period and will have an appropriately increased quantity of inputs. The scheme of classification in Figure 1.1 produces a three (columns) by two (rows) matrix in which we can classify the basic microeconomic forces which determine, in a plant, the productivity of inputs. Along the top row and down the first column we have four ‘pure’ categories of forces, each of which we may regard as analytically distinct. In the remaining two boxes we have categories of mixed forces, which often occur in the real world. This book discusses (in turn): mechanization; economies of scale; and mixed mechanization and economies of scale. This book does not discuss technological change and learning. The four ‘pure’ categories have the following identifying (or ‘diagnostic’) features. Mechanization involves using more capital input (‘equipment’) in relation to the labour input (and so may more specifically be known as ‘capital—labour substitution’) but within (more or less) the same technology. Mechanization reduces the quantity of labour required per unit of output produced but increases the quantity of capital required per unit of output, produced. For example, using an electric typewriter instead of a manual typewriter in the process of document production increases the productivity of the typist (more document-pages per typist-hour, or, conversely, fewer typist-hours— or typist-minutes—per document-page) but at the cost of more equipment (the electric motor and requisite attachments). This change can be considered to be within (more or less) the same basic technology of document production. Economies of scale involves using greater quantities of all inputs to produce a greater quantity of output per period within (more or less) the same technology. This simultaneously reduces both the quantity of labour required per unit of output and also the quantity of capital required per unit of output. For example, a large ‘jumbo’ passenger-jet is designed from the outset to carry more passengers and to produce more passenger-miles (a measure of output) per unit of inputs than a smaller passenger-jet. In the real world mechanization often leads to an increase in the scale of production and/or an increase in the scale of production may require mechanization. For example, to be fully discussed in this book, in the 1920s the mechanization of the production of pig in blast furnaces usually led to an increase in the scale of production from the (mechanized) blast furnace, while the enlargement of the capacity of a blast furnace required to be supported by mechanization. The Resource Costs o f Production 7

Technological change involves an alteration in the technology of production. This generally reduces both the quantity of labour required per unit of output and also the quantity of capital required per unit of output, but all at the same scale of output per period. Technological change may also reduce the quantity of material or fuels input per unit of output produced. Technological change is furthermore often associated with an improvement in the quality of the product. For example, the change in document production from using an electric typewriter to using a word-processor is a clear case of technological change; this not only increases labour productivity but also improves the quality of the document. Technological change generally involves either (1) different equipment embodying a new technology; or (2) m odified equipment embodying an improved technology. The first is the popular view of technological change and we may call this ‘new-plant technological change’. The second is prevalent in the real world and is probably the form of change most commonly encountered; we may call this ‘in-plant technological change’. The learning effect reduces the quantity of labour required to produce a unit of output but this happens in the same plant with physically unaltered equipment using the same technology. For example, in learning to use a keyboard to type, proficiency improves with experience: that is, the learner can gradually produce more document- pages per typing-hour. This phenomenon can be studied through what is known as the learning curve.

1.2 Resources: labour and capital

This book is about how mechanization and economies of scale, either separately or in combination, affect efficiency in the use of real resources in the process of production. The general definition of the word ‘resource’ is a means o f supplying some want, a stock upon which one can draw. The words ‘input’ or ‘means’—input to production, means of production—can also be used as synonyms of the word ‘resource’. Finance, or less technically money, is also a stock upon which one may draw, but finance is of use only insofar as it can be used to obtain real resources. (Robinson Crusoe has a profound lesson on the difference between real resources and money when he becomes the sole survivor of a shipwreck on a desert island. Crusoe has available from the wreck the ship’s carpenter’s tools 8 Profitability, Mechanization and Economies o f Scale and some money in die form of gold and silver coins: in his isolated state he wryly reflects that the money is of no use to him but the tools certainly are.) The word ‘real’ in the term ‘real resource’ (or in other like terms such as ‘real services’ or ‘real assets’) means that the resource itself (the itself or the asset itself) is directly of use in the process of production; by contrast, finance is of use only indirectly or only at one remove. The adjective ‘real’ is thus meant to be the opposite of the adjective ‘financial’. We may divide real resources among the following three main categories. First, natural resources, which are naturally occurring phenomena such as mineral resources (for example, a seam of ), vegetable resources (for example, natural timber) or animal resources (for example, fish in the sea), together with what we might generally call amenities such as a natural harbour to be used by shipping or a pleasant bathing beach used by a tourist hotel. Second, economic resources, which are capital (real assets), labour, and land. Third, knowledge in the form of technology. This book is about how mechanization and economies of scale affect the efficiency with which the economic resources of capital and labour are used. Economic resources may also be called the ‘’. The meaning of the word ‘capital’ as it is used in economics is a produced means o f production. The word ‘capital’ as used throughout this book refers only to tangible assets or real things. Financial assets—claims on others— should not in economics be called ‘capital’ despite a common tendency in accountancy and elsewhere to include financial assets under ‘capital’. The word ‘wealth’ may be used to refer to the total value of capital owned and financial assets owned. More technically, the term ‘net worth’ may be used to refer to: the value of capital owned plus the value of financial assets owned minus the value of financial liabilities owed. There are two types of capital: fixed capital and circulating capital. Fixed capital may also be referred to as ‘fixed assets’; circulating capital is more commonly referred to as ‘inventories’. The defining characteristic of fixed capital is that any item in the stock of fixed capital has a repeated use in the process of production; that is, an item of fixed capital can be used to produce one piece of output and it then remains available to produce another piece of output and so on. The defining characteristic of circulating capital is that any item in the stock of circulating capital has a once-for-all use in the process of production; that is, once an item of circulating capital has been used to produce one piece of output it is then completely ‘used up’ and is not available to produce another piece of output. The Resource Costs o f Production 9

To illustrate: the sewing machine of a dress-maker is an item of fixed capital; the dress fabric used by a dress-maker is an item of circulating capital. But both sewing machine and dress fabric are capital: a produced means of production. The quantity of circulating capital used in production can usually be measured straightforwardly in terms of whatever physical quantity units are appropriate: square metres of dress fabric or linear metres of a standardized width. The measurement of the quantity of fixed capital used in production will be discussed further in Sections 1.4 and 1.5 when we discuss the quantity of capital and depreciation. With regard to labour, generally the services of labour are hired in return for performance of work duties during specified periods of time, so we shall call this the resource input of labour-time and we shall generally measure the quantity of labour input in terms of the total number of labour-hours used as an input during the production period.

1.3 Transactions

Each and every cost is, basically, a transaction. A transaction occurs when someone provides something of economic value to someone else. There are four basic types of transaction, and the analytic classification of transactions is shown in Figure 1.2. On the one hand, a transaction may be actual or imputed; on the other hand, a transaction may be requited or unrequited. Put together, these criteria for classification make a two-by-two matrix, and any transaction can be put into one, and only one, of the four basic categories delineated in Figure 1.2. An actual transaction occurs where there is an actual cash flow or an oligation to pay in the future is incurred (we may think of this obligation as delayed payment). An imputed transaction occurs where there is no cash flow, nor is any obligation to make a payment in the future incurred. A requited transaction occurs where something specific is provided in return for something also specific; we may think of a requited transaction as a two-way exchange. An unrequited transaction occurs where nothing specific is, or nothing specific has (eventually) to be, provided in return; an unrequited transaction is, in this respect, one-sided. Most transactions are requited and actual. That is, someone provides something specific of economic value to someone else in exchange for money 10 Profitability, Mechanization and Economies of Scale

Figure 1.2 The basic classification of transactions

(or in exchange for a promise to pay money at a future date). For example, a labour cost is a requited and actual transaction: someone (die worker) provides specific labour services of economic value to someone else (the employer) in exchange for money (the ). Some transactions are actual and unrequited, as happens when the government pays an age pension (a social security pension) to an elderly person: the age pensioner gives or does nothing in return for the pension, so this is said to be an unrequited transaction. It is also an actual transaction, because cash changes hands from the government to the pensioner. Such unrequited and actual transactions may also be known as ‘transfer payments’ or ‘grants’. There is an important class of transfer payments and grants which we should know about because these transfer payments considerably affect enterprises as producers. However, this book will not discuss such transactions, except to point out where they occur. These transfer payments comprise: payments by producers to governments: (1) taxes on output; The Resource Costs o f Production 11

(2) taxes on the performance of an activity; and (3) taxes on inputs; payments by governments to producers: (4) subsidies on production; (5) subsidies on the use of inputs; and (6) subsidies on investment (or capital grants). These payments are classified as unrequited transactions because nothing specific is provided exclusively in return for the payment. Although such payments by producers to governments may appear to be a cost (especially to the producer), they are a very different type of cost from costs in the form of requited transactions where resources are used to provide a specific and exclusive quid pro quo. This book deals with only those costs which are requited transactions. At this juncture it is appropriate to mention the transaction of paying interest on a loan. The payment by an enterprise of interest arising out of a loan to the enterprise is a requited actual transaction: the interest requites and is requited by the use of the finance and cash changes hands. However, the payment of interest is not itself in return for the using of a real resource because finance is not a real resource. Because the payment of interest is not in return for the use of a real resource, interest and other like ‘distributions’ to providers of finance form a distinct class of requited (and actual) transactions. To the producer, interest payments appear very much like a cost, but as economists we must appreciate the distinctive nature of interest as a cost, and this issue will be discussed at length in Chapter 3. Most transactions are actual in the sense that money changes hands (or an obligation to pay is incurred), but some transactions may be imputed. An imputed transaction occurs where something specific of value is provided but where money does not change hands (and no obligation to pay is incurred), and where it is necessary or useful to pretend or deem that there has been a transaction, called an ‘imputed transaction’, for the purpose of measuring the value of the transaction or measuring the value or cost of something. Some imputed transactions are very important. Most imputed transactions are requited, but there are a few examples of unrequited and imputed transactions (for example, one might wish to impute a value to the various unrequited concessions in kind which may be made available to age pensioners). 12 Profitability, Mechanization and Economies of Scale

To illustrate a requited and imputed transaction: suppose the of a dairy farmer consumes some of the dairy farm’s milk—in this situation no money changes hands between the dairy farm and the household (nor is any obligation to pay incurred). We may consider this to be a requited transaction because the dairy farmer takes the milk as part of the remuneration (in kind) for running the dairy farm. If we want to measure the money value of the dairy farm’s output and/or the value of the household’s consumption then we must impute a transaction, between the dairy farm and the dairy farmer’s household, measured by the value of the milk supplied and consumed. This imputed transaction is a pretend or deemed sale or expenditure, but it is nonetheless important and real; without it, our reckoning of the value of the dairy farm’s output or of the household’s consumption would be incomplete. Note that in many (but not all) imputed transactions we may also have to make, or pretend to or deem, an otherwise rather artificial distinction in regard to the entity involved. For example, in the case just discussed, we have to deem that there is a distinction between the dairy farm (the dairy farmer as producer paying remuneration in kind) and the dairy farmer’s household (the dairy farmer as consumer receiving remuneration in kind). However, it is not unusual to make such a distinction with regard to the role one person (an individual transactor) is playing. One difficulty which imputed transactions cause is that there is no actual flow of cash corresponding to the imputed transaction. To illustrate, if we impute a value to the dairy farm’s milk consumed by the dairy farmer’s household, then the cash flowing into the dairy farm from (actual) sales of milk is different from (lower than) the value of the dairy farm’s output of milk, because this latter value includes the imputed value of the milk consumed by the farm household. This is a difficulty because most of us almost automatically identify transactions with cash flows (in accordance with our common and everyday experience); accordingly we are unaccustomed to dealing with imputed transactions which do not involve a cash flow and so we may somehow (and very wrongly) think of imputed transactions as ‘not being real’ or as ‘not being important’. The solution to this difficulty is not to ignore imputed transactions (many of which are important and all of which are as ‘real’ as the milk consumed by the dairy farmer’s household), but simply to think carefully about the difference between cash flows and other values involving imputed transactions. A most important imputed transaction with which we shall be much concerned is depreciation on fixed capital. Understanding depreciation requires The Resource Costs o f Production 13 an explanation of the economic nature of fixed capital and the quantity of fixed capital.

1.4 The quantity of fixed capital

A cost is incurred upfront when acquiring an item of fixed capital. This cost, or outlay on acquiring the fixed asset, I shall call the ‘acquisition cost’ of the fixed asset. The defining characteristic of all fixed assets is that fixed assets have a repeated use in the process of production; that is, once a fixed asset has been used to produce a piece of output it remains available to be used again and again. There are, then, three important economic features of a fixed asset. First, the asset will generally last for more than one accounting period (which, following convention, we will take to be one year). Second, the fixed asset will nevertheless have a limited ‘life’; that is, the fixed asset will at some point in the future come to the end of its useful working life and it will then be ‘retired’ or ‘scrapped’. Third, at the end of the ‘life’ of the fixed asset there may be some recovery of funds from its sale for scrap or from a ‘-in’. However, this recovery value is likely to be small relatively to the initial acquisition cost of the fixed asset. We shall call this recovery value the ‘scrap value’. Although we consider scrap value in this chapter, generally in this book we shall assume the scrap value to be zero; because of its generally small size relative to acquisition cost this assumption does not matter too much in practice and it greatly simplifies the explanation, and thence one’s theoretical understanding, of basic principles. (It is also possible for scrap value to be negative; that is, the owner has to pay for the asset to be disposed of at the end of its working life. We shall not digress to consider this awkward case, but it can be accommodated within the conceptual framework here presented.) An upfront acquisition cost is incurred in acquiring a fixed asset and there may be some (eventual) recovery of funds from the scrap value. Accordingly we can, for any fixed asset, define and calculate a ‘lifetime capital cost’ as follows:

Lifetime capital = Acquisition - Scrap value cost cost (if any) 14 Profitability, Mechanization and Economies o f Scale

If we take any newly produced fixed asset (that is, not a second-hand fixed asset), the acquisition cost of that new fixed asset—technically also known as the final expenditure on the fixed asset—represents and measures the value added incorporated in that fixed asset. (For the relationship between, and the concepts of, final expenditure and value added see my book The Australian Economy, Macmillan, 1989, Chapters 1 and 12.) Technically, the value added here referred to is throughout value added at producers’ values (alternatively, value added at factor cost), because we exclude transfer payments from consideration.) To be technically precise, the acquisition cost of a new fixed asset would be known by some such term as ‘gross fixed capital [final] expenditure’ or ‘gross fixed capital formation’. As shall shortly be explained, a new fixed asset can be considered as both a ‘store’ of real services to be provided over the fixed asset’s working life and thereby also a ‘store’ of value added. Furthermore, the scrap value represents and measures both the real services and also the value added remaining at the end of the working life of the fixed asset. For example, take the acquisition cost of a new motor vehicle. This final expenditure measures all the value added produced to make that motor vehicle. The cost of the in the motor vehicle represents the value added in iron ore mining plus the value added in making the iron ore into pig iron and thence into the steel used to make the motor vehicle. Likewise with the cost of the tyres: the cost of the tyres represents the value added in producing rubber plus the value added in making the rubber into the tyres used in the motor vehicle. The total acquisition cost of a new motor vehicle—the final expenditure on the vehicle—thus represents and measures the total value added ‘in’ the motor vehicle. What is the economic significance of this total value added? Figure 1.3 shows the explanation of what a new fixed asset essentially is, using for illustrative figures the example of a new motor vehicle costing, say, $20,000 and having a working life of, say, five years. In the first instance, and at the top of the diagram is the motor vehicle as the physical entity or object familiar to everybody. But, in the second instance, underlying this physical entity are two distinct but related economic phenomena. First, what the motor vehicle represents in terms of real physical services (directly of use in production) is five years of motoring services. These are the real services primarily required and expected by whomsoever acquires the motor vehicle. (As we shall shortly see in connection with scrap value, other real services may also be acquired with the motor vehicle, but The R esource Costs o f Production 15

Figure 1.3 Why gross fixed capital final expenditure on total value added in a new fixed asset is a measure of the quantity of fixed capital installed these ‘scrap value services’, as they may be called to distinguish these from the motoring transport services primarily required, are only incidental and are only secondarily required; indeed the acquirer of the fixed asset may not be much concerned with these incidental services at all.) Thus we can quite 16 Profitability, Mechanization and Economies o f Scale reasonably think of the motor vehicle as being a ‘store’ of motoring transport services where this store is basically to be conceived of as, and valued in terms of, the lifetime capital cost. The motor vehicle is also a store of scrap value services, which are, however, only secondarily required. (Although it may seem somewhat arbitrary and strained to think of a motor vehicle as comprising a sum of distinct motoring transport services and scrap value services—after all, the motoring transport services are not in any practical sense separable from the metal (which provides the scrap value)—it is necessary for a clear conceptualization of the capital input to make this theoretical distinction.) Second, however, the final expenditure on the new motor vehicle also measures the value added in die vehicle. This incontrovertible proposition simply explicates the economic significance of final expenditure. This value added achieves, so to speak, its ‘value’ to the acquirer of the fixed asset by virtue of the motor vehicle being a ‘store’ of motoring transport services and of scrap value services. In other words and most significantly, the quantity o f real services 'stored’in the fixed asset achieves a monetary value in terms o f the value added which the final expenditure on the asset represents. Consequently in Figure 1.3 we can show two arrows descending from the motor vehicle, each of which points to one of these two economic phenomena. The first arrow points to the economic phenomenon of the motor vehicle being a ‘store’ of real services; the second arrow points to the economic phenomenon that the $20,000 final expenditure measures the value added in the new vehicle. Consequently this value added can be thought of as a ‘store’ of value added; here the ‘store’ is measured in monetary terms. Equivalendy, the total value added in the new motor vehicle can be thought of as expressing a monetary valuation of the real physical services ‘stored’ in the new motor vehicle (comprising both the motoring transport services and the scrap value services). The monetary value of this value added is derived from, or is based on, the fact that the motor vehicle is a ‘store’ of real physical services; consequently we can show in Figure 1.3 a bold arrow leading from 5 years of ‘stored’ motoring transport to the $20,000 final expenditure on/value added in the new motor vehicle: the quantity of real services to be provided by the motor vehicle is the basis for the money value. The rationale for Figure 1.3 is that it serves to explain why we can use the acquisition cost of a fixed asset (any fixed asset) to measure, in monetary terms, the quantity of real services ‘stored’ in any fixed asset. In other words, we can use the acquisition cost of any fixed asset to measure the quantity of The Resource Costs o f Production 17 that fixed asset; we may thus reasonably regard the acquisition cost—say, of a motor vehicle—as the quantity of capital which is required to be installed if the required production services are to be obtained (over the asset’s working life) together with the residual scrap value services. This will shortly be explained more fully, but we must first deal with the matter of scrap value. Regarding the scrap value, we may interpret the scrap value as the value added remaining in the fixed asset at the end of its lifetime of providing the services primarily required. Firstly (on the left), we may regard the scrap value as a sort of additional secondary or incidental real service remaining to be obtained from the fixed asset after the store of services primarily required has all been used up. Secondly (on the right), we may interpret this secondary or incidental service as the value added still remaining in the (otherwise used up) fixed asset. For example, if we consider the scrap value of a motor vehicle as (mostly) the scrap value of the metal then we may say that this scrap value represents firstly the real services still remaining in the otherwise used-up fixed asset, and secondly the value added still remaining. This is the true economic meaning of scrap value. Consequently the lifetime capital cost represents and measures the total monetary value of the services primarily required and which will be used up over the working life of the fixed asset. The importance of this is that we can consider the lifetime capital cost as the quantity of real resources which are (to be) used up while producing output with the fixed asset. In order for all this to hold we must, of course, adjust for any price occurring over time, so that all values must be measured in the of some common ‘base’ year or period. But such adjustment for price inflation is commonplace and introduces no issues of principle. For example, it is not sensible or meaningful to compare the acquisition cost of a 60-horsepower tractor as the price of that tractor was in 1985 with the acquisition cost of an 85-horsepower tractor as the price of that tractor was in 1995. For making such a comparison, either the 1985 price of 60- horsepower tractor must be adjusted to a 1995 base, or the 1995 price of the 85-horsepower tractor must be adjusted to a 1985 base. Only if we work consistently in constant-price terms can we use the acquisition cost of a fixed asset to measure the quantity of fixed capital to be used in production over the asset’s working life together with the scrap value. Figure 1.3 as a whole thus explains why we can use the acquisition cost of a new fixed asset to measure the quantity of real services which will be stored in that new fixed asset. Not all of these real services are primarily required by 18 Profitability, Mechanization and Economies o f Scale the acquirer of a new fixed asset (for example, the purchaser of a new motor vehicle does not primarily require the services of the scrap metal at the end of the working life of that asset), but there is some (eventual) gain from this scrap value and so we must understand where it fits into the scheme of things. Figure 1.3’s use of a measure in money terms of constant-price dollars to measure the ‘quantity’ of the resource of fixed capital needs to be carefully understood. For example, we would be saying that in the contrast between a 60-horsepower tractor with an acquisition cost of say, $35,000 and an 85- horsepower tractor with an acquisition cost of $55,000 (each price referring to the same ‘base’ year), the 85-horsepower tractor represents, by comparison with the 60-horsepower tractor, an increase in the quantity of capital of 57 per cent (= (($55,000/$35,000) -1)100). This is not the same as the proportionate difference in horsepower, which is 42 per cent (= ((85 horsepower/60 horsepower) - 1)100). We are thus saying that horsepower cannot adequately represent the ‘quantity’ of capital; we are saying that when a farmer buys a tractor the farmer buys, or is looking for, more things or features in terms of real resources than can be accounted for simply by horsepower (although, undeniably, horsepower will be one of the most important physical features of a tractor). We are saying that such features and their services, by ‘physical quantity’, can only be encompassed in their totality and in their diversity by taking the money acquisition cost (at constant prices) of the asset or assets. The money acquisition cost thus measures in one money value figure the total ‘quantity’ of (a probably very diverse range of) real physical services which the acquirer of a (new) item of fixed capital wishes to have (both primarily and secondarily). And if a farmer acquired both a 60-horsepower tractor (for continuous light work on the farm) and also an 85-horsepower tractor (for simultaneous continuous heavy work on the farm), then we would say that the farmer required to install a total ‘quantity’ of tractor input on the farm of $90,000; that is, a total ‘quantity’ of ‘stored’ physical services in (a combination of) tractors, where this total ‘quantity’ could be measured in monetary units as $90,000. Likewise for a new motor vehicle: $20,000 would measure the quantity of stored real services (to be) provided by the fixed asset over its lifetime. Such a measurement, through the money (dollar) acquisition cost, of die total quantity of fixed capital installed is not only reasonable in itself (and would be familiar to any purchaser of any item of equipment where features and real services (to be) provided versus acquisition cost tends to be carefully assessed before purchase), but also—as we shall show—leads to sensible results in relation to the cost in production of using fixed capital. The Resource Costs o f Production 19

The lifetime capital cost thus measures, in monetary terms, the quantity of real services which is actually (to be) used up during the working life of the fixed asset (these are the services primarily required). The scrap value measures, in monetary terms, the quantity of real services not used up during the working life of the fixed asset (these are the services which are incidentally and secondarily acquired); as a corollary these real services are those remaining at the end of the working life of the fixed asset. Together, the lifetime capital cost and the scrap value comprise the acquisition cost of the fixed asset; in other words, the acquisition cost measures, in monetary terms, the quantity of a ll the real services (to be) provided by the fixed asset. This is shown schematically at the bottom of Figure 1.3. With this understanding of the quantity of fixed capital and of lifetime capital cost and scrap value we can turn to an explanation of depreciation.

1.5 Depreciation

Depreciation is a transaction which allocates the lifetime capital cost over each of the production periods for which the fixed asset is used. Generally, the production period is taken as the conventional accounting period of one year, and so we shall nearly always deal with annual depreciation. In this book we shall, for good economic reason, use only the simplest method for calculating annual depreciation and this is the method which gives the same money amount of depreciation in each year. There are other methods of calculating annual depreciation (which may bring tax or other advantages) but all these other methods result in variations in the money amount of annual depreciation over the fixed asset’s lifetime. We are, in this book, concerned only to describe and analyze the costs of production and if nothing substantively changes in relation to the annual quantity of output and quantities of inputs then it is impossible to justify having a varying annual total cost of production simply because of the method adopted to calculate depreciation. This is why we keep to the simplest and most readily- understood method of calculating depreciation. The method we shall use to calculate annual depreciation is known as the ‘straight-line method’ because the value of the depreciated asset (that is, the acquisition cost minus the cumulated depreciation to that date) declines in a straight-line. The straight-line method is very simple: the lifetime capital cost is divided by the fixed asset’s length of life in years as follows: 20 Profitability, Mechanization and Economies of Scale

Figure 1.4 The concept of depreciation The Resource Costs o f Production 21

Table 1.1 Straight-line depreciation: ‘maintaining wealth intact’ (hypothetical data)

Years Value Flow of Cumulated Total of life second-hand depreciation depreciation wealth remaining of taxi-cab between dates, at date, at date Date at date at date (a\ $ $ per annum $ $

End of Year 0 5 20,000 (new) _ 0 20,000 End of Year 1 4 16,000 4,000 4,000 20,000 End of Year 2 3 12,000 4,000 8,000 20,000 End of Year 3 2 8,000 4,000 12,000 20,000 End of Year 4 1 4,000 4,000 16,000 20,000 End of Year 5 0 0 (scrap value) 4,000 20,000 20,000

If five years of service cost $20,000 (lifetime capital cost), then, pro rata, one year of service has a capital cost of $20,000/5 - $4,000; consequently, the value second-hand of the vehicle is determined as: years of life remaining multiplied by $4,000.

Sum of value, second-hand, of taxi-cab and cumulated depreciation. This example assumes that the owner of the taxi-cab provided the initial finance ($20,000) required to purchase the fixed asset.

Flow of = (Lifetime capital cost)/Length of life in years depreciation per annum (straight line) = (Acquisition cost - Scrap value (if any))/ Length of life in years

Because both the acquisition cost and the scrap value are measured in money (dollar) terms, the flow of depreciation so calculated is an annual money (dollar) amount. Because the lifetime capital cost measures in monetary terms the quantity of real services (to be) used up over the working life of the fixed asset, annual depreciation must, by simple division, measure in monetary terms the quantity of real services used during each year of the fixed asset’s working life. Depreciation is thus an annual using up of a quantity of real services, such as motoring transport services—the services primarily required, where the quantity of a diverse range of services is measured as a money amount (at constant prices). 22 Profitability, Mechanization and Economies o f Scale

This annual money amount is to be considered as a transaction, albeit a transaction of a distinctive type: according to the classification scheme for transactions shown in Figure 1.2, depreciation is to be regarded as an imputed and requited transaction. That depreciation is an imputed requited transaction is a very important proposition which it is essential to understand fully. Figure 1.4 shows schematically die economist’s understanding of depreciation as an imputed and requited transaction. From an economic point of view depreciation has simultaneously two important and essential functions. The first essential function (already argued for in Figure 1.3) is to measure the real resource cost incurred during die production period by using a fixed asset. The second essential function is to ensure that the enterprise ‘maintains its wealth intact’; in other words that die enterprise does not ‘live off its wealth’, so putting it in a position where it cannot continue production when the fixed asset comes to the end of its useful life. All this may be explained as follows. Suppose that a new motor vehicle is purchased to be used as a taxi-cab; suppose that the new taxi-cab has an acquisition cost of $20,000 when new, has a life when new of 5 years, and has zero scrap value, then, on the straight- line method, annual depreciation may be calculated as: ($20,000 - $0)/5 years = $4,000 per annum (Note that we introduce here our simplifying assumption of zero scrap value; because the scrap value of a motor vehicle at the end of its working life is usually very small relative to its acquisition cost—which is usually die case for most fixed assets—the practical implications of this assumption are not greatly important.) As economists, we can say that it costs $20,000 (lifetime capital cost) to be equipped to provide taxi-rides for five years (here we are referring only to the lifetime capital cost of the fixed asset; we are not concerned with the running costs (fuel etc.) of providing the taxi-cab rides). From this it follows that, pro rata, there is an annual capital cost of $4,000 to provide taxi-cab rides. From an economic point of view and as explained in Figure 1.3, what the taxi-cab enterprise buys when it buys a taxi-cab should be seen not as a physical piece of equipment but rather as both a ‘store’ of real services—this is the resource which the fixed asset is—and also a added. The store of value added measures in monetary terms the value of the real services to be provided and assuming zero scrap value this store of value added measures in The R esource Costs o f Production 23 monetary terms the value of the real services primarily required. By using up this store of real services/value added the enterprise has the ability to provide taxi-cab rides for five years and thereby to make a living. This is what the taxi-cab represents when it is initially acquired. Annual depreciation then apportions, in an imputed transaction, the lifetime capital cost over each year of the fixed asset’s life. This imputed transaction of $4,000 per annum is a simultaneously a measure of, and a (monetary) valuation of, the specific annual service, or real resource input, provided by this fixed asset (under the assumption of zero scrap value). Depreciation is thus an imputed real resource cost of production. Depreciation has to be imputed year by year because the actual cost—the actual cash transaction—is incurred ‘upfront’ when die taxi-cab is initially acquired. The further importance of this imputed depreciation (or capital) cost can be understood as follows. If someone were to offer to sell the enterprise a one-year old (‘second-hand’) taxi-cab with four years of productive life remaining, then (in die straight-line method of assessing depreciation) the enterprise would be prepared to pay only $16,000 for die second-hand taxi­ cab; that is, the enterprise would pay 4 years x $4,000. If someone were to offer to sell the enterprise a two-year-old taxi-cab with three years of productive life remaining, then the enterprise would be prepared to pay only $12,000 for the second-hand taxi-cab; that is, the enterprise would pay 3 years x $4,000. And so on. (This assumes that there is no inflation in the price of new taxi­ cabs, but inflation is a complication which need not concern us here because it is essential throughout to work in constant price terms.) Table 1.1 shows this determination of the value of a second-hand taxi-cab. In principle, such a sort of decline in the (second-hand) value of a fixed asset applies to all fixed assets which have a finite working life. Hence, in Figure 1.4 we can refer generally to the decline in the value of a fixed asset. Table 1.1 shows in the first column the years of life remaining to the taxi­ cab at each date. The second column shows the value, second-hand, of the taxi-cab at each date. If the numbers of this column are plotted (on a vertical axis) against each date (on a horizontal axis), then the plot points form a straight line; hence the name ‘straight-line depreciation’. The third column shows the annual flow of depreciation. This flow of depreciation is an imputed transaction, and it is an annual sum of money which should be set aside from sales receipts (from fares received in the case of the taxi-cab enterprise). This imputed transaction may also be called a ‘provision’ or an ‘allowance’ (these words signalling that it is not a cash outflow 24 Profitability, Mechanization and Economies o f Scale in the way that, say, payment of by the enterprise to its employees is a cash outflow). Annual depreciation provisions have to be set aside from annual sales receipts; that is, in the unfortunate event that there are no sales receipts (!), then there is no possibility of making provision for depreciation. Alternatively, if sales receipts cover only the cash outflow costs then there is no possibility of making provision for depreciation. However, this book will not be concerned with such loss-making situations. The fourth column of Table 1.1 shows the cumulated depreciation to that date. You can see that the second column can also be calculated as the acquisition cost of the fixed asset minus the cumulated depreciation to that date. This is why the second-hand value of a fixed asset can be referred to as the ‘depreciated value of the asset’. What is to happen to the depreciation provisions which are thus set aside? The answer is that the provisions should be used by the owner to acquire assets or to repay debt in order to maintain wealth (more strictly, net worth) intact. You can see in Table 1.1 that, having started at the end of Year 0 with a fixed asset worth $20,000 (the new taxi-cab), at the end of Year 1 the enterprise has a fixed asset worth $16,000 (the second-hand value of a one-year old taxi-cab). Therefore, unless the enterprise acquires during (or by the end of) Year 1 an asset worth $4,000, the total value of its assets will have diminished. The asset so acquired may be either a real asset or a financial asset; for the purpose of maintaining wealth intact—of maintaining a constant net worth— it does not matter which, or which combination, of the two types of assets is acquired. Alternatively or in combination, the enterprise may, if the enterprise owes outstanding debts, decrease the stock of financial liabilities owed (may repay debt). Using depreciation provisions so as to maintain wealth intact fulfils the second of the two essential functions of depreciation. If die economic transactions of any transactor result in the wealth—strictly, the net worth—of that transactor being reduced, then the transactor is said to be ‘living off wealth’ (or ‘living off capital’). Living off wealth is, in general, considered to be something to avoid for the obvious reason that, if the transactor’s wealth is finite, then the transactor cannot live off wealth indefinitely. Therefore we accept die need for, and the importance of, regularly setting aside a provision for depreciation and investing each provision so made in an asset (or in repaying liabilities) so as to maintain the total value of the transactor’s wealth intact—so as to maintain a constant net worth. (If the transactor invests more than the minimum required to maintain wealth intact (invests more than the provisions for depreciation), then the transactor’s The R esource Costs of Production 25 wealth—or net worth—increases. But such an outcome, which is satisfactory, is not of present concern: our only concern, in regard to depreciation, is that the transactor should avoid the unsatisfactory outcome from annual transactions of diminished wealth.) We can thus argue that, as illustrated in Figure 1.4 depreciation has a two­ fold essential function. First, it measures the annual real resource cost, to the transactor as producer, of using the real resource of fixed capital in production—of using up part of the store of real services that the acquisition cost of the fixed asset measures. Here we have the cost-payment aspect of the imputed transaction of annual depreciation. Second, by investing the depreciation provisions in assets (real or financial) or by using the depreciation provisions to repay debt, the transactor as owner maintains wealth or net worth intact. Here we have the receipt aspect of the imputed transaction of annual depreciation. In Figure 1.4 we note that the producer and the owner are one and the same transactor so that in order to understand depreciation we have to pretend to or deem an otherwise artificial distinction between the transactor-as- producer and the transactor-as-owner. The fact that the producer is nearly always the owner means that depreciation is generally an imputed transaction in this way. (If the producer leases or rents the fixed asset from the owner— another transactor—then the annual leasing or rental charge would simply include the annual depreciation provision.) In this book we shall concentrate mainly on the real resource cost aspect of depreciation, but this is not to say that the other function of depreciation is unimportant—it is simply that we are concerned with the economics of the costs of production rather than with the economics of maintaining wealth intact.

1.6 Cost

Economic efficiency means minimizing the cost of production for a given quantity (and quality) of output. The concept of cost therefore needs to be fully understood so that we know what we are supposed to be discussing when we consider cost minimization. In this book we are concerned mostly with costs relating to the use of real resources; these costs we shall refer to as ‘resource costs’. At one level, cost can be quite simply be reckoned as the price of each resource input multiplied by the quantity of input of that resource and summed 26 P rofitability; Mechanization and Economies of Scale

Figure 1.5 The economic concept of cost The R esource Costs o f Production 27 over all inputs. However, there are two important questions of concern to economists. Why in principle, does an input have a price? and: Why does a particular input have that particular price? Figure 1.5 shows the economic concept of cost based on trying to answer the two questions raised. Resource cost depends upon a quantity of an input and the price of that input. In regard to any single input, the unqualified word ‘cost’ can be used to refer to any of the following three things: the quantity alone; the price alone; or the quantity multiplied by price, which multiplication gives the money amount expended. In regard to more than one input taken together the word ‘cost’ can be used to refer only to the sum, over those inputs, of the (money) amounts expended on each input. The economic concept of a cost refers to that which must be given up, or ‘sacrificed’, in order that something may be done. The idea of ‘sacrifice’ is the core of the economic concept of cost, with the main meaning o f‘sacrifice’ being the giving up of something valued for the sake of obtaining (or accomplishing) something which is more valued. In this sense, there is a significant two-fold aspect of die meaning of the word ‘sacrifice’ which importantly carries over into the essential meaning of ‘cost’ as economists use the word. The two-fold aspect is that, first, there is the sacrifice of a resource which one actually has (in the sense of having it available beforehand) and which one actually surrenders or gives up—so there is an actual sacrifice. Second, there is the sacrifice of something which one could, potentially and hypothetically, have had (or have done) by using that resource in an alternative way. (Here we use the word ‘hypothetical’ in the rather specialized sense of a hypothetical necessity—a necessity that exists not absolutely but only on the supposition that something is or is to be.) This second aspect of the sacrifice involved in a resource use we shall call the ‘opportunity cost’—meaning thereby the opportunity forgone in consequence of that actual use of the resource. There are, of course, many different possible (hypothetical) opportunities forgone, but we shall focus only on the one which is ‘best’ or which is most highly valued, and this, as the best alternative next to the use actually chosen, will be called the opportunity cost. Consequently, in Figure 1.5 we show two aspects of cost descending from the main meaning of ‘sacrifice’: the use of a resource; and the opportunity cost. 28 P rofitability, Mechanization and Economies of Scale

Oppportunity cost is important because it is the opportunity cost which gives an economic value to the use of a resource. The economist’s view of cost as the amount of money expended on a resource input—or resource cost— is as follows:

Amount of Price Quantity money expended = of X of on input input input Resource Price depends on Use o f cost opportunity cost: resource ‘resource price’/ ‘input price’

v Two-fold aspect o f resource cost

The most useful answer to the questions about input price is that die use of a resource has a price because there is at least one other, alternative, useful purpose to which that scarce resource could be devoted. In order to get a scarce economic resource devoted to this particular purpose the resource has to be attracted away from the other alternative purpose, and such payments will have to exceed, and certainly at least equal, the value of what the resource could have produced in that other next-best alternative. The resource use and the opportunity cost go together in the economist’s concept of resource cost. Figure 1.5 shows the price of an input as depending on the opportunity cost. The value of this next-best forgone alternative, produced by one unit of the input, we shall in full call the ‘opportunity cost resource price’ of the input. In the term ‘opportunity cost resource price’, I use the qualifier ‘opportunity cost’ to signify that this is the underlying economic reason for the price or valuation, and use the further qualifier ‘resource’ to signify (1) that this refers to the price of an input of a real resource, and (2) that this price excludes any charge for finance,finance not being a real resource. (Alternative terms, used in cost—benefit analysis, are ‘shadow price’ or ‘social accounting price’, neither of which are descriptively helpful.) For short, I shall sometimes use the synonyms ‘resource price’ or ‘input price’. In line with this book’s exclusion of unrequited transactions, we do not include any government-levied taxes on inputs in the opportunity cost resource price. Obviously, in a broader context such taxes would have to be considered; for example, a tax on labour input such as a payroll tax raises the relative cost The R esource Costs of Production 29

of labour to an employer in much the same way as does an increase in the wage rate. But for the purposes of this book we do not have to be concerned with producer payments in the form of unrequited transactions. A price is usually given as a price per some standard unit of measurement of physical quantity. There is the obvious distinction between the price of the output being produced and the price of an input. When necessary we can signify the distinction by referring to the price of the product as ‘product price’ or, synonymously, ‘output price’ or ‘selling price’. In regard to the input of labour, the opportunity cost resource price is more commonly known as a wage or a wage rate, and may be measured per hour, or per week, or per any other period of elapsed time. Less commonly, the wage rate may be a rate per task completed or per piece of output, such rates being known as piece-rates, but we will not be concerned with the somewhat specialized matter of piece-rates in this book. In regard to the input of capital (as will shortly be explained), the opportunity cost resource price is conceptually complex, and here the qualifier ‘resource’ is especially important as signifying the exclusion of any charge for financing. This distinguishes the resource price of capital from the rental price of capital, which latter price includes, besides the resource price, a charge for financing. (The rental price of capital will be explained in Chapter 3.) The economist’s argument is that the opportunity cost resource price determines, or at least lies behind, the price for an input (the market price is simply what an enterprise has to pay, in ‘the market’, to obtain a unit of the input). We must immediately qualify this argument, because people, enterprises, trade unions, and governments are all notorious for ‘rigging’ or trying to ‘fix’ markets in their favour. But if we ask what such ‘rigging’ or ‘fixing’ means, we must answer that it generally means trying to get and to maintain a situation in which the market price differs from the opportunity cost resource price. For our explanation of the costs of production we will assume that each market price (excluding any taxes) closely coincides with the relevant opportunity cost resource price. In the context of the economics of production this is an acceptable assumption. In many other contexts, such as or cost— benefit analysis, the assumption is most definitely not acceptable and, indeed, those subjects are much concerned with the situation in which market price diverges from the opportunity cost resource price. Opportunity cost is important in explaining the determination of the price of an input, and it is also important in the entirely different context of deciding to invest finance in capital (real assets). This is because an enterprise which 30 Profitability, Mechanization and Economies o f Scale

(or a person who) uses, or proposes to use, finance to invest in (real) capital incurs an opportunity cost in the form of interest forgone on the alternative financial assets which could have been acquired with that finance. Such interest forgone we shall call the ‘financial opportunity cost’ and in Figure 1.5 we show this financial opportunity cost as descending from opportunity cost. However, such a financial opportunity cost does not represent a use of real resources, and this issue must be treated as entirely separate and distinct from the issue of resource cost. The calculation and use of the financial opportunity cost will be explained in Chapter 3. Accordingly, throughout this book the unqualified word ‘cost’ must be understood as, and must be taken as, referring to the cost of real resources only. When interest is to be considered the word ‘cost’ will always be qualified with the adjective ‘financial’. The resource cost is simply a physical quantity of each input multiplied by its (opportunity cost) resource price. Accordingly, in Figure 1.5 we have two arrows, one from Quantity of input and one from Price of input, together determining the (money amount of the) resource cost. As shown in Figure 1.5, the resource cost may be divided between private cost and . A private cost is a sacrifice which falls upon, and is borne by, the producing enterprise itself. An example of a private cost would be any cost incurred by an enterprise itself in consequence of its own productive activities. The concept of social cost can be defined in either an exclusive definition or an inclusive definition. Figure 1.5 gives the exclusive definition o f ‘social cost’ as any sacrifice which falls on other entities in consequence of one entity’s productive activities. This is how the term ‘social cost’ is usually used. The inclusive definition of ‘social cost’ is that it is the total resource cost falling upon society as a whole in consequence of an entity’s productive activities; that is, it comprises the entity’s private cost plus the (exclusively defined) social cost falling upon other entities. Social costs often involve die sacrifice of natural resources, especially amenities. Social costs (in either definition) are important in the specialist subjects of welfare economics, environmental economics, and cost—benefit analysis, but we shall not discuss social costs because our present concern is only with private costs pertaining to the process of production. Throughout the remainder of this book, the term ‘resource cost’ should be taken as referring to private cost only. Private costs are costs which result from the use of resource inputs and which are paid, or borne, by the entity itself. We may call such private costs, valued at market prices, the ‘costs of sales’ meaning the costs of producing and selling or services, including all ancillary costs such as The R esource Costs o f Production 31 administration, , etc. Thus, Figure 1.5 shows costs of sales beneath, and as an elaboration of, private cost. The costs of sales may be classified according to the type of real resource used. We may deal with actual transaction costs first. The cost of materials (tiie cost of using up circulating capital) may be simply treated as one type of cost; here we simplify the use of inventories into a cash by assuming that materials are bought in as and when needed for use (this simplifying assumption raises no issue of principle for production economics although it would not be acceptable in the context of cost accountancy). The cost of labour (the payments for the use of labour-time) is another cash transaction cost. Next we should note that rent on land is a cash transaction cost. We will not consider rent any further, largely because rent depends upon ownership arrangements for land, and if land is most only owned by the producer then rent is subsumed into the producer’s profits, and partly because rent as a cost has complex peculiarities of its own, the discussion of which would serve no useful purpose in the present context of analyzing the costs of industrial production. (In other contexts, especially analyzing agricultural production, rent would have to be considered as a cost important in its own right.) Next we have the imputed transaction cost of depreciation (the annual cost of using up fixed capital). This conceptually complex cost has already been explained through Figures 1.3 and 1.4. The next steps are to consider the concepts of gross and net operating surplus (or ‘profit’), how these costs relate to gross and net operating surplus, and how profitability may best be assessed for the purposes of production economics through the efficiency rate of profit. These tasks are undertaken in the following chapter.