THE BUSINESS FIRM AND ITS COST

In a market economy, consumer demands direct what is produced. We turn now to look in detail at the way business firms respond to consumer demands—at the supply side of the demand and supply interaction.

General Motors supplies Chevrolets. You and I buy them. Westinghouse supplies light bulbs and we buy them. In most cases where a firm manufactures a physical product, wholesalers and retailers intervene between manufacturer and consumer. In others, consumers demand services rather than goods—for instance, shirt laundering and air travel.

Obviously, there are many different kinds of suppliers. To simplify, however, in the next few chapters we shall consider manufacturing firms as suppliers and consumers as demanders, with no intermediaries. This is unrealistic, but it gives a simple first approximation to the working of the market system. And the goal here is to explain the main framework of how the economic system responds to changing consumer demands, changing cost conditions, and other such factors. You can see the main issues without getting enmeshed in the mass of detail that surrounds many markets in the real world.

WHY WORRY ABOUT COSTS?

Why worry about costs? Because a businessman’s costs will largely determine how much he will produce in response to different demands. If customers will only pay $1 for a widget and the minimum cost of producing a widget is $1.25, you don’t need to be an expert economist to see that not many widgets will be produced. Thus, viewed fundamentally, costs are important because they exercise a restraint on production. If there were no costs in making a product, we could get unlimited supplies whenever we wanted them. But since it does cost something to produce almost everything, we can’t expect everything we want free. And how far any business will go in producing what we want will depend on how much that article costs to produce relative to what we are willing to pay for it.

Business costs are important for another reason. Looked at as wages and salaries, rent, and interest payments, business costs are the incomes of workers and of resource-owners. In explaining business costs, therefore, we are simultaneously explaining why most people receive the incomes they do.

This chapter considers the kinds of costs faced by business concerns. Chapter 23 then explains how these costs influence business production and pricing practices.

WHAT ARE COSTS?

Since costs are so important, they deserve careful analysis. First, how do costs look to the businessman?

Back in the profit-and-loss statement costs were broken down into materials, labor cost, depreciation on plant and equipment, maintenance and repairs, selling and administrative costs, taxes, and interest payments on borrowed funds. Every business has its own way of classifying costs, but these main categories show up in most such statements.

Most of these costs represent direct cash outlays—wages; payments for materials; tax payments; and so on. But it is important to remember that cash outlays are by no means identical with costs.

Depreciation is an example. Depreciation is merely a bookkeeping entry estimating how much of the value of plant and equipment has been used up in producing goods during a certain time period. It is not a cash outlay at all.

Cost of materials is another illustration. This item shows the cost of materials used to produce goods sold during the period. It may be more or less than the cost of materials bought during the period. For example, a business with big materials inventories might run a whole month without buying any materials. Yet it should obviously consider as costs the value of the materials used up from inventory during the month.

These examples emphasize another point. Many important business costs are necessarily estimated costs. What the accountant tries to do is to get the best possible approximation of the cost of producing one ton of steel or one quart of milk. But this is a more complex problem than it sounds, both because it is hard to allocate many types of cost accurately to individual units of output, and because cost per unit in most companies varies with the scale of output and the passage of time. The problem is especially acute when a company uses the same facilities, officials, and labor to produce a variety of products. For example, how much of the president’s salary should be allocated to plows, harrows, and harvesters, respectively, in the International Harvester Company?

One other reminder about costs. The modern business has losts of costs not directly related to turning out its products. For example, as a practical matter, it must give to the Community Chest and keep its plant looking reasonably attractive if it wants to be a good citizen in the community —and most companies do. It probably has to contribute to health and retirement funds for its employees, in addition to direct wages. Partly these are just examples of managerial philanthropy, but competition also drives firms to make these expenditures, just as it drives them to pay the going wages and prices for their workers and materials.

Alternative Costs

The economist is interested in these calculations. But his concern with the over-all allocation of resources in the economy leads him on to some further questions. Thinking in “real” terms, the economist is driven by the basic fact of scarcity to the conclusion that the “real” cost of producing anything is the alternatives that are foregone. For example, the real cost of producing an auto is the other commodities given up that might otherwise have been produced with the same steel, glass, rubber, and labor. The real cost is an “alternative cost” —the alternative uses of the resources that are given up when the resources are used in producing autos. Sometimes alternative cost is called “opportunity” cost.

This fact is most obvious in a war economy, when the guns-or-butter alternative stares us in the eye. We can make more tanks, but only at the cost of giving up trucks. The real cost of the tanks is the alternative use of steel and labor foregone— trucks, refrigerators, or other civilian hard goods. The same thing is true in a peacetime economy, unless unemployed resources are available. If we use our resources for one thing, we can’t use them for another.

This concept of alternative, or opportunity, cost can be put into money terms. Thus, the cost of producing one TV set is the amount of money necessary to get the factors of production needed for the set away from alternative uses. For example, as a TV manufacturer, you have to pay enough for mechanics to get them away from auto and radar plants. You have to pay enough for copper wire to bid it away from telephone companies. And so it is for every resource you use. In economic terms, the total cost of the TV set is the amount necessary to bid all the required resources away from the strongest competing uses.