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Law of Cost of Production

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Jonathan M. F. Catalán posted on Sat, Oct 9 2010 4:06 PM

I am trying to fully understand Böhm-Bawerk's law of cost, and its implications, as "explained" by George Reisman in Capitalism.  It may be the fact that Reisman simply quotes Böhm-Bawerk in length (and then does little in explaining Böhm-Bawerk in simplified, modern English), or it may be how Reisman applies Böhm-Bawerk's law (he does so in his discussion on economic monopoly and the [rejection of the] principle of marginal revenue) that throws me off, or makes it a difficult concept for me to grasp. 

I'd appreciate any help in simplifying the concept, thanks.  For reference, see Reisman 1990, 414–417.

Böhm-Bawerk offers the example of the case of "group of means of production G2".  He then goes on to provide the fact that means of production G2 comprises a second order capitall good which can produce consumer goods A, B, and C. The marginal utility of these goods are valued as follows: 100, 120, 200, respectively.  Böhm-Bawerk rightfully asserts that the value of the capital good, or means of production G2, is represented by the marginal utility of good A.  This is because the loss of one capital-good is not necessarily represented in that of good B or C, but by good A.  This is because the producer can simply sacrifice one unit of good A, instead of B or C.

Now, he loses me when he writes, "Because of the opportunity which production offers for substitution, a specimen C is therefore not valued in accordance with its own marginal utility of 200, but in accordance with the marginal utility of the least valuable related product, the product A; its value is therefore 100."

Böhm-Bawerk writes, "If now we consider what good B or C is worth to us our first response is, 'Just exactly as much as the means of production are to us from which we can at any moment replace the product.'"

I guess what I don't get is why the marginal utility of goods B and C are now 100.  I don't understand the transition from the fact that in the marginal utility of lost group G2 is 100 (or that of the lowest good it produces) to the value of the other goods which can possibly be produced.

Also, near the end, Böhm-Bawerk writes, "And now the whole truth about the celebrated law of costs is revealed.  It is indeed quite correct to say that the costs govern value."

Govern value to whom?  Previously, Böhm-Bawerk writes that the marginal utility of supply to the producer is actually zero (because supply is so great), so I am a bit confused here. 

Hopefully someone can clarify all of this.

EDIT: Reisman applies this to his rejection of the principle of marginal revenue (that it doesn't pay monopolists to cut prices), but Reisman's application seems to be completely different.  He uses this as a method by which to show that prices are governed by the costs of production of competitors, which I understand, but I don't see the relation to Böhm-Bawerk's law.  (Also, is it just me, or does Reisman's argument against the possibility of economic monopoly pressupose the existence of competition?  This just seems like a circular argument.)

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The key is to nail down what he means by "value". Clearly he doesn't mean "marginal utility", as you have shown.

My guess is that it means "price the consumer will wind up paying".

As for Reisman's argument against the possibility of economic monopoly, it presupposes the existence of free entry [a potential competetitor], not of an actual competitor.

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The key is to nail down what he means by "value". Clearly he doesn't mean "marginal utility", as you have shown.

My guess is that it means "price the consumer will wind up paying".

Okay, but this doesn't clarify the relationship for me.

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relationship between what and what?

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How the fact that the marginal utility, to the producer, of G2 (the lowest marginal utility of the goods it produces) relates to the price of the good.  Now, beforehand (a number of chapters back) Reisman provides the example of the automobile.  The price of the automobile is not based on the marginal utility of the automobile itself, but on the marginal utility of all the capital-goods that go into manufacturing it; but to me this only makes sense only after applying the uniformity-of-cost principle,  In other words, the price of the automobile is derived through supply and demand, in conjunction with economic competition, and the cost of manufacturing the automobile only guides prices in the sense that it guides the allocation of capital into enlarging the supply.

But, in this case, Reisman and Böhm-Bawerk are suggesting a more straightforward derivation of price, seemingly independent of all these other factors.

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The gist of what he's saying is that, due to potential competition, producers may wind up charging less than what a buyer would be willing to pay.

The fellow who wants good C is willing to pay 200 for it [that's the marginal utility it has for him, meaning what he's willing to pay]. However, since G2 is used in making A, which is sold for 100, then people making A [and seeing that they can make C instead and charge 200], will move out of A and make C's, increasing the supply of C and dropping the price, till it gets to 100.

As long as there is free entry, the current producer might be the only one making C's, and he will charge 100 for C anyway, because he thinks ahead and fears that charging 200 will bring the A makers into his field as competitors. So to keep them making A's and preserve his niche, he will only charge 100 for C's.

That what both Bahm Bawerk and Reisman are saying.

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Oh, ok, so it is applying the uniformity-of-profit principle.

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"But, in this case, Reisman and Böhm-Bawerk are suggesting a more straightforward derivation of price, seemingly independent of all these other factors."

Well. let's examine the other factors.

1. You mention supply and demand, which is certainly a factor. But he's saying that provides an upper bound on the ultimate price. In certain cases, the price will be lower than what supply and demand would dictate. Because the demand won't pump up the price, since there are those vultures making A ready to swoop down and make C. So that the C maker charges 100, instead of the 200 he could get by supply and demand.

2. Economic competition is certainly a factor here, obviously, the A makers.

3. Cost of manufacturing sets a lower bound on the price. If it costs 110 to make a C, the price will never be 100, no matter what else is going on.

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Thinking about it, the uniformity-of-profit is not a satisfactory explanation of what Böhm-Bawerk and Reisman are discussing.  The uniformity-of-profit principle does not mean that the utility of good C is the same as the utility of the good with the lowest marginal utility from what can be manufactured from G2.  The uniformity-of-profit principle is a tendency; in other words, prices tend toward their cost of production (which, we don't know in this case, anyways).

This is something else, but I can't place my finger on it.  Reisman seems to be applying an implication of Böhm-Bawerk's law, not Böhm-Bawerk's law itself, and so this may confuse matters (Reisman is talking about economic competition, and Böhm-Bawerk is talking about a single firm).

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If anybody is interested, I ask the same question at my blog and sort of through it all again: http://www.economicthought.net/2010/10/question-law-of-cost-of-production/

I think my dissatisfaction is with Reisman's belief that Böhm-Bawerk's insights suggest costs are derived from costs of production, or perhaps a criticism of his terminology.

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