New Fabian Research Bureau
E. 14. Memorandum by R. F. Harrod on the Possible Scope of the Costings Group's Work [a] , 
I must apologise for the extreme inadequacy of this memorandum. After promising to contribute it, I found myself overwhelmed with a mass of other work which has kept me working continuously at high pressure.
I shall confine myself to presenting for the consideration of cost accountants, the economic principles involved in their broadest outline. The application of these principles will be widely different in the cases of--e.g. a railway service, a factory and a farm. I should be grateful for further opportunities of working out their detailed application. Furthermore I apprehend that practical accountants might find great difficulty to [b] make the price calculations which these principles require. I should be deeply interested to hear how great the accountants, after giving the matter their mature consideration, would judge these difficulties to be.
1. In the first place it must be emphasised that the economist does not attach much importance to a matter, which must normally be of primary interest to cost accountants, namely the equality of receipts to outgoings in a particular undertaking. If there is not an exact balance the difference can be made good from any excess paid into the funds of a planning authority.
2. It is necessary to explain what, in the economist's view, is the proper function of a price. The economic function of a price is to restrict the buyers demand. On what principle should the demand be restricted? It should be restricted by a price pressure proportional to the real cost of the service to the community.
(I deliberately place outside the scope of this memorandum, possibilities (1) of price manipulation designed to favour the poor at the expense of the rich and (2) of price manipulation for moral purposes, i.e. to encourage or discourage consumption, according to the notions of what is "good for people" entertained by an external authority. Price manipulation of this sort could easily be superimposed on a price structure designed for more technically economic ends. It remains important to get a proper basic price structure, which puts all goods, many of which may be of equal significance to the poor and also of equal moral significance, into their proper relation.)
The function of price-pressure may be explained by reference to Robinson Crusoe. He can acquire all sorts of comforts at a certain price (in labour) and he restricts his use of certain comforts by reference to the hardness of the labour required to obtain them. He pits [c] the pleasure he hopes to derive from them against his expenditure of effort directly. In an exchange economy with division of labour, this pitting of satisfaction of need against the cost of satisfaction can only be done indirectly through pricing. The price should be proportional to the real cost.
3. What is the real cost? At any point of time certain parts of the real cost of producing a given commodity have already been expended and embodied in fixed plant. Whether the plant is used or not, this cost cannot be recovered. Robinson Crusoe having made certain tools, for good or for ill, can use those tools without any more expenditure or effort upon them than is required to keep them in order. Once the tools are made he no longer debits against his prospective comforts the cost of making the tools. These costs are over and done with. The effort expended can never be recovered, even if the tools are never used.
The cost of making the tools corresponds roughly to "overheads" 1 and the labour expended in using them to what economists call prime costs.
Robinson Crusoe will only pit his prime costs against the prospective comforts. He will not reckon in overheads. Prime cost must include an allowance for depreciation of the tools, provided that there is any chance [d] of using them for other purposes.
This principle should also be applied in the exchange economy. Prime costs alone are relevant to economic pricing. The price charged against any commodity should be equal to the costs which at that point of time need not be incurred if the commodity is not produced, pressure on consumers should be relieved and their demand be allowed to expand to the point at which price is not higher than the prime cost.
4. It might appear from the foregoing, that all undertakings would be subject to a heavy deficit (representing overheads 2 ). But this is not so.
Besides the distinction between prime and overhead costs, there is another equally important but quite different, distinction between marginal and average costs. Suppose n units of output are turned out at a given plant, the marginal cost is the difference between the prime cost of producing n units and the prime cost of producing (n - 1) units. The price charged should be equal to the marginal cost so defined. If plants are worked much under capacity, the marginal cost may be less than the average prime cost. But under the system of releasing demand by charging only the prime cost against the commodity, this unemployment of capacity would be less likely to occur. If it did, it must be admitted that the deficit to be made up would be correspondingly expanded.
But after a certain employment of fixed plant, the marginal costs begins to rise. There must be no hesitation in charging the consumer a price proportional to the marginal cost. The reason of this is that the price which the consumer is prepared to pay is equal to the marginal utility of the commodity to him. If the marginal cost is greater than the marginal utility there is social waste, and it is desirable to transfer productive resources to other occupations.
When, under reasonably full employment of fixed plant, marginal costs begin to rise, they will soon become higher than the average prime cost. If an appropriate price (equals marginal prime cost per unit) is charged total receipts will exceed total prime costs and the difference may go to meet overheads. In certain cases this difference may exceed overheads, and the surplus should be appropriated for the relief of deficits elsewhere. In private enterprise the difference goes as surplus profit. Some industries, e.g. coal mining, would normally show such surpluses. It is entirely contrary to economic principles to use this surplus to subsidise marginal output in the industry itself, e.g. by the pooling of profits. For then the marginal cost of production would exceed the marginal utility of [e] the commodity to the consumer.
5. The treatment of overheads envisaged here has one great difficulty. If the price of the product is not normally expected to include an allowance for overheads, what is to be the check on capital construction? This is really the crux of the difficulty.
In the case where the capital construction consists of an alternative method of performing an operation (a labour saving device), there is a solution to hand. The labour cost without, and the labour cost with [f] , the device can be compared taking into account a standard rate of interest, and whichever method is cheaper can be adopted. Once the labour saving device is adopted, the commodity should be charged with the marginal prime cost only.
Where the capital construction is not of the kind, the difficulty is more severe. The correct solution of the problem is that the capital construction should be undertaken, if the price that the consumers could bear would be sufficient to cover the overhead costs entailed. Once the capital construction is undertaken, they should not be asked to pay the price, unless the demand is so great that the marginal cost becomes higher than the average prime cost and represents such a price.
I am aware that such a solution is artificial and depends on an hypothesis which may in a particular case be unverifiable. I can only claim that this is the true economic solution and would ask others to explore avenues by which it might be rendered practicable.
I apologise once more for the sketchy nature of this memorandum. I appreciate that the treatment has been very cursory. I only hope that it may provide some basis for an initial discussion. 
2. This question found its way to one of the questionnaires the Oxford Economists' Research Group submitted to the first three entrepreneurs in their inquiry on prices and interest early in 1936. The questions relating to costs run as follows:
4. How would your accountants compute the cost of an addition to output? Would orders ever be accepted at prices which cover no more than direct costs of production; and if so, in what circumstances. (Economic Research Group, "Questions for discussion. No. 2", [January 1936])
When the questionnaire was eventually substituted by "General Questionnaire No. II" on 12 March 1936, question 3 was retained, albeit in a modified form, while question 4 was dropped altogether (for a chronology of the changes in the questionnaires see D. Besomi, "Roy Harrod and the Oxford Economists' Research Group's Inquiry on Prices and Interest, 1936-39", Oxford Economic Papers 50, 1998, pp. 539-43, in particular note 7). The reason probably lies in the disappointing replies of the entrepreneurs, who seemed to follow rules of thumb rather than calculating in terms of marginal costs (Harrod, minutes of the "Visit of Mr. H. F. Scott-Stokes on 31.i.36", in HCN 5/1/7 ; "Oxford Economic Research Group. Visit of Sir Kenneth Lee on 21.ii.36", in HCN 5/11 and ABP 46; Harrod, "Oxford Economic Research Group. Visit of Mr. J. L. Cadbury on 6.iii.36", in HCN 5/2/13-14). This was discussed in correspondence with Henderson in February 1936 (see letters 525 , 526 and 527 ), and eventually led the group to formulate the "full cost principle" (for Harrod's argument see essays 18 and 17 ).
3. Representatives of both firms were interviewed by the Oxford Economic Research Group (see note 2 to this essay for further details). In his "Supplementary Notes of Interview with Mr. F. Impey, Managing Director, Kalamazoo Ltd." (A draft in HCN 6.33.10, final T draft "to be printed and circulated" in HCN 6.33.8) Harrod remarked that Morland and Impey "have a system of marginal costing [...]. They correctly defined marginal cost as that cost which would be avoided if the order was not taken". He added, however, that "Since they reckon that marginal costs are independent of volume of output, their `marginal' costs are tantamount to `prime' costs'". The secretary of the firm, however, while accepting as correct the definition of marginal costs, disagreed with Harrod's identification with prime costs, as a significant proportion of their costs "varies with the volume of business, and must therefore be regarded as a part of marginal costs" (A. D. Neish to Harrod, 14 July 1938, in HCN 6.33.5). Cadbury was submitted question 4 cited in note 2 to this essay; however, only his reply to the second part is recorded in the minutes (Harrod, "Oxford Economic Research Group. Visit of Mr. J. L. Cadbury on 6.iii.36", in HCN 5/2/13-14).
4. Harrod's memorandum was commented upon by Austen Albu on 24 November ("Reply to memorandum by R. F. Harrod on Possible Scope of the Costings Group's work"), H. A Franklin on 28 November ("Criticism of Harrod's memorandum on Costing"), Colin Clark on 7 December ("Notes on Harrod's memorandum on Costing", in FS J 30/10-11) and again by Albu on 10 January 1934 ("Further Comments on Harrod's Memorandum on `Costing' & Colin Clark's Notes: With Special Reference to Marginal Costs in Manufacturing Industry", in FS J 30/1/15-16). All commentators were more interested in the practical implications and requirements of costing concerning socialization, rather than in Harrod's theoretical statements.
3. "Hear hear! Two firms I know of try to do this. Cadbury: See Hugh <Weakes>. Morland and Impeys. See Mr Sawyer"  [annotation in unknown hand].
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