Trade Cycle Group [1]

 

E. 17. Notes on Interviews with Entrepreneurs [a] , [2]

(autograph draft)

I should like to emphasize that the following notes are entirely provisional and tentative. It is not always easy to disentangle what is essential in the explanation of procedures in the dossiers, and consequently my summary descriptions may not always be correct. If these notes are judged of value, it might be good for me to submit all such statements of fact to the independent judgement of Miss Bowley [3] and to collaborate with her in revision when necessary. [4] Classification of procedures is often very difficult. In certain cases we have very clear statements; in others one has to classify after weighing a number of different statements in the relevant section of the dossier.

The generalizations and conclusions also are tentative. They are put forward with the idea of stimulating discussion and ascertaining whether certain lines of thought are judged by the group to be likely to lead in a good direction. Also they may serve to sharpen our weapons of attack in any further questioning of entrepreneurs.

Preliminary

It appears to me that our questionnaire [5] centres upon two fundamental problems:-- 1

1. What determines business men in the volume of current output which they produce? The question how they fix prices is subsumed under this, since the sales are presumably a function of price.

2. What determines business men in the amount of fixed equipment which they install?

Now the economist has a ready-made answer to both these questions. The entrepreneur will so behave as to maximize his profits present and prospective. This may be put otherwise by saying that he behaves so as to maximize the present value of his business. The present value depends on current net revenue and expected net revenue. Any action tending to raise the value of net revenue expected in future pro tanto raises the present value of his business.

The principal objection to this a priori analysis is that it assumes knowledge where there is in fact ignorance. The entrepreneur is often largely ignorant about the value and elasticity of the demand curves for his goods here and now and a fortiori about their prospective value and elasticity. What the future is destined to bring is relevant to decisions under (i) as well as under (ii). This may be considered under the heads of (a) depreciation of physical assets and (b) depreciation of goodwill.

(a) To assess current net revenue it is necessary to arrive at a figure for the true depreciation of physical assets. But this depends inter alia upon the use to which it may be possible to put these assets in future. Mr. Keynes has sketched out certain points here in his treatment of User Cost. [6] For a more exhaustive analysis, see G. D. A. MacDougall's article in the Economic Journal (September 1936) on the definition of prime and supplementary costs. [7]

(b) Similarly it is necessary to arrive at a true figure for depreciation of goodwill. An entrepreneur may reduce prices more than he would otherwise have done in order not to lose customers, i.e. in order not to deprive himself of part of a potential market in future, or he may keep prices higher than he would otherwise have done, in order not to spoil his price, because, given institutional arrangements, the ill-will due to a rise (in future) may be greater than the goodwill [b] secured by a present reduction.

Having in mind this de facto ignorance, I suggest a three-fold classification of procedures into rational, irrational, and anti-rational.

1. Rational. A decision can only be rational if all the data required for a correct assessment, on the economist's criterion, are known. But in fact they never are all known. Therefore rational procedure can only be regarded as an ideal, or a limit towards which irrational procedure tends, as the knowledge of relevant data increases.

2. Irrational. This covers all procedures followed in the absence of the necessary data, provided that they are not based on any rival criterion. Thus irrational decisions in this sense do not imply any departure from the economist's criterion. They may represent the most "sensible" thing that can be done in the circumstances. But they are not rational because in the absence of data rationality is impossible.

(It might be held that the connotation of irrational is pejorative and that the term is therefore inappropriate. This is a mere matter of nomenclature. Who will suggest a more suitable term?) [8]

3. A procedure is anti-rational if it is based on a rival criterion, e.g. an ethical consideration. It may be that an ethical consideration may be the façade of an economic one based on the dictum that a fair price is the best policy. But it would be rash to assert that this is always the case. It may be that in certain cases clear and substantial economic loss would lead to the abandonment of the ethical criterion, but that the ethical criterion is maintained in the face of minor losses. It seems unlikely that entrepreneurs who have the ethical criterion in mind behave precisely as they would do if it were not. But if that is so, the anti-rational criterion has some influence: it is all a question of what weight to assign to it.

If this is so it is important to get an inventory of all the ethical considerations that are borne in mind. If they were properly classified, it might be possible to demonstrate a priori that they have a certain, even if only a minor, significance in the cycle.

Are there any other rival criteria besides the ethical? Is pure conservatism such, viz. the maxim that you should do what has always been done? We shall be better placed to form a judgement upon this, after the field of the irrational has been explored more fully.

The irrational

1. It was observed above that it is probable that no decision is ever perfectly rational, since it is most unlikely that all the necessary data should be present. But it is possible that the rational provides limits within which the irrational must lie. Thus a man may be able to give perfectly good reasons, based on ascertainable facts, for not doubling or halving his price. These limits may none the less allow for a fairly wide range of choice.

2. It is necessary to introduce the distinction between qualitative and quantitative judgements. An entrepreneur may believe--on good grounds or bad--that a rise in price would entail a considerable loss of market, but may be unable to reduce his judgements to quantitative terms. He may claim that his policy is based on a qualitative judgement. There is the danger, however, of a fallacy coming in here. A judgement may be, so far as the explicit consciousness is concerned, only qualitative and yet have a quantitative implication. Thus if an entrepreneur affirms that on qualitative grounds 1/- is the right price, there is a quantitative implication. Since the decision itself is quantitatively determined, i.e. the price must actually be lld., 1/-, 1/1, etc., the situation supposed to justify it must be quantitatively determinate also. Given the entrepreneur's claim that 1/- is the right price, it should be possible to show him the quantitative implication. He presupposes the elasticity of demand to be precisely so much.

If he then demurs that he is unable to put so fine a point upon it, it should be possible by suggesting alternative elasticities to determine the range within which he believes himself to be ignorant. From that it would be possible to argue back to the right price and demonstrate that so far as his presumed knowledge was concerned anything between 10d. and 1/2 would be equally good. Thus in spite of the ostensibly qualitative character of his judgement we should be back in the position of the foregoing paragraph with a quantitatively fixed range of irrational choice, lying between rational limits. But since he has in fact to fix his price at some specific value, there must be some irrational factors at work determining him, over and above his qualitative judgement.

3. It is necessary also to introduce the concept of probability. Presented with a range of alternative elasticities, an entrepreneur might express genuine ignorance as to which was the true one, but plump for a particular one as the most probable. If his conduct was in accord, it would bear a considerable resemblance to that characterized as rational. The difference consists in that in one case procedure is strictly determined by the facts as they are, these facts being known, in the other by judgement about the facts, in themselves incompletely known.

From this it appears that the investigations of factors determining irrational procedure should be divided into two parts (i) factors influencing judgement where the facts are incompletely known, and (ii) factors influencing conduct where judgement admits itself unable to determine the best line of conduct to a precise point.

4. It does not seem likely that our enquiries will make much headway under the heading (i). It does not appear that we shall elicit important factors biasing judgement which are unperceived by the subject of our enquiries.

It is worth, however, mentioning a leading example of a factor supposed to operate in this way, viz. psychological optimism and pessimism. In the case of our second problem (installation of equipment [9] ) I suppose it is clear which way the factors would work, namely, optimism would lead to excessive and pessimism to deficient installation. But with regard to the first problem I have always been unable to see why optimism should tend to increase output, since it might equally well lead an entrepreneur to set the price too high, viz. hope he could sell more than he actually could at a given price and so sell and produce less than he would have done if his judgement had been more balanced. Which way optimism would work might then depend on institutional arrangements and it might be advantageous to classify these with this end in view.

5. It is possible that the search for both sets of factors is doomed to be fruitless. This would be the case if both judgement and conduct within the range of the irrational depended solely upon chance. I believe that the view that this is so is often implicit in economic theorizing. If there are a large number of operators, then, on the assumption of rational limits there are likely to be as many deviations on one as on the other side of the best course, and so, again if there are a large number of operators, the same effect will be produced as if each man acted rationally. Hence the assumption of universal rational action is justified! I am not confident if this conclusion is correct. It appears to me that we might obtain valuable assistance at this point from our experts on the theory of probability.

6. One result of the investigations we have already made seems to militate against the view of the last paragraph, anyhow so far as our first problem is concerned (current output). It has appeared that despite their admittedly great ignorance of current market elasticities, various firms are strongly wedded to rather definite procedures (formulae with regard to cost, the habit of not lowering prices, etc.). [10] It seems on the face of it probable that these established procedures do constitute factors biasing action in a certain way within the range of the irrational and by the aid of theoretical reasoning it might be possible to determine, from the procedures, what the bias would be in the various phases of the cycle.

Though each particular procedure may be irrational or contain irrational elements, it is by no means irrational that they should exist. For in each particular case something has to be done and where a decision has to be irrational in any case, it must greatly contribute to time-saving and therefore to efficiency that the decision should be reached to some extent automatically.

7. The last two paragraphs lead to a reflexion, about which I am not sure what practical effect could be given to it in our enquiries, but which certainly suggests a link or "bridge" with allied subjects. We often speak of competition as weeding out inefficient producers, and in our minds are apt to think of the inefficient producer as being less intelligent, industrious, punctual, etc. But it may be that industrial evolution proceeds more on the lines of evolution in nature. New businesses arise and as a matter of practical expediency are bound to adopt some regular procedure with regard to price fixing. In so far as these lie within the range of the irrational (and that may be a very large one) no one procedure can be regarded as more intelligent than any other. Yet in fact one may give results lying on the average over a term of years nearer the optimum than another. Competition will weed out the procedures less well adapted to the environment. Thus when Scott Stokes' father-in-law justifies his procedure on the ground that it has been used in his business for a number of decades, he may be on very strong ground. [11]

8. The adoption of new (irrational) procedure is analogous to mutations in the theory of natural selection. [12] The more frequent the occurrence of new mutations, the greater the opportunity for industrial adaptation. I suggest that the greatest opportunity for new mutations is on the birth of new firms. Adaptation to environment would in our case be the spread of a procedure which in fact resulted in a closer approximation to the maximization of profit. Such adaptation is more likely to occur if new mutations are frequent. Thus it might be the case that in circumstances of a very high birth-rate of new firms the assumption of profit maximization would be a fairly close approximation to the truth, while in the event of a much lower birth-rate it might be quite wide off [d] the mark.

V olume of Output

1. I venture to begin with a statement of the economic principle, albeit highly theoretical, on the ground that it may serve as a criterion for gauging the limits of the irrational and for judging the various procedures adopted by firms. In perfect competition the price should be equated to the marginal prime cost of production. [13] In imperfect competition the price should be made to exceed this by an amount (x - y) equal to the difference between two quantities now to be defined.

x is the difference between the price received and marginal revenue and its value depends on the elasticity of demand at the stated price. [14]

y may be called the appreciation of goodwill. [15] The attachment of customers throughout future time may be regarded as a function of, among other things, the present price, or, what comes to the same thing, the present level of the firm's sales. Starting from the point of zero present sales we may suppose some increment of goodwill to be associated with every increment of sales achieved. With every increase of customer attachment an increase of probable net revenue in the future may be associated. y is the present value of that increase for the marginal increment of sales. 2

y may normally be expected to have a positive value. But the case must be borne in mind in which entrepreneurs are unwilling to reduce the present price because they wish to avoid the ill-will which would be incurred by a raise in future. Customer attachment is thus a function not only of the price but of changes in price and it appears from our evidence that a given price decrease may in certain circumstances cause an amount of goodwill less than the amount of ill-will caused by an equi-proportional increase. [16]

2. It appears from the replies that there is fairly widespread ignorance with regard to the value of x. With regard to the still more difficult quantity of y we did not even attempt to probe very far. The only firm which appeared fairly self-confident with regard to their knowledge of x was Murphy Radio; [17] and they did not use their knowledge for price policy (except indirectly in order to get an accurate estimate of overheads per unit), probably because they thought a policy based on "full cost" would make a better adjustment to the y factor, possibly also because of an anti-rational (ethical) factor.

With regard to prime costs on the other hand there is usually fairly full knowledge.

Furthermore, there is also a reasonable degree of knowledge with regard to certain other data, viz. overhead costs, which from the point of view of the analysis of the foregoing paragraph are irrelevant.

What appears to happen in a great many cases is that this apparently irrelevant knowledge is brought in to fill the gap caused by ignorance of the relevant data. The manner in which this is done may cause systematic deviations from the optimum procedure during the course of the cycle.

3. The bringing in of overheads is a natural if prima facie irrational procedure. The entrepreneur knows that his overheads must in the long run be covered.

How would overheads be covered if the economist's criterion were followed?

(i) Perfect competition. In this case overheads are covered in one of two ways. (a) Marginal prime costs may be rising (most usual assumption of theory). In this case marginal prime will [e] exceed average prime and by charging a price equal to marginal prime, the excess over average prime will in equilibrium be sufficient to cover overheads. (b) If the plant is being worked to full capacity, a price in excess of computed marginal prime may be charged. Or, to put the same thing in another way, the marginal prime cost may be regarded as anything between the computed marginal prime in the given plant and the cost of adding sufficient extra plant to produce an extra unit plus the computed prime cost of producing it with the aid of that extra plant. Any price between these limits may be charged and in equilibrium it will be high enough to provide an excess over average prime sufficient to cover overheads. [18] This analysis (b) only applies where plant is being worked to full capacity.

In practice we did not have cases of perfect competition. Nor did we have any instances of appreciably rising prime costs. Again in many cases plant was not worked to full capacity. So these factors tending to make provision for overheads did not come into play. Attention may be drawn, however, in this connexion to the case of Higgs, who recently decided to put prices up because he could not give early delivery. [19] This was clearly a case of production up to capacity but with demand insufficiently strong to cause an immediate increase of capacity. Attention may also be drawn to the statement of S that there was a strong instinct to put prices up when trade was booming and labour tending to be scarce. [20]

(ii) Imperfect competition. In this case the theoretic provision for overhead comes out of the excess of price over marginal prime cost due to the x and y factors. There was no scintilla of evidence that this mode of analysis was consciously present to the minds of our entrepreneurs. It would be sufficient for the theoretic postulate, however, that it should be implicitly present, viz. that they should take such account of the demand (x and y) factors as to make the necessary provision for overheads, even if this taking account and this provision were not consciously linked in their minds.

4. It may be well first to consider those firms which pay least attention to overhead costs. It was generally agreed that, save in very exceptional circumstances, the price was not allowed to go below prime cost.

On inspection it appears that these are less than might at first sight appear. And in almost every case there is some reservation.

Brooks. [21] Price determined by competition, level of turnover, time of year, etc. Their only reservation was that in theory price should be determined by cost!

T. Reservation:--Uneasy about letting price go below full cost unless you are sure you are covering your total overheads on some lines.

Sir John Grey and Orr. Price determined by competition. Attempt to cover overheads abandoned because there would be no trade if you did. But both these have in mind that in normal times prices would be deliberately fixed to cover overheads.

Rowntrees. Competition primary determinant but cost has some influence.

Simon. Prices may vary from those sufficient to cover only variable costs upwards.

These are the firms which, as I interpret the matter, have gone furthest in throwing overheads to the winds. It must not be inferred that they were pre-eminent in their knowledge about the precise nature of demand factors affecting them.

I confess that I find a considerable vagueness in the dossiers--probably representing some vagueness in their minds--with regard to their actual procedure. The clearest case is that of Rowntrees, in which prices appear on the whole to be fixed by the dominant duopolist. This being so it is possible that the theory of the determination of Rowntree output should resolve itself into the pure theory of advertisement.

With regard to the rest it must be emphasized that there is still something left unspecified with regard to their procedures. It is not enough to say that they accept the competitive price. That would only apply to the case of perfect competition; but in all these cases including those of the cotton spinners competition is decidedly imperfect. The elasticity of demand in all these cases was anything but infinite. It remains therefore to determine by what laws their respective shares of their markets fall to them. To arrive at these a more detailed specification of their procedures is requisite.

It may be that their actual conduct is determined by an implicit judgement of the most probable values of x and y. It may be that there is a large fortuitous element within the limits of the irrational. I was not able to detect in the dossiers definitely biasing factors.

5. In all other cases, as it appears to me, overhead costs play a dominant part in price determination. I do not suggest that they all adopt a rigid rule in the manner of Scott-Stokes. [22] They tend to allow a certain latitude upwards and downwards. They are often willing to go below "full cost" on certain specified occasions, such as in the early stage of development of a new firm (Beiersdorf [f] ), on certain lines in order to secure full working (Cresta Silk), in a slump (Cadbury), on bringing out a new line (Higgs, Cadbury, Lee) etc. [23]

6. It is necessary to clarify the position of a certain class of entrepreneurs who accept the price as set by the market, and therefore appear prima facie to be working on the principle of what the market will bear, but in reality work upon the "full cost" principle. [24] I refer to those who first ascertain the market price for a certain broad type of article and adjust their quality accordingly, so as to cover their "full cost" at that price. Their view may be summarized in the remark of Mr. Meyer (Beiersdorf) that it is no good trying to sell a 1/- expectorant at 1/6.

It must be emphasized that this class of entrepreneurs are working on the "full cost" principle. Whether you produce an article, compute its full cost and enter that in the catalogue, or you take the catalogue price as given and put just so much quality into the article as to make its full cost equal to that price, you are equally following the "full cost" principle and not what the market will bear. [25]

To see that this is so, it is only necessary to consider what line of action the opposite principle would entail. An entrepreneur would have to consider not what was the best quality he could give at the price, but what was the quality [g] which, taking demand and goodwill into account, would maximize the present value of his business. If he knew the data he might find in certain circumstances that it would pay him to give less quality than he could at the price and in others to give more quality. If, ignorant of these data, he follows the full cost rule of thumb we must admit that willy-nilly he is not directly adopting the criterion of what the market will bear.

This view is reinforced by a consideration of certain opposite cases, viz. loss leaders and prices charged by firms in the early stage of operation (e.g. Beiersdorf). In these cases goods are deliberately sold below their full cost. And the reason is forthcoming. Low prices are charged because the entrepreneurs are confident in these circumstances that the value of y is great. When in special circumstances there is knowledge or strong opinion about the probable value of y, that is used. In the absence of such opinion, there is a reversion to the rule of thumb.

I give examples of the entrepreneurs who adjust quality to price and therefore ought to be included among those who follow the "full cost" principle:--

Barnet Combs.

Murphy

(first stage only: in the final stage the price in the catalogue is fixed independently of the market).

Barlow

Lee

Scott-Stokes.

It may be assumed that other producers who believe in the "full cost" principle make quality adjustments, even when the point was not mentioned in their dossiers.

7. Other producers who believe in the full cost principle may be listed:

Wedgewood.

Gledhill

Thornber

(save in very exceptional cases)

Cadbury

(save in depression)

Higgs, S.

(but with some latitude) [h] .

Cresta Silk

(so far as the bottom limit of price is concerned).

Beiersdorf

(but cannot necessarily apply it in present early stage of operation).

8. It must be observed that when the full cost principle and the economist's principle yield different results the profit under the former principle must be less. If there is any difficulty in covering overheads, success would be less likely to be achieved if to do so were made the specific criterion of price policy than if demand were accurately taken into account. This is a paradox. Surely a price which is set so as to cover overheads must cover them!

The fact is that any accurate estimate of the addition for overheads required per unit (on cost) depends on accurate forecasting of turnover. But to make an accurate forecast of turnover implies a knowledge of elasticity of demand, which is precisely what is lacking. The full cost principle based on a true and accurate forecast of turnover would yield the same result as the economist's principle, anyhow so far as the x factor is concerned. If the forecast could be made, rational action would be possible. In a slump it would be recognized that overheads could not be covered and forecasting could be used to minimize the deficit.

The irrational resumes its sway if accurate forecasting is impossible.

9. In order to isolate this irrational element it is necessary to eliminate the firms (i) which paid scant attention to overheads (see para. 4), and (ii) which did not know what it was to work below capacity (Cresta Silk). That leaves:

Firm

Turnover assumed for computing on-cost

Higgs

conventional but variable on-cost, not apparently closely related to prospective turnover.

Wedgewood

on-cost based on normal or fairly good trading conditions.

Beiersdorf

?

Barnet Combs

?

Murphy

accurate forecasting

Gledhill

on-cost based on full working

Barlow

"on-cost not raised if production falls off": per contra he states that on-cost based on actual output.

T.

on-cost as assumption that plant 80% occupied.

Thornber

?

Lancashire Cotton Corporation

full capacity operation.

S.

Budget output.

Stamp

?

Cadbury

In case of growing line on-cost based on turnover hoped for in future rather than present level.

Lee

?

Scott-Stokes

room charges on previous year: dead charges conventional figure of 50%.

Of these 15 cases, in 5 nothing definite was elicited and 1 was self-contradictory; of the remaining 9, in 3 on-cost was based on forecasting, in 2 a conventional ratio was adopted and in 4 full working or something approaching it was assumed. The conventional ratio and the assumption of full working have this in common that on-cost does not vary with turnover. In 6 out of 9 cases we have a method adopted which explicitly does not attempt to cover overheads in a time of slack trade. That this method would thus fail of its purported object cannot have been overlooked; its adherents doubtless had one eye fixed on demand.

10. In the case of firms adopting a forecasting method one would expect that on occasion it would become apparent that no system of pricing could cover overheads, and that attention would be directed to minimizing the deficit. Cadburys have, however, been accelerating during most of the period and Murphys accelerating very rapidly. S. does not appear to have been so fortunate, but it interprets the "full cost" principle with very great latitude allowing as much as 40% variation of price in relation to cost; its specification of procedure is not sufficiently detailed to make it plain how it deals with on-cost in a slack season.

Where forecasting has made it plain that overheads cannot in any case be covered, it is probable that firms have abandoned the attempt to relate price to full cost (cf. the cotton spinners) or to use costing based on forecasting as a means of minimizing the deficit, and have, instead, looked direct to demand to determine their prices. To use forecasting in order to determine an on-cost in order to determine a price is only a roundabout way of relating price directly to demand. The more roundabout method is unnecessarily cumbersome.

This suggests a corollary. Where a firm bases its price policy on demand rather than on "full cost", this need not indicate that the firm in question has better data about demand than the firm which continues to use the costing principle. It may merely indicate that the firm has passed through a period in which the costing system failed of its object, viz. was unable to provide a price which would in fact cover overheads. Where the cost system has survived it is probably owing to the fact that either owing to its peculiar cost structure or the nature of its market the firm in question has not gone through such an experience.

11. The fixed percentage method and the assumption of full output may be jointly designated by the expression flat rate of on-cost. [26] The flat rate of on-cost may be regarded as a less well developed system than that based on forecasting. Yet in our small sample it appears that of those who attach importance to "full cost", more use the flat rate than use forecasting. The reason for this may be conjectured. The deficiencies of the flat rate become obvious if the output is subject to great fluctuation. But this same cause which renders the flat rate system objectionable tends to undermine the cost principle altogether: so that only a few firms are stranded in the midway position.

12. It might be thought that the argument of the foregoing paragraph could be carried further so as to show that a forecasting system of determining on-cost would never be used. If the forecasting system is only a roundabout way of taking into account the elasticity of demand, would it not always give way to the simpler method? No; such an argument would be based on a misconception. Forecasting systems differ greatly in elaborateness from Murphy's distribution of purchasing power curve to Mr. Yate's dictum that foresight is ninety per cent. hindsight. [27]

The simplest forecasting system is to assume that next year's turnover will be equal to that of the last. Such a system would give a different rate of oncost from the flat rate system and yet take no account of elasticity of demand whatever. Indeed it is probable that the great majority of forecasting systems, even very elaborate ones, take no account of the elasticity of demand. They are more likely to be based on a computation of secular trend suitably corrected for the phase of the trade cycle.

There may well be a range of cases, therefore, in which the flat rate system proved unworkable, but in which the situation had not got so bad, but that overheads could be covered by a system which budgeted the next year's output in the light of such broad trends. It requires a more adverse situation to produce the result that cost cannot be covered on the budgeted output. Only in such a situation would it be necessary to make alternative computations for various possible outputs and their appropriate prices (i.e. work on the forecast elasticity of demand) and when that point is reached the "full cost" system is likely to be abandoned altogether.

13. It should be noticed that the flat rate system tempers the price to the market more than the forecasting system. This may account for its survival despite its illogicality. It may also be noticed that in 3 out of 6 flat rate firms (the seventh, Barlow, does not specify this particular), the addition was made as a percentage of the total direct cost (Scott-Stokes, Higgs, Wedgewood), which includes raw material. This procedure is illogical, as was candidly admitted by Scott-Stokes, but tends further to temper the price to the market, on the assumption that raw material prices move up and down in sympathy with the general state of trade. Thus this illogicality, too, may have its survival value.

14. The justification alleged for the use of the "full cost" principle is twofold. (i) As setting a bottom limit for the price it is justified on the ground that overheads must be covered. This procedure, we have seen, is fundamentally irrational, but in the absence of data no more rational procedure may be possible. (ii) As setting a top limit it is justified on the ground that a firm charging higher prices will in the long run be undermined by competition. Thus the use of the costing principle to determine a top limit is intimately connected with the unknown y. Though lacking the precision of an ideally perfect forecast, there are reasons for regarding it at least quasi-rational. But here doubt may be entertained as to whether it is as widely practised as professed. For its widespread use would seem to be incompatible with the existence of a high rate of profit on invested capital in the firms professing it. (Would it be worth while for our research branch to investigate the rate of profit on capital actually earned by the firms which profess never to go above a full cost price?)

15. It may be well at long last to say something about the trade cycle. Here my remarks must be tentative in the extreme. In my judgement in this stage at all events attention should be concentrated upon establishing upon a firm foundation our premisses with regard to the nature of procedures, from which deductions concerning behaviour within the cycle may be drawn later.

Let us first consider the x factor alone. If a flat rate of on-cost is adopted, the difference between the price and the prime cost remains constant. This would be justified by the economist's criterion if it were true that elasticity of demand also remained constant in boom and slump (i.e. if x = price - marginal revenue were constant.) It is my private opinion that elasticity of demand does not remain constant but increases in a slump. This if so would account for the tendency of which there has been some evidence (Cadburys, cotton producers, [28] etc.) to be more inclined to let the price run below full cost in a slump than in a boom. With one eye on demand they would tend to weaken in their "full cost" policy.

Forecasting for on-cost may be classified as crude and refined. By crude I mean forecasting based on past experience, the estimation of trends, etc. By refined I mean forecasting which takes into account elasticity of demand. We have had no evidence of the existence of refined forecasting, with the doubtful exception of Murphys, and they have had no experience of a slump in their own trade. On-costing based on crude forecasting tempers the price to the market less than flat rate on-costing. For if the budgeted turnover is below normal, owing to a low figure for the first year of the slump (past experience) or to a conscious recognition of the existence of the slump, the on-cost chargeable will be higher. Therefore if flat rate on-costing reduces the price too little, a fortiori will on-costing based on forecasts. To justify on-costing based on forecast it would be necessary to assume that elasticity of demand actually becomes less in a slump and this is not to be believed.

If what I say is right, the full cost principle contains a bias away from the adoption of optimum policy in a slump and should militate against the survival of firms which adhere to it. Is not the survival of such firms evidence against my view? Not necessarily so. The alternative to the full cost principle is to embark on the uncharted sea of demand estimation with no reliable data. It is possible that the "full cost" principle even if containing an adverse bias in relation to fluctuation contains valuable elements in relation to the secular trend; e.g. the theory already mentioned that in the long run adherence to it prevents a firm being undermined by competitors.

16. To say that the "full cost" principle militates against the firm adhering to it is not to say that it tends to aggravate a depression. It may be quite the contrary. This may not be the place to introduce special theories of the cycle. But if our results are to have any meaning it will be necessary to consider them against the background of such a theory.

If it is true that in a slump activity must be so reduced as to limit the volume of saving to the investment demand, [29] the shift away from profit in a slump is a factor tending to reduce the amount of recession required to fulfil that condition. A factor tending to reduce the shift from profit would pro tanto tend to increase the amplitude of the recession. Thus it may be that as firms get more cunning in knowing how to mitigate the reduction of profit in a slump, the slump will thereby be made worse for all. [30]

17. So far I have only spoken of the x factor. It is necessary to revert to the y factor (appreciation of goodwill, as a function of price charged or level of sales). How does this behave in boom and slump? Clearly the matter is a complex one. [31]

The simplest assumption with regard to y would be to assume it constant. Such an assumption would be justified as follows. The loss of future goodwill might be regarded as proportional to the loss of present custom expressed in sales value. Thus a present price reduction which caused sales to stand at O n + 1 instead of O n would entail an accretion of goodwill the present value of which is y and y would be the same for all values of O. The price should always be fixed so that marginal cost exceeded marginal revenue by a constant y. This assumption of constancy in y would leave the argument of the foregoing paragraphs unimpaired.

But it is possible that we ought to make an assumption about y which would reinforce those arguments. At any time a firm may be conceived to have a body of fluctuating customers and a body of steady customers, the two classes being divided by no rigid line but shading off into each other. Now the loss of a steady customer during the slump may be regarded as involving a greater loss of goodwill than the loss of a fluctuating customer. y may then be supposed to increase as we move from the marginal sale to the marginal customer leftwards.

Now suppose that in the slump a given firm loses sales, but does so in harmony with its rivals, retaining its fair share of the market. This cannot be defined of course as an equi-proportional shrinkage because its particular class of goods may be of a kind (e.g. luxury) for which the demand might normally be supposed to shrink more than in proportion in a slump. We must content ourselves with the phrase harmonious shrinkage, a precise definition of which might possibly be devised.

So long as the shrinkage was only harmonious y might be supposed to have the same value as previously. 3 But if the shrinkage is greater than this, the marginal value of y may be presumed to be greater.

If it is true that the full cost principle is biased against an appropriate price reduction, then if we divide firms into two classes, those which follow it and those which do not, the shrinkage of the former would be out of harmony with (greater than) that of the latter. The value of y at the margin would be higher for the former than the latter and this would be a further factor, additional to that mentioned in the foregoing paragraphs, causing the prices actually charged by the "full cost" firms to be in excess of the optimum prices.

18. Summary

(i) To fix a true price it is necessary to know the marginal prime cost of production and the values of x, viz. prices minus marginal revenue and y, viz. current appreciation of goodwill considered as a function of the volume of current sales.

(ii) Most entrepreneurs have knowledge with regard to prime costs but are very ignorant with regard to x and y.

(iii) Firms often have a considerable knowledge with regard to overhead costs and this, though strictly irrelevant to the true price, is brought in to fill the gap caused by ignorance of the relevant factors.

(iv) A surprisingly large number of firms adopt the system of relating price to "full cost", albeit often diverging from this principle in certain specified circumstances. This appears if we add to the firms which explicitly base their price on computed "full cost" those firms which take the market price as given and adopt their quality in such wise as to give the best quality which they can, covering "full cost", at the specified price.

(v) A perfectly accurate estimate of on-cost implies an accurate forecast of turnover, and since turnover depends among other things upon the price charged, the on-cost chargeable should be represented as a function of the price finally arrived at. Such an accurate system implies knowledge about elasticity of demand. If it were adopted as a method of fixing a price it would only constitute a more cumbersome and roundabout method of getting the same result as could be got by relating price directly to the elasticity of demand without bothering about on-cost. In practice either turnover is not forecasted in computing on-cost, or, if it is, a much cruder method is used.

(vi) Methods of on-costing may be divided into two groups: (i) the flat rate of oncost (subdivided into (a) conventional percentage addition and (b) assumption of full or fairly full use of plant), and (ii) a rate of on-cost based on a forecast of turnover. Cases using method (i) were in the majority, although from the point of view of securing the defined objective, viz. covering overheads, method (ii) is more logical.

(vii) This may be due to the fact that the same causes which tend to make method (i) unsuitable tend to disrupt the "full cost" principle altogether. Also method (ii) tempers the price to the market less than method (i) and this may account for the survival of method (i). The same factor may account for the occasional survival of the illogical practice of including the cost of raw materials in the base which is multiplied by the on-cost percentage.

(viii) On the assumption with regard to the behaviour of x in a slump which appears to me most reasonable, the flat rate of on-cost does not allow a sufficient reduction of price compared with that required by the true criterion. A fortiori an on-cost determined by crude forecasting does not give a sufficient reduction of price.

(ix) It does not follow from the last paragraph that the adoption of the full cost principle aggravates the slump, though of course it does make for lower output in the firms adopting it. If it is true that the shift away from profit in a slump tends to reduce the amount of recession required for the establishment of a new equilibrium in the circumstances, cunning methods by which the reduction of a profit in a slump is lessened may actually aggravate the slump.

(x) The simplest assumption with regard to the value of y, viz. that it remains constant, leaves the conclusion embodied in (viii) unimpaired. A more complex and, as it seems to me, more reasonable assumption reinforces that conclusion.

  1. 1. Harrod occasionally called "Trade Cycle Group" the Oxford Economists' Research Group (see letters 511 , [jump to page] ; 614 R, [jump to page] ; and 630 , [jump to page] ). These "Notes" clearly belong to the OERG activities: this is revealed by the content, and the document is also cited in a number of OERG documents, including the announcement of the meeting at which the paper was discussed (OERG, meeting announcement, in ABP 45) and a list of documents produced by the group (OERG, "List of Questionnaires, Reports etc. to July 1st 1937, in ABP 170).

    2. A first attempt by James Meade to analyse the reports of the Oxford Economists' Research Group's interviews with entrepreneurs ("Analysis of reports of interviews with business men, February - October 1936", in ABP 171), revealed that although the entrepreneurs' replies diverged in most cases, often without apparent reason, there was general agreement regarding the lack of importance of the bank rate in the decisions regarding expansion or contraction of activity, and some concordance as to pricing policy. Meade's analysis was discussed by the group on 12 December 1936, with the latter topic stimulating attempts to provide a theoretical framework for understanding the entrepreneurs' policy. The discussion is summarized as follows:

    • Mr. Harrod asked whether we could attempt to classify the psychological principles of different entrepreneurs--e.g. managers of old and new businesses--as such psychological principles would be of great importance when business men seemed to behave as economic theory said they should not behave. He suggested three categories of economic rationality or irrationality: (1) Having full data, a man reacts rationally to it; (2) Having scanty data, a man acts in a way which appears irrational, because he lacks a rational basis for action; (3) a man acts according to tradition and so perhaps irrationally in opposition to known data. Mr. Henderson suggested that business men accepted a conventional code of business ethics, and might be restrained from charging very high prices in the same way they were restrained from cheating at cards. Mr. Harrod expresses doubts as to this. [...] Mr. Marschak made a plea for a careful distinction in our investigations between `rational' and `traditional' behaviour--`traditional' behaviour to include only the 3rd of Mr. Harrod's categories [...] and Mr. Henderson's `code of business ethics'. [Meade, "Summary of Discussion on `Analysis of Reports of interviews with Business men, February - October 1936', at meeting held in Magdalen College 12 December 1936", in ABP 45, 46 and 171]

    At this point, with the number of interviewed entrepreneurs totalling 26 (OERG, "List of Reports of Interviews received up to December 5, 1936", in HCN 4.11.2), Harrod undertook the task he envisaged during the meeting. He went through the reports, summarized the replies concerning pricing principles (the document is reproduced below, in note 10 ), and drafted these "Notes on Interviews with Entrepreneurs". The paper was circulated among the group, and was discussed on 5 February 1937 (OERG, meeting announcement, in ABP 45). The minutes of the meeting do not seem to have survived. However, an incomplete and anonymous set of comments on Harrod's "Notes", drafted shortly after the meeting, refers to the appointment of a drafting committee (some of these comments are reported in notes 13 , 16 and 18 to this essay). No further references to this committee have been found; the papers were, however, further elaborated at a later stage, but by Harrod himself (see note 4 to this essay).

    Probably as a result of these discussions within the group, the subject of pricing policy was taken up by Robert Hall ("Notes on the behavior of entrepreneurs during trade depression", mimeograph, 22 pages, September 1937, in ABP 173 and HCN 4.31.6) and Charles Hitch ("Notes on Imperfect Competition and the Trade Cycle", mimeograph, 27 pages, [October 1937], in ABP 46 and 173 and HCN 4.23.1). For an outline of the differences between their approaches and Harrod's 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. 542-43.

    3. Marian Bowley was the secretary to the Oxford Economists' Research Group from June 1936 to December 1937: See W. Young and F. Lee, Oxford Economics and Oxford Economists (1993), p. 130.

    4. The paper was later revised, with a notable shift of emphasis, as "Business Experience and Economists' Assumptions" for presentation before the British Association 1937 annual meeting. It is reproduced here as essay 18 .

    5. The method of inquiry consisted in submitting in advance a questionnaire to entrepreneurs, which defined a guideline rather than a rigid format for the interview (for a description of the interviewing procedure see e.g. Harrod, "The Pre-War Faculty", Oxford Economic Papers NS 5, 1953, Supplement Sir Hubert Henderson 1890-1952, p. 60; Harrod, Economic Essays London: Macmillan 1952, pp. x-xi; F. S. Lee, "The Oxford Challenge to Marshallian Supply and Demand: The History of the Oxford Economists' Research Group", Oxford Economic Papers 33:3, November 1981, p. 340).

    The first three entrepreneurs were interviewed following a list of "Questions for discussion" (in ABP 170 and HCN 4.19.1-9: ), a first set of which concerned the determination of profits and their distribution between dividends, reserves, purchase of securities and extension or improvements of plants. Another question focused on the importance of the short- and long-term rates of interest on capital extension and on the level of stocks. A third set of questions regarded the determination of prices, the computation of costs--with special attention to overhead--and of depreciation allowance, price policy during depressions (in particular, the OERG was interested in the response of demand to price cuts) and marketing policies and costs. (The interviews and the questionnaires used are listed in a "List of Questionnaires, Reports etc. to July 1st 1937", in ABP 170.)

    This first questionnaire was revised several times. The "Revised general questionnaire" (in HCN 4.18.1 ) is very similar to the draft of questionnaire 2, marked "Q.2.R." (in ABP 170 and RAC, RF, 1.1, series 401s, Box 75, Folder 991), which was eventually discarded and substituted by one marked "General Questionnaire No. II as revised at the Meeting on March 12th 1936" (ABP 170). The questions were quite different, both in emphasis and in nature. The ultimate version is dated 12 March 1936, and was used as a generic basis for interviewing a number of entrepreneurs till the end of 1938. Although it covered the same ground as the first questionnaire, the questions were rearranged and there was a shift of emphasis. While the first questionnaire asked impersonal questions on "the average business concern", the revised questionnaire directly addressed the entrepreneur. As a preliminary, entrepreneurs were asked about the factors affecting their business during the last ten years. The questions on the determination of prices and costs were asked first and made much more precise, particularly those regarding the composition of costs and the marketing of the product; a reference to the degree of competition was introduced. Questions on the firm's policy regarding stocks were added, while the questions on profits referred more specifically the firm's practice in regard to their undistributed part. [see also the "Suggestions for improvement of questionnaire No. II". Original in the Harrod Collection, Nagoya University of Commerce and Business Administration, file 4.2.2]

    By June 1936, Hall had prepared an additional questionnaire specifically addressed to retailers and wholesalers ("Questionnaire No. III for Retailers (drawn up 8 Oct. 1936)", in ABP 170), while Harrod had agreed to draft a further one for bankers (minutes of the committee meeting of 11 June 1936, in ABP 45). The former was definitely approved by the Committee on 8 October (minutes of the committee meeting of 8 October 1936, in ABP 45); the latter does not seem to have survived. Both, however, seem to have been used once only ("List of Questionnaires, Reports etc. to July 1st 1937"). The questionnaire for retailers inquired into the composition of costs, the margins they apply on price, marketing policy and movements of prices and stocks during depressions. Other questions were analogous to those in the general questionnaire.

    6. J. M. Keynes, The General Theory (1936), pp. 66-73. The concept was discussed with Harrod in correspondence at the proof stage: see letters 458 , 463 , 464 , 465 and 475 .

    7. G. D. A. MacDougall, "The Definition of Prime and Supplementary Costs" (1936). The paper was submitted to Keynes on Harrod's suggestion: see letter 574 , and in particular notes 1 and 2 .

    8. The following passage was crossed out at this point of the Ms:

    • It must be observed that while no decision is perfectly rational (vid. sup.) the rational may provide limits between which the irrational choice may lie. Thus a man may be able to give perfectly good reasons, based on ascertainable data, why it would be fatal to double or halve his price. The irrational element in decision lies between these or closer limits.

    9. Above, [jump to page] .

    10. These formulae and habits are summarized as follows in Harrod's abstracts of the reports of the interviews with entrepreneurs (untitled and undated AD, four pages, in HCN 4.10.5, drafted for Harrod's own use; the document is reproduced in full without, however, respecting Harrod's original line breaks; some punctuation is added).

    • Brooks & Co. In theory arrive at cost, add profit & set price. In practice. Competition. State of <+>'s activity. Time of year. Overheads. % of d[irect] c[osts] according to dept. Level of output provided in budget which is largely based on past experience.

      Higgs. Doesnt go more than 15% above costs, as if wide margin is taken competitors are sure to cut in. Adjusts prices from time by reg. to realized surplus of previous quarter. Has just decided to raise prices because cannot give early delivery. Effects of price changes depend on policy of competitors. Doesnt believe in detailed costing. 100%, 120% & 130% for o. & p. on d.c. & mat. Chooses one of these after considering competitors' prices. New model. Follows competitors' prices. System works out well provided he doesnt cut into 100% on cost too often.

      Wedgewoods. Doesnt go below full cost. Margin of profit varies with line. Other firms go bankrupt on <theory> by losing on some lines & getting back. In slump use of cost information to secure economies more important than in better times. Overheads in proportion to direct costs. O[verheads] based on normal or fairly good trading conditions.

      Beiersdorf. 3 <times> direct cost (based on int. experience). ideal. dont adhere to this. Mechanical tapes. Costs dont allow to go down to competitive price. When reduce costs wont put price down because present price too low (cf costs) but dont put present price up. Tooth paste comp. Skin cream comp. Expectorant comp. O calculated on raw mats & direct labour. Dont include depreciation.

      Barnet Comb. O 150% on d.c. Comp. fixes price within certain limits.

      Murphy Price determined by cost. But works to acceptable price. pro ratas inc mat. d.c. & carriage.

    . O based on estimate of sales. Personal & psychological factor. They do not go in for high profit. Adds prices based on cost = what market will bear.

    • Gledhill. <+>.B. least information. O machine hour rates on basis of full working. relates prices to cost.

      Barlow. Price fixed by custom & competition. Accurate costing to determine what article can be produced. Dont sell below cost. (presumably full cost). Object to making losses. O per unit not raised if <prod> fell off. (Doesnt say what percentage addition based on).

      Cresta Silk. Right market price. Fine costing waste of time. Cost bottom limit. But they did sell at a price which would not cover O sometimes. O in proportion to time.

      Midlands (light manu). What market will bear. Price must cover <+> especially if overheads are already covered. O on assumption plant 80% occupied. Factory overheads on d.c. or floor space or machine. General overheads. What the <mill> will bear.

      Thornber. Bargaining in market. Minimum reservation prices (cost). Dont go below this. O 1/2 or 5/8 on d.c. They might accept something less, but very little & very rarely. O not over various types in prop to d.c.

      Sir John Grey. Bargaining. Cost <+> but cannot often be fully covered. O on experience of [preceding] 6 months. On d.c. specific percentages are allocated to each grade.

      Orr. No trade if prices covered full costs. For O L[ancashire] C[otton] C[orporation] assumes capacity operation.

      Midlands (light metal). Prices based on cost. 40% difference between highest & lowest prices he would accept. Low for big order. Gen prepared to go below works cost. Instinctive feeling against not covering cost. High price & low output or vice versa. Instinctive choice of former. Put up margin when trade is booming. when lab difficult to get & hard to manage. Greater part of O on direct labour. On annually budgeted output. Selling cost on raw mat. (prop of raw mat to d.c. fairly constant).

      Rowntrees. Comp and cost. Primary comp. O on budgeted sales.

      Simon. 80 variable, 20 fixed O, 20 selling, 10 profit. Prices between 80 and 130 occasionally 150. O based on turnover in last year or two, but not if very slack.

      Stamp. Evenly in proportion to direct costs.

      Cadbury. Normal. Price based on cost. In depression direct + incurred overheads. Reluctant to confine selling with large margin because experience teaches that it they do so ground <wet> under their feet. It may pay to go 8% below zero (zero includes all O). In a depression they may go down. Rarely below direct & incurred.

      Lee. <Making> to a <certain> price. New article at lower price without relation to cost. If accountants cost <cant> be covered by price they think of a new article. Almost all o can be allocated.

      Scott-Stokes.

  • The full reports of the interviews are housed in HCN, boxes 5 and 6, with the exception of Rowntrees, which is not even mentioned in the most complete list of entrepreneurs interviewed by the group ("[list of 51 interviews]", one page, mimeo, marked "Private and Confidential", not dated--but the last of the dated interviews took place on 5 November 1938--, in HCN 4.4.1 and ABP 49 and 171; the three pages Ms version of this document in P. W. S. Andrews's hand is in ABP 173; a draft is extant in ABP 635).

    11. Scott-Stokes (sheepskin products) was the first entrepreneur interviewed by the OERG. According to the report of the "Visit of Mr. H. F. Scott-Stokes on 31.i.36", drafted by Harrod (in HCN 5.1.5), the following rigid formula was used in computing price:

    • In pricing next year, the costs of each article in terms of raw materials and wages are computed; an addition is then made equal to

    ¥ direct wages cost to the article. This gives the cost in the factory. To this is added 50% for dead charges to make the sales price.

    (room charges are the overhead particularly connected with the productive process, dead charges with sales). The report continues:

    • Questioned as to the prudence of following the formula so <+> in making a price, Mr. Scott-Stokes referred to the age (about 70) of the head of the business.

    12. The natural selection analogy was also referred to in Harrod's "Business Experience and Economists' Assumptions": essay 18 , [jump to page] .

    13. Asked "which kind of cost curve Mr. Harrod was referring when he used the term `prime cost'", he "explained that he meant short period marginal cost curves" (P. W. S. Andrews, "Report of business meeting held in Mr. Bretherton's rooms at Wadham College on Tuesday, December 7, 1937", in ABP 171). In the copy of this essay found in the Andrews papers (ABP 173) the final words of the sentence are actually corrected in Harrod's hand as "... equated to the short period marginal cost of production".

    The following comment survives, relating to this passage and to Harrod's specification:

    • Harrod p. 9. Perfect Competition. (assuming that action is rational and informed).

      "Price should be equated to the (short period) marginal cost."

      Price is equated to marginal cost simply because price equals marginal revenue: the economic principle is that marginal revenue and marginal cost are equated.

      Harrod's qualification "short period" relates to a difficulty that crops up again on page 11, case (i) b. [ [jump to page] ] [incomplete, untitled and anonymous comment, TS, 2 pages, in HCN 4/23/2; the passages relating to imperfect competition are reproduced in note 16 to this essay].

    14. This passage was crossed out at this point of the Ms, and substituted by the next paragraph in the text:

    • y may be called the gain due to the appreciation of goodwill. The attachment of customers throughout future time may be regarded as a function of, among other things, the present price. Let p m be the price securing the maximum amount of customer attachment, it being assumed that any price below p m would put off rather than attract customers because they would think that there was something "funny" about it. The higher the degree of customer attachment the greater the value of future net revenue to be anticipated in various possible circumstances. Compute the present value of the probable excess of net revenue due to a given increase of customer attachment. For any value of p above p m , y is a [c] negative quantity equal to the loss of present value due to the prospect of a lower net revenue due to the difference between the customer attachment resulting from p m and the customer attachment resulting from the actual value of p.

    15. Harrod was criticized by Henderson for not taking account of the appreciation of goodwill in the analysis of prices and profits in The Trade Cycle: see letter 527 , [jump to page] .

    16. The following comment (part of which, referring to the perfect competition case, is reproduced in note 13 to this essay) survives regarding this passage:

    • Imperfect Competition. (action rational and informed).

      Harrod says that "price should be made to exceed this {marginal cost?} by an amount (x - y)".

      "x is the difference between the price received and marginal revenue and its value depends on the elasticity of demand at the stated price". {i.e. x = price/h}

      y is called the {marginal} appreciation of goodwill. (It may be negative).

      It is the present value of the probable future increment of aggregate net revenue per increment of present sales. {If Y + K = present value of future aggregate net revenue (where K is the constant expected net revenue when present sales are zero) and X = present value of sales, y = dY/dX}

    ( Harrod crossed out the word «value» and wrote «volume» instead. This seems to have given rise to interesting discussions among members of the group: see note 7 to letter 630 ).

    • Harrod's x constitutes no difficulty. Abstracting from his y, the economic principle remains "marginal cost = marginal revenue". At this output price would be such that it would be x = price/h above marginal cost.

      But does the introduction of his y affect the economic principle?

      If y is negative, the situation is the Marshallian one of spoiling the market. Selling at the price which would rule without taking account of this would cause a permanent shift in the demand curve to the left and therefore a fall in the present value of plant. If account were taken of this in the Marshallian way an allowance for it would be added to cost. It is a variable cost. Therefore it raises the marginal cost curve. Alternatively, a deduction could be made from average revenue; but I have always regarded this as more difficult and less satisfactory. Mutatis mutandis the same applies when y is positive. Hence the economic principle remains marginal cost = marginal revenue. [Incomplete, untitled and anonymous comment, TS, 2 pages, in HCN 4/23/2]

    17. Murphy Radio's position is summarized in note 10 , [jump to page] .

    18. The following comments survives regarding this passage. With regard to case (a):

    • I should prefer to say that an average overhead cost curve is added to the average prime cost curve to get an average total cost curve. In equilibrium price = marginal cost = average total cost; and overheads are covered.

      The necessary condition of equilibrium is still marginal cost = marginal revenue; the sufficient conditions require average cost = average revenue. This latter condition may be attained by the demand line moving, possibly in conjunction with movements in the cost curves (with changes in the size of firms). [Incomplete, untitled and anonymous comment, TS, 2 pages, in HCN 4/23/2]

    With regard to case (b):

    • I have two difficulties here:

      (i) In perfect competition the firm has not the freedom with respect to price fixing that seems to be implied here. This is probably only a formal point. It does not affect our cases, as Harrod recognises (p. 12, line 1) [ [jump to page] ]. [Incomplete (the TS interrupts at this point), untitled and anonymous comment, 2 pages, in HCN 4/23/2]

    19. Higg's position is summarized in note 10 , [jump to page] .

    20. The Midlands light metal working concern was indicates by "S", as its name could not be divulged. Its position is summarized in note 10 , [jump to page] .

    21. The position of these firms is summarized in note 10 . "T" indicates the light manufacturing concern in the Midlands, whose name could not be divulged.

    22. On Scott-Stokes's formula see note 11 to this essay.

    23. The position of these firms is summarized in more detail in note 10 to this essay.

    24. In "Business Experience and Economists' Assumptions", Harrod did not refer to the practice of covering overhead as the "full cost principle". The surviving documents do not provide any evidence regarding the reasons for this decision. The terminology, however, was retained by other members of the group: Hitch and Hall, for instance, refer to full cost in their "Notes on Imperfect Competition and the Trade Cycle" and "Notes on the behavior of entrepreneurs during trade depression" (full reference is given in note 2 to this essay), and in their joint article "Price Theory and Business Behaviour" (1939).

    25. This seems to develop a remark that emerged during the discussion on Meade's "Analysis of reports of interviews with business men" (cited in note 2 to this essay): "It was pointed out that Scott Stokes cut quality instead of price, and that his unwillingness to cut price was due (a) to the belief that it would not increase sales (except possibly in his cheaper lines), and (b) to rigid adherence to his price formula" (the formula is reported in note 11 to this essay).

    26. This argument was further developed in Harrod's "Business Experience and Economists' Assumptions" (essay 18 , [jump to page] ).

    27. H. B. Yate was the assistant managing director of Brooks & Co., Ltd., manufacturers of cycle saddles, general leather goods, and steel equipment, Birmingham. The firm's costing policy is summarized in note 10 above.

    28. The cotton producers interviewed up to that point by the OERG were Kenneth Lee (Tootals), Thomas Barlow, B. Thornber, John Grey, W. J. Orr (Lancashire Cotton Corporation).

    29. This passage was further developed with reference to a trade cycle theory "of the type propounded by Mr. Keynes": see Harrod, "Business Experience and Economists' Assumptions" (essay 18 , [jump to page] ).

    30. In the discussion concerning this paper in connection with Hall's "Notes on the behavior of entrepreneurs during trade depression" and Hitch's "Notes on Imperfect Competition and the Trade Cycle", it is reported that "Mr. Harrod agreed that his conclusion, (referred to in p. 22 of Mr. Hitch's paper), that it would pay an industry to cut in depression, might be the result of fallacious reasoning from the part to the whole", having extended to the industry conclusions valid for the firm (P. W. S. Andrews, "Report of business meeting held in Mr. Bretherton's rooms at Wadham College on Tuesday, December 7, 1937", in ABP 171).

    31. The following passage was crossed out at this point in the Ms:

    • At first sight the analysis of y appears appallingly complex. But I suggest that the matter may be treated on very simple lines. This treatment depends on the view that gain (or loss) of future goodwill is in some sense proportional to the gain (or loss) of present sales.

      If the amount of sales lost by a unit drop in price is great the amount of goodwill lost is great. Thus the value of y like that of x related to any value p of price [i] depends upon the elasticity of demand at p.

      1. a. Of this notes three versions survive, all indicating: "By R. F. Harrod". The first draft () is an AD, 31 leaves (pages numbered 1-28, with numerous corrections, passages crossed out and insertions on leaves numbered 1a, 9a etc.), in HCN 4/24/3. The second version is a TDCc with a handful of autograph corrections in the style, being a typescript of the above, 34 pages, in HNC 4/24/2. The final version is a mimeograph TD, 27 pages with autograph corrections, being the same as the former draft, of which it incorporates the autograph corrections, in HCN 4/24/1 and ABP 173 (a photocopy of the latter is in HP (NC)). The latter is rendered here.

        b. TS: «good-will».

        c. Ms: «is negative».

        d. Ts: «of».

        e. Ts (last version only): «with».

        f. Ts: «Beiersdorff».

        g. Ts: the words «best» and «quality» in this sentence are only partly legible.

        h. Ts: brackets omitted.

        i. Ms: «value of p price».


1. There is also the independent problem, which, am I wrong in saying, we have been tending to neglect, of the distribution of purchasing power by allocation to dividends, reserves etc. in the phases of boom and slump.

2. Even if the firm sells nothing for a given finite period it may have some goodwill left at the end; but y is then zero. If it sells 1 unit, y 1 is the difference between the goodwill at the end of the finite period in which that unit sale occurred and what the goodwill would have been had it not occurred. y 2 is the difference between the goodwill at the end of the period supposing 2 units of sale and what it would have been, had there only been one unit of sale, etc.

3. This is not quite accurate. y would shrink somewhat in the slump because any given customer has less absolute value by reason of the nearness of the years in which his custom is destined to be weak (later stages of slump). These years count for more than later years in the present value of goodwill both because of the lower compound interest deduction from prospective net revenue in them (this is probably a factor of small importance) and because of the smaller deduction for uncertainty, which grows rapidly as we look further ahead.


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