Dr. W. A. Paton is Professor Emeritus of Accounting and of Economics at the University of Michigan. This article is adapted from one section of a paper prepared for the "Mises 90th Birthday Collection," copyright by The Institute for Humane Studies.
Conceptions of the marginal entity ranging from the fuzzy to the downright indefensible are frequently encountered in current discussions of business management and finance and perhaps this justifies some comments aimed at clarification and sharper definition.
Marginal Firm Defined
In making use of the term "marginal" in this connection there is a need, to begin with, to have clearly in view the quality or characteristics we are looking for when attempting to define the marginal enterprise. In this search our concern, presumably, is with the price making process, and we are focusing attention on the business firm that occupies the crucial position in this process, for a special field or market area, at a particular point or period in time.
The definition I consider appropriate may be stated as follows:
The marginal producer is the one who is just barely induced to remain in operation by the existing state of affairs and who is so situated with respect to volume of output that his dropping out will exert sufficient pressure on the array of price influencing forces, through the supply side of the market, as to bring about a recognizable change in product price.
This was the description of the marginal man or firm, as I recall it, stressed by my revered mentor, Fred Manville Taylor, when I was in his graduate courses sixty years ago. A slightly different version that is acceptable is: The marginal producer is the one who will he the first to withdraw unless conditions improve.
The Break-Even Approach
The most common conception of the marginal producer nowadays, so it seems, is that of the entity that is precisely at the breakeven, zero earnings stage. The textbooks in the courses in management and other subjects in the schools of business administration are full of charts which identify the breakeven position as of critical importance. I am one of those who are getting very tired of this preoccupation with breakeven "analysis." In my judgment no convincing case has ever been made for the view that the zero earning level is a decisively significant spot in connection with business decision making. And when the "analysis" includes the designation of the firm at the breakeven point as "marginal" those who know anything about either economic theory or actual business operation can feel their hackles rising.
The notion that the marginal position is occupied by the breakeven producer finds no solid support in business experience. Even firms operating at a loss often hang on for years. This is particularly true in the case of the small or medium sized firms with ownership and control residing in a family or small local group, but the condition is not unknown among relatively large enterprises. As long as revenues cover current expenditures, including attractive salaries for executives, immediate management has a strong urge to continue operations, even if the outlook is unpromising to the point of being downright gloomy. This accounts for the phenomenon of corporations that are worth more dead than alive. Examples are not rare of substantial concerns whose shares have been quoted for months or even years at less than net liquidation value (that is, at less than could be realized if the entity disposed of all assets for what they would bring, paid all liabilities, and distributed the balance to shareholders).
In some of these cases the announcement, finally, that the directors had decided on a program of liquidation has caused a sharp advance in the price of the stock. I recall one example, a mining company, with shares listed on a major exchange, where the market price of the stock — which had been hovering under $2 per share for some time — promptly moved up to $16 when the plan to go out of business was formally decided upon at a board meeting. The low price preceding the announcement was of course based on the assumption — by those trading in the company’s shares — that the management would continue to fritter away the liquid resources in unprofitable operation and exploration. (By these observations I am not intending to deny that there have been many cases where tenacity in the face of a poor showing over a considerable time has finally paid off.)
It may be safely concluded that in a given situation neither the firm at the zero earning point nor the concern suffering persistent losses is necessarily the vulnerable, marginal entity, the enterprise just barely hanging on, and that will be the first to drop out if conditions become less favorable. And it may also be concluded that even the most badly situated firm, the one at the very bottom of the stairway of earning power (or that shows the greatest level of loss) need not be in the marginal position in the sense defined above. (Of course, the term might be used to designate the worst-off enterprise — and some seem to employ it for this purpose.)
Profit Maker May Be Marginal
Indeed the marginal producer, soundly defined, may be an enterprise that has an established earning power. Assume, for example, a producer operating in a high risk field for some time has been achieving an earning rate of 4 per cent on the stockholder capital employed (computed in terms of the current value of resources less liabilities). Assume, further, that a 10 per cent annual return is regarded as the necessary lure for risk capital in this field, as evidenced by the data of the investment market. With these conditions the management may well decide to curtail production — or stop operations altogether as soon as practicable — and thus step into the marginal entity role. Remember, it’s the producer just on the verge of dropping out, and whose decision will have an effect on product price, who may be regarded as marginal.
In practice, it must be conceded, the identification of the marginal producer in a given industry and time period may be difficult if not impossible. This is especially true when we think of such producers as poised on the brink of withdrawal, but not yet having taken decisive action. The difficulty in the way of specific identification, however, is no warrant for adoption of sloppy or unsound concepts and definitions. A good guess would be that seldom does reaching the precise position of a zero level of earnings signal or trigger a cease production decision.
The Cost of Capital Furnishing
In conclusion I wish to return to the fashionable breakeven charts and discussions for a moment to register an objection somewhat outside the question of the definition of the marginal firm. From the standpoint of good market economy theory the basic difficulty with all this rubbish lies in an improper conception of what it means to "break even." If capital furnishing is a primary, essential factor in the productive process — and that this is the case has been brilliantly demonstrated by economists over and over again —it shouldn’t be ignored in the computation of total cost in the broad sense of price influencing cost. And if, in a given situation, this cost is omitted from the reckoning, and revenues just match the recognized costs, the producer is not truly breaking even. Instead, he is operating at a loss (even if this is not the way the accountants look at it). Here is a crucial point in the case for the free market economy as opposed to socialism, and certainly those who strongly prefer control by the market to authoritarian directives (including "freezes") shouldn’t use concepts and terms that play into the enemy’s hands.
How to Attract Capital
There is no real shortage of capital in the world, and I do not know of any major project which has been held up solely because of the lack of money. Capital is plentiful wherever it is "wanted and well treated." The real bottleneck in the development of the world is the shortage of human capital: people with the skill, training, and education intelligently to employ the world’s resources.
The facts are that when political freedom and free enterprise spread, markets increase, and that the expansion of markets is only prevented through political motivation. The interest of American business in the expansion of a free enterprise system around the world as part of a free political system is based not only upon moral considerations, but on the hard fact that there is no market for consumer goods among slaves.
WALTER B. WRISTON