CEO Courses:  Executive Education

Supply and Demand by Hubert D. Henderson M.A.
with an Introduction by J.M. Keynes M.A., C.B.
1922.
 

Introduction
The Theory of Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions. It is not difficult in the sense in which mathematical and scientific techniques are difficult; but the fact that its modes of expression are much less precise than these, renders decidedly difficult the task of conveying it correctly to the minds of learners.
Before Adam Smith this apparatus of thought scarcely existed. Between his time and this it has been steadily enlarged and improved. Nor is there any branch of knowledge in the formation of which Englishmen can claim a more predominant part. It is not complete yet, but important improvements in its elements are becoming rare. The main task of the professional economist now consists, either in obtaining a wide knowledge of relevant facts and exercising skill in the application of economic principles to them, or in expounding the elements of his method in a lucid, accurate and illuminating way, so that, through his instruction, the number of those who can think for themselves may be increased.
This Series is directed towards the latter aim. It is intended to convey to the ordinary reader and to the uninitiated student some conception of the general principles of thought which economists now apply to economic problems. The writers are not concerned to make original contributions to knowledge, or even to attempt a complete summary of all the principles of the subject. They have been more anxious to avoid obscure forms of expression than difficult ideas; and their object has been to expound to intelligent readers, previously unfamiliar with the subject, the most significant elements of economic method. Most of the omissions of matter often treated in textbooks are intentional; for as a subject develops, it is important, especially in books meant to be introductory, to discard the marks of the chrysalid stage before thought had wings.
Even on matters of principle there is not yet a complete unanimity of opinion amongst professors. Generally speaking, the writers of these volumes believe themselves to be orthodox members of the Cambridge School of Economics. At any rate, most of their ideas about the subject, and even their prejudices, are traceable to the contact they have enjoyed with the writings and lectures of the two economists who have chiefly influenced Cambridge thought for the past fifty years, Dr. Marshall and Professor Pigou.
J.M. Keynes.
Contents
Chapter I
The Economic World
§1. Theory And Fact 1
§2. The Division Of Labor 3
§3. The Existence Of Order 5
§4. Some Reflections Upon Joint Products 7
§5. Some Reflections Upon Capital 11
§6. The Fundamental Character Of Many Economic Laws 17
Chapter II
The General Laws of Supply and Demand
§1. Preliminary Statement Of Three Laws 18
§2. Diagrams And Their Uses 21
§3. Ambiguities Of The Expressions, "Increase In Demand," Etc. 24
§4. Reactions Of Changes In Demand And Supply On Price 27
§5. Some Paradoxical Reactions Of Price Changes On Supply 30
§6. The Disturbances Of Monetary Changes 33
§7. The Trade Cycle 34
Chapter III
Utility and the Margin of Consumption
§1. The Forces Behind Supply And Demand 37
§2. The Law Of Diminishing Utility 40
§3. The Relation Between Price And Marginal Utility 43
§4. The Marginal Purchaser 44
§5. The Business Man As Purchaser 47
§6. The Diminishing Utility Of Money 49
Chapter IV
Cost and the Margin of Production
§1. An Illustration From Coal 52
§2. The Various Aspects Of Marginal Cost 55
§3. The Dangers Of Ignoring The Margin 57
§4. A Misinterpretation 59
§5. Some Consequences Of A Higher Price Level 60
§6. General Relation Between Price, Utility And Cost 65
Chapter V
Joint Demand and Supply
§1. Marginal Cost Under Joint Supply 66
§2. Marginal Utility Under Joint Demand 69
§3. A Contrast Between Cotton And Cotton-Seed, And Wool And Mutton 71
§4. The Importance Of Being Unimportant 74
§5. Capital And Labor 76
§6. Conclusions As To Joint Supply And Joint Demand 79
§7. Composite Supply And Composite Demand 79
§8. Ultimate Real Costs 82
Chapter VI
Land
§1. The Special Characteristics Of Land 83
§2. The Scarcity Aspect 84
§3. The Differential Aspect 87
§4. The Margin Of Transference 94
§5. The Necessity Of Rent 98
§6. The Question Of Real Costs 100
§7. Rent And Selling Price 102
Chapter VII
Risk-Bearing and Enterprise
§1. Profits And Earnings Of Management 104
§2. The Payment For Risk-Bearing 104
§3. Monte Carlo And Insurance 105
§4. Risk Under Large Scale Organization 111
§5. The Entrepreneur 113
§6. Risk-Taking And Control 116
§7. General Analysis Of Profits 117
Chapter VIII
Capital
§1. A Reference To Marx 119
§2. Waiting For Production 120
§3. Waiting For Consumption 121
§4. Capital Not A Stock Of Consumable Goods 123
§5. The Essence Of Waiting 126
§6. Individual And Social Saving 127
§7. The Necessity Of Interest 129
§8. The Supply Of Capital 130
§9. Involuntary Saving 134
§10. Interest And Distribution 137
Chapter IX
Labor
§1. A Retrospect On Laissez-Faire 139
§2. Ideas And Institutions 141
§3. The General Wage-Level 143
§4. The Supply Of Labor In General 145
§5. The Apportionment Of Labor Among Places 147
§6. The Apportionment Of Labor Among Social Grades 149
§7. The Apportionment Of Labor Among Occupations 153
§8. Women's Wages 157
Chapter X
The Real Costs Of Production
§1. Comparative Costs 162
§2. The Allocation Of Resources 166
§3. Utility And Wealth 170
§4. Criteria Of Policy 172
Supply and Demand

Chapter I
The Economic World
§1. Theory and Fact. The controversy between the "Theorist" and the "Practical Man" is common to all branches of human affairs, but it is more than usually prevalent, and perhaps more than usually acrid in the economic sphere. It is always a rather foolish controversy, and I have no intention of entering into it, but its prevalence makes it desirable to emphasize a platitude. Economic theory must be based upon actual fact: indeed, it must be essentially an attempt, like all theory, to describe the actual facts in proper sequence, and in true perspective; and if it does not do this it is an imposture. Moreover, the facts which economic theory seeks to describe are primarily economic facts, facts, that is to say, which emerge in, and are concerned with, the ordinary business world; and it is, therefore, mainly upon such facts that the theory must be based. People sometimes speak as though they supposed the economist to start from a few psychological assumptions (e. g. that a man is actuated mainly by his own self-interest) and to build up his theories upon such foundations by a process of pure reasoning. When, therefore, some advance in the study of psychology throws into apparent disrepute such ancient maxims about human nature, these people are disposed to conclude that the old economic theory is exploded, since its psychological premises have been shown to be untrue. Such an attitude involves a complete misunderstanding not merely of economics, but of the processes of human thought. It is quite true that the various branches of knowledge are interrelated very intimately, and that an advance in one will often suggest a development in another. By all means let the economist and psychologist avoid a pedantic specialism and let each stray into the other's province whenever he thinks fit. But the fact remains that they are primarily concerned with different things: and that each is most to be trusted when he is upon his own ground. When, therefore, the economist indulges in a generalization about psychology, even when he gives it as a reason for an economic proposition, in nine cases out of ten the economics will not depend upon the psychology; the psychology will rather be an inference (and very possibly a crude and hasty one) from the economic facts of which he is tolerably sure.
But the purpose of economic theory is not merely to describe the facts of the economic world; it is to describe them in their proper sequence and true perspective. It must begin with those facts which are most general and which have the widest possible significance. Those are not likely to be the facts which our practical experience forces most insistently upon our notice. For it is the particular and not the general, the differences between things rather than their resemblances, that concern us most in daily life. Nor are we likely to find the universal facts which we require in the sphere of public controversy. We must rather look for them in the dark recesses of our consciousness, where are stored those truths which are so obvious that we hardly notice them, which are so indisputable that we seldom examine them, which seem so trite that we are apt to miss their full significance.
§2. The Division of Labor. There is one such truth in the economic sphere which it is essential to appreciate vividly and fully, with the widest sweep of the imagination and the sharpest clarity of thought. Man lives by cooperating with his fellow-men. In the modern world, that cooperation is of a boundless range and an indescribable complexity. Yet it is essentially undesigned and uncontrolled by man. The humblest inhabitant of the United States or Great Britain depends for the satisfaction of his simplest needs upon the activities of innumerable people, in every walk of life and in every corner of the globe. The ordinary commodities which appear upon his dinner table represent the final product of the labors of a medley of merchants, farmers, seamen, engineers, workers of almost every craft. But there is no human authority presiding over this great complex of labor, organizing the various units, and directing them towards the common ends which they subserve. Wheel upon wheel, in a ceaseless succession of interdependent processes, the business world revolves: but no one has planned and no one guides the intricate mechanism whose smooth working is so vital to us all. Man, indeed, can organize and has organized much. Within a large factory the efforts of thousands of work-people, each engaged on the repetition of a single small process, are fitted together so as to form an ordered whole by the conscious direction of the management. Sometimes factory is joined with factory, with farms, fisheries, mines, with transport and distributing agencies, as one gigantic business unit, controlled by a common will. These giant businesses are remarkable achievements of man's organizing gifts. The individuals who control them wield an immense power, which so impresses the public imagination that we dub them "kings," "supermen," "Napoleons of industry." But how small a portion of man's economic life is dominated by such men! Even as regards the affairs of their own businesses, how narrow, after all, are the limits of their influence! The prices at which they can buy their materials and borrow their capital, the quantities of their products which the public will consume, are factors at once vital to their prosperity and outside their own control.
A great business, like a nation, may cherish visions of self-sufficiency, may stretch its tentacles forward to the consumer and backwards to its supplies of raw material; but each fresh extension of its activities serves only to multiply its points of contact with the outside world. When those points are reached, the largest business, like the smallest, is out on the open sea of an economic system immeasurably larger and more powerful than itself. There it must meet—the better perhaps for its inherent strength and accumulated knowledge—the impact of rude forces, which it is powerless to control. Beneath the blasts of a trade depression, or some other tendency of world-wide scope, the authority of the mightiest industrial magnate, and equally of any Government, assumes the same essential insignificance as the pride of a man humbled by contact with the elemental powers of nature.
§3. The Existence of Order. The parallel can be pursued further with advantage. Just as in the world of natural phenomena, which for long seemed to man so wayward and inexplicable, we have come gradually to perceive an all-pervading uniformity and order; so there is manifest in the economic world, uniformity, order, of a similar if less majestic kind. Upon the cooperation of his fellowmen, man depends for the very means of life: yet he takes this cooperation for granted, with a complacent confidence and often with a naive unconsciousness, as he takes the rising of to-morrow's sun. The reliability of this unorganized cooperation has powerfully impressed the imagination of many observers.
"On entering Paris which I had come to visit," exclaimed Bastiat some seventy years ago, "I said to myself—Here are a million of human beings who would all die in a short time if provisions of every kind ceased to flow towards this great metropolis. Imagination is baffled when it tries to appreciate the vast multiplicity of commodities which must enter to-morrow through the barriers in order to preserve the inhabitants from falling a prey to the convulsions of famine, rebellion, and pillage. And yet all sleep at this moment, and their peaceful slumbers are not disturbed for a single instant by the prospect of such a frightful catastrophe. On the other hand, eighty departments have been laboring to-day, without concert, without any mutual understanding, for the provisioning of Paris."
The theme may well excite wonder. But wonder should always be watched with a wary eye; for he is apt to bring in his train a hanger-on called worship, who can do nothing but mischief here. It is a short step from a passage like that quoted above to a glorification of the existing system of society, to a defence of all manner of indefensible things; and a cross-grained attitude towards all projects of reform. It is a short step; but it is one which it is quite unjustifiable to take. For the evils of our economic system are too plain to be ignored; too many people have harsh personal experience of the wastefulness of its production, the injustice of its distribution; of its sweating, its unemployment and slums. And when the attempt is made to plaster over evils, such as these with obsequious rhetoric about the majesty of economic law, it is not surprising that the spirit of many men should revolt and that they should retort by denying the existence of order in the business world, by declaring that the spectacle which they see is one of discord, confusion and chaos. And then we are engulfed in a controversy as stale, flat and unprofitable as that between the "theorist" and the "practical man."
The truth is that the language of praise and obloquy is quite inappropriate. In the first place, it may be well to note that the order of which I have spoken manifests itself not merely in those economic phenomena which are beneficial to man, but hardly less in those which work to his hurt. Even in those alternations of good and bad trade, which spell so much unemployment and misery, there is discernible a rhythmic regularity like that of the process of the seasons, or the ebb and flow of the tide. This is not an elegance to be admired. Furthermore, in so far as the order comprises adjustments and tendencies which are beneficial (as, indeed, is mainly true), there is no warrant for assuming that these are either adequate to secure a prosperous community or dependent upon the social arrangements which happen to exist. Let us, therefore, refrain from premature polemics and examine in a spirit of detachment some further aspects of the elaborate, but yet unorganized, cooperation of which so much has been already said.
§4. Some Reflections upon Joint Products. A quite inadequate idea of the complexity of this coöperation is obtained by dwelling on the numbers of people who participate in it, or the immense distances over which it extends. The deficiency can be partially supplied by referring to some of the more obvious of the many subtle interconnections which exist between different commodities and different trades.
There are innumerable groups of commodities (which it is customary to term "joint products") such that the production of one commodity belonging to the group necessarily implies or very greatly facilitates the production of the others. Wool and mutton; beef and hides; cotton and cotton-seed are a few familiar illustrations. The important feature of these "joint products" is the fairly precise relation which must exist between the quantities in which the different products are supplied. If you plant a certain crop of cotton, it will yield you so much cotton lint and so much cotton-seed. You can, of course, if you choose, throw away part of the seed, as indeed at one time planters used to do; but unless you do this, you cannot vary the proportions of the two things which you will have for sale. Similarly, if you keep a flock of sheep, or a herd of cattle, you will obtain wool and mutton in the one case, or beef and hides in the other, in proportions, which indeed you can vary within certain limits by choosing a different breed,[1] but which you cannot radically transform. When, however, we turn to the uses to which these products are put, no similar relation is to be discovered. Cotton lint is used chiefly for making articles of clothing; cotton-seed for crushing into oil, on the one hand, and cake for cattle fodder on the other. There is no apparent connection of any kind between the demands for these different things, and still less is there any obvious reason why these demands should bear to one another the particular proportions which characterize their respective supplies. It is very much the same with wool and mutton; with beef and hides; with all "joint products." Why should we consume mutton on the one hand and woolen clothing on the other, in a ratio at all commensurate with that in which they are yielded by the sheep?
[1] These possibilities of small variation are of very great importance as will be shown in Chapter V, but they do not affect the present argument.
What, then, might we expect to find if order was nonexistent in the economic world? Surely that some things such as wool would be produced in quantities many times in excess of the demand for them, quite possibly five, ten, or twenty times in excess; while conversely the supplies of others such as mutton might fall far short of what was required. But in practice we find nothing of the sort. Somehow it comes about that an equilibrium is established between the demand for and the supply of every commodity; and that this applies to wool and mutton, to beef and hides, as surely as to commodities which are produced quite independently. It is true that this equilibrium is a rough, imperfect one; and it may happen that what is called a "glut" of wool may co-exist for a short period with what is called a scarcity of mutton. But qualifications of this nature are in the strictest sense of the phrase, the exceptions which prove the rule. For the departures from equilibrium which gluts and scarcities represent are always transient and are usually confined within narrow limits. A strong prevailing trend towards an adjustment of demand and supply is unmistakably manifest amid all the vagaries of changing circumstance. Let me carry the argument a step further for the benefit of any reader who is restrained by a repugnance too deep and instinctive to be readily overcome, from admitting fairly to his mind that conception of order which I am endeavoring to emphasize. He will in all probability be one who, cherishing ideals of a better and fairer system of society, looks forward to a time when an organized coöperation will be substituted for what he regards as the existing chaos. Let us suppose that his visions were fulfilled as completely as he could desire; and that an immense system of Socialism were in existence, embracing not one country only, but the whole world. Suppose all the difficulties of human perversity and administrative technique to have been surmounted and a wise, disinterested executive to be in supreme control of our business life. Let us suppose all this, and ask only the question: How would this executive treat the humdrum case of wool and mutton? How would it decide the number of sheep it would maintain?
Shall we suppose that it is inspired by the ideal "to each according to his need," and that it resolves accordingly that the commodities which people require for a decent standard of life shall be supplied to them as a matter of course? How, then, would it proceed? It might estimate the amount of woolen clothing which a normal family requires, allowing for differences in climate, and possibly indulging somewhat the caprices of human taste. On this basis, a certain number of sheep would be indicated. It might perform a similar calculation for mutton, and again a certain number of sheep would be indicated. But it would be an extraordinary coincidence if the numbers which resulted from these independent calculations were nearly equal to one another, or were even of the same order of magnitude; and, if they differed widely, what number would our world executive select? Would it decide to waste an immense quantity of either wool or mutton; or would it decide that it could not, after all, supply the full human needs for one or other of the commodities?
Of course, if the executive were sensible it could solve the problem satisfactorily enough. It could retain the monetary system we know to-day and it could supply the commodities to the consumers, not as a matter of right, but by selling them to them at a price. This price it could then move upwards or downwards, raising, say, the price of mutton and reducing that of wool, until it found that the consumption of the two things was adjusted in the required ratio. But if it acted in this manner, what essentially would it be doing? It would be seeking by deliberate contrivance to reproduce, in respect of this particular problem, the very conditions which occur to-day without aim or effort on the part of anyone at all.
The moral of this illustration must not be misinterpreted. It does not show the folly of Socialism or the superiority of Laissez-faire. What it does show is the existence in the economic world of an order more profound and more permanent than any of our social schemes, and equally applicable to them all.
§5. Some Reflections upon Capital. Another aspect of the great cooperation is of even greater significance. It embraces not only a multitude of living men, but it links the present together with the future and the past. The goods and services which we enjoy to-day we owe only in part to the labors of the week, the month, or the year, only in part even to the efforts of our contemporaries. The men, long since dead and forgotten, who built our railways, or sunk our coal mines, or engaged in any of a great variety of tasks, are still contributing to the satisfaction of our daily wants. The expression is not altogether fanciful; for, had it not been reasonable to expect that those labors would be of use to us to-day, many of them in all probability would never have been undertaken. It was to meet our present wants, and even our future wants, that many men toiled on monotonous tasks ten, twenty, thirty years ago. And yet, of course, we should deceive ourselves if we supposed that this was the motive of these men, that our welfare was the centre of their heart's desire. We in our turn dedicate to the future, and often to a distant future, an immense portion of our energies. Let any reader who doubts this, study the statistics of the occupations of the people, and reflect on how long a period must elapse before the labors of this trade or that can fulfil their ultimate function. How long would the period be in the case of a man making bricks, which will later be employed in the erection of a factory, where machinery will be made, to equip an electrical generating station designed to supply, over a period of many years, light, heat, and power to people living in a remote Continent? A longer time, it may be hazarded, than he is accustomed to look ahead.
Like the daily cooperation of living men, this cooperation of past, present and future is essential to the well-being of mankind, and yet it is undesigned and unorganized. As private individuals, men do, indeed, deliberately provide for their own future, and for that of their kith and kin: as the directors of businesses, they try to forecast the trend of demand. But such conscious calculations and deliberate acts would avail little if they stood alone. They are hardly more than the necessary spokes in the great wheel which regulates the relations of past, present and future. The hub of the wheel is an elaborate system of borrowing and lending, essentially similar to the buying and selling of commodities. The private individual in order to provide for his family or for his old age "saves" and "invests." But what exactly does this mean? It means that he transfers so much purchasing power, which he might have spent on his personal pleasures, to some one else in return for the expectation of receiving, year by year in the future, he and his heirs after him, a certain smaller quantity of purchasing power. The other party to the transaction will be, we may suppose, a business man who enters into it because he sees the opportunity of a promising industrial development, to undertake which he requires more purchasing power than he himself possesses. And, because this transaction is entered into, a smaller number of us will shortly be engaged in making motorcars, or gramaphones, and a larger number of us in making factories and machinery, which will later enhance the world's productive power.
Many transactions of the kind take place daily in modern communities, and their multiplicity gives rise to a mass of phenomena with which we are all tolerably familiar. We recognize a short-loan market, a stock exchange, a number of "markets" where lenders and borrowers are brought together by the aid of various intermediaries, such as banks, bill brokers, and stock jobbers, who correspond to dealers in commodities. Between these different specialized markets, we are aware of an interconnection so close and strong that we speak more generally of a Capital Market, of which the stock exchange, the short-loan market and so forth, are the component parts. Now, "market" is a word which was originally used to denote a place where tangible commodities were bought and sold; and the more closely we examine the phenomena of the Capital Market, the more closely do we perceive the profound resemblance between the mechanism of borrowing and lending, and that of buying and selling. Corresponding to the price of a commodity is the rate of interest (in the short-loan market we actually call the rate of Discount "the price of money," and speak of money being cheap or dear); and between the rate of interest, the demand for and the supply of capital there exist relations precisely similar to those between price, demand, and supply in commodity markets. Above all there is the same strong prevailing trend towards an adjustment of demand and supply.
This fundamental resemblance between two such apparently incommensurable things as the buying of material commodities and the borrowing of capital is highly significant; it is another instance of that order in the economic world, of which the reader may now be growing weary. But so difficult is it to see clearly and fully something which one sees, as it were, every day of one's life, that a few more moments of reflection on the special case of capital will be time well spent. Let us revert then to our fantasy of a world socialist commonwealth; and humbly submit another poser to its supreme executive. The question this time will be whether some great constructional work, such, let us say, as the recently mooted Severn barrage scheme, should or should not be undertaken. Let us suppose that the costs and future benefits of the undertaking can be estimated accurately; and that the problem reduces itself to one of expending now a sum, let us say, of $100,000,000, with the prospects of obtaining in the future an income of power, or whatever it may be, worth $5,000,000 per annum. I have assumed for the sake of simplicity that we shall still be reckoning in terms of money, though possibly the executive may have substituted Marxian labor units; but it is quite immaterial to the present argument what the measuring rod may be. The point to be observed is, that it is impossible to tackle the problem at all without the conception of a rate of interest. For suppose that you tried to do without it, and said, "We shall take a long view. The interests of the future are no less our concern than those of the present; we shall not discriminate between them. We shall regard as an enterprise worthy to be undertaken whatever promises to yield in the course of time a return larger than the outlay." Where will this lead you? The particular proposal set out above would clearly pass the test; for in twenty years the resultant benefits would have added up to a figure equivalent to the initial cost. But equally clearly, the cost might have been more than $100,000,000; it might have been $250,000,000, $500,000,000, whatever figure you care to take, and if you extend the period similarly to fifty or one hundred years, sooner or later the gains would top the cost. Now there is no limit to the enterprises which would pay their way on this basis; and it would be quite impossible to undertake them all. For they would swallow up all and more than all your labor and your materials, and would leave you with no resources with which to meet the recurrent daily wants of men. Clearly, then, in some way or other, you must pick and choose, you must reject some enterprises as insufficiently worth while. But how would you proceed to choose? Without a clear principle, a simple criterion to guide you, you would be plunged in utter chaos. You could not say, "Let all proposals involving capital expenditure be submitted to a central committee, who shall compare them with one another in a sort of competitive examination and, after deciding the number of applications they can pass on the basis of the volume of resources which they can devote to the future, award the places to those which head the list." Such a prospect is a nightmare of officialism and delay. You would be driven to formulate a simple, intelligible rule or measure, and leave that rule to be applied by the unfettered judgment of innumerable men to individual problems, as and when they arose. And for such a rule or measure, you could not do better than a rate of interest; you would have to lay it down that only those projects should be approved which promised a return of 6 per cent, or whatever it might be. Even in deciding what it should be, the limits of your choice would be narrowly confined. If, for instance, you fixed on 1 or 2 per cent, you would probably discover that you had not achieved your object, that the undertakings for distant returns which passed this test, still consumed far more resources than you could spare. You would be compelled then to raise the rate until it had cut these enterprises down within manageable limits. But, once more, what essentially would you be doing? You would be using the instrument of the rate of interest to adjust the demand for and supply of capital, though indeed the interest might not be paid away as now to private individuals. You would be reproducing by the method of deliberate trial and error, the adjustments which occur automatically as things are, in the actual world. Once again the most perfectly contrived Utopia would be compelled to pay to the unorganized coöperation of our epoch the sincerest flattery of imitation.
§6. The Fundamental Character of many Economic Laws. But again perhaps a word of warning may be desirable. There is much controversy in these days about something called "Capitalism" or "The capitalist system." When these words are used with any precision, they usually refer to the arrangement so prevalent at present, whereby the ownership and sole ultimate control of a business rests with those who hold its stocks and shares. There is much to be said upon the merits and demerits of this system; something will perhaps be said upon the matter in the fifth volume of this series; but I shall not discuss it here. Nothing that I have said so far has any real bearing on it whatsoever; to suppose that it has, is indeed to miss the whole point of this chapter.
The order, which I have sought to reveal, pervading and moving the most diverse phenomena of the economic world, would be a far less noteworthy and impressive thing were it merely the peculiar product of capitalism. Merchant adventurers, companies, and trusts; Guilds, Governments and Soviets may come and go. But under them all, and, if need be, in spite of them all, the profound adjustments of supply and demand will work themselves out and work themselves out again for so long as the lot of man is darkened by the curse of Adam.
Chapter II
The General Laws of Supply and Demand
§1. Preliminary Statement of Three Laws. The recognition of order in any branch of natural phenomena is but the prelude to the formulation of a set of laws, the simpler as the order is more universal, which describe, and as we say, explain it. Thus the perception of the even, elliptical courses of the heavenly bodies led to the statement of the law of gravitation and the laws of motion.
In economics, similar laws have long since been enunciated, and have proved themselves such valuable instruments for the understanding of the daily problems of the workaday world, that they have been woven into the texture of our ordinary speech and thought. I have already touched upon them in the preceding chapter. But it is now desirable to set them out in order, in the most concise and formal manner possible.
I. When, at the price ruling, demand exceeds supply, the price tends to rise. Conversely when supply exceeds demand the price tends to fall.
II. A rise in price tends, sooner or later, to decrease demand and to increase supply. Conversely a fall in price tends, sooner or later, to increase demand and to decrease supply.
III. Price tends to the level at which demand is equal to supply.
These three laws are the cornerstone of economic theory. They are the framework into which all analysis of special, detailed problems must be fitted. Their scope is very wide. I have purposely refrained from introducing into my statement of them any reference to commodities; for they extend far beyond commodities. Subject to an important qualification, they apply to capital, the price paid for the use of capital being what we call the rate of interest. They apply hardly less to "services," to the remuneration of labor of every kind and grade. People sometimes protest warmly against the idea of treating labor "like a commodity." If this indignation expresses no more than a belief that in matters concerning conditions of work, and relations between employees and the management, the sensibilities of human nature should be taken into due account, it is based on elementary decency and commonsense. But if, as sometimes appears, it is directed against the fact that the remuneration of labor is controlled by the laws of supply and demand, it is a mere baying at the moon, with singularly little provocation. For these laws are in no way peculiar to commodities, and it is no one's fault that they include commodities too within their scope.
But let us go back to the laws themselves, and probe them and dissect them, and turn them this way and that, so that we may perceive their full content, and grasp it firmly in our minds. The third law implies a prevailing tendency for demand to be equal to supply. This tendency, as was suggested in Chapter I, can be verified by anyone from his experience and observation (provided he is a reasonable person, and not the tiresome kind who would dispute the law of gravitation because he sees that a feather falls to the ground more slowly than a stone). But it can also be deduced as a corollary from the two preceding laws; and to regard it in this way will help us to appreciate its significance. Start, for instance, by supposing that demand is in excess of supply. Then the price will tend to rise. After the price has risen, the supply will become larger, while the demand will fall away. The excess of demand with which we started will thus clearly be diminished. But if there remains any portion of this excess, the same reactions will continue; the price will rise further, and for the same reason; demand will be further checked and supply further stimulated. In other words, these forces must persist until the entire excess of demand over supply is eliminated. If we start by supposing supply to exceed demand, the converse chain of sequences will operate. Now these very simple steps of reasoning illuminate the nature of the normal equilibrium of demand and supply. They reveal that the equilibrium is established and maintained by the agency of changes in price, and they enable us to lay it down as perhaps the most important thing that can be said about the price of anything that it will tend to be such as will equate demand and supply. But that is not all that they reveal. They reveal also the extreme dependence of both demand and supply upon price. Now this is a fact which it is most important to realize vividly. It is apt to be obscured by customary modes of speech. In ordinary times the prices of most commodities and services do not change by very much, unless indeed over a long period of years; the amounts demanded and supplied may therefore seem to maintain a fairly constant level; and we may be tempted to speak of Great Britain producing so many million tons of coal, or America consuming so many millions of motor-cars per annum, almost as though these quantities were independent of price considerations. But we should never forget that there is no service or commodity produced by man, however essential it may seem, the demand for or the supply of which might not be reduced to nothing, if the price were sufficiently raised on the one hand, or lowered on the other. How easy it is sometimes to forget this simple truth may be seen from the mistake so commonly made of supposing, because the peoples of Central Europe were left, on the cessation of the war, starving and destitute of the means of life and the materials of work, that they must necessarily become heavy purchasers of imported goods; without pausing to consider whether the prices were such as they could afford to pay.
§2. Diagrams and their Uses. It will help to prevent mistakes like this and more generally to make sharp and clear the fundamental relations which exist between demand, supply and price, if we exhibit them pictorially in the form of a diagram. Such diagrams are of great service in many parts of economic theory, not because they can prove anything which could not be proved otherwise, but because, being really a simpler medium of expression than words, they enable the mind to grasp more readily and to retain more vividly the essential facts of complex relations.

Figure 1
In Fig. 1 the curve DD' represents the conditions of demand. It is supposed to be drawn in such a way that if any point, Q, be taken on the curve, and the perpendicular QN be drawn to meet the base line, or axis OX, then ON will represent the amount that will be demanded at a price represented by QN (or Ol). In other words, distances measured along OY represent prices, and distances measured along OX represent quantities of the commodity, or service, or whatever it may be. Clearly, then, the demand curve, DD', must slope downwards from left to right, since the lower the price asked, the greater will be the amount demanded. Similarly the curve SS' represents the conditions of supply. It is supposed to be so drawn that if any point q be taken upon it, and the perpendicular qN be drawn to meet OX, then ON will represent the amount that will be supplied at a price represented by qN (or Ok). Equally clearly this supply curve must slope upwards from left to right, since the higher the price obtainable, the greater will be the quantity offered. Take the point P where the two curves meet, and draw the perpendicular PM to meet OX. Then the third law enunciated at the beginning of this chapter corresponds to the statement that PM or Om will represent the price at which the commodity or service will be exchanged.
It can readily be seen that no other price could be maintained. For suppose the price to be less than Om, suppose it to be Ok, then, at this price, ON (or kq) will be the amount supplied, and kr the amount demanded. The demand will thus exceed the supply, and the price will tend to rise, i.e. to move upwards towards Om. Similarly if we suppose the price to be Ol, which is larger than Om, the supply (lR) will exceed the demand (lQ) and the price will fall downwards towards Om. Thus, again, we have deduced Law III from Laws I and II with the form and precision of a proposition in Euclid. Now, when once the eye has become familiar with this diagram, it ought to be impossible for the mind to lose even momentarily its grip on the fact that demand and supply are both dependent upon price. For these curves do not represent any particular amounts; they represent a series of relations between amount and price; if the price is QN the amount demanded is ON, and so forth. The terms demand and supply in the sense, in which I have been using them, of the respective amounts demanded and supplied are, indeed, strictly meaningless without reference to some particular price. The reference may sometimes be implicit; but, whenever there is a chance of ambiguity, it should be explicitly made.
§3. Ambiguities of the Expressions, "Increase in Demand," etc. It is the more important to be precise upon this point, in that there is a further possible confusion which we have now to consider. Demand and supply, as we have seen, are dependent upon price; but equally clearly they are dependent upon other things as well. Demand depends upon the needs, tastes and habits of the people, as well as upon the length of their purse; supply depends upon such things as the cost of production in the case of commodities. None of these things are constant factors, all of them are liable to change, and it may well happen that we shall want to consider in some concrete problem the probable consequences of such a change. Now the most usual and natural way of describing such changes in the medium of words is to use the expression "increase" or "decrease in demand," and "increase" or "decrease in supply," the same expressions, which we employed before to describe the consequences of a change in price. This identity of language conceals a fundamental distinction between the phenomena described; and to make this distinction plain we cannot do better than revert to our diagrammatic presentation of the laws.

Figure 2
In Fig. 2 we start as before with our demand curve, and supply curve, cutting one another at the point P. We then suppose that some alteration takes place in the conditions of demand; there has been a growth in the general taste for the commodity or service, and the demand, as we say, has increased accordingly. How is this fact to be represented in the diagram? Plainly not by taking another point on the curve, DD', at a further distance from OY. For this would merely indicate the larger amount that would be taken, if the conditions of demand had remained unaltered but the sellers had reduced their prices. The correct way of representing the change we have supposed is to construct a new demand curve (in the figure, the dotted curve dd'), lying at every point above the old demand curve. For this indicates that larger quantities will be purchased at the old prices, which is exactly what we want to represent. Similiarly if we wish to represent a change in the conditions of supply, such as might result, in the case of a commodity, from a tax imposed on its production, we must draw a new supply curve, ss', which in the case supposed, must lie everywhere above the old supply curve. On the other hand, the decrease or increase in demand or supply, resulting from a change in price, is represented simply by a shifting of the equilibrium from one point to another on the same curve. The striking pictorial contrast between a movement from one curve to another, and a movement along the same curve should help to make vivid to our minds the fundamental distinction between a change in the conditions of demand, arising from new tastes, enhanced purchasing power, etc.; and a mere change in the amount purchased resulting from an alteration in the price which the sellers ask. Words, as this necessarily cumbrous sentence shows, are a clumsy instrument for the expression of abstract relations; it is not very easy to see which words in a sentence are the significant, commanding ones, and which are performing, as it were, ordinary routine duties. A diagram is not exposed to similar ambiguities of emphasis.
The particular distinction, to which attention has been called, is important. The reader who has grasped it clearly will be able to perceive many instances of the confusion arising out of its neglect in the ordinary discussions of economic questions which take place in the press and on the platform. It is not uncommon, for instance, for an argument to run something like this: "The effect of a tax on this commodity might seem at first sight to be an advance in price. But an advance in price will diminish the demand; and a reduced demand will send the price down again. It is not certain, therefore, after all, that the tax will really raise the price." A glance at the diagram will keep us out of such a bog of sophistry and muddle. For if we suppose the amount of the tax per unit of the commodity to be represented by Ss, the curve ss' (drawn, as it is, roughly parallel to SS') will represent the new conditions of supply after the tax has been imposed. The new position of equilibrium will be given by the point P', where ss' cuts DD', the demand curve. Now P' lies to the left of P the old point of equilibrium; hence, since DD' must slope downwards from left to right, it is clear that, if, as it is fair here to assume, the conditions of demand have remained unaltered, the new price P'M', must be greater than the old.
§4. Reactions of Changes in Demand and Supply on Price. Having now made clear the meaning that must be attached to the terms, let us consider the question which naturally arises, whether we can lay down any general propositions or laws as to the effect upon price, of an increase or decrease in demand or supply. Another glance at the diagram suggests that we can. An increase in demand is represented in Fig. 2 by a movement from DD' to dd', which cuts the supply curve, SS', at p, to the right of P. Since the supply curve (drawn, as it is best to draw it, to represent the amount which will be supplied in response to a given price) must always slope upwards from left to right, the new price, pm, must be greater than the old, PM. Conversely a decrease in demand is represented by a movement from dd' to DD', and the new price is seen to be less than the old. We have already seen that a decrease in supply, which is represented by a movement from SS' to ss' results in a higher price; and it is the obvious converse that an increase in supply will have the opposite effect. It would seem then that we might lay down quite generally that an increase in demand or a decrease in supply will raise the price while a decrease in demand or an increase in supply will lower it.
But here it is necessary to be cautious. All conclusions as to the effects of causes are necessarily based, implicitly, if not explicitly, upon the assumption "other things being equal." This method of reasoning, which some people appear to find so irritating in the economic sphere, and as they say so "theoretical" and "unreal," is one which they adopt readily enough in every other department of life. No one, for instance, objects to the statement that the sun, when it comes out, makes a room warmer, although it may very well happen, if a fire is dying at the same time, that the room grows colder in point of fact. For in our general statement we assume implicitly that "other things" such as fires, are unchanged. But assumptions of this kind are legitimate only when there is no reason to suppose that the cause, the effects of which are being studied, will itself produce a change in the "other things." If (as I have often been told; I really do not know if it is true) the rays of the sun help to put a fire out, the statement made above would be the better for some qualification.
Now we can only say that an increase in demand raises price if we assume the conditions of supply (as represented by the supply curve) to remain unchanged. But in practice, an increase in demand may cause a change in the conditions of supply. An increase, for instance, in the demand for a commodity may give rise to a revolution in the methods of production, to the introduction of labor-saving machinery and so forth, which will eventually result in the commodity being produced more cheaply. It will certainly take a considerable time before reactions of this kind can exert an appreciable influence; and we can, therefore, feel reasonably sure that over a short period an increase in demand will raise the price. But we cannot be sure what the ultimate effect will be. A similar alteration in the condition of demand is less likely to result from an increase or decrease in supply; but it may conceivably occur. We must, therefore, be careful to qualify any general propositions which we lay down in this connection, by explicit reference to a short period of time. We can add the following to our body of laws:—
IV. An increase in demand, or a decrease in supply will tend to raise the price for a short period at least. Conversely a decrease in demand, or an increase in supply will tend to lower the price for a short period at least.
This law, like the others, applies to commodities, services, capital, to anything which can be said, literally, or by analogy, to have a price. "A short period" is, however, a vague expression and, since precision is the hallmark of an important law, we must accord to this one a status inferior to that which the preceding three can rightly claim.
§5. Some paradoxical reactions of price changes on supply. Let us turn, though, once more to these earlier laws, and with a heightened critical sense let us submit them to the test of the whole gamut of our experience, and see if in any of them we can find the smallest flaw. The first of them will pass through the ordeal—let each reader prove it for himself—unscathed. The second will emerge with a few hairs, as it were, singed. It tells us, for instance, that a rise in price will tend to augment the supply. Now there are some things the supply of which cannot possibly be augmented; these are the capital resources of nature, of which land is the most important for our present purpose. Land is bought and sold, it commands a price. In a certain sense, it may be said to be possible to increase the supply of land, in response to a rise in price, by drainage and reclamation schemes; and it will certainly happen that a rise in the price which land can command for any particular purpose will increase the amount which is devoted to that purpose. But, speaking broadly, the supply of land available for purposes of every kind is a fixed unvarying factor, with an inertia which the cajolery of price-changes is powerless to disturb. This is a most important fact, and it gives rise to some peculiar features of the price and rent of land, which we shall have to consider later as a separate problem. It constitutes a limiting case rather than an exception to the general law. But we have not yet done with the reactions of price upon supply. In the case of capital, the nature of those reactions has been much discussed as a highly controversial question. That a rise in the rate of interest will cause some people to save more than before, is generally admitted; but it is pointed out that the effect upon others may be the exact opposite, because it means that they do not need to save so much to acquire the same future annual income. It is unwise to say dogmatically that the former tendency outweighs the latter; though upon the whole it seems highly probable that it does. We cannot, therefore, in this case feel confident that a change in price will react upon supply in the manner which our law indicates. Similarly it is possible to argue that a rise in the general level of real wages may reduce the supply of labor, even, or some might say particularly, if the term is used to denote not the number of workpeople, but the quantity of work done. For there may be a tendency for workpeople, when more comfortably off, to work less regularly or less hard. Here again we cannot be sure. In none of these cases, however, including that of land, is there any reason to doubt that a rise in price will diminish demand, or conversely that a fall will increase it. Since, therefore, in the reasoning by which we deduced the third law, the conclusion will hold good, even if the effects of price-changes on supply are of the above paradoxical kind, provided that they do not continually outweigh the effects upon demand, there is no reason to cast doubt on the solidity of Law III, which, indeed, as we suggested before, commends itself directly to experience. But Law II seems now, perhaps, somewhat the worse for wear.
The damage, however, is not considerable. For in each case the uncertainty arises only when we are dealing with one of the factors of production, land, labor or capital, regarded as a whole. If we are dealing with the capital available for a particular industry, a rise in the rate of profit in that industry will certainly increase the supply of capital available there; for it will tend to attract savings that might otherwise have been employed elsewhere. We can even be fairly sure that an increase in the general rate of interest prevailing in any particular country will increase the total supply of capital available for the businesses of that country, since capital has in modern times acquired a considerable migratory power. In the case of labor, we cannot go so far as this; but here, too, there is no doubt that an increase in the remuneration offered in any particular occupation will attract an increased labor supply (always supposing, of course, that "other things are equal"). No similar difficulty arises for land, labor or capital, as regards the effect of price-changes on demand; while for ordinary commodities there is no such difficulty on the side either of demand or of supply. Hence the only qualification which the strictest accuracy would require us in this connection to attach to our statement of Law II is the postscript:—
"Except that, in the case of land, the aggregate supply is unalterable; while in the case of capital or labor we cannot be sure how price-changes will affect the aggregate supply."
Much significance attaches to these exceptions, as later will appear.
§6. The Disturbances of Monetary Changes. But let us still keep a critical eye on Law II, and submit it to another flashlight from our practical experience. The recent world war made us all acutely aware of a remarkable rise in the price of almost everything, which yet did not seem to diminish appreciably the demand. The explanation of this paradox is not difficult to find. There was an immense increase in the volume of nominal purchasing power, due to a complex set of causes, of which "currency inflation" may be taken as the symbol. Now perhaps we are entitled to assume the absence of such currency changes as part of the "other things being equal" which is always understood as implied. But it is rash to take this particular assumption for granted, more especially in these days. Already people are too apt to speak as though the trade depression (which as these pages are written holds us in its grip) cannot pass away until pre-war prices are restored, ignoring altogether the great and probably permanent increase in nominal purchasing power which the war has left behind it. It would be safer, therefore, to add explicitly to Law II the reservation, "Assuming that there is no change in the general volume of purchasing power."
Monetary and allied questions will form the subject of the second volume of this series. It must not be supposed that our general laws have no bearing on them. On the contrary, Law I, which all this time has remained serene and undisturbed by the occasional discomfitures of Law II, is the gateway through which all questions of currency, banking and the foreign exchanges should be approached. It is well to note, as an inexorable corollary of Law I, that prices can rise only if demand exceeds supply, and fall only if supply exceeds demand; and hence that it is only through the agency of changes in the demand for and supply of commodities and services that an inflation or deflation of the currency can influence the price level. Further, since a condition of things in which supply generally exceeds demand spells what we know and fear as a trade depression, it may be well to note at once that falling prices and unemployment are inseparable bedfellows. For we are far too apt to shut our eyes to these unpleasant truths. But we cannot pursue them further here; and in the remainder of this volume we shall not be concerned (except, perhaps, incidentally) with questions affecting the general level of prices or of purchasing power; but rather with the relation which the price of one commodity bears to that of another, with the rate of interest (which being a rate per cent is not essentially dependent on the price level), with "real" wages (as distinct from money wages) and the like.
§7. The Trade Cycle. But our reference to trade depressions suggests a final comment on Law II. One small qualification was embodied in our original statement of it, namely the words "sooner or later." A rise in price may not check the demand immediately (even if the printing presses are standing idle in the Treasuries); it may actually stimulate it for a time. For people may fear that the price will rise further still, and hasten to buy what they must buy before very long. Sellers may share the same opinion, and be reluctant on their side to part. When prices are falling the roles are reversed, and we are likely to see the sellers tumbling over one another in a frantic eagerness to sell, the buyers wary and aloof. Sooner or later, indeed, these tendencies must dissolve and disappear; but they may persist for a longer period than might seem probable at first. For the raw material of one trade is, as we say, the finished product of another. The demand for one thing gives rise to a demand for other things, for the labor with which to make them, and so on in an expanding circle. A sympathy, subtle and intense, unites the business world, and a wave of depression or animation arising in any quarter may spread itself far and wide, heightened by the gusts of human hope and fear, and continue long before its influence is spent.
Here we are upon the threshold of one of the most striking and formidable of economic facts, the regular alternation of periods of good and bad trade, each very widespread, if not world-wide, in its range, each comprising certain regular phases of acceleration and decay, and each infallibly yielding sooner or later to the other. The details of these phenomena are highly complex, some of them obscure; an immense literature has already been devoted to the subject, yet its systematic study is hardly more than begun. The account given in the preceding paragraph is incomplete and meagre. It is inserted here in the hope that it will impress the reader with a sense both of the fact of these alternations and of the deeply rooted nature of the causes from which they spring. They take a heavy toll of human happiness and wealth; and there is no object that more urgently calls for concerted human effort than that of mitigating them, and of alleviating the misery which they bring in their train. Still better, of eradicating them if that is possible; but let none suppose that it can be lightly done. Meanwhile, let us always remember that they form the atmosphere and medium in which the enduring tendencies of the business world must work themselves out. It is often convenient to speak of "normal conditions" in this trade or that; but hardly ever can it be truly said of a particular moment that conditions are normal. The normal is rather a mean level about which oscillations to and fro, round and about, are constantly taking place, but which itself is reached only by accident, if at all. Whenever we say that some new factor should in the long run lower the price of this or that commodity or service, the picture which these words should convey to our mind is one of the price rising less on times of boom, and falling more in times of depression than is the case with other things. And if ever our faith in some honored economic law is shaken by the apparent ease with which, perhaps, in times of active trade, sellers are able to advance their prices to whatever figure (so it almost seems) they choose to name, let us rally our sense of economic rhythm, and reserve our judgment until the trade cycle has run its course.
Chapter III
Utility and the Margin of Consumption
§1. The Forces behind Supply and Demand. The laws enunciated in the preceding chapter constitute the framework and skeleton of all economic analysis; but they do not carry us very far. It is only through the agency of these laws that any influence can affect the price of anything: but what influences may so affect it is a question which we have still to consider.
Let us begin with ordinary commodities and ask ourselves, in the light of experience and common sense, upon what factors their price seems mainly to depend? Two factors spring to mind at once; their cost of production and their usefulness. As regards the former, the case seems clear enough. We may indeed sometimes grumble that the price of this or that commodity is unconscionably high in comparison with its cost; but this only goes to show that we conceive a relation between price and cost as the normal, governing rule. If one commodity cost only a half as much to produce as another, we should think that something had gone very wrong indeed, if the former commodity were sold for the higher price. But, when we turn to the usefulness of commodities, the case is not so clear. Usefulness has some connection with price, so much is certain; for an entirely useless thing, fit only for the dust-bin (and known to be such, it may be well to add) will fetch no price at all, however costly it may be to produce. But it is not easy to express the connection in quantitative terms. It seems reasonable enough to say that the prices of commodities are roughly proportionate to their costs of production. But directly we contemplate saying a similar thing of their usefulness, we are pulled up short. As we look round the world, and enumerate the commodities which by common consent are the most useful, salt, water, bread, and so forth, the striking paradox presents itself that these are among the cheapest of all commodities; far cheaper than champagne, motor-cars or ball-dresses, which we could very well get on without. As things are, of course, a ball-dress, or a motor-car costs more to produce than a loaf of bread or a packet of salt; and the common-sense explanation of the paradox seems, therefore, to be that the cost of production is a more weighty influence than the usefulness, or utility, as we will henceforth call it (so as to include the satisfaction we derive from not strictly useful things). We are thus tempted to conclude that, provided a commodity possesses some utility, its price will be determined by the cost of production, the degree of utility being unimportant. This was exactly how the position was gummed up for many years in systematic treatises upon Political Economy; and it was not until fully half a century after the Wealth of Nations that a discovery was made which threw a fresh light on the whole matter.
First of all, let it be clearly observed how very unsatisfactory is the above account. In Chapter II where we were treading surely, with a sense of solid ground beneath us, we drew no such invidious distinction between supply and demand. They seemed then to possess an equal status. But cost of production is the chief factor which, in the case of commodities, ultimately determines the conditions of supply. Utility, similarly, is the chief factor which ultimately determines the conditions of demand. Must not then the symmetrical relations between demand and supply be reflected in a corresponding symmetry between the utility and the costs which underlie them? Demand springs obviously from utility; the only motive for buying anything is that it will serve some real or fancied use. Can we then accord to demand so dignified and to utility so subordinate a place? There is here an inconsistency which we must somehow reconcile. It will not serve as a solution to distinguish between different periods of time, and to say, as economists used to say not very long ago, that price is governed over a short period by demand and supply, but in the long run by the cost of production. This still leaves our sense of symmetry unsatisfied. Moreover, the conception of cost of production, when we consider it as ruling over a long period, frequently seems to lose any precision, as an independent factor, which it may otherwise possess. Motor-cars, we have agreed, are more costly to produce than loaves of bread; but, as we know well, the cost of producing motor-cars varies enormously, accordingly as they are produced on a small or a large scale. By the methods of mass production they can be turned out at a relatively low cost per car. But this requires that they should be purchased in large numbers and this in turn throws us back to the demand for motor-cars, and plainly enough, to people's judgment as to their utility. In some cases, the opposite phenomenon occurs. In the case of British coal, for instance, the average cost of production would be much lower than it is if the output were reduced to a fraction of its present volume, and if only the richer seams of the more fertile mines were worked. Once again, therefore it is difficult to measure the cost of production until we know the magnitude of the demand, which in a manner, which we have still to elucidate, clearly depends upon the utility.
If we take the problem of joint products, the conception of cost of production fails us still more conspicuously. For what is the cost of producing wool, or the cost of producing mutton? We can speak of the cost of rearing sheep: but it is hardly possible to allot this cost, except quite arbitrarily, between the two products. How, then, can we explain the separate prices of these things by reference to cost alone? Instances of joint production are becoming so common in the modern world, or at least, with the growing attention to the utilization of by-products, are assuming so much more heightened a significance, that an explanation of price, which does not apply to them, is a very feeble one indeed.
§2. The Law of Diminishing Utility. Let us turn back, then, to the factor of utility, and see if we cannot put on a more satisfactory basis the relation between utility and price. The clue to the puzzle is to be found in a brief reflection on the implications of the second general law propounded in Chapter II. A rise in price, it was there stated, will sooner or later diminish the demand. This was asserted as a matter of fact, observed from and confirmed by experience. But what does it signify? To what causes is this familiar fact to be attributed? The first stage of the answer is very ample. The many individuals, whose purchases make up the demand for the commodity, will buy smaller quantities now that the price is higher. Possibly some of them may cease to buy it altogether; but as a rule it would be reasonable to suppose that most people continue to buy a certain amount though a smaller amount than hitherto. Let us turn our attention, then, to the individual purchaser, and ask ourselves why he (or let us say she) acts in the manner indicated. The obvious answer is that the more she already has of anything, the less urgently does she require a little more of it. If she buys 6 pounds of sugar every week when the price is 7 cents a pound, but only 5 pounds when the price is 8 cents, she shows by her action that she does not consider that the additional utility she will derive from buying 6 pounds a week rather then 5 pounds is worth as much as 8 cents. But she shows at the same time that she thinks it worth 7 cents. For, when the price is 7 cents, no one compels her to buy that sixth pound. She could stop, if she chose, at five; and it may serve to make the point quite plain if we suppose her actually to hesitate before she buys the sixth. She has hitherto, let us say, been buying 5 pounds a week at 8 cents. To-day she enters the shop and finds the price is down to 7 cents. She asks for her customary 5 pounds; then she pauses, and a minute later turns her order into six. What are the alternatives which she has been weighing one against the other in that momentary pause? Not the utility of the whole 6 pounds of sugar against the total price of 42 cents. For she has already ordered the first 5 pounds; and the decision to buy the sixth is taken independently and subsequently. She has been sizing up the increment of utility which a sixth pound would yield, and she decides that this is worth the expenditure of a further 7 cents. Again, when the price was 8 cents she need not have bought as many as 5 pounds. She could have stopped at 4 had she chosen, and the fact that she did buy 5 pounds shows that the increment of utility derived from buying a fifth pound, when she might be said already to have 4, was worth at least 8 cents in her judgment.
This trite illustration enables us to lay down two important laws relating to utility. To state them shortly, it is convenient to employ one or two technical terms, which, unlike every term employed hitherto, are not very commonly used in their present sense in everyday life. Their adoption is desirable not merely for the sake of convenience, but because they help to stamp clearly on the mind a most illuminating conception, that of the "margin," which supplies the clue to many complicated problems. The last pound of sugar which the housewife purchased, the fifth pound when the price was 8 cents, or the sixth pound when the price was 7 cents, we call the "marginal" pound of sugar. And the increment of utility which she derives from buying this marginal pound we call the "marginal utility" of sugar to her. We are thus able to state the fact that the more a person has of anything the less urgently does he require a little more of it, in the following formal terms:—
V. The marginal utility of a commodity to anyone diminishes with every increase in the amount he has.
The total utility will, of course, increase with an increase in the amount, but at a diminishing rate. This law is usually called The Law of Diminishing Utility.
§3. Relation between Price and Marginal Utility But this is not all. We are now in a position to perceive the true relation between utility and price. The relation is one which exists not between price and total utility, but between price and marginal utility. If we know only that a housewife will buy weekly 5 pounds of sugar at 8 cents per pound, but 6 pounds at 7 cents, we know nothing of the total utility of sugar to her. We do not know how much she might be prepared to pay rather than go without 3 pounds, 2 pounds, or any sugar at all. But we do know that, when she buys 6 pounds, the marginal utility of sugar is in her judgment worth something which does not differ greatly from the price. We can, therefore, say in general terms that the price of a commodity measures approximately its marginal utility to the purchaser.
This statement is perfectly consistent with the paradox noted above that the most useful commodities such as bread, salt and water are very cheap. For when we say that these commodities are supremely useful, we mean only that their total utility is very great; that, rather than do without them altogether, we would offer for them a large proportion of our means. But we would not value very highly a small addition to the bread, water or salt that we habitually consume; nor would most of us feel it as a very serious deprivation if our consumption of these things were curtailed by a small percentage. In other words, their marginal utilities are small, and it is only the marginal utility that has any relation to price.
§4. The Marginal Purchaser. A possible objection to the preceding argument deserves to be considered. Some readers may find the picture I have drawn of the hesitating housewife entirely unconvincing. They may declare that her mind does not work at all in the manner I have indicated. She will have formed certain habits in regard to her weekly purchases of sugar, which are connected very vaguely, if at all, with any conscious processes of thought. She will buy so many pounds of sugar weekly without troubling her head over the specific utility of the last pound she buys. When the price falls she may, indeed, buy more; but it will not be because she separates out and considers by itself the extra utility of an additional pound. She may buy more, because she has formed the habit of spending so much money on sugar; and now that the price has fallen, the same amount of money will enable her to buy more pounds. Or, perhaps, she may be moved by instinctive and irresistible attraction to buy more of a thing when it is cheaper, similar to that which inspires so many people to face with ardor the horrors of a bargain sale. In any case the fine calculations I have imagined convey a fantastic picture of her state of mind. And how much more fantastic, the critic may continue, of the state of mind in which things of a different kind are bought by less careful people. When, for instance, one of us happy-go-lucky males (more liberally supplied, perhaps, than the housewife with the necessary cash), decides to buy a motor bicycle, or to replenish his stock of collars or ties, does the above analysis bear any resemblance to the actual facts? In the case of the motor bicycle, the purchaser may, indeed, weigh the price fairly carefully against the pleasure and benefit, though contrariwise he may be a rich enough gentleman hardly to bother about this. But, one motor bicycle is as much as he is at all likely to buy, and what becomes, then, of the distinction between total and marginal utility? In the case of the ties and collars, the vagueness of many of us about the price will be extreme. We probably have been uneasily conscious for some time of an inconvenient shortage of these troublesome articles and eventually will go off (or perhaps will be sent off with ignominy) to the nearest suitable shop to make good the deficiency. How can we speak here with a straight face of the relation between marginal utility and price?
These are very pertinent criticisms; but they do not make nearly as much nonsense of the notion of marginal utility as may seem at first. The last point, indeed, serves rather to give it a fresh aspect of much significance. Those of us who do not bother about the price we pay for our ties and collars owe a debt of gratitude, of which we are insufficiently conscious, to the more careful people who do; as well as to the custom which prevails in shops in Western countries (as distinct from the bazaars of the East) of charging as a rule a uniform price to all customers. If we were the only people who bought these things, an enterprising salesman would be able to charge us very much what he chose. He could put up his price, and we would hardly be aware of it. And, as by lowering his price he could not tempt us to buy any more, price reductions would be few and far between. But fortunately there are always some people who do know what the price is, even when they are buying collars and ties; and who will adjust the amount they buy in accordance with the price. It is these worthy people who make the laws of demand work out as we well know they do. It is they who will curtail their consumption if the price has fallen and it is they who constitute the seller's problem, and help to keep down prices for the rest of us. The rest of us—it is well to be quite blunt about it—simply do not count in this connection. We have no cause then to plume ourselves that we have disproved the truth of economic laws when we declare that we seldom weigh the utility of anything against its price. All that this shows is that our actions are too insignificant to be described by economic laws since they exert no appreciable influence on the price of anything. And this in turn shows the extreme importance of grasping clearly the conception of the margin. Just as it is the marginal purchase, so it is the marginal purchaser who matters. It is the man who, before he buys a motor bicycle, weighs the matter up very carefully indeed and only just decides to buy it, whose demand affects the price of motor bicycles. It is the utility which he derives that constitutes the marginal utility, which is roughly measured by the price.
As to the housewife, I am not prepared to concede that my picture is in essentials very fanciful. She may be a creature of habits and instincts like the rest of us, but most habits and instincts affecting household expenditure are based ultimately on some calculation, if not one's own, and reason has a way of paying, as it were, periodic visits of inspection, and pulling our habits and instincts into line, if they have gone far astray. I am not satisfied that the housewife does not envisage the utility of a sixth pound of sugar as something distinct from the utility of the other five; she may buy it, for example, with the definite object of giving the children some sugar on their bread, and she may have a very clear idea as to the price which sugar must not exceed before she will do any such thing. Possibly I may exaggerate. I have the profound respect of the incorrigibly wasteful male for the care and skill she displays in laying out her money to the best advantage.
§5. The Business Man as Purchaser. But if the reader still finds the picture unconvincing, let us shift the scene from domestic economy to commerce, and substitute for the careful housewife an enterprising business man. Now, as anyone who has a business man for his father will have often heard him say, the vagueness and caprice which characterize our personal expenditure would be quite intolerable in business affairs. There you must weigh and measure with the utmost possible precision. You must be for ever watching the several channels of your expenditure, careful to see that in none does the stream rise higher than the level at which further expenditure ceases to be profitable. You will not even engage typists or install a telephone in your office without weighing up fairly carefully the number of typists or the number of switches that it is worth your while to have. And in deciding whether to employ say, five typists, or six, you will not vaguely lump the services of the whole six typists together, and consider whether as a whole they are worth to you the wages you must give them. You will, in the most direct and literal manner, weigh up the additional benefit you would derive from a sixth typist, and if that does not seem to you equivalent to her wage, you will not engage her, however essential it may be to you to have one or two typists in your office. If on the other hand, the utility of having a sixth typist seems to you worth much more than her pay, the chances are that you will be well advised to consider the employment of a seventh. And so, where you stop employing further typists, the utility to you of the last one, of the "marginal typist" as it were, is unlikely to differ greatly from her pay.
Now this is not a fancy picture of some remote abstraction called an "economic man." Allowing for the over-emphasis which is necessary to drive home the central point, it is a bald account of the aims and methods of the actual man of business. To ascertain the margin of profitable expenditure in each direction, to go thus and no further, is the very essence of the business spirit, as the business man himself conceives it. When he condemns the extravagance of Government departments, it is their lack of just this marginal sense that he chiefly has in mind. "The lore of nicely calculated less or more" may be rejected by High Heaven and Whitehall, but no one can afford to despise it in the business world.
The transition from household to business expenditure involves an extended use of the word utility, which is worth noting. Commodities like bread, sugar, or privately owned motor-cars are sometimes called "consumers' goods" in contrast to "producers' goods," which comprise things such as raw materials, machinery, the services of typists and so forth, which are bought by business men for business purposes. The line of division between the two classes is not a sharp one, and we need not trouble with fine-spun questions as to whether a particular commodity should in certain circumstances be included under the one head or the other. But, broadly speaking, things of the former type yield a direct utility; they contribute directly to the satisfaction of our pleasures or our wants. Things of the latter type yield rather an indirect utility. Their utility to the business man who buys them lies in the assistance they give him in making something else from which he will derive a profit. The utility of these things is therefore said to be derived from that of the consumers' goods or services to which they ultimately contribute. This conception of derived utility leads to certain complications which we shall have to notice later.
§6. The Diminishing Utility of Money. But one important point must be emphasized in this chapter. The utility which a business man derives from the things which he buys for business purposes is the extra receipts which he obtains thereby. Derived utility, in other words, is expressed in terms of money, and the idea of its relation to price presents no difficulty. But the utility of things which are bought for personal consumption means the satisfaction which they yield, and this is clearly not a thing which is commensurable with money. When, therefore, it is said that the prices measure their respective marginal utilities, what exactly is meant? What was it that the argument of §3 went to show? That the utility of the marginal pound of sugar would seem to the housewife just worth the price that she must pay for it; in other words, that it would be roughly equal to the utility she could obtain by spending the money in other ways. The respective marginal utilities which she obtains from the different things she buys will thus be proportionate to their prices. But if she were to receive a legacy which gave her a much larger income to spend, she might buy larger quantities of practically every commodity; and, though she would obtain a greater total utility thereby, the marginal utility she would obtain in each direction would be smaller, in accordance with the law of diminishing utility. The prices might not have changed; the respective marginal utilities to her of the different things would again be proportionate to their prices, but they would constitute a smaller satisfaction than before.
Thus we can only say that the prices of commodities will be proportionate to their real marginal utilities, when we are considering the different purchases of one and the same individual. The amounts of money which different people are prepared to pay for different consumers' goods are no reliable indication of the real utilities, the amounts of human satisfaction which they yield. Here we must take account not only of varying needs and capacities for enjoyment, but of the very unequal manner in which purchasing power is distributed among the people. The cigars which a rich man may buy will yield him an immeasurably smaller satisfaction than that which a poor family could obtain by spending the same amount of money on boots, or clothes or milk. When, therefore, we compare commodities which are bought by essentially different consuming publics, their respective prices may bear no close relation to their real utility, whether marginal or otherwise. Thus the law of diminishing utility applies to money or purchasing power, as well as to particular commodities. The more money a man has the less is the marginal utility which it yields him; and, where the marginal utility of money to a man is small, so also will be the real marginal utility he derives in each direction of his expenditure. The extreme inequality of the distribution of wealth gives immense importance to this consideration. Its practical implications will be discussed in Chapter V. Meanwhile, we may express the conclusions of the present chapter by the statement that the price of a commodity tends to equal its marginal utility, as measured in terms of money, i.e. relatively to the marginal utility of money to its purchaser.
Chapter IV
Cost and the Margin of Production
§1. An Illustration from Coal. We have already had occasion to note the symmetry which characterizes the relations of demand and supply to price. This symmetry was apparent throughout the argument of Chapter II, and it was a striking feature of the diagrams which we employed to illustrate the argument. We shall do well to cultivate a lively sense of this symmetry, for it will frequently save us from ignoring factors which have a vital bearing on the problems we are considering. We should never leave an important feature of demand without turning to see whether it has a counterpart on the supply side, though indeed we may not always find one. In the last chapter we examined the relation between utility and price, and found that the true relation was between the price and what we termed the marginal utility. Corresponding to utility on the demand side is cost of production on the supply side. The question should thus at once suggest itself—"Can we speak appropriately of the marginal cost of production, and will this serve to make clear the relation between cost and price?" To answer these questions, let us take one of the instances in which we found that price could not be explained satisfactorily by the bare phrase "cost of production."
An important feature of the coal industry, which recent events have brought into sharp prominence, is the great diversity of conditions between different coalfields and different collieries. We speak of rich seams and poor seams, of fertile and unfertile mines, and we are aware that the costs of raising coal to the surface differ very widely in accordance with these diverse natural conditions. Nor must we confine our attention to the cost price at the pit-head. If we wish to speak of cost of production as a factor determining price, we must use the term in a broad sense to include the transport and other charges necessary to bring the coal to market.
In this respect also one coalfield differs greatly from another. Some are well situated close to a large market, or within easy reach of the seaboard; others must incur very heavy transport charges to bring their coal to any considerable centre of consumption. These varying conditions lead, as we well know, to great variations in the financial prosperity of different colliery concerns. In Great Britain, under the abnormal conditions which prevailed during the war, and subsequently, these variations were so huge as to constitute a most formidable embarrassment and to contribute, more perhaps than any other single factor, to the unrest and instability by which the industry has been afflicted. But they are always with us, if usually upon a more modest scale.
What, then, is the normal relation between price and cost in the case of coal? Should we direct our attention to the average costs over the whole industry, or the costs incurred by the richer and better situated mines, or, lastly, that of the poorer and worse situated? Now, as things are, it is clear enough that no concern will continue indefinitely producing at a loss. It may do so for a time, rather than close down altogether, hoping to recoup itself later when the market has taken a more favorable turn. But, in the long run, taking good years with bad, it must expect to obtain receipts sufficient not only to cover its necessary expenditure, but to provide also a reasonable profit on the capital employed. Of course, once the capital has been sunk and embodied in plant and buildings, which are of little use for any other purpose, a business may continue for many years, with a rate of profit far below what it had anticipated. But plant and buildings gradually wear out, and need to be replaced; the course of technical improvement calls continually for fresh capital outlay, which a business in a bad way is reluctant to undertake. The tendency, therefore, when profits rule low over a considerable period, is for the plant to fall gradually into disrepair and obsolescence, and finally for the business to disappear. We can thus include an ordinary rate of profit under the head of cost of production, and say with substantial accuracy that for no business can this cost for long exceed the price if the business is to continue to exist. If then the relatively poor and badly situated mines are to be worked, the price of coal, taking good years together with bad, must cover the costs at which these mines can produce. If the price rules lower than this, sooner or later they will close down, and we will be left with a smaller number of mines, among which great variations of conditions will still prevail. Once more, the price must cover the cost incurred by the least profitable of these remaining mines, unless their number is still further to be diminished. Thus we can conceive of a "margin of production" which will shift backwards to more profitable or forwards to include less profitable mines, according as the demand for coal contracts or expands. But, wherever this margin may be, there is no escaping the conclusion that it is the cost of production of the "marginal mines," of those that is to say which it is only just worth while to work, to which the price of coal will approximate.
It follows that there is no real connection between price and cost of production throughout the industry as a whole. It follows incidentally that those concerns which can market their coal at an appreciably lower cost than the marginal concerns, are likely to reap more than an ordinary rate of profit, though royalties may absorb part of the excess.
§2. The Various Aspects of Marginal Cost. This relation cuts much deeper than the particular system under which the mines are at present owned and worked. If, for instance, we supposed that the various mines were amalgamated together in a few giant concerns, each of which comprised some of the richer and some of the poorer mines, the preceding argument would need to be recast in form, but its substance would be unaffected. For though a great coal trust could in a sense afford to sell at a price lower than the marginal cost, setting its losses on the poorer against its gains on the better pits, is it likely it would do so? Why should it dissipate its profits in this way? It is clearly more reasonable to suppose that it would close down the poorer pits (unless it could advance the price of coal), and thereby maintain its profits at a higher figure. If, indeed, the mines were nationalized the deliberate policy might be pursued of selling coal at a price which left the industry no more than self-supporting as a whole. Some coal might thus be sold at less than its cost price, and the selling price would conform roughly to the average cost. But such a policy, though in special circumstances it might be justified, would represent a very dangerous principle, which could not be applied widely without the most serious results. Nothing could be more fatal to any enterprise, whether it be in the hands of an individual, a joint-stock company, a State department, or a Guild, than that the management should content themselves with results which in the lump seem satisfactory, and regard losses here or there with an indifferent eye. That way lies stagnation, waste, progressive inefficiency and ultimate disaster. To inquire searchingly into every nook and cranny of the business, to construct, as it were, for each part a separate balance-sheet of profit and loss, to expand in those directions where further development promises good results, and to curtail activity where loss is already evident, is the very essence of good management. Here, it will be observed, we are using language very similar to that in which we described the principles which govern a business man's expenditure. The resemblance is inevitable and significant, for we are dealing here with what is essentially another aspect of the same thing. The object is to secure that nowhere does expenditure fail to yield a commensurate return. This we express, when we consider a business in its aspect as a consumer, by saying that its consumption of anything will not be carried beyond the point at which the marginal utility exceeds the price it will have to pay. When we consider it as a producer, we say that its production of anything will not be carried beyond the point at which the marginal cost exceeds the price it will obtain.
§3. The Dangers of Ignoring the Margin. This at least is the general rule. A business may decide deliberately to sell part of its output below cost, because, for instance, this will serve as an advertisement, bring it connections, and enable it to obtain a larger profit at a later date, or immediately on other portions of its sales. In so acting, it recognizes that the price obtained for a thing may be an inadequate measure of the real return it yields. In the same way, though for different reasons, a nationalized coal industry might conceivably be justified in selling some coal below cost price, because, let us say, it held that the price which the immediate purchasers were willing to pay was an inadequate measure of the utility of coal to the community as a whole. But in all such cases it is essential to be very clear as to what exactly you are doing; so that you may be at least moderately clear as to whether the policy is well advised. It may be sound enough to lose on the swings and make good this loss on the roundabouts, but only if your loss on the swings helps you to a larger profit on the roundabouts. If you would get the same return on the roundabouts in any case, it would be better to cut the swings out altogether. So, if you are directing the policy of a nationalized coal industry, and decide to make a loss on a portion of your sales, you will need to know that the indirect benefit which the community will derive from this particular part of your coal output is worth the loss which you incur. You will certainly come to grief, if you pursue a vague ideal of lumping all results together, and regarding a profit somewhere as a sufficient excuse or a positive reason for making a loss elsewhere.
It is quite true that in big undertakings, where there are large standing charges, and where the organization possesses some of the characteristics of an integral whole, it is not easy to measure accurately the specific costs which should be assigned to any particular portion of the output. But this difficulty is one of the most serious weaknesses of large undertakings; precise detailed measurement is the great prophylactic of business efficiency, and, where it is lacking the bacilli of waste will enter in and multiply. So clearly is this recognized, that the development of large scale business has led to the evolution of new methods of accountancy, designed to make detailed mensuration possible. We have most of us heard of them vaguely under such names as "comparative costings," but too few of us appreciate their full significance. It is hardly too much to say that the issue as to whether the size of the typical business unit will continue to become larger and larger, or whether it has already overshot the point of maximum efficiency will turn largely upon the capacity of accountancy to supply large and complex undertakings with more accurate instruments of detailed financial measurement.
§4. A Misinterpretation. The price, then, of a commodity tends roughly to equal its marginal cost of production; and this marginal cost (in perfect symmetry with what we observed as regards marginal utility), may be conceived as applying either to the marginal producer or to the marginal output of any producer. In the former aspect it is open to a misinterpretation, against which it will be well to guard. Some advocates of socialism have argued, as one of the counts in their indictment of the present industrial system, that the price of a commodity is determined by the cost at which the least efficient concern in the industry can produce. They say, in effect, "Under the present competitive regime, you have to pay for everything you buy a price which far exceeds the necessary cost to a concern which is managed with ordinary ability. For, as economic theory has shown, it is the cost of the marginal concern, i.e. the concern managed by the most incompetent, and half-witted fellow in the trade; it is the cost incurred by him, together with a profit on his capital, that the price has got to cover. The producer of no more than average capacity is therefore making out of you a surplus profit, which would be quite unnecessary in any well-arranged society." Such an argument is a gross caricature of the marginal conception. The half-witted incompetent will, as we know well enough, speedily disappear under the stress of competition, and his place will be taken by more efficient men. There is an essential difference between him and the "marginal coal mine" of which we spoke above. For the probabilities are that of the coal resources, whose existence is clearly known, the more fertile and better situated parts will already be in process of exploitation; and there is not likely, therefore, to be a supply of substantially better seams which can be substituted for the worst of those in actual use. There is likely, on the other hand, to be available a supply of decent business capacity which can be substituted for the most inefficient of existing business men. The marginal concern, in other words, must be conceived as that working under the least advantageous conditions in respect of the assistance it derives from the strictly limited resources of nature, but under average conditions as regards managerial capacity and human qualities in general. Thus in agriculture we can speak of a marginal farm, which we should conceive as the least fertile and worst situated farm which it is just worth while to cultivate (of which more will be said when we come to the phenomenon of rent), but we must assume it to be cultivated by a farmer of average ability.
§5. Some Consequences of a Higher Price Level. The foregoing controversy will be of service to us, if it makes clear the manner and the spirit in which the marginal conception should be handled. It should be regarded not as a rigid formula which we can apply to diverse problems without considering the special features they present, but rather as a signpost which will enable us to find our way, a compass by which we may steer between the shoals of triviality and sophistry to the crux of any problem with which we have to deal. Let us illustrate its practical uses by an example which is of great interest and far-reaching practical importance at the present day. As has been already observed, the war has left behind it in all countries a great and almost certainly permanent increase in nominal purchasing power. Since the armistice prices have moved upwards and downwards with unprecedented violence; and it would be very rash to prophesy the precise level at which they will ultimately settle (using that word with considerable relativity). But, for reasons for which the reader is referred to Volume II in this series, it is safe enough to say that the general level of post-war will greatly exceed that of pre-war prices. Now this will apply not only to consumers' goods like milk and clothes, or to raw materials like pig-iron and cotton, but in very much the same degree to things like factories and machinery. Things of this last type are sometimes called "capital goods," because it is in them that a large part of the capital of a business is embodied. Now the fact that it will cost much more than it did before the war to construct fresh capital goods, has a significance which very few people appreciate. An existing factory cost, let us say, $500,000 to build and equip with machinery before the war. To construct a similar factory to-day would cost, let us assume (it is probably a moderate assumption) $1,000,000. Suppose 10 per cent to be the gross profit that is necessary to attract capital to the particular industry. Then it will not pay to construct this new factory unless the trade prospects point to the probability of a profit of about $100,000 per annum. But if the old factory is equally well managed, it too should be able to earn this $100,000, which upon the capital actually sunk would represent a rate of 20 per cent. The particular figures given are, of course, purely illustrative; the conclusion to which they point is that, if new enterprises are to be undertaken, pre-war enterprises are likely to yield a rate of profit, on their fixed capital at least, increased in rough proportion to the price-level. Of course, in years when trade is bad, the factory which dates from pre-war times will not earn a profit of this kind, it may very likely make an actual loss. At those times it is very certain that few new factories will be erected. But it is difficult to reconcile a condition of trade activity, in which the constructional industries are busily employed, with a rate of profit to pre-war businesses on the fixed part of their capital of a lesser order of magnitude than has been indicated. It makes no difference, it should be observed, whether we suppose the new enterprises to take the form of starting of new concerns or extending old ones; in neither case will they be undertaken, unless there is reason to expect an adequate return on the capital which they require at post-war constructional prices. High profits (taking always good years together with bad) on capital sunk before the war in buildings and machinery are thus a likely consequence of an increase in the price-level.
This fact is, indeed, the counterpart or complement of another phenomenon with which we are more familiar. While prices are actually rising, profits, as we have come to recognize, necessarily rule high, because every trader or manufacturer is constantly in the position of selling at a higher price-level, stock which he purchased, or goods made from materials which he purchased at a lower level. He thus acquires an abnormal profit on his circulating capital, which is essentially similar to the profit on fixed capital, which we have just examined. The difference is that the former profit is crowded into the years when prices are actually on the increase, and thus is very noticeable indeed; while the latter profit continues to accrue in smaller instalments after prices have settled down, as it were, at the higher level, and is not exhausted until the buildings and machinery have become obsolete. But the two profits are essentially similar, and in the long run should be commensurate. In the one case, stock can be sold for a large profit, because it cannot be replaced except at a higher price; in the other case, plant and buildings yield a higher income because they cannot be replaced except at a higher price. Indeed, if the owners choose, the plant and building can, like the stock, be sold at their appreciated value, as has been widely done by the owners of cotton mills in Great Britain since the armistice.
There is nothing in these considerations that should surprise us, or even shock our moral sense. For what they have indicated is an increase of money profits in rough proportion to the price-level, so that the aggregate profits will represent about as much real income as before.[1] The conclusion therefore amounts to no more than this, that you cannot alter fundamentally the distribution of wealth between labor and capital by merely inflating the currency, or otherwise juggling with the price-level. And this is only what we should expect, if there are any laws of distribution of sufficient importance and permanence to justify the many volumes which have been devoted to them.
[1] Assuming that the rate of interest has remained unaltered. In fact it has greatly increased since pre-war days, and this points to a still further increase of money profits, and an increase in the real income which they represent. See Chapter VIII, p. 138.
But this somewhat tame conclusion does not make it any less important to grasp clearly the significance of the appreciation in the value of capital goods. A failure to realize it lies at the root of our bewildered muddling of many crucial problems of the day. In the matter of housing, for instance, we know we cannot build houses at less than two or three times their prewar cost, and yet we cannot endure to see the owners of pre-war houses obtaining a commensurate increase of rent. And so, in Great Britain, we pass Rent Restriction Acts, and Housing Acts, and then, in a fit of economy we suspend the latter, and let the former stand, while the housing shortage becomes steadily more acute. When we hand the railways back from State control to private hands, our horror at the idea of the companies receiving larger money profits than they did before the war leads us to lay down principles for the fixing of fares and freight charges, which take no account of post-war construction costs; and then, in alarm lest we may have thereby made it unprofitable for the companies to spend a single penny of fresh capital upon further development, we seek to provide for capital expenditure by cumbrous and dubious expedients. Doubtless we shall muddle through somehow with such policies: and, public opinion being what it is, they may perhaps have been about the best policies that were practicable. But the problems would have been easier to handle, if the public generally were a little less disposed to think in terms of averages, and a little more in terms of margins, if we all of us instinctively realized that the cost that really matters is the cost at which additional production is profitable under the conditions ruling at the time, or in the immediate future.
§6. General Relation between Price, Utility and Cost. Let us conclude this chapter by summing up the conclusions which have emerged as to the relations of utility and cost to price.
The price of a commodity is determined by the conditions of both supply and demand; and neither can logically be said to be the superior influence, though it may sometimes be convenient to concentrate our attention on one or other of them. The chief factor on which the conditions of demand depend is the utility (as measured in terms of money). The chief factor on which the conditions of supply depend is the cost of production (again as measured in terms of money). The prevailing trend towards an equilibrium of demand and supply can thus be expressed as follows:—
VI. A commodity tends to be produced on a scale at which its marginal cost of production is equal to its marginal utility, as measured in terms of money, and both are equal to its price.
Chapter V
Joint Demand and Supply
§1. Marginal Cost under Joint Supply. Several references have been made above to joint products, a relation which it will be convenient now to describe as that of Joint Supply. Our sense of symmetry should make us look for a parallel relation on the side of demand; and it is not far to seek. There is a "joint demand" for carriages and horses, for golf clubs and golf balls, for pens and ink, for the many groups of things which we use together in ordinary life. But the most important instances of Joint Demand are to be found when we pass from consumers' to producers' goods. There, indeed, Joint Demand is the universal rule. Iron ore, coal and the services of many grades of operatives are all jointly demanded for the production of steel; wool, textile machinery and again the services of many operatives are jointly demanded for the production of woollen goods (to mention in each case only a few things out of a very extensive list). Now we have already noted that, when commodities are jointly supplied, there is an obvious difficulty in allocating to each of them its proper share of the joint cost of production. There is a similar difficulty in estimating the utility of a commodity which is demanded jointly with others. Thus, the utility of wool is derived from that of the woollen goods which it helps to make. But the utility of the factories, the machinery and the operatives employed in the woollen and worsted industries is derived from precisely the same source. How much, then, of the utility of woollen goods should be attributed to the wool and how much to the textile machinery? Can we make any sense of the notion of utility as applying to one of these things, taken by itself? And, if not, how can we explain the price of a thing like wool in terms of utility and cost, since we cannot disentangle its cost from that of mutton, nor its utility from that of a great variety of other things?
Here the conception of the margin enables us to grapple with a problem which would otherwise be insoluble. For, while it is impossible to separate out the total utility and cost of wool, it is not impossible to disentangle its marginal utility and its marginal cost. The proportion in which wool and mutton are supplied cannot be radically transformed; but it can be varied within certain limits, by rearing, for instance, a different breed of sheep. Variations of this kind have been an important feature of the economic history of Australasia, where sheep farming is the leading industry. Before the days of cold storage, Australia and New Zealand could not export their mutton to European markets, though they could export their wool. Wool was accordingly much the most valuable product; the mutton was sold in the home markets, where, the supply being very plentiful, the price was very low. In the circumstances, the Australasian farmers naturally concentrated on breeding a variety of sheep whose wool-yielding were superior to their mutton-yielding qualities. The development of the arts of refrigeration led in the eighties to an important change. It became possible to obtain relatively high prices for frozen mutton in overseas markets. There was, therefore, a marked tendency, especially in New Zealand, to substitute, for the merino, the crossbred sheep which yields a larger quantity of mutton and a smaller quantity of wool of poorer quality. Now if we calculate the cost of maintaining the number of merino sheep which will yield a given quantity of wool, and calculate the cost of maintaining the larger number of crossbred sheep which will be required to yield the same quantity of wool (allowing for differences of quality) the extra cost which would be incurred in the latter case must be attributed entirely to the extra mutton that would be obtained. This extra cost we can regard as constituting the marginal cost of mutton. So long as this marginal cost falls short of the price of mutton, it will be profitable to extend further the substitution of crossbred for merino sheep. The process of substitution will in fact be continued until we reach the point at which the marginal cost is about equal to the price. Similarly by starting with the numbers of merino and crossbred sheep which would yield the same quantity of mutton, we can calculate the marginal cost of wool; and again the tendency will be for this marginal cost to be equal to the price.[1]
[1] It may be found difficult to grasp this point when stated in general terms. The following arithmetical example may make it plainer:—
Suppose a merino sheep yields 9 units of mutton and 10 units of wool.
Suppose a crossbred sheep yields 10 units of mutton and 8 units of wool.
Suppose, further, that a merino sheep and a crossbred sheep each cost the same sum, say, for convenience, £10, to rear and maintain; and that there are no special costs assignable to the wool and the mutton respectively, as, of course, in fact there are.
Then 10 merino sheep, yielding 90 units of mutton + 100 units of wool, cost £100; while 9 crossbred sheep, yielding 90 units of mutton + 72 units of wool, cost £90.
Hence you could obtain an extra 28 units of wool for an extra cost of £10, by maintaining 10 merino sheep rather than 9 crossbred sheep. The marginal cost of wool is thus £ 10/28 per unit.
Similarly 8 merino sheep, yielding 72 units of mutton + 80 units of wool, cost £80; while 10 crossbred sheep, yielding 100 units of mutton + 80 units of wool, cost £100.
Hence you could obtain an extra 28 units of mutton for an extra cost of £20, by maintaining 10 crossbred sheep in place of 8 merinos. The marginal cost of mutton is thus £ 20/28 per unit.
So long as the price obtainable for wool exceeds £ 10/28, and that obtainable for mutton does not exceed £ 20/28 per unit, it will pay to substitute merino for crossbred; and conversely. If the price of wool exceeds £ 10/28 and the price of mutton also exceeds £ 20/28, it will be profitable to expand the supply of both breeds, until as the result of the increased supply, one of the above conditions ceases to obtain. Conversely, if the prices of both products are less than the figures indicated, sheep farming of both kinds will be restricted. The resultant of the processes of expansion or restriction, and substitution, will be that, unless one of the breeds is eliminated, the prices of mutton and wool will equal their respective marginal costs. These marginal costs may, of course, alter as the process of substitution extends. For the relative cost of maintaining merinos and crossbreds will not be the same for every farmer. Here again it is the costs at the "margin of substitution" that matter.
§2. Marginal Utility under Joint Demand. On the side of demand there exist as a rule similar possibilities of variation. Some machinery, some labor, some materials of various kinds, are all indispensable in the production of any manufactured commodity. But the proportions in which these factors are combined together can be varied, and are frequently varied in practice as the result of the ceaseless pursuit of economy by business men. To produce pig-iron, you need both coal and iron ore; but, if coal becomes more costly, it is possible to economize its use. Machinery and labor must be used together, in some cases in proportions which are absolutely fixed. But there is in nearly every industry a debated question as to whether the introduction of some further labor-saving machine would be worth while, or some improved machine which would represent the substitution of more capital plus less labor for less capital plus more labor. A farmer can cultivate his land, to use a common expression, more intensively or less intensively; in other words, he can apply larger or smaller quantities of capital and labor (the proportion between which he can also vary) to the same amount of land. The problem is essentially the same as that of the substitution of the crossbred for the merino. We can take the various possible combinations of the factors of production, and contrast two cases in which different quantities of one factor are employed, together with equal quantities of the others. The extra product which will be yielded in the case in which the larger quantity of the varying factor is employed can then be regarded as the marginal product (or marginal utility) of the extra quantity of that factor; and we can say that the employment of this factor will be pushed forward to the point where this marginal product will be roughly equal to the price that must be paid for it. We can thus lay down the most important proposition that the relation between marginal utility and price holds good generally of the ultimate agents of production; that the rent of land, the wages of labor, and, we can even add, the profits of capital tend to equal their (derived) marginal utilities, or, as it is sometimes expressed, their marginal net products.
Whenever, therefore, the proportions in which two or more things are produced or used together can be varied, the relations of joint supply and joint demand are perfectly consistent with a specific marginal cost and marginal utility for each commodity.
§3. A contrast between Cotton and Cotton-seed, and Wool and Mutton. But it sometimes happens that such variations cannot be made. Thus, it has not been found possible (so far as I am aware) to alter the proportions in which cotton lint and cotton-seed are yielded by the cotton plant. Roughly speaking, you get about 2 pounds of cotton-seed for every 1 pound of cotton lint (or raw cotton), and though this proportion may vary somewhat from plantation to plantation, it is upon the knees of the gods, and not upon the will of the planter that the variation depends. We cannot, therefore, speak with accuracy of the separate marginal costs of raw cotton and cotton-seed. It is true that some plantations are so far distant from any seed-crushing mill that it is not worth while to sell the seed as a commercial product; and it might seem, therefore, as though we might regard the entire costs of cotton growing on such plantations as constituting the marginal costs of raw cotton. But planters, so situated, derive a considerable value from their cotton-seed by using it as fodder for their live stock or as a manure. You can, of course, argue that proper allowance is automatically made for this factor, as a deduction from the costs of raw cotton, when you add up the expenses of the plantation. In the same way you can deduct the price which a planter who sells his cotton-seed obtains for it, from the total costs of the plantation, and call the remainder the costs of the raw cotton. But this is really to reason in a circle. For in either case the magnitude of the deduction depends on the marginal utility of the cotton-seed. And the notion of the cost of anything becomes blurred and blunted if we so use it that it must be deduced from the utility of something else, which is not an agent in the production of the thing in question.
This point is not merely an academic one. It means that we cannot explain the relative prices of cotton lint and cotton-seed in terms of cost at all, whether marginal or otherwise. The influence of cost will be confined to the sum of the prices of the two things. Upon this sum it will exert precisely the same influence as it exerts upon price in general, by affecting the total quantities of the two things that will be supplied. But upon the distribution of this sum between lint and seed, cost will exert no influence whatever, because it cannot affect the proportions in which they are supplied. It may assist some readers if I state the matter in more concrete terms. Cost of production will be one of the factors which will result in the production of an annual cotton crop in the United States of, let us say, 10 million tons of seed cotton. This crop will yield roughly 6-2/3 million tons of cotton-seed, and 3-1/3 million tons (or rather more than 13 million bales) of lint. The combined price received by the planter of (let us say) 14.4 cents for 1 pound of lint plus 2 pounds of seed should correspond roughly to the marginal joint costs of production. But the factor of cost has no influence at all in determining that this combined price is made up of a price of 12 cents per pound for lint, and only 1.2 cents per pound (or $24 per ton) for cotton-seed. To account for this we must rely entirely upon demand. We can say, shortly, that the respective prices must be such as will enable the demand to carry off 6-2/3 million tons of seed, and 3-1/3 million tons of raw cotton. Or we can go further and say that the marginal utility of a pound of raw cotton, when 3-1/3 million tons are supplied, is ten times as great as that of a pound of seed when 6-2/3 million tons are supplied.
If accordingly the demand for cotton-seed were to expand considerably owing, say, to the discovery of some new use for the oil, which is its most valuable constituent; the effect would be first a rise in the price of cotton-seed, and, subsequently, by stimulating cotton growing, a more plentiful supply and a lower price for raw cotton. And so far at least as the increased supply is concerned, this must necessarily be the effect, "other things being equal"; though, to be sure, it might be outweighed and obscured by other influences