THE REAL COSTS OF PRODUCTION
§1. COMPARATIVE COSTS
§2. THE ALLOCATION OF RESOURCES
§3. UTILITY AND WEALTH
§4. CRITERIA OF POLICY
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?
[Footnote 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.
LAW I. When, at the price ruling, demand exceeds supply, the price
tends to rise. Conversely when supply exceeds demand the price
tends to fall.
LAW 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.
LAW 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:
Y
|
| S'
| *
D | **
|* **
| ** *
| ** *
| * *
| ** **
| ** *
| ** *
| ** **
| ** *
| ** Q **
_l_|--------------*------------* R
| |*** **
| | ** P **
_m_|--------------------***
| | *** |***
_k_|--------------***----+---** _r_
| _q_*| | ***
| *** | | ****
| *** | | ****
| *** | | ***
S |**** | | ****
| | | ** D'
| | |
| | |
| | |
| | |
0+-------------------------------------------------------- X'
N M.
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 O_l_). 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 _q_N be drawn to meet OX, then ON will
represent the amount that will be supplied at a price represented by
_q_N (or O_k_). 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 O_m_ 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 O_m_, suppose it to be O_k_, 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 O_m_. Similarly
if we suppose the price to be O_l_, which is larger than O_m_, the
supply (_l_R) will exceed the demand (_l_Q) and the price will fall
downwards towards O_m_. 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:
Y |
|
_d_|
|.
| .
| . _s'_
| . .
D | . .
|** . . * S'
| ** .. . *
| ** . . *
| ** . .. *
| * .. . **
| ** . . **
| ** .. .. **
| * . . *
| ** . . *
| ** .. . **
| ** .. .. **
| ** .. .. **
| ** . .. **
| ** p' .. **
| **.. .. **
| ..|**p **._p_
| .. | **** | ..
| ... |**|** | ..
| .. *| | *| ..
| ..... *** | | |** .
_s_|...... *** | | | ** ..
| *** | | | ** ...
| ***** | | | ** ...
S |***** | | | ** ..
| | | | *** .._d'_
| | | | ***
| | | | **
| | | | **D'
| | | |
| | | |
0+---------------------------------------------------------
M' M _m_
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 S_s_, 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:--
LAW 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:--
LAW 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.