The Intellectual Foundations of Political Economy
19th Century Classical Economists
Principles of Economics: An Introductory Volume
Book 5: The General Relations of Demand
|Chapter I||Chapter V||Chapter IX||Chapter XIII|
|Chapter II||Chapter VI||Chapter X||Chapter XIV|
|Chapter III||Chapter VII||Chapter XI||Chapter XV|
|Chapter IV||Chapter VIII||Chapter XII|
A business firm grows and attains great strength, and afterwards perhaps stagnates and decays; and at the turning point there is a balancing or equilibrium of the forces of life and decay: the latter part of Book IV has been chiefly occupied with such balancing of forces in the life and decay of a people, or of a method of industry or trading. And as we reach to the higher stages of our work, we shall need ever more and more to think of economic forces as resembling those which make a young man grow in strength, till he reaches his prime; after which he gradually becomes stiff and inactive, till at last he sinks to make room for other and more vigorous life. But to prepare the way for this advanced study we want first to look at a simpler balancing of forces which corresponds rather to the mechanical equilibrium of a stone hanging by an elastic string, or of a number of balls resting against one another in a basin.
We have now to examine the general relations of demand and supply; especially those which are connected with that adjustment of price, by which they are maintained in "equilibrium." This term is in common use and may be used for the present without special explanation. But there are many difficulties connected with it, which can only be handled gradually: and indeed they will occupy our attention during a great part of this Book.
Illustrations will be taken now from one class of economic problems and now from another, but the main course of the reasoning will be kept free from assumptions which specially belong to any particular class.
Thus it is not descriptive, nor does it deal constructively with real problems. But it sets out the theoretical backbone of our knowledge of the causes which govern value, and thus prepares the way for the construction which is to begin in the following Book. It aims not so much at the attainment of knowledge, as at the power to obtain and arrange knowledge with regard to two opposing sets of forces, those which impel man to economic efforts and sacrifices, and those which hold him back.
We must begin with a short and provisional account of markets: for that is needed to give precision to the ideas in this and the following Books. But the organization of markets is intimately connected both as cause and effect with money, credit, and foreign trade; a full study of it must therefore be deferred to a later volume, where it will be taken in connection with commercial and industrial fluctuations, and with combinations of producers and of merchants, of employers and employed.
2. When demand and supply are spoken of in relation to one another, it is of course necessary that the markets to which they refer should be the same. As Cournot says, "Economists understand by the term Market, not any particular market place in which things are bought and sold, but the whole of any region in which buyers and sellers are in such free intercourse with one another that the prices of the same goods tend to equality easily and quickly." (1) Or again as Jevons says: — "Originally a market was a public place in a town where provisions and other objects were exposed for sale; but the word has been generalized, so as to mean any body of persons who are in intimate business relations and carry on extensive transactions in any commodity. A great city may contain as many markets as there are important branches of trade, and these markets may or may not be localized. The central point of a market is the public exchange, mart or auction rooms, where the traders agree to meet and transact business. In London the Stock Market, the Corn Market, the Coal Market, the Sugar Market, and many others are distinctly localized; in Manchester the Cotton Market, the Cotton Waste Market, and others. But this distinction of locality is not necessary. The traders may be spread over a whole town, or region of country, and vet make a market, if they are, by means of fairs, meetings, published price lists, the post-office or otherwise, in close communication with each other." (2)
Thus the more nearly perfect a market is, the stronger is the tendency for the same price to be paid for the same thing at the same time in all parts of the market: but of course if the market is large, allowance must be made for the expense of delivering the goods to different purchasers; each of whom must be supposed to pay in addition to the market price a special charge on account of delivery. (3)
3. In applying economic reasonings in practice it is often difficult to ascertain how far the movements of supply and demand in any one place are influenced by those in another. It is clear that the general tendency of the telegraph, the printing-press and steam traffic is to extend the area over which such influences act and to increase their force. The whole Western World may, in a sense, be regarded as one market for many kinds of stock exchange securities, for the more valuable metals, and to a less extent for wool and cotton and even wheat; proper allowance being made for expenses of transport, in which may be included taxes levied by any customs houses through which the goods have to pass. For in all these cases the expenses of transport, including customs duties, are not sufficient to prevent buyers from all parts of the Western World from competing with one another for the same supplies.
There are many special causes which may widen or narrow the market of any particular commodity: but nearly all those things for which there is a very wide market are in universal demand, and capable of being easily and exactly described. Thus for instance cotton, wheat, and iron satisfy wants that are urgent and nearly universal. They can be easily described, so that they can be bought and sold by persons at a distance from one another and at a distance also from the commodities. If necessary, samples can be taken of them which are truly representative: and they can even be "graded," as is the actual practice with regard to grain in America, by an independent authority; so that the purchaser may be secure that what he buys will come up to a given standard, though he has never seen a sample of the goods which he is buying and perhaps would not be able himself to form an opinion on it if he did. (4)
Commodities for which there is a very wide market must also be such as will bear a long carriage: they must be somewhat durable, and their value must be considerable in proportion to their bulk. A thing which is so bulky that its price is necessarily raised very much when it is sold far away from the place in which it is produced, must as a rule have a narrow market. The market for common bricks for instance is practically confined to the near neighbourhood of the kilns in which they are made: they can scarcely ever bear a long carriage by land to a district which has any kilns of its own. But bricks of certain exceptional kinds have markets extending over a great part of England.
4. Let us then consider more closely the markets for things which satisfy in an exceptional way these conditions of being in general demand, cognizable and portable. They are, as we have said, stock exchange securities and the more valuable metals.
Any one share or bond of a public company, or any bond of a government is of exactly the same value as any other of the same issue: it can make no difference to any purchaser which of the two he buys. Some securities, principally those of comparatively small mining, shipping, and other companies, require local knowledge, and are not very easily dealt in except on the stock exchanges of provincial towns in their immediate neighbourhood. But the whole of England is one market for the shares and bonds of a large English railway. In ordinary times a dealer will sell, say, Midland Railway shares, even if he has not them himself; because he knows they are always coming into the market, and he is sure to be able to buy them.
But the strongest case of all is that of securities which are called "international," because they are in request in every part of the globe. They are the bonds of the chief governments, and of very large public companies such as those of the Suez Canal and the New York Central Railway. For bonds of this class the telegraph keeps prices at almost exactly the same level in all the stock exchanges of the world. If the price of one of them rises in New York or in Paris, in London or in Berlin, the mere news of the rise tends to cause a rise in other markets; and if for any reason the rise is delayed, that particular class of bonds is likely soon to be offered for sale in the high priced market under telegraphic orders from the other markets, while dealers in the first market will be making telegraphic purchases in other markets. These sales on the one hand, and purchases on the other, strengthen the tendency which the price has to seek the same level everywhere; and unless some of the markets are in an abnormal condition, the tendency soon becomes irresistible.
On the stock exchange also a dealer can generally make sure of selling at nearly the same price as that at which he buys; and he is often willing to buy first class stocks at a half, or a quarter, or an eighth, or in some cases even a sixteenth per cent less than he offers in the same breath to sell them at. If there are two securities equally good, but one of them belongs to a large issue of bonds, and the other to a small issue by the same government, so that the first is constantly coming on the market, and the latter but seldom, then the dealers will on this account alone require a larger margin between their selling price and their buying price in the latter case than in the former. (5) This illustrates well the great law, that the larger the market for a commodity the smaller generally are the fluctuations in its price, and the lower is the percentage on the turnover which dealers charge for doing business in it.
Stock exchanges then are the pattern on which markets have been, and are being formed for dealing in many kinds of produce which can be easily and exactly described, are portable and in general demand. The material commodities however which possess these qualities in the highest degree are gold and silver. For that very reason they have been chosen by common consent for use as money, to represent the value of other things: the world market for them is most highly organized, and will be found to offer many subtle illustrations of the actions of the laws which we are now discussing.
5. At the opposite extremity to international stock exchange securities and the more valuable metals are, firstly, things which must be made to order to suit particular individuals, such as well-fitting clothes; and, secondly, perishable and bulky goods, such as fresh vegetables, which can seldom be profitably carried long distances. The first can scarcely be said to have a wholesale market at all; the conditions by which their price is determined are those of retail buying and selling, and the study of them may be postponed. (6)
There are indeed wholesale markets for the second class, but they are confined within narrow boundaries; we may find our typical instance in the sale of the commoner kinds of vegetables in a country town. The market-gardeners in the neighbourhood have probably to arrange for the sale of their vegetables to the townspeople with but little external interference on either side. There may be some check to extreme prices by the power on the one side of selling, and on the other of buying elsewhere; but under ordinary circumstances the check is inoperative, and it may happen that the dealers in such a case are able to combine, and thus fix an artificial monopoly price; that is, a price determined with little direct reference to cost of production, but chiefly by a consideration of what the market will bear.
On the other hand, it may happen that some of the market-gardeners are almost equally near a second country town, and send their vegetables now to one and now to the other; and some people who occasionally buy in the first town may have equally good access to the second. The least variation in price will lead them to prefer the better market; and thus make the bargainings in the two towns to some extent mutually dependent. It may happen that this second town is in close communication with London or some other central market, so that its prices are controlled by the prices in the central market; and in that case prices in our first town also must move to a considerable extent in harmony with them. As news passes from mouth to mouth till a rumour spreads far away from its forgotten sources, so even the most secluded market is liable to be influenced by changes of which those in the market have no direct cognizance, changes that have had their origin far away and have spread gradually from market to market.
Thus at the one extreme are world markets in which competition acts directly from all parts of the globe; and at the other those secluded markets in which all direct competition from afar is shut out, though indirect and transmitted competition may make itself felt even in these; and about midway between these extremes lie the great majority of the markets which the economist and the business man have to study.
6. Again, markets vary with regard to the period of time which is allowed to the forces of demand and supply to bring themselves into equilibrium with one another, as well as with regard to the area over which they extend. And this element of Time requires more careful attention just now than does that of Space. For the nature of the equilibrium itself, and that of the causes by which it is determined, depend on the length of the period over which the market is taken to extend. We shall find that if the period is short, the supply is limited to the stores which happen to be at hand: if the period is longer, the supply will be influenced, more or less, by the cost of producing the commodity in question; and if the period is very long, this cost will in its turn be influenced, more or less, by the cost of producing the labour and the material things required for producing the commodity. These three classes of course merge into one another by imperceptible degrees. We will begin with the first class; and consider in the next chapter those temporary equilibria of demand and supply, in which "supply" means in effect merely the stock available at the time for sale in the market; so that it cannot be directly influenced by the cost of production.
1. Recherches sur les Principes Mathématiques de la Théorie des Richesses, ch. IV. See also above III, IV, section 7.
2. Theory of Political Economy, ch. IV.
3. Thus it is common to see the prices of bulky goods quoted as delivered "free on board" (f.o.b.) any vessel in a certain port, each purchaser having to make his own reckoning for bringing the goods home.
4. Thus the managers of a public or private "elevator," receive grain from a farmer, divide it into different grades, and return to him certificates for as many bushels of each grade as he has delivered. His grain is then mixed with those of other farmers; his certificates are likely to change hands several times before they reach a purchaser who demands that the grain shall be actually delivered to him; and little or none of what that purchaser receives may have come from the farm of the original recipient of the certificate.
5. In the case of shares of very small and little known companies, the difference between the price at which a dealer is willing to buy and that at which he will sell may amount to from five per cent. or more of the selling value. If he buys, he may have to carry this security a long time before he meets with any one who comes to take it from him, and meanwhile it may fall in value: while if he undertakes to deliver a security which he has not himself got and which does not come on the market every day, he may be unable to complete his contract without much trouble and expense.
6. A man may not trouble himself much about small retail purchases: he may give half-a-crown for a packet of paper in one shop which he could have got for two shillings in another. But it is otherwise with wholesale prices. A manufacturer cannot sell a ream of paper for six shillings while his neighbour is selling it at five. For those whose business it is to deal in paper know almost exactly the lowest price at which it can be bought, and will not pay more than this. The manufacturer has to sell at about the market price, that is at about the price at which other manufacturers are selling at the same time.
1. The simplest case of balance or equilibrium between. desire and effort is found when a person satisfies one of his wants by his own direct work. When a boy picks blackberries for his own eating, the action of picking is probably itself pleasurable for a while; and for some time longer the pleasure of eating is more than enough to repay the trouble of picking. But after he has eaten a good deal, the desire for more diminishes; while the task of picking begins to cause weariness, which may indeed be a feeling of monotony rather than of fatigue. Equilibrium is reached when at last his eagerness to play and his disinclination for the work of picking counterbalance the desire for eating. The satisfaction which he can get from picking fruit has arrived at its maximum: for up to that time every fresh picking has added more to his pleasure than it has taken away; and after that time any further picking would take away from his pleasure more than it would add. (1)
In a casual bargain that one person makes with another, as for instance when two backwoodsmen barter a rifle for a canoe, there is seldom anything that can properly be called an equilibrium of supply and demand: there is probably a margin of satisfaction on either side; for probably the one would be willing to give something besides the rifle for the canoe, if he could not get the canoe otherwise; while the other would in case of necessity give something besides the canoe for the rifle.
It is indeed possible that a true equilibrium may be arrived at under a system of barter; but barter, though earlier in history than buying and selling, is in some ways more intricate; and the simplest cases of a true equilibrium value are found in the markets of a more advanced state of civilization.
We may put aside as of little practical importance a class of dealings which has been much discussed. They relate to pictures by old masters, rare coins and other things, which cannot be "graded" at all. The price at which each is sold, will depend much on whether any rich persons with a fancy for it happen to be present at its sale. If not, it will probably be bought by dealers who reckon on being able to sell it at a profit; and the variations in the price for which the same picture sells at successive auctions, great as they are, would be greater still if it were not for the steadying influence of professional purchasers.
2. Let us then turn to the ordinary dealings of modern life; and take an illustration from a corn-market in a country town, and let us assume for the sake of simplicity that all the corn in the market is of the same quality. The amount which each farmer or other seller offers for sale at any price is governed by his own need for money in hand, and by his calculation of the present and future conditions of the market with which he is connected. There are some prices which no seller would accept, some which no one would refuse. There are other intermediate prices which would be accepted for larger or smaller amounts by many or all of the sellers. Everyone will try to guess the state of the market and to govern his actions accordingly. Let us suppose that in fact there are not more than 600 quarters, the holders of which are willing to accept as low a price as 35s.; but that holders of another hundred would be tempted by 36s.; and holders of yet another three hundred by 37s. Let us suppose also that a price of 37s. would tempt buyers for only 600 quarters; while another hundred could be sold at 36s., and yet another two hundred at 35s. These facts may be put out in a table thus: —
At the price Holders will be Buyer will be
willing to sell willing to buy
37s. 1000 quarters 600 quarters
36s. 700 " 700 "
35s. 600 " 900 "
Of course some of those who are really willing to take 36s. rather than leave the market without selling, will not show at once that they are ready to accept that price. And in like manner buyers will fence, and pretend to be less eager than they really are. So the price may be tossed hither and thither like a shuttlecock, as one side or the other gets the better in the "higgling and bargaining" of the market. But unless they are unequally matched; unless, for instance, one side is very simple or unfortunate in failing to gauge the strength of the other side, the price is likely to be never very far from 36s.; and it is nearly sure to be pretty close to 36s. at the end of the market. For if a holder thinks that the buyers will really be able to get at 36s. all that they care to take at that price, he will be unwilling to let slip past him any offer that is well above that price.
Buyers on their part will make similar calculations; and if at any time the price should rise considerably above 36s. they will argue that the supply will be much greater than the demand at that price: therefore even those of them who would rather pay that price than go unserved, wait; and by waiting they help to bring the price down. On the other hand, when the price is much below 36s., even those sellers who would rather take the price than leave the market with their corn unsold, will argue that at that price the demand will be in excess of the supply: so they will wait, and by waiting help to bring the price up.
The price of 36s. has thus some claim to be called the true equilibrium price: because if it were fixed on at the beginning, and adhered to throughout, it would exactly equate demand and supply (i.e. the amount which buyers were willing to purchase at that price would be just equal to that for which sellers were willing to take that price); and because every dealer who has a perfect knowledge of the circumstances of the market expects that price to be established If he sees the price differing much from 36s. he expects that a change will come before long, and by anticipating it he helps it to come quickly.
It is not indeed necessary for our argument that any dealers should have a thorough knowledge of the circumstances of the market. Many of the buyers may perhaps underrate the willingness of the sellers to sell, with the effect that for some time the price rules at the highest level at which any buyers can be found; and thus 500 quarters may be sold before the price sinks below 37s. But afterwards the price must begin to fall and the result will still probably be that 200 more quarters will be sold, and the market will close on a price of about 36s. For when 700 quarters have been sold, no seller will be anxious to dispose of any more except at a higher price than 36s., and no buyer will be anxious to purchase any more except at a lower price than 36s. In the same way if the sellers had underrated the willingness of the buyers to pay a high price, some of them might begin to sell at the lowest price they would take, rather than have their corn left on their hands, and in this case much corn might be sold at a price of 35s.; but the market would probably close on a price of 36s. and a total sale of 700 quarters. (2)
3. In this illustration there is a latent assumption which is in accordance with the actual conditions of most markets; but which ought to be distinctly recognized in order to prevent its creeping into those cases in which it is not justifiable. We tacitly assumed that the sum which purchasers were willing to pay, and which sellers were willing to take, for the seven hundredth quarter would not be affected by the question whether the earlier bargains had been made at a high or a low rate. We allowed for the diminution in the buyers' need of corn [its marginal utility to them] as the amount bought increased. But we did not allow for any appreciable change in their unwillingness to part with money [its marginal utility]; we assumed that that would be practically the same whether the early payments had been at a high or a low rate.
This assumption is justifiable with regard to most of the market dealings with which we are practically concerned. When a person buys anything for his own consumption, he generally spends on it a small part of his total resources; while when he buys it for the purposes of trade, he looks to re-selling it, and therefore his potential resources are not diminished. In either case there is no appreciable change in his willingness to part with money. There may indeed be individuals of whom this is not true; but there are sure to be present some dealers with large stocks of money at their command; and their influence steadies the market. (3)
The exceptions are rare and unimportant in markets for commodities; but in markets for labour they are frequent and important. When a workman is in fear of hunger, his need of money [its marginal utility to him] is very great; and, if at starting, he gets the worst of the bargaining, and is employed at low wages, it remains great, and he may go on selling his labour at a low rate. That is all the more probable because, while the advantage in bargaining is likely to be pretty well distributed between the two sides of a market for commodities, it is more often on the side of the buyers than on that of the sellers in a market for labour. Another difference between a labour market and a market for commodities arises from the fact that each seller of labour has only one unit of labour to dispose of. These are two among many facts, in which we shall find, as we go on, the explanation of much of that instinctive objection which the working classes have felt to the habit of some economists, particularly those of the employer class, of treating labour simply as a commodity and regarding the labour market as like every other market; whereas in fact the differences between the two cases, though not fundamental from the point of view of theory, are yet clearly marked, and in practice often very important.
The theory of buying and selling becomes therefore much more complex when we take account of the dependence of marginal utility on amount in the case of money as well as of the commodity itself. The practical importance of this consideration is not very great. But a contrast is drawn in Appendix F between barter and dealings in which one side of each exchange is in the form of general purchasing power. In barter a person 's stock of either commodity exchanged needs to be adjusted closely to his individual wants. If his stock is too large he may have no good use for it. If his stock is too small he may have some difficulty in finding any one who can conveniently give him what he wants and is also in need of the particular things of which he himself has a superfluity. But any one who has a stock of general purchasing power, can obtain any thing he wants as soon as he meets with any one who has a superfluity of that thing. he needs not to hunt about till he comes across "the double coincidence" of a person who can spare what he wants, and also wants what he can spare. Consequently every one, and especially a professional dealer, can afford to keep command over a large stock of money; and can therefore make considerable purchases without depleting his stock of money or greatly altering its marginal value.
1. See IV, I, section 2, and Note XII in the Mathematical Appendix.
2. A simple form of the influence which opinion exerts on the action of dealers, and therefore on market price, is indicated in this illustration: we shall be much occupied with more complex developments of it later on.
3. For instance a buyer is sometimes straitened for want of ready money, and has to let offers pass by him in no way inferior to others which he has gladly accepted: his own funds being exhausted, he could not perhaps borrow except on terms that would take away all the profit that the bargains had at first sight offered. But if the bargain is really a good one, some one else, who is not so straitened, is nearly sure to get hold of it.
Again, it is possible that several of those who had been counted as ready to sell corn at a price of 36s. were willing to sell only because they were in urgent need of a certain amount of ready money; if they succeeded in selling some corn at a high price, there might be a perceptible diminution in the marginal utility of ready money to them; and therefore they might refuse to sell for 36s. a quarter all the corn which they would have sold if the price had been 36s. throughout.
In this case the sellers in consequence of getting an advantage in bargaining at the beginning of the market might retain to the end a price higher than the equilibrium price. The price at which the market dosed would be an equilibrium price; and though not properly described as the equilibrium price, it would be very unlikely to diverge widely from that price.
Conversely, if the market had opened much to the disadvantage of the sellers and they had sold some corn very cheap, so that they remained in great want of ready money, the final utility of money to them might have remained so high that they would have gone on selling considerably below 36s. until the buyers had been supplied with all that they cared to take. The market would then close without the true equilibrium price having ever been reached, but a very near approach would have been made to it.
1. We have next to inquire what causes govern supply prices, that is prices which dealers are willing to accept for different amounts. In the last chapter we looked at the affairs of only a single day. and supposed the stocks offered for sale to be already in existence. But of course these stocks are dependent on the amount of wheat sown in the preceding year; and that, in its turn, was largely influenced by the farmers' guesses as to the price which they would get for it in this year. This is the point at which we have to work in the present chapter.
Even in the corn-exchange of a country town on a market-day the equilibrium price is affected by calculations of the future relations of production and consumption; while in the leading corn-markets of America and Europe dealings for future delivery already predominate and are rapidly weaving into one web all the leading threads of trade in corn throughout the whole world. Some of these dealings in "futures" are but incidents in speculative manoeuvres; but in the main they are governed by calculations of the world's consumption on the one hand, and of the existing stocks and coming harvests in the Northern and Southern hemispheres on the other. Dealers take account of the areas sown with each kind of grain, of the forwardness and weight of the crops, of the supply of things which can be used as substitutes for grain, and of the things for which grain can be used as a substitute. Thus, when buying or selling barley, they take account of the supplies of such things as sugar, which can be used as substitutes for it in brewing, and again of all the various feeding stuffs, a scarcity of which might raise the value of barley for consumption on the farm. If it is thought that the growers of any kind of grain in any part of the world have been losing money, and are likely to sow a less area for a future harvest; it is argued that prices are likely to rise as soon as that harvest comes into sight, and its shortness is manifest to all. Anticipations of that rise exercise an influence on present sales for future delivery, and that in its turn influences cash prices; so that these prices are indirectly affected by estimates of the expenses of producing further supplies.
But in this and the following chapters we are specially concerned with movements of price ranging over still longer periods than those for which the most far-sighted dealers in futures generally make their reckoning.. we have to consider the volume of production adjusting itself to the conditions of the market, and the normal price being thus determined at the position of stable equilibrium of normal demand and normal supply.
2. In this discussion we shall have to make frequent use of the terms cost and expenses of production; and some provisional account of them must be given before proceeding further.
We may revert to the analogy between the supply price and the demand price of a commodity. Assuming for the moment that the efficiency of production depends solely upon the exertions of the workers, we saw that "the price required to call forth the exertion necessary for producing any given amount of a commodity may be called the supply price for that amount, with reference of course to a given unit of time." (1) But now we have to take account of the fact that the production of a commodity generally requires many different kinds of labour and the use of capital in many forms. The exertions of all the different kinds of labour that are directly or indirectly involved in making it; together with the abstinences or rather the waitings required for saving the capital used in making it: all these efforts and sacrifices together will be called the real cost of production of the commodity. The sums of money that have to be paid for these efforts and sacrifices will be called either its money cost of production, or, for shortness, its expenses of production; they are the prices which have to be paid in order to call forth an adequate supply of the efforts and waitings that are required for making it; or, in other words, they are its supply price. (2)
The analysis of the expenses of production of a commodity might be carried backward to any length; but it is seldom worth while to go back very far. It is for instance often sufficient to take the supply prices of the different kinds of raw materials used in any manufacture as ultimate facts, without analysing these supply prices into the several elements of which they are composed; otherwise indeed the analysis would never end. We may then arrange the things that are required for making a commodity into whatever groups are convenient, and call them its factors of production.
Its expenses of production when any given amount of it is produced are thus the supply prices of the corresponding quantities of its factors of production. And the sum of these is the supply price of that amount of the commodity.
3. The typical modern market is often regarded as that in which manufacturers sell goods to wholesale dealers at prices into which but few trading expenses enter. But taking a broader view, we may consider that the supply price of a commodity is the price at which it will be delivered for sale to that group of persons whose demand for it we are have considering; or, in other words, in the market which we have in view. On the character of that market will depend how many trading expenses have to be reckoned to make up the supply price. (3) For instance, the supply price of wood in the neighbourhood of Canadian forests often consists almost exclusively of the price of the labour of lumber men: but the supply price of the same wood in the wholesale London market consists in a large measure of freights; while its supply price to a small retail buyer in an English country town is more than half made up of the charges of the railways and middlemen who have brought what he wants to his doors, and keep a stock of it ready for him. Again, the supply price of a certain kind of labour may for some purposes be divided up into the expenses of rearing, of general education and of special trade education. The possible combinations are numberless; and though each may have incidents of its own which will require separate treatment in the complete solution of any problem connected with it, yet all such incidents may be ignored, so far as the general reasonings of this Book are concerned.
In calculating the expenses of production of a commodity we must take account of the fact that changes in the amounts produced are likely, even when there is no new invention, to be accompanied by changes in the relative quantities of its several factors of production. For instance, when the scale of production increases, horse or steam power is likely to be substituted for manual labour; materials are likely to be brought from a greater distance and in greater quantities, thus increasing those expenses of production which correspond to the work of carriers, middlemen and traders of all kinds.
As far as the knowledge and business enterprise of the producers reach, they in each case choose those factors of production which are best for their purpose; the sum of the supply prices of those factors which are used is, as a rule, less than the sum of the supply prices of any other set of factors which could be substituted for them; and whenever it appears to the producers that this is not the case, they will, as a rule, set to work to substitute the less expensive method. And further on we shall see how in a somewhat similar way society substitutes one undertaker for another who is less efficient in proportion to his charges. We may call this, for convenience of reference, The principle of substitution.
The applications of this principle extend over almost every field of economic inquiry. (4)
4. The position then is this: we are investigating the equilibrium of normal demand and normal supply in their most general form; we are neglecting those features which are special to particular parts of economic science, and are confining our attention to those broad relations which are common to nearly the whole of it. Thus we assume that the forces of demand and supply have free play; that there is no close combination among dealers on either side, but each acts for himself, and there is much free competition; that is, buyers generally compete freely with buyers, and sellers compete freely with sellers. But though everyone acts for himself, his knowledge of what others are doing is supposed to be generally sufficient to prevent him from taking a lower or paying a higher price than others are doing. This is assumed provisionally to be true both of finished goods and of their factors of production, of the hire of labour and of the borrowing of capital. We have already inquired to some extent, and we shall have to inquire further, how far these assumptions are in accordance with the actual facts of life. But meanwhile this is the supposition on which we proceed; we assume that there is only one price in the market at one and the same time; it being understood that separate allowance is made, when necessary, for differences in the expense of delivering goods to dealers in different parts of the market; including allowance for the special expenses of retailing, if it is a retail market.
In such a market there is a demand price for each amount of the commodity, that is, a price at which each particular amount of the commodity can find purchasers in a day or week or year. The circumstances which govern this price for any given amount of the commodity vary in character from one problem to another; but in every case the more of a thing is offered for sale in a market the lower is the price at which it will find purchasers; or in other words, the demand price for each bushel or yard diminishes with every increase in the amount offered.
The unit of time may be chosen according to the circumstances of each particular problem: it may be a day, a month, a year, or even a generation: but in every case it must be short relatively to the period of the market under discussion. It is to be assumed that the general circumstances of the market remain unchanged throughout this period; that there is, for instance, no change in fashion or taste, no new substitute which might affect the demand, no new invention to disturb the supply.
The conditions of normal supply are less definite; and a full study of them must be reserved for later chapters. They will be found to vary in detail with the length of the period of time to which the investigation refers; chiefly because both the material capital of machinery and other business plant, and the immaterial capital of business skill and ability and organization, are of slow growth and slow decay.
Let us call to mind the "representative firm," whose economies of production, internal and external, are dependent on the aggregate volume of production of the commodity that it makes; (5) and, postponing all further study of the nature of this dependence, let us assume that the normal supply price of any amount of that commodity may be taken to be its normal expenses of production (including gross earnings of management (6)) by that firm. That is, let us assume that this is the price the expectation of which will just suffice to maintain the existing aggregate amount of production; some firms meanwhile rising and increasing their output, and others falling and diminishing theirs; but the aggregate production remaining unchanged. A price higher than this would increase the growth of the rising firms, and slacken, though it might not arrest, the decay of the falling firms; with the net result of an increase in the aggregate production. On the other hand, a price lower than this would hasten the decay of the falling firms, and slacken the growth of the rising firms; and on the whole diminish production: and a rise or fall of price would affect in like manner though perhaps not in an equal degree those great joint-stock companies which often stagnate, but seldom die.
5. To give definiteness to our ideas let us take an illustration from the woollen trade. Let us suppose that a person well acquainted with the woollen trade sets himself to inquire what would be the normal supply price of a certain number of millions of yards annually of a particular kind of cloth. He would have to reckon (i) the price of the wool, coal, and other materials which would be used up in making it, (ii) wear-and-tear and depreciation of the buildings, machinery and other fixed capital, (iii) interest and insurance on all the capital, (iv) the wages of those who work in the factories, and (v) the gross earnings of management (including insurance against loss), of those who undertake the risks, who engineer and superintend the working. He would of course estimate the supply prices of all these different factors of production of the cloth with reference to the amounts of each of them that would be wanted, and on the supposition that the conditions of supply would be normal; and he would add them all together to find the supply price of the cloth.
Let us suppose a list of supply prices (or a supply schedule) made on a similar plan to that of our list of demand prices: (7) the supply price of each amount of the commodity in a year, or any other unit of time, being written against that amount. (8) As the flow, or (annual) amount of the commodity increases, the supply price may either increase or diminish; or it may even alternately increase and diminish. (9) For if nature is offering a sturdy resistance to man's efforts to wring from her a larger supply of raw material, while at that particular stage there is no great room for introducing important new economies into the manufacture, the supply price will rise; but if the volume of production were greater, it would perhaps be profitable to substitute largely machine work for hand work and steam power for muscular force; and the increase in the volume of production would have diminished the expenses of production of the commodity of our representative firm. But those cases in which the supply price falls as the amount increases involve special difficulties of their own; and they are postponed to chapter XII of this Book.
6. When therefore the amount produced (in a unit of time) is such that the demand price is greater than the supply price, then sellers receive more than is sufficient to make it worth their while to bring goods to market to that amount; and there is at work an active force tending to increase the amount brought forward for sale. On the other hand, when the amount produced is such that the demand price is less than the supply price, sellers receive less than is sufficient to make it worth their while to bring goods to market on that scale; so that those who were just on the margin of doubt as to whether to go on producing are decided not to do so, and there is an active force at work tending to diminish the amount brought forward for sale. When the demand price is equal to the supply price, the amount produced has no tendency either to be increased or to be diminished; it is in equilibrium.
When demand and supply are in equilibrium, the amount of the commodity which is being produced in a unit of time may be called the equilibrium-amount, and the price at which it is being sold may be called the equilibrium-price.
Such an equilibrium is stable; that is, the price, if displaced a little from it, will tend to return, as a pendulum oscillates about its lowest point; and it will be found to be a characteristic of stable equilibria that in them the demand price is greater than the supply price for amounts just less than the equilibrium amount, and vice versa. For when the demand price is greater than the supply price, the amount produced tends to increase. Therefore, if the demand price is greater than the supply price for amounts just less than an equilibrium amount; then, if the scale of production is temporarily diminished somewhat below that equilibrium amount, it will tend to return; thus the equilibrium is stable for displacements in that direction. If the demand price is greater than the supply price for amounts just less than the equilibrium amount, it is sure to be less than the supply price for amounts just greater: and therefore, if the scale of production is somewhat increased beyond the equilibrium position, it will tend to return; and the equilibrium will be stable for displacements in that direction also.
When demand and supply are in stable equilibrium, if any accident should move the scale of production from its equilibrium position, there will be instantly brought into play forces tending to push it back to that position; just as, if a stone hanging by a string is displaced from its equilibrium position, the force of gravity will at once tend to bring it back to its equilibrium position. The movements of the scale of production about its position of equilibrium will be of a somewhat similar kind. (10)
But in real life such oscillations are seldom as rhythmical as those of a stone hanging freely from a string; the comparison would be more exact if the string were supposed to hang in the troubled waters of a mill-race, whose stream was at one time allowed to flow freely, and at another partially cut off. Nor are these complexities sufficient to illustrate all the disturbances with which the economist and the merchant alike are forced to concern themselves. If the person holding the string swings his hand with movements partly rhythmical and partly arbitrary, the illustration will not outrun the difficulties of some very real and practical problems of value. For indeed the demand and supply schedules do not in practice remain unchanged for a long time together, but are constantly being changed; and every change in them alters the equilibrium amount and the equilibrium price, and thus gives new positions to the centres about which the amount and the price tend to oscillate.
These considerations point to the great importance of the element of time in relation to demand and supply, to the study of which we now proceed. We shall gradually discover a great many different limitations of the doctrine that the price at which a thing can be produced represents its real cost of production, that is, the efforts and sacrifices which have been directly and indirectly devoted to its production. For, in an age of rapid change such as this, the equilibrium of normal demand and supply does not thus correspond to any distinct relation of a certain aggregate of pleasures got from the consumption of the commodity and an aggregate of efforts and sacrifices involved in producing it: the correspondence would not be exact, even if normal earnings and interest were exact measures of the efforts and sacrifices for which they are the money payments. This is the real drift of that much quoted, and much-misunderstood doctrine of Adam Smith and other economists that the normal, or "natural," value of a commodity is that which economic forces tend to bring about in the long run. It is the average value which economic forces would bring about if the general conditions of life were stationary for a run of time long enough to enable them all to work out their full effect. (11)
But we cannot foresee the future perfectly. The unexpected may happen; and the existing tendencies may be modified before they have had time to accomplish what appears now to be their full and complete work. The fact that the general conditions of life are not stationary is the source of many of the difficulties that are met with in applying economic doctrines to practical problems.
Of course Normal does not mean Competitive. Market prices and Normal prices are alike brought about by a multitude of influences, of which some rest on a moral basis and some on a physical; of which some are competitive and some are not. It is to the persistence of the influences considered, and the time allowed for them to work out their effects that we refer when contrasting Market and Normal price, and again when contrasting the narrower and the broader use of the term Normal price. (12)
7. The remainder of the present volume will be chiefly occupied with interpreting and limiting this doctrine that the value of a thing tends in the long run to correspond to its cost of production. In particular the notion of equilibrium, which has been treated rather slightly in this chapter, will be studied more carefully in chapters V and XII of this Book: and some account of the controversy whether "cost of production" or "utility" governs value will be given in Appendix I. But it may be well to say a word or two here on this last point.
We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens.
In the same way, when a thing already made has to be sold, the price which people will be willing to pay for it will be governed by their desire to have it, together with the amount they can afford to spend on it. Their desire to have it depends partly on the chance that, if they do not buy it, they will be able to get another thing like it at as low a price: this depends on the causes that govern the supply of it, and this again upon cost of production. But it may so happen that the stock to be sold is practically fixed. This, for instance, is the case with a fish market, in which the value of fish for the day is governed almost exclusively by the stock on the slabs in relation to the demand: and if a person chooses to take the stock for granted, and say that the price is governed by demand, his brevity may perhaps be excused so long as he does not claim strict accuracy. So again it may be pardonable, but it is not strictly accurate to say that the varying prices which the same rare book fetches, when sold and resold at Christie 's auction room, are governed exclusively by demand.
Taking a case at the opposite extreme, we find some commodities which conform pretty closely to the law of constant return; that is to say, their average cost of production will be very nearly the same whether they are produced in small quantities or in large. In such a case the normal level about which the market price fluctuates will be this definite and fixed (money) cost of production. If the demand happens to be great, the market price will rise for a time above the level; but as a result production will increase and the market price will fall: and conversely, if the demand falls for a time below its ordinary level.
In such a case, if a person chooses to neglect market fluctuations, and to take it for granted that there will anyhow be enough demand for the commodity to insure that some of it, more or less, will find purchasers at a price equal to this cost of production, then he may be excused for ignoring the influence of demand, and speaking of (normal) price as governed by cost of production — provided only he does not claim scientific accuracy for the wording of his doctrine, and explains the influence of demand in its right place.
Thus we may conclude that, as a general rule, the shorter the period which we are considering, the greater must be the share of our attention which is given to the influence of demand on value; and the longer the period, the more important will be the influence of cost of production on value. For the influence of changes in cost of production takes as a rule a longer time to work itself out than does the influence of changes in demand. The actual value at any time, the market value as it is often called, is often more influenced by passing events and by causes whose action is fitful and short lived, than by those which work persistently. But in long periods these fitful and irregular causes in large measure efface one another's influence; so that in the long run persistent causes dominate value completely. Even the most persistent causes are however liable to change. For the whole structure of production is modified, and the relative costs of production of different things are permanently altered, from one generation to another.
When considering costs from the point of view of the capitalist employer, we of course measure them in money; because his direct concern with the efforts needed for the work of his employees lies in the money payments he must make. His concern with the real costs of their effort and of the training required for it is only indirect, though a monetary assessment of his own labour is necessary for some problems, as will be seen later on. But when considering costs from the social point of view, when inquiring whether the cost of attaining a given result is increasing or diminishing with changing economic conditions, then we are concerned with the real costs of efforts of various qualities, and with the real cost of waiting. If the purchasing power of money, in terms of effort has remained about constant, and if the rate of remuneration for waiting has remained about constant, then the money measure of costs corresponds to the real costs: but such a correspondence is never to be assumed lightly. These considerations will generally suffice for the interpretation of the term Cost in what follows, even where no distinct indication is given in the context.
1. IV, I, section 2.
2. Mill and some other economists have followed the practice of ordinary life in using the term Cost of production in two senses, sometimes to signify the difficulty of producing a thing, and sometimes to express the outlay of money that has to be incurred in order to induce people to overcome this difficulty and produce it. But by passing from one use of the term to the other without giving explicit warning, they have led to many misunderstandings and much barren controversy. The attack on Mill's doctrine of Cost of Production in relation to Value, which is made in Cairnes' leading Principles, was published just after Mill's death; and unfortunately his interpretation of Mill's words was generally accepted as authoritative, because he was regarded as a follower of Mill. But in an article by the present writer on "Mill's Theory of Value" (Fortnightly Review, April 1876) it is argued that Cairnes had mistaken Mill's meaning, and had really seen not more but less of the truth than Mill had done.
The expenses of production of any amount of a raw commodity may best be estimated with reference to the "margin of production" at which no rent is paid. But this method of speaking has great difficulties with regard to commodities that obey the law of increasing return. It seemed best to note this point in passing: it will be fully discussed later on, chiefly in ch. XII.
3. We have already (II, iii) noticed that the economic use of the term "production", includes the production of new utilities by moving a thing from a place in which it is less wanted to a place in which it is more wanted, or by helping consumers to satisfy their needs.
4. See III, v and IV, VII, section 8.
5. See IV XIII, section 2.
6. See last paragraph of IV, XII.
7. See III, III, section 4.
8. Measuring, as in the case of the demand curve, amounts of the commodity along Ox and prices parallel to 0y, We get for each point M along Ox a line MP drawn at right angles to it measuring the supply price for the amount OM, the extremity of which, P, may be called a supply point; this price MP being made up of the supply prices of the several factors of production for the amount OM. The locus of P may be called the supply curve.
Suppose, for instance, that we classify the expenses of production of our representative firm, when an amount OM of cloth is being produced under the heads of (i) Mp1' the supply price of the wool and other circulating capital which would be consumed in making it, (ii) p1 p2 the corresponding wearand-tear and depreciation on buildings, machinery and other fixed capital; (iii) p2p3 the interest and insurance on all the capital, (iv) p3p4 the wages of those who work in the factory, and (v) p4P the gross earnings of management, etc. of those who undertake the risks and direct the work. Thus as M moves from O towards the right p1' p2, p3' p4 will each trace out a curve, and the ultimate supply curve traced out by P will be thus shown as obtained by superimposing the supply curves for the several factors of production of the cloth.
It must be remembered that these supply prices are the prices not of units of the several factors but of those amounts of the several factors which for producing a yard of the cloth. Thus, for instance, p3p4 is the supply price are required not of any fixed amount of labour but of that amount of labour which is employed in making a yard where there is an aggregate production of OM yards. (See above, section 3.) We need not trouble ourselves to consider just here whether the groundrent of the factory must be put into a class by itself: this belongs to a group of questions which will be discussed later. We are taking no notice of rates and taxes, for which he would of course have to make his account.
9. That is, a point moving along the supply curve towards the right may either rise or fall, or even it may alternately rise and fall; in other words, the supply curve may be inclined positively or negatively, or even at some parts of its course it may be inclined positively and at others negatively. (See footnote on p. 99.)
10. Compare V, I, section 1. To represent the equilibrium of demand and supply geometrically we may draw the demand and supply curves together as in Fig. 19. If then OR represents the rate at which production is being actually carried on, and Rd the demand price is greater than Rs the supply price, the production is exceptionally profitable, and will be increased. R, the amount-index, as we may call it, will move to the right. On the other hand, if Rd is less than Rs, R will move to the left. If Rd is equal to Rs, that is, if R is vertically under a point of intersection of the curves, demand and supply are in equilibrium.
This may be taken as the typical diagram for stable equilibrium for a commodity that obeys the law of diminishing return. But if we had made SS' a horizontal straight line, we should have represented the case of "constant return," in which the supply price is the same for all amounts of the commodity. And if we had made SS' inclined negatively, but less steeply than DD' (the necessity for this condition will appear more fully later on), we should have got a case of stable equilibrium for a commodity which obeys the law of increasing return. In either case the above reasoning remains unchanged without the alteration of a word or a letter; but the last case introduces difficulties which we have arranged to postpone.
11. See below V, v, section 2 and Appendix H, section 4.
12. See above, pp. 34-6.
1. The first difficulty to be cleared up in our study of normal values, is the nature of the motives which govern the investment of resources for a distant return. It will be well to begin by watching the action of a person who neither buys what he wants nor sells what he makes, but works on his own behalf; and who therefore balances the, efforts and sacrifices which he makes on the one hand against the pleasures which he expects to derive from their fruit on the other, without the intervention of any money payments at all.
Let us then take the case of a man who builds a house for himself on land, and of materials, which nature supplies gratis; and who makes his implements as he goes, the labour of making them being counted as part of the labour of building the house. He would have to estimate the efforts required for building on any proposed plan; and to allow almost instinctively an amount increasing in geometrical proportion (a sort of compound interest) for the period that would elapse between each effort and the time when the house would be ready for his use. The utility of the house to him when finished would have to compensate him not only for the efforts, but for the waitings. (1)
If the two motives, one deterring, the other impelling, seemed equally balanced, he would be on the margin of doubt. Probably the gain would much more than outweigh the "real" cost with regard to some part of the house. But as he turned over more and more ambitious plans, he would at last find the advantages of any further extension balanced by the efforts and waitings required for making it; and that extension of the building would be on the outer limit, or margin of profitableness of the investment of his capital.
There would probably be several ways of building parts of the house; some parts for instance might almost equally well be built of wood or of rough stones: the investment of capital on each plan for each part of the accommodation would be compared with the advantages offered thereby, and each would be pushed forward till the outer limit or margin of profitableness had been reached. Thus there would be a great many margins of profitableness: one corresponding to each kind of plan on which each kind of accommodation might be provided.
2. This illustration may serve to keep before us the way in which the efforts and sacrifices which are the real cost of production of a thing, underlie the expenses which are its money cost. But, as has just been remarked, the modern business man commonly takes the payments which he has to make, whether for wages or raw material, as he finds them; without staying to inquire how far they are an accurate measure of the efforts and sacrifices to which they correspond. His expenditure is generally made piece-meal; and the longer he expects to wait for the fruit of any outlay, the richer must that fruit be in order to compensate him. The anticipated fruit may not be certain; and in that case he will have to allow for the risk of failure. After making that allowance, the fruit of the outlay must be expected to exceed the outlay itself by an amount which, independently of his own remuneration, increases at compound interest in proportion to the time of waiting. (2) Under this head are to be entered the heavy expenses, direct and indirect, which every business must incur in building up its connection.
For brevity we may speak of any element of outlay (allowance being made for the remuneration of the undertaker himself) when increased by compound interest in this way, as accumulated; just as we used the term discounted to represent the present value of a future gratification. Each element of outlay has then to be accumulated for the time which will elapse between its being incurred and its bearing fruit; and the aggregate of these accumulated elements is the total outlay involved in the enterprise. The balance between efforts and the satisfactions resulting from them may be made up to any day that is found convenient. But whatever day is chosen, one simple rule must be followed: — Every element whether an effort or a satisfaction, which dates from a time anterior to that day, must have compound interest for the interval accumulated upon it: and every element, which dates from a time posterior to that day, must have compound interest for the interval discounted from it. If the day be anterior to the beginning of the enterprise, then every element must be discounted. But if, as is usual in such cases, the day be that when the efforts are finished, and the house is ready for use; then the efforts must carry compound interest up to that day, and the satisfactions must all be discounted back to that day.
Waiting is an element of cost as truly as effort is, and it is entered in the cost when accumulated: it is therefore of course not counted separately. Similarly, on the converse side, whatever money or command over satisfaction "comes in" at any time is part of the income of that time: if the time is before the day for which accounts are balanced up, then it must be accumulated up to that day; if after it must be discounted back. If, instead of being converted to immediate enjoyment, it is used as a stored up source of future income, that later income must not be counted as an additional return to the investment. (3)
If the enterprise were, say, to dig out a dock-basin on a contract, the payment for which would be made without fail when the work was finished; and if the plant used in the work might be taken to be worn out in the process, and valueless at the end of it; then the enterprise would be just remunerative if this aggregate of outlays, accumulated up to the period of payment, were just equal to that payment.
But, as a rule, the proceeds of the sales come in gradually. and we must suppose a balance-sheet struck, looking both backwards and forwards. Looking backwards we should sum up the net outlays, and add in accumulated compound interest on each element of outlay. Looking forwards we should sum up all net incomings, and from the value of each subtract compound interest for the period during which it would be deferred. The aggregate of the net incomings so discounted would be balanced against the aggregate of the accumulated outlays: and if the two were just equal, the business would be just remunerative. In calculating the outgoings the head of the business must reckon in the value of his own work. (4)
3. At the beginning of his undertaking, and at every successive stage, the alert business man strives so to modify his arrangements as to obtain better results with a given expenditure, or equal results with a less expenditure. In other words, he ceaselessly applies the principle of substitution, with the purpose of increasing his profits; and, in so doing, he seldom fails to increase the total efficiency of work, the total power over nature which man derives from organization and knowledge.
Every locality has incidents of its own which affect in various ways the methods of arrangement of every class of business that is carried on in it: and even in the same place and the same trade no two persons pursuing the same aims will adopt exactly the same routes. The tendency to variation is a chief cause of progress; and the abler are the undertakers in any trade the greater will this tendency be. In some trades, as for instance cotton-spinning, the possible variations are confined within narrow limits; no one can hold his own at all who does not use machinery, and very nearly the latest machinery, for every part of the work. But in others, as for instance in some branches of the wood and metal trades, in farming, and in shopkeeping, there can be great variations. For instance, of two manufacturers in the same trade, one will perhaps have a larger wages bill and the other heavier charges on account of machinery; of two retail dealers one will have a larger capital locked up in stock and the other will spend more on advertisements and other means of building up the immaterial capital of a profitable trade connection. And in minor details the variations are numberless.
Each man's actions are influenced by his special opportunities and resources, as well as by his temperament and his associations: but each, taking account of his own means, will push the investment of capital in his business in each several direction until what appears in his judgment to be the outer limit, or margin, of profitableness is reached; that is, until there seems to him no good reason for thinking that the gains resulting from any further investment in that particular direction would compensate him for his outlay. The margin of profitableness, even in regard to one and the same branch or sub-branch of industry, is not to be regarded as a mere point on any one fixed line of possible investment; but as a boundary line of irregular shape cutting one after another every possible line of investment.
4. This principle of substitution is closely connected with, and is indeed partly based on, that tendency to a diminishing rate of return from any excessive application of resources or of energies in any given direction, which is in accordance with general experience. It is thus linked up with the broad tendency of a diminishing return to increased applications of capital and labour to land in old countries which plays a prominent part in classical economics. And it is so closely akin to the principle of the diminution of marginal utility that results in general from increased expenditure, that some applications of the two principles are almost identical. It has already been observed that new methods of production bring into existence new commodities, or lower the price of old commodities so as to bring them within the reach of increased numbers of consumers: that on the other hand changes in the methods and volume of consumption cause new developments of production, and new distribution of the resources of production: and that though some methods of consumption which contribute most to man's higher life, do little if anything towards furthering the production of material wealth, yet production and consumption are intimately correlated. (5) But now we are to consider more in detail how the distribution of the resources of production between different industrial undertakings is the counterpart and reflex of the distribution of the consumers' purchases between different classes of commodities. (6)
Let us revert to the primitive housewife, who having "a limited number of hanks of yarn from the year's shearing, considers all the domestic wants for clothing and tries to distribute the yarn between them in such a way as to contribUte as much as possible to the family well-being. She will think she has failed if, when it is done, she has reason to regret that she did not apply more to making, say, socks, and less to vests. But if, on the other hand, she hit on the right points to stop at, then she made just so many socks and vests that she got an equal amount of good out of the last bundle of yarn that she applied to socks, and the last she applied to vests." (7) If it happened that two ways of making a vest were open to her, which were equally satisfactory as regards results, but of which one, while using up a little more yarn, involved a little less trouble than the other; then her problems would be typical of those of the larger business world. They would include first decisions as to the relative urgency of various ends; secondly, decisions as to the relative advantages of various means of attaining each end; thirdly, decisions, based on these two sets of decisions, as to the margin up to which she could most profitably carry the application of each means towards each end.
These three classes of decisions have to be taken on a larger scale by the business man, who has more complex balancings and adjustments to make before reaching each decision. (8) Let us take an illustration from the building trade. Set us watch the operations of a "speculative builder" in the honourable sense of the term: that is, a man who sets out to erect honest buildings in anticipation of general demand; who bears the penalty of any error in his judgment; and who, if his judgment is approved by events, benefits the community as well as himself. Let him be considering whether to erect dwelling houses, or warehouses, or factories or shops. He is trained to form at once a fairly good opinion as to the method of working most suitable for each class of building, and to make a rough estimate of its cost. He estimates the cost of various sites adapted for each class of building: and he reckons in the price that he would have to pay for any site as a part of his capital expenditure, just as he does the expense to which he would be put for laying foundations in it, and so on. He brings this estimate of cost into relation with his estimate of the price he is likely to get for any given building, together with its site. If he can find no case in which the demand price exceeds his outlays by enough to yield him a good profit, with some margin against risks, he may remain idle. Or he may possibly build at some risk in order to keep his most trusty workmen together, and to find some occupation for his plant and his salaried assistance: but more on this later on.
Suppose him now to have decided that (say) villa residences of a certain type, erected on a plot of ground which he can buy, are likely to yield him a good profit. The main end to be sought being thus settled, he sets himself to study more carefully the means by which it is to be obtained, and, in connection with that study, to consider possible modifications in the details of his plans.
Given the general character of the houses to be built, he will have to consider in what proportions to use various materials-brick, stone, steel, cement, plaster, wood, etc., with a view to obtaining the result which will contribute most, in proportion to its cost, to the efficiency of the house in gratifying the artistic taste of purchasers and in ministering to their comfort. In thus deciding what is the best distribution of his resources between various commodities, he is dealing with substantially the same problem as the primitive housewife, who has to consider the most economic distribution of her yarn between the various needs of her household.
Like her, he has to reflect that the yield of benefit which any particular use gave would be relatively large up to a certain point, and would then gradually diminish. Like her, he has so to distribute his resources that they have the same marginal utility in each use: he has to weigh the loss that would result from taking away a little expenditure here, with the gain that would result from adding a little there. In effect both of them work on lines similar to those which guide the farmer in so adjusting the application of his capital and labour to land, that no field is stinted of extra cultivation to which it would have given a generous return, and none receives so great an expenditure as to call into strong activity the tendency to diminishing return in agriculture. (9)
Thus it is that the alert business man, as has just been said, "pushes the investment of capital in his business in each several direction until what appears in his judgment to be the outer limit, or margin, of profitableness is reached; that is, until there seems to him no good reason for thinking that the gains resulting from any further investment in that particular direction would compensate him for his outlay." He never assumes that roundabout methods will be remunerative in the long run. But he is always on the look out for roundabout methods that promise to be more effective in proportion to their cost than direct methods: and he adopts the best of them, if it lies within his means.
5. Some technical terms relating to costs may be considered here. When investing his capital in providing the means of carrying on an undertaking, the business man looks to being recouped by the price obtained for its various products; and he expects to be able under normal conditions to charge for each of them a sufficient price; that is, one which will not only cover the special, direct, or prime cost, but also bear its proper share of the general expenses of the business; and these we may call its general, or supplementary cost. These two elements together make its total cost.
There are great variations in the usage of the term Prime cost in business. But it is taken here in a narrow sense. Supplementary costs are taken to include standing charges on account of the durable plant in which much of the capital of the business has been invested, and also the salaries of the upper employees: for the charges to which the business is put on account of their salaries cannot generally be adapted quickly to changes in the amount of work there is for them to do. There remains nothing but the (money) cost of the raw material used in making the commodity and the wages of that part of the labour spent on it which is paid by the hour or the piece and the extra wear-and-tear of plant. This is the special cost which a manufacturer has in view, when his works are not fully employed, and he is calculating the lowest price at which it will be worth his while to accept an order, irrespectively of any effect that his action may have in spoiling the market for future orders, and trade being slack at the time. But in fact he must as a rule take account of this effect: the price at which it is just worth his while to produce, even when trade is slack, is in practice generally a good deal above this prime cost, as we shall see later on. (10)
6. Supplementary costs must generally be covered by the selling price to some considerable extent in the short run. And they must be completely covered by it in the long run; for, if they are not, production will be checked. Supplementary costs are of many different kinds; and some of them differ only in degree from prime costs. For instance, if an engineering firm is in doubt whether to accept an order at a rather low price for a certain locomotive, the absolute prime costs include the value of the raw material and the wages of the artisans and labourers employed on the locomotive. But there is no clear rule as to the salaried staff: for, if work is slack, they will probably have some time on their hands; and their salaries will therefore commonly be classed among general or supplementary costs. The line of division is however often blurred over. For instance, foremen and other trusted artisans are seldom dismissed merely because of a temporary scarcity of work; and therefore an occasional order may be taken to fill up idle time, even though its price does not cover their salaries and wages. That is they may not be regarded as prime costs in such a case. But, of course the staff in the office can be in some measure adjusted to variations in the work of the firm by leaving vacancies unfilled and even by weeding out inefficient men during slack times; and by getting extra help or putting out some of the work in busy times.
If we pass from such tasks to larger and longer tasks, as for instance the working out a contract to deliver a great number of locomotives gradually over a period of several years, then most of the office work done in connection with that order must be regarded as special for it: for if it had been declined and nothing else taken in its place, the expenses under the head of salaries could have been reduced almost to a proportionate extent.
The case is much stronger when we consider a fairly steady market for any class of staple manufactures extending over a long time. For then the outlay incurred for installing specialized skill and organization, the permanent office staff, and the durable plant of the workshops can all be regarded as part of the costs necessary for the process of production. That outlay will be increased up to a margin at which the branch of manufacture seems in danger of growing too fast for its market.
In the next chapter the argument of Chapter III and of this chapter is continued. It is shown in more detail how those costs which most powerfully act on supply and therefore on price, are limited to a narrow and arbitrary group in the case of a single contract for, say, a locomotive; but are much fuller, and correspond much more truly to the broad features of industrial economy in the case of a continuous supply to a fairly steady general market: the influence of cost of production on value does not show itself clearly except in relatively long periods; and it is to be estimated with regard to a whole process of production rather than a particular locomotive, or a particular parcel of goods. And a similar study is made in Chapters VIII-X of variations in the character of those prime and supplementary costs which consist of charges for interest (or profits) on investments in agents of production, according as the periods of the market under consideration are long or short.
Meanwhile it may be noticed that the distinction between prime and supplementary costs operates in every phase of civilization, though it is not likely to attract much attention except in a capitalistic phase. Robinson Crusoe had to do only with real costs and real satisfactions: and an old-fashioned peasant family, which bought little and sold little, arranged its investments of present "effort and waiting" for future benefits on nearly the same lines. But, if either were doubting whether it was worth while to take a light ladder on a trip to gather wild fruits, the prime costs alone would be weighed against the expected benefits: and yet the ladder would not have been made, unless it had been expected to render sufficient service in the aggregate of many little tasks, to remunerate the cost of making it. In the long run it had to repay its total costs, supplementary as well as prime.
Even the modern employer has to look at his own labour as a real cost in the first instance. He may think that a certain enterprise is likely to yield a surplus of money incomings over money outgoings (after proper allowances for risks and for discountings of future happenings); but that the surplus will amount to less than the money equivalent of the trouble and worry that the enterprise will cause to himself: and, in that case, he will avoid it. (11)
1. For he might have applied these efforts, or efforts equivalent to them, to producing immediate gratifications; and if he deliberately chose the deferred gratifications, it would be because, even after allowing for the disadvantages of waiting, he regarded them as outweighing the earlier gratifications which he could have substituted for them. The motive force then tending to deter him from building the house would be his estimate of the aggregate of these efforts, the evil or discommodity of each being increased in geometrical proportion (a sort of compound interest) according to the corresponding interval of waiting. The motive on the other hand impelling him to build it, would be expectation of the satisfaction which he would have from the house when completed; and that again might be resolved into the aggregate of many satisfactions more or less remote, and more or less certain, which he expected to derive from its use. If he thought that this aggregate of discounted values of satisfactions that it would afford him, would be more than a recompense to him for all the efforts and waitings which he had undergone, he would decide to build. (See III, v, section 3, IV, VII, section 8 and Note XIII in the Mathematical Appendix.)
2. We may, if we choose, regard the price of the business undertaker's own work as part of the original outlay, and reckon compound interest on it together with the rest. Or we may substitute for compound interest a sort of "compound profit." The two courses are not strictly convertible: and at a later stage we shall find that in certain cases the first is to be preferred, and in others the second.
3. In the aggregate the income from the saving will in the ordinary course be larger in amount than the saving by the amount of the interest that is the reward of saving. But, as it will be turned to account in enjoyment later than the original saving could have been, it will be discounted for a longer period (or accumulated for a shorter); and if entered in the balance sheet of the investment in place of the original saving, it would stand for exactly the same sum. (Both the original income which was saved and the subsequent income earned by it are assessed to income tax; on grounds similar to those which make it expedient to levy a larger income tax from the industrious than from the lazy man.) The main argument of this section is expressed mathematically in Note XIII.
4. Almost every trade has its own difficulties and its own customs connected with the task of valuing the capital that has been invested in a business, and of allowing for the depreciation which that capital has undergone from wear-and-tear, from the influence of the elements, from new inventions, and from changes in the course of trade. These two last causes may temporarily raise the value of some kinds of fixed capital, at the same time that they are lowering that of others. And people whose minds are cast in different moulds, or whose interests in the matter point in different directions, will often differ widely on the question what part of the expenditure required for adapting buildings and plant to changing conditions of trade, may be regarded as an investment of new capital; and what ought to be set down as charges incurred to balance depreciation, and treated as expedenditure deducted from the current receipts, before determining the net profits of true income earned by the business. These difficulties, and the consequent differences of opinion, are greatest of all with regard to the investment of capital in building up a business connection, and the proper method of appraising the goodwill of a business, or its value "as a going concern." On the whole of this subject see Matheson's Depreciation of Factories and their Valuation.
Another group of difficulties arises from changes in the general purchasing Power of money. If that has fallen, or, in other words, if there has been a rise of general prices, the value of a factory may appear to have risen when it has really remained stationary. Confusions arising from this source introduce greater errors into estimates of the real profitableness of different classes of business than would at first sight appear probable. But all questions of this kind must be deferred till we have discussed the theory of money.
5. See pp. 84-91, and 64-7.
6. The substance of part of this section was placed in VI, i, section 7 in earlier editions. But it seems to be needed here in preparation for the central chapters of Book V.
7. See III, v, section i.
8. The remainder of this section goes very much on the lines of the earlier half of Note XIV in the Mathematical Appendix; which may be read in connection with it. The subject is one in which the language of the differential calculusnot its reasonings — are specially helpful to clear thought: but the main outlines can be presented in ordinary language.
9. See above III, iii section 1; and the footnote on pp. 156-7.
10. Especially in V, IX, "There are many systems of Prime Cost in vogue... we take Prime Cost to mean, as in fact the words imply, only the original or direct cost of production; and while in some trades it may be a matter of convenience to include in the cost of production a proportion of indirect expenses, and a charge for depreciation on plant and buildings, in no case should it comprise interest on capital or profit." (Garcke and Fells, Factory Accounts, ch. i.)
11. The Supplementary costs, which the owner of a factory expects to be able to add to the prime costs of its products, are the source of the quasi-rents which it will yield to him. If they come up to his expectation, then his business so far yields good profits: if they fall much short of it, his business tends to go to the bad. But this statement bears only on long-period problems of value: and in that connection the difference between Prime and Supplementary costs has no special significance. The importance of the distinction between them is confined to shortperiod problems.
1. The variations in the scope of the term Normal, according as the periods of time under discussion are long or short, were indicated in Chapter III. We are now ready to study them more closely.
In this case, as in others, the economist merely brings to light difficulties that are latent in the common discourse of life, so that by being frankly faced they may be thoroughly overcome. For in ordinary life it is customary to use the word Normal in different senses, with reference to different periods of time; and to leave the context to explain the transition from one to another. The economist follows this practice of every-day life: but, by taking pains to indicate the transition, he sometimes seems to have created a complication which in fact he has only revealed.
Thus, when it is said that the price of wool on a certain day was abnormally high though the average price for the year was abnormally low, that the wages of coal-miners were abnormally high in 1872 and abnormally low in 1879, that the (real) wages of labour were abnormally high at the end of the fourteenth century and abnormally low in the middle of the sixteenth; everyone understands that the scope of the term normal is not the same in these various cases.
The best illustrations of this come from manufactures where the plant is long-lived, and the product is short-lived.
When a new textile fabric is first introduced into favour, and there is very little plant suitable for making it, its normal price for some months may be twice as high as those of other fabrics which are not less difficult to make, but for making which there is an abundant stock of suitable plant and skill. Looking at long periods we may say that its normal price is on a par with that of the others: but if during the first few months a good deal of it were offered for sale in a bankrupt's stock we might say that its price was abnormally low even when it was selling for half as much again as the others. Everyone takes the context as indicating the special use of the term in each several case; and a formal interpretation clause is seldom necessary, because in ordinary conversation misunderstandings can be nipped in the bud by question and answer. But let us look at this matter more closely.
We have noticed (1) how a cloth manufacturer would need to calculate the expenses of producing all the different things required for making cloth with reference to the amounts of each of them that would be wanted; and on the supposition in the first instance that the conditions of supply would be normal. But we have yet to take account of the fact that he must give to this term a wider or narrower range, according as he was looking more or less far ahead.
Thus in estimating the wages required to call forth an adequate supply of labour to work a certain class of looms, he might take the current wages of similar work in the neighbourhood: or he might argue that there was a scarcity of that particular class of labour in the neighbourhood, that its current wages there were higher than in other parts of England, and that looking forward over several years so as to allow for immigration, he might take the normal rate of wages at a rather lower rate than that prevailing there at the time. Or lastly, he might think that the wages of weavers all over the country were abnormally low relatively to others of the same grade, in consequence of a too sanguine view having been taken of the prospects of the trade half a generation ago. He might argue that this branch of work was overcrowded, that parents had already begun to choose other trades for their children which offered greater net advantages and yet were not more difficult; that in consequence a few years would see a falling-off in the supply of labour suited for his purpose; so that looking forward a long time he must take normal wages at a rate rather higher than the present average. (2)
Again, in estimating the normal supply price of wool, he would take the average of several past years. He would make allowance for any change that would be likely to affect the supply in the immediate future; and he would reckon for the effect of such droughts as from time to time occur in Australia and elsewhere; since their occurrence is too common to be regarded as abnormal. But he would not allow here for the chance of our being involved in a great war, by which the Australian supplies might be cut off; he would consider that any allowance for this should come under the head of extraordinary trade risks, and not enter into his estimate of the normal supply price of wool.
He would deal in the same way with the risk of civil tumult or any violent and long-continued disturbance of the labour market of an unusual character; but in his estimate of the amount of work that could be got out of the machinery, etc. under normal conditions, he would probably reckon for minor interruptions from trade disputes such as are continually occurring, and are therefore to be regarded as belonging to the regular course of events, that is as not abnormal.
In all these calculations he would not concern himself specially to inquire how far mankind are under the exclusive influence of selfish or self-regarding motives. He might be aware that anger and vanity, jealousy and offended dignity are still almost as common causes of strikes and lockouts, as the desire for pecuniary gain: but that would not enter into his calculations. All that he would want to know about them would be whether they acted with sufficient regularity for him to be able to make a reasonably good allowance for their influence in interrupting work and raising the normal supply price of the goods. (3)
2. The element of time is a chief cause of those difficulties in economic investigations which make it necessary for man with his limited powers to go step by step; breaking up a complex question, studying one bit at a time, and at last combining his partial solutions into a more or less complete solution of the whole riddle. In breaking it up, he segregates those disturbing causes, whose wanderings happen to be inconvenient, for the time in a pound called Caeteris Paribus. The study of some group of tendencies is isolated by the assumption other things being equal: the existence of other tendencies is not denied, but their disturbing effect is neglected for a time. The more the issue is thus narrowed, the more exactly can it be handled: but also the less closely does it correspond to real life. Each exact and firm handling of a narrow issue, however, helps towards treating broader issues, in which that narrow issue is contained, more exactly than would otherwise have been possible. With each step more things can be let out of the pound; exact discussions can be made less abstract, realistic discussions can be made less inexact than was possible at an earlier stage. (4)
Our first step towards studying the influences exerted by the element of time on the relations between cost of production and value may well be to consider the famous fiction of the "Stationary state" in which those influences would be but little felt; and to contrast the results which would be found there with those in the modern world.
This state obtains its name from the fact that in it the general conditions of production and consumption, of distribution and exchange remain motionless; but yet it is full of movement; for it is a mode of life. The average age of the population may be stationary; though each individual is growing up from youth towards his prime, or downwards to old age. And the same amount of things per head of the population will have been produced in the same ways by the same classes of people for many generations together; and therefore this supply of the appliances for production will have had full time to be adjusted to the steady demand.
Of course we might assume that in our stationary state every business remained always of the same size, and with the same trade connection. But we need not go so far as that; it will suffice to suppose that firms rise and fall, but that the "representative" firm remains always of about the same size, as does the representative tree of a virgin forest, and that therefore the economies resulting from its own resources are constant: and since the aggregate volume of production is constant, so also are those economies resulting from subsidiary industries in the neighbourhood, etc. [That is, its internal and external economies are both constant. The price, the expectation of which just induced persons to enter the trade, must be sufficient to cover in the long run the cost of building up a trade connection; and a proportionate share of it must be added in to make up the total cost of production.]
In a stationary state then the plain rule would be that cost of production governs value. Each effect would be attributable mainly to one cause; there would not be much complex action and reaction between cause and effect. Each element of cost would be governed by "natural" laws, subject to some control from fixed custom. There would be no reflex influence of demand; no fundamental difference between the immediate and the later effects of economic causes. There would be no distinction between long-period and short-period normal value, at all events if we supposed that in that monotonous world the harvests themselves were uniform: for the representative firm being always of the same size, and always doing the same class of business to the same extent and in the same way, with no slack times, and no specially busy times, its normal expenses by which the normal supply price is governed would be always the same. The demand lists of prices would always be the same, and so would the supply lists; and normal price would never vary.
But nothing of this is true in the world in which we live. Here every economic force is constantly changing its action, under the influence of other forces which are acting around it. Here changes in the volume of production, in its methods, and in its cost are ever mutually modifying one another; they are always affecting and being affected by the character and the extent of demand. Further all these mutual influences take time to work themselves out, and, as a rule, no two influences move at equal pace. In this world therefore every plain and simple doctrine as to the relations between cost of production, demand and value is necessarily false: and the greater the appearance of lucidity which is given to it by skilful exposition, the more mischievous it is. A man is likely to be a better economist if he trusts to his common sense, and practical instincts, than if he professes to study the theory of value and is resolved to find it easy.
3. The Stationary state has just been taken to be one in which population is stationary. But nearly all its distinctive features may be exhibited in a place where population and wealth are both growing, provided they are growing at about the same rate, and there is no scarcity of land: and provided also the methods of production and the conditions of trade change but little; and above all, where the character of man himself is a constant quantity. For in such a state by far the most important conditions of production and consumption, of exchange and distribution will remain of the same quality, and in the same general relations to one another, though they are all increasing in volume. (5)
This relaxation of the rigid bonds of a purely stationary state brings us one step nearer to the actual conditions of life: and by relaxing them still further we get nearer still. We thus approach by gradual steps towards the difficult problem of the interaction of countless economic causes. In the stationary state all the conditions of production and consumption are reduced to rest: but less violent assumptions are made by what is, not quite accurately, called the statical method. By that method we fix our minds on some central point: we suppose it for the time to be reduced to a stationary state; and we then study in relation to it the forces that affect the things by which it is surrounded, and any tendency there may be to equilibrium of these forces. A number of these partial studies may lead the way towards a solution of problems too difficult to be grasped at one effort. (6)
4. We may roughly classify problems connected with fishing industries as those which are affected by very quick changes, such as uncertainties of the weather; or by changes of moderate length, such as the increased demand for fish caused by the scarcity of meat during the year or two following a cattle plague; or lastly, we may consider the great increase during a whole generation of the demand for fish which might result from the rapid growth of a high-strung artisan population making little use of their muscles.
The day to day oscillations of the price of fish resulting from uncertainties of the weather, etc., are governed by practically the same causes in modern England as in the supposed stationary state. The changes in the general economic conditions around us are quick; but they are not quick enough to affect perceptibly the short-period normal level about which the price fluctuates from day to day: and they may be neglected [impounded in caeteris paribus] during a study of such fluctuations.
Let us then pass on; and suppose a great increase in the general demand for fish, such for instance as might arise from a disease affecting farm stock, by which meat was made a dear and dangerous food for several years together. We now impound fluctuations due to the weather in caeteris paribus, and neglect them provisionally: they are so quick that they speedily obliterate one another, and are therefore not important for problems of this class. And for the opposite reason we neglect variations in the numbers of those who are brought up as seafaring men: for these variations are too slow to produce much effect in the year or two during which the scarcity of meat lasts. Having impounded these two sets for the time, we give our full attention to such influences as the inducements which good fishing wages will offer to sailors to stay in their fishing homes for a year or two, instead of applying for work on a ship. We consider what old fishing boats, and even vessels that were not specially made for fishing, can be adapted and sent to fish for a year or two. The normal price for any given daily supply of fish, which we are now seeking, is the price which will quickly call into the fishing trade capital and labour enough to obtain that supply in a day's fishing of average good fortune; the influence which the price of fish will have upon capital and labour available in the fishing trade being governed by rather narrow causes such as these. This new level about which the price oscillates during these years of exceptionally great demand, will obviously be higher than before. Here we see an illustration of the almost universal law that the term Normal being taken to refer to a short period of time an increase in the amount demanded raises the normal supply price. This law is almost universal even as regards industries which in long periods follow the tendency to increasing return. (7)
But if we turn to consider the normal supply price with reference to a long period of time, we shall find that it is governed by a different set of causes, and with different results. For suppose that the disuse of meat causes a permanent distaste for it, and that an increased demand for fish continues long enough to enable the forces by which its supply is governed to work out their action fully (of course oscillations from day to day and from year to year would continue: but we may leave them on one side). The source of supply in the sea might perhaps show signs of exhaustion, and the fishermen might have to resort to more distant coasts v, and to deeper waters, Nature giving a Diminishing Return to the increased application of capital and labour of a given order of efficiency. On the other hand, those might turn out to be right who think that man is responsible for but a very small part of the destruction of fish that is constantly going on; and in that case a boat starting with equally good appliances and an equally efficient crew would be likely to get nearly as good a haul after the increase in the total volume of the fishing trade as before. In any case the normal cost of equipping a good boat with an efficient crew would certainly not be higher, and probably be a little lower after the trade had settled down to its now increased dimensions than before. For since fishermen require only trained aptitudes, and not any exceptional natural qualities, their number could be increased in less than a generation to almost any extent that was necessary to meet the demand; while the industries connected with building boats, making nets, etc. being now on a larger scale would be organized more thoroughly and economically. If therefore the waters of the sea showed no signs of depletion of fish, an increased supply could be produced at a lower price after a time sufficiently long to enable the normal action of economic causes to work itself out: and, the term Normal being taken to refer to a long period of time, the normal price of fish would decrease with an increase in demand. (8)
Thus we may emphasize the distinction already made between average price and normal price. An average may be taken of the prices of any set of sales extending over a day or a week or a year or any other time: or it may be the average of sales at any time in many markets; or it may be the average of many such averages. But the conditions which are normal to any one set of sales are not likely to be exactly those which are normal to the others: and therefore it is only by accident that an average price will be a normal price; that is, the price which any one set of conditions tends to produce. In a stationary state alone, as we have just seen, the term normal always means the same thing: there, but only there, "average price" and "normal price" are convertible terms. (9)
5. To go over the ground in another way. Market values are governed by the relation of demand to stocks actually in the market; with more or less reference to "future" supplies, and not without some influence of trade combinations.
But the current supply is in itself partly due to the action of producers in the past; and this action has been determined on as the result of a comparison of the prices which they expect to get for their goods with the expenses to which they will be put in producing them. The range of expenses of which they take account depends on whether they are merely considering the extra expenses of certain extra production with their existing plant, or are considering whether to lay down new plant for the purpose. In the case, for instance, of an order for a single locomotive, which was discussed a little while ago (10), the question of readjusting the plant to demand would hardly arise: the main question would be whether more work could conveniently be got out of the existing plant. But in view of an order for a large number of locomotives to be delivered gradually over a series of years, some extension of plant "specially" made for the Purpose, and therefore truly to be regarded as prime marginal costs would almost certainly be carefully considered.
Whether the new production for which there appears to be a market be large or small, the general rule will be that unless the price is expected to be very low that portion of the supply which can be most easily produced, with but small prime costs, will be produced: that portion is not likely to be on the margin of production. As the expectations of price improve, an increased part of the production will yield a considerable surplus above prime costs, and the margin of production will be pushed outwards. Every increase in the price expected will, as a rule, induce some people who would not otherwise have produced anything, to produce a little; and those, who have produced something for the lower price, will produce more for the higher price. That part of their production with regard to which such persons are on the margin of doubt as to whether it is worth while for them to produce it at the price, is to be included together with that of the persons who are in doubt whether to produce at all; the two together constitute the marginal production at that price. The producers, who are in doubt whether to produce anything at all, may be said to lie altogether on the margin of production (or) if they are agriculturists, on the margin of cultivation). But as a rule they are very few in number, and their action is less important than that of those who would in any case produce something.
The general drift of the term normal supply price is always the same whether the period to which it refers is short or long; but there are great differences in detail. In every case reference is made to a certain given rate of aggregate production; that is, to the production of a certain aggregate amount daily or annually. In every case the price is that the expectation of which is sufficient and only just sufficient to make it worth while for people to set themselves to produce that aggregate amount; in every case the cost of production is marginal; that is, it is the cost of production of those goods which are on the margin of not being produced at all, and which would not be produced if the price to be got for them were expected to be lower. But the causes which determine this margin vary with the length of the period under consideration. For short periods people take the stock of appliances for production as practically fixed; and they are governed by their expectations of demand in considering how actively they shall set themselves to work those appliances. In long periods they set themselves to adjust the flow of these appliances to their expectations of demand for the goods which the appliances help to produce. Let us examine this difference closely.
6. The immediate effect of the expectation of a high price is to cause people to bring into active work all their appliances of production, and to work them full time and perhaps overtime. The supply price is then the money cost of production of that part of the produce which forces the undertaker to hire such inefficient labour (perhaps tired by working overtime) at so high a price, and to put himself and others to so much strain and inconvenience that he is on the margin of doubt whether it is worth his while to do it or not. The immediate effect of the expectation of a low price is to throw many appliances for production out of work, and slacken the work of others; and if the producers had no fear of spoiling their markets, it would be worth their while to produce for a time for any price that covered the prime costs of production and rewarded them for their own trouble.
But, as it is, they generally hold out for a higher price; each man fears to spoil his chance of getting a better price later on from his own customers; or, if he produces for a large and open market, he is more or less in fear of incurring the resentment of other producers, should he sell needlessly at a price that spoils the common market for all. The marginal production in this case is the production of those whom a little further fall of price would cause, either from a regard to their own interest or by formal or informal agreement with other producers, to suspend production for fear of further spoiling the market. The price which, for these reasons, producers are just on the point of refusing, is the true marginal supply price for short periods. It is nearly always above, and generally very much above the special or prime cost for raw materials, labour and wear-and-tear of plant, which is immediately and directly involved by getting a little further use out of appliances which are not fully employed. This point needs further study.
In a trade which uses very expensive plant, the prime cost of goods is but a small part of their total cost; and an order at much less than their normal price may leave a large surplus above their prime cost. But if producers accept such orders in their anxiety to prevent their plant from being idle, they glut the market and tend to prevent prices from reviving. In fact however they seldom pursue this policy constantly and without moderation. If they did, they might ruin many of those in the trade, themselves perhaps among the number; and in that case a revival of demand would find little response in supply, and would raise violently the prices of the goods produced by the trade. Extreme variations of this kind are in the long run beneficial neither to producers nor to consumers; and general opinion is not altogether hostile to that code of trade morality which condemns the action of anyone who "spoils the market" by being too ready to accept a price that does little more than cover the prime cost of his goods, and allows but little on account of his general expenses. (11)
For example, if at any time the prime cost, in the narrowest sense of the word, of a bale of cloth is £100; and if another £100 are needed to make the cloth pay its due share of the general expenses of the establishment, including normal profits to its owners, then the practically effective supply price is perhaps not very likely to fall below £150 under ordinary conditions, even for short periods; though of course a few special bargains may be made at lower prices without much affecting the general market.
Thus, although nothing but prime cost enters necessarily and directly into the supply price for short periods, it is yet true that supplementary costs also exert some influence indirectly. A producer does not often isolate the cost of each separate small parcel of his output; he is apt to treat a considerable part of it, even in some cases the whole of it, more or less as a unit. He inquires whether it is worth his while to add a certain new line to his present undertakings, whether it is worth while to introduce a new machine and so on. He treats the extra output that would result from the change more or less as a unit beforehand; and afterwards he quotes the lowest prices, which he is willing to accept, with more or less reference to the whole cost of that extra output regarded as a unit.
In other words he regards an increase in his processes of production, rather than an individual parcel of his products, as a unit in most of his transactions. And the analytical economist must follow suit, if he would keep in close touch with actual conditions. These considerations tend to blur the sharpness of outline of the theory of value: but they do not affect its substance. (12)
To sum up then as regards short periods. The supply of specialized skill and ability, of suitable machinery and other material capital, and of the appropriate industrial organization has not time to be fully adapted to demand; but the producers have to adjust their supply to the demand as best they can with the appliances already at their disposal. On the one hand there is not time materially to increase those appliances if the supply of them is deficient; and on the other, if the supply is excessive, some of them must remain imperfectly employed, since there is not time for the supply to be much reduced by gradual decay, and by conversion to other uses. Variations in the particular income derived from them do not for the time affect perceptibly the supply; and do not directly affect the price of the commodities produced by them. The income is a surplus of total receipts over prime cost; [that is, it has something of the nature of a rent as will be seen more clearly in chapter VIII]. But unless it is sufficient to cover in the long run a fair share of the general costs of the business, production will gradually fall off. In this way a controlling influence over the relatively quick movements of supply price during short periods is exercised by causes in the background which range over a long period; and the fear of "spoiling the market" often makes those causes act more promptly than they otherwise would.
7. In long periods on the other hand all investments of capital and effort in providing the material plant and the organization of a business, and in acquiring trade knowledge and specialized ability, have time to be adjusted to the incomes which are expected to be earned by them: and the estimates of those incomes therefore directly govern supply, and are the true long-period normal supply price of the commodities produced.
A great part of the capital invested in a business is generally spent on building up its internal organization and its external trade connections. If the business does not prosper all that capital is lost, even though its material plant may realize a considerable part of its original cost. And anyone proposing to start a new business in any trade must reckon for the chance of this loss. If himself a man of normal capacity for that class of work, be may look forward ere long to his business being a representative one, in the sense in which we have used this term, with its fair share of the economies of production on a large scale. If the net earnings of such a representative business seem likely to be greater than he could get by similar investments in other trades to which he has access, he will choose this trade. Thus that investment of capital in a trade, on which the price of the commodity produced by it depends in the long run, is governed by estimates on the one hand of the outgoings required to build up and to work a representative firm, and on the other of the incomings, spread over a long period of time, to be got by such a price.
At any particular moment some businesses will be rising and others falling: but when we are taking a broad view of the causes which govern normal supply price, we need not trouble ourselves with these eddies on the surface of the great tide. Any particular increase of production may be due to some new manufacturer who is struggling against difficulties, working with insufficient capital, and enduring great privations in the hope that he may gradually build up a good business. Or it may be due to some wealthy firm which by enlarging its premises is enabled to attain new economies, and thus obtain a larger output at a lower proportionate cost: and, as this additional output will be small relatively to the aggregate volume of production in the trade, it will not much lower the price; so that the firm will reap great gains from its successful adaptation to its surroundings. But while these variations are occurring in the fortunes of individual businesses, there may be a steady tendency of the long-period normal supply price to diminish, as a direct consequence of an increase in the aggregate volume of production.
8. Of course there is no hard and sharp line of division between "long" and "short" periods. Nature has drawn no such lines in the economic conditions of actual life; and in dealing with practical problems they are not wanted. Just as we contrast civilized with uncivilized races, and establish many general propositions about either group, though no hard and fast division can be drawn between the two; so we contrast long and short periods without attempting any rigid demarcation between them. If it is necessary for the purposes of any particular argument to divide one case sharply from the other, it can be done by a special interpretation clause: but the occasions on which this is necessary are neither frequent nor important.
Four classes stand out. In each, price is governed by the relations between demand and supply. As regards market prices, Supply is taken to mean the stock of the commodity in question which is on hand, or at all events " in sight." As regards normal prices, when the term Normal is taken to relate to short periods of a few months or a year, supply means broadly what can be produced for the price in question with the existing stock of plant, personal and impersonal, in the given time. As regards normal prices, when the term Normal is to refer to long periods of several years, Supply means what can be produced by plant, which itself can be remuneratively produced and applied within the given time; while lastly, there are very gradual or Secular movements of normal price, caused by the gradual growth of knowledge, of population and of capital, and the changing conditions of demand and supply from one generation to another. (13)
The remainder of the present volume is chiefly concerned with the third of the above classes: that is, with the normal relations of wages, profits, prices, etc., for rather long periods. But occasionally account has to be taken of changes that extend over very many years; and one chapter, Book VI, ch. XII, is given up to "The Influence of Progress on Value," that is, to the study of secular changes of value.
1. V, III, section 5.
2. There are indeed not many occasions on which the calculations of a business man for practical purposes need to look forward so far, and to extend the range of the term Normal over a whole generation: but in the broader applications of economic science it is sometimes necessary to extend the range even further, and to take account of the slow changes that in the course of centuries affect the supply price of the labour of each industrial grade.
3. Compare I, II, section 7.
4. As has been explained in the Preface, pp. vi-ix, this volume is concerned mainly with normal conditions; and these are sometimes described as Statical. But in the opinion of the present writer the problem of normal value belongs to economic Dynamics: partly because Statics is really but a branch of Dynamics, and partly because all suggestions as to economic rest, of which the hypothesis of a Stationary state is the chief, are merely provisional, used only to illustrate particular steps in the argument, and to be thrown aside when that is done.
5. See below, V, XII, section 3; and compare Keynes, Scope and Method of Political Economy, VI, 2.
6. Compare the Preface and Appendix H, section 4.
7. See V, XII, section I.
8. Tooke (History of Prices, Vol. I, p. 104) tells us: "There are particular articles of which the demand for naval and military purposes forms so large a proportion to the total supply, that no diminution of consumption by individuals can keep pace with the immediate increase of demand by government; and consequently, the breaking out of a war tends to raise the price of such articles to a great relative height. But even of such articles, if the consumption were not on a progressive scale of increase so rapid that the supply, with all the encourage ment of a relatively high price, could not keep pace with the demand, the tendency is (supposing no impediment, natural or artificial, to production or importation) to occasion such an increase of quantity, as to reduce the price to nearly the same level as that from which it had advanced. And accordingly it will be observed, by reference to the table of prices, that salt petre, hemp, iron, etc., after advancing very considerably under the influence of a greatly extended demand for military and naval purposes, tended downwards again whenever that demand was not progressively and rapidly increasing." Thus a continuously progressive increase in demand may raise the supply price of a thing even for several years together; though a steady increase of demand for that thing, at a rate not too great for supply to keep pace with it, would lower price.
9. V, III, section 6. The distinction will be yet further discussed in V, XII and Appendix H. See also Keynes, Scope and Method of Political Economy, ch. VII.
10. pp. 360-7.
11. Where there is a strong combination, tacit or overt, producers may sometimes regulate the price for a considerable time together with very little reference to cost of production. And if the leaders in that combination were those who had the best facilities for production, it might be said, in apparent though not in real contradiction to Ricardo's doctrines, that the price was governed by that part of the supply which was most easily produced. But as a fact, those producers whose finances are weakest, and who are bound to go on producing to escape failure, often impose their policy on the rest of the combination: insomuch that it is a common saying, both in America and England, that the weakest members of a combination are frequently its rulers.
12. This general description may suffice for most purposes: but in chapter XII there will be found a more detailed study of that extremely complex notion, a marginal increment in the processes of production by a representative firm; together with a fuller explanation of the necessity of referring our reasonings to the circumstances of a representative firm, especially when we are considering industries which show a tendency to increasing return.
13. Compare the first section of this chapter. Of course the periods required to adapt the several factors of production to the demand may be very different; the number of skilled compositors, for instance, cannot be increased nearly as fast as the supply of type and printing presses. And this cause alone would prevent any rigid division being made between long and short periods. But in fact a theoretically perfect long period must give time enough to enable not only the factors of production of the commodity to be adjusted to the demand, but also the factors of production of those factors of production to be adjusted and so on; and this, when carried to its logical consequences, will be found to involve the supposition of a stationary state of industry, in which the requirements of a future age can be anticipated an indefinite time beforehand. Some such assumption is indeed unconsciously implied in many popular renderings of Ricardo's theory of value, if not in his own versions of it; and it is to this cause more than any other that we must attribute that simplicity and sharpness of outline, from which the economic doctrines in fashion in the first half of this century derived some of their seductive charm, as well as most of whatever tendency they may have to lead to false practical conclusions.
Relatively short and long period problems go generally on similar lines. In both use is made of that paramount device, the partial or total isolation for special study of some set of relations. In both opportunity is gained for analysing and comparing similar episodes, and making them throw light upon one another; and for ordering and co-ordinating facts which are suggestive in their similarities, and are still more suggestive in the differences that peer out through their similarities. But there is a broad distinction between the two cases. In the relatively short-period problem no great violence is needed for the assumption that the forces not specially under consideration may be taken for the time to be inactive. But violence is required for keeping broad forces in the pound of Caeteris Paribus during, say, a whole generation, on the ground that they have only an indirect bearing on the question in hand. For even indirect influences may produce great effects in the course of a generation, if they happen to act cumulatively; and it is not safe to ignore them even provisionally in a practical problem without special study. Thus the uses of the statical method in problems relating to very long periods are dangerous; care and forethought and self-restraint are needed at every step. The difficulties and risks of the task reach their highest point in connection with industries which conform to the law of Increasing Return; and it is just in connection with those industries that the most alluring applications of the method are to be found. We must postpone these questions to chapter XII and Appendix H.
But an answer may be given here to the objection that since "the economic world is subject to continual changes, and is becoming more complex,... the longer the run the more hopeless the rectification": so that to speak of that position which value tends to reach in the long run is to treat "variables as constants." (Devas, Political Economy, Book IV, ch. v.) It is true that we do treat variables provisionally as constants. But it is also true that this is the only method by which science has ever made any great progress in dealing with complex and changeful matter, whether in the physical or moral world. See above V, v, section 2.
1. Bread satisfies man's wants directly: and the demand for it is said to be direct. But a flour mill and an oven satisfy wants only indirectly, by helping to make bread, etc., and the demand for them is said to be indirect. More generally: —
The demand for raw materials and other means of production is indirect and is derived from the direct demand for those directly serviceable products which they help to produce.
The services of the flour mill and the oven are joined together in the ultimate product, bread: the demand for them is therefore called a joint demand. Again, hops and malt are complementary to one another; and are joined together in the common destination of ale: and so on. Thus the demand for each of several complementary things is derived from the services which they jointly render in the production of some ultimate product, as for instance a loaf of bread, a cask of ale. In other words there is a joint demand for the services which any of these things render in helping to produce a thing which satisfies wants directly and for which there is therefore a direct demand: the direct demand for the finished product is in effect split up into many derived demands for the things used in producing it. (1)
To take another illustration, the direct demand for houses gives rise to a joint demand for the labour of all the various building trades, and for bricks, stone, wood, etc. which are factors of production of building work of all kinds, or as we may say for shortness, of new houses. The demand for any one of these, as for instance the labour of plasterers, is only an indirect or derived demand.
Let us pursue this last illustration with reference to a class of events that are of frequent occurrence in the labour market; the period over which the disturbance extends being short, and the causes of which we have to take account as readjusting demand and supply being only such as are able to operate within that short period.
This case has important practical bearings, which give it a special claim on our attention; but we should notice that, referring as it does to short periods, it is an exception to our general rule of selecting illustrations in this and the neighbouring chapters from cases in which there is time enough for the full long-period action of the forces of supply to be developed.
Let us then suppose that the supply and demand for building being in equilibrium, there is a strike on the part of one group of workers, say the plasterers, or that there is some other disturbance to the supply of plasterers' labour. In order to isolate and make a separate study of the demand for that factor, we suppose firstly that the general conditions of the demand for new houses remain unchanged (that is, that the demand schedule for new houses remains valid); and secondly we assume that there is no change in the general conditions of supply of the other factors, two of which are of course the business faculties and the business organizations of the master builders; (that is, we assume that their lists of supply prices also remain valid). Then a temporary check to the supply of plasterers' labour will cause a proportionate check to the amount of building: the demand price for the diminished number of houses will be a little higher than before; and the supply prices for the other factors of production will not be greater than before. (2) Thus new houses can now be sold at prices which exceed by a good margin the sum of the prices at which these other requisites for the production of houses can be bought; and that margin gives the limit to the possible rise of the price that will be offered for plasterers' labour, on the supposition that plasterers' labour is indispensable. The different amounts of this margin, corresponding to different checks to the supply of plasterers' labour, are governed by the general rule that: The price that will be offered for any thing used in producing a commodity is, for each separate amount of the commodity, limited by the excess of the price at which that amount of the commodity can find purchasers, over the sum of the prices at which the corresponding supplies of the other things needed for making it will be forthcoming.
To use technical terms, the demand schedule for any factor of production of a commodity can be derived from that for the commodity by subtracting from the demand price of each separate amount of the commodity the sum of the supply prices for corresponding amounts of the other factors. (3)
2. When however we come to apply this theory to the actual conditions of life, it will be important to remember that if the supply of one factor is disturbed, the supply of others is likely to be disturbed also. In particular, when the factor of which the supply is disturbed is one class of labour, as that of the plasterers, the employers' earnings generally act as a buffer. That is to say, the loss falls in the first instance on them; but by discharging some of their workmen and lowering the wages of others, they ultimately distribute a great part of it among the other factors of production. The details of the process by which this is effected are various, and depend on the action of trade combinations, on the higgling and bargaining of the market, and on other causes with which we are not just at present concerned.
Let us inquire what are the conditions, under which a check to the supply of a thing that is wanted not for direct use, but as a factor of production of some commodity, may cause a very great rise in its price. The first condition is that the factor itself should be essential, or nearly essential to the production of the commodity, no good substitute being available at a moderate price.
The second condition is that the commodity in the production of which it is a necessary factor, should be one for which the demand is stiff and inelastic; so that a check to its supply will cause consumers to offer a much increased price for it rather than go without it; and this of course includes the condition that no good substitutes for the commodity are available at a price but little higher than its equilibrium price. If the check to house building raises the price of houses very much, builders, anxious to secure the exceptional profits, will bid against one another for such plasterers' labour as there is in the market. (4)
The third condition is that only a small part of the expenses of production of the commodity should consist of the price of this factor. Since the plasterers' wages are but a small part of the total expenses of building a house, a rise of even 50 per cent in them would add but a very small percentage to the expenses of production of a house and would check demand but little. (5)
The fourth condition is that even a small check to amount demanded should cause a considerable fall in the supply prices of other factors of production; as that will increase the margin available for paying a high price for this one. (6) If, for instance, bricklayers and other classes of workmen, or the employers themselves cannot easily find other things to do, and cannot afford to remain idle, they may be willing to work for much lower earnings than before, and this will increase the margin available for paying higher wages to plasterers. These four conditions are independent, and the effects of the last three are cumulative.
The rise in plasterers' wages would be checked if it were possible either to avoid the use of plaster, or to get the work done tolerably well and at a moderate price by people outside the plasterers' trade: the tyranny, which one factor of production of a commodity might in some cases exercise over the other factors through the action of derived demand, is tempered by the principle of substitution. (7)
Again, an increased difficulty in obtaining one of the factors of a finished commodity can often be met by modifying the character of the finished product. Some plasterers' labour may be indispensable; but people are often in doubt how much plaster work it is worth while to have in their houses, and if there is a rise in its price they will have less of it. The intensity of the satisfaction of which they would be deprived if they had a little less of it, is its marginal utility; the price which they are just willing to pay in order to have it, is the true demand price for plasterers' work up to the amount which is being used.
So again there is a joint demand for malt and hops in ale. But their proportions can be varied. A higher price can be got for an ale which differs from others only in containing more hops; and this excess price represents the demand for hops. (8)
The relations between plasterers, bricklayers, etc., are representative of much that is both instructive and romantic in the history of alliances and conflicts between trades-unions in allied trades. But the most numerous instances of joint demand are those of the demand for a raw material and the operatives who work it up; as for instance cotton or jute or iron or copper, and those who work up these several materials. Again, the relative prices of different articles of food vary a good deal with the supply of skilled cooks' labour: thus for instance many kinds of meat and many parts of vegetables which are almost valueless in America, where skilled cooks are rare and expensive, have a good value in France, where the art of cooking is widely diffused.
3. We have already (9) discussed the way in which the aggregate demand for any commodity is compounded of the demands of the different groups of people who may need it. But we now may extend this notion of composite demand to requisites of production which are needed by several groups of producers.
Nearly every raw material and nearly every kind of labour is applied in many different branches of industry, and contributes to the production of a great variety of commodities. Each of these commodities has its own direct demand; and from that the derived demand for any of the things used in making it can be found, and the thing is "distributed between its various uses" in the manner which we have already discussed. (10) The various uses are rivals, or competitors with one another; and the corresponding derived demands are rival or competitive demands relatively to one another. But in relation to the supply of the product, they co-operate with one another; being "compounded" into the total demand that carries off the supply: in just the same way as the partial demands of several classes of society for a finished commodity are aggregated, or compounded together into the total demand for it. (11)
4. We may now pass to consider the case of joint products: i.e. of things which cannot easily be produced separately; but are joined in a common origin, and may therefore be said to have a joint supply, such as beef and hides, or wheat and straw. (12) This case corresponds to that of things which have a joint demand, and it may be discussed almost in the same words, by merely substituting "demand" for "supply," and vice versa. As there is a joint demand for things joined in a common destination: so there is a joint supply of things which have a common origin. The single supply of the common origin is split up into so many derived supplies of the things that proceed from it. (13)
For instance, since the repeal of the Corn Laws much of the wheat consumed in England has been imported, of course without any straw. This has caused a scarcity and a consequent rise in the price of straw, and the farmer who grows wheat looks to the straw for a great part of the value of the crop. The value of straw then is high in countries which import wheat, and low in those which export wheat. In the same way the price of mutton in the wool-producing districts of Australia was at one time very low. The wool was exported, the meat had to be consumed at home; and as there was no great demand for it, the price of the wool had to defray almost the whole of the joint expenses of production of the wool and the meat. Afterwards the low price of meat gave a stimulus to the industries of preserving meat for exportation, and now its price in Australia is higher.
There are very few cases of joint products the cost of production of both of which together is exactly the same as that of one of them alone. So long as any product of a business has a market value, it is almost sure to have devoted to it some special care and expense, which would be diminished, or dispensed with if the demand for that product were to fall very much. Thus, for instance, if straw were valueless, farmers would exert themselves more than they do to make the ear bear as large a proportion as possible to the stalk. Again, the importation of foreign wool has caused English sheep to be adapted by judicious crossing and selection so as to develop heavy weights of good meat at an early age, even at the expense of some deterioration of their wool. It is only when one of two things produced by the same process is valueless, unsaleable, and yet does not involve any expense for its removal, that there is no inducement to attempt to alter its amount; and, it is only in these exceptional cases that we have no means of assigning its separate supply price to each of the joint products. For when it is possible to modify the proportions of these products, we can ascertain what part of the whole expense of the process of production would be saved, by so modifying these proportions as slightly to diminish the amount of one of the joint products without affecting the amounts of the others. That part of the expense is the expense of production of the marginal element of that product; it is the supply price of which we are in search. (14)
But these are exceptional cases. It more frequently happens that a business, or even an industry finds its advantage in using a good deal of the same plant, technical skill, and business organization for several classes of products. In such cases the cost of anything used for several purposes has to be defrayed by its fruits in all of them: but there is seldom any rule of nature to determine either the relative importance of these uses, or the proportions in which the total cost should be distributed among them: much depends on the changing features of markets. (15)
5. We may pass to the problem of composite supply which is analogous to that of composite demand. A demand can often be satisfied by any one of several routes, according to the principle of substitution. These various routes are rivals or competitors with one another; and the corresponding supplies of commodities are rival, or competitive supplies relatively to one another. But in relation to the demand they co-operate with one another; being "compounded" into the total supply that meets the demands. (16)
If the causes which govern their production are nearly the same, they may for many purposes be treated as one commodity. (17) For instance, beef and mutton may be treated as varieties of one commodity for many purposes; but they must be treated as separate for others, as for instance for those in which the question of the supply of wool enters. Rival things are however often not finished commodities, but factors of production: for instance, there are many rival fibres which are used in making ordinary printing paper. We have just noticed how the fierce action of derived demand for one of several complementary supplies, as e.g. for the supply of plasterers' labour, was liable to be moderated, when the demand was met by the competitive supply of a rival thing, which could be substituted for it. (18)
6. All the four chief problems which have been discussed in this chapter have some bearing on the causes that govern the value of almost every commodity: and many of the most important cross connections between the values of different commodities are not obvious at first sight.
Thus when charcoal was generally used in making iron, the price of leather depended in some measure on that of iron; and the tanners petitioned for the exclusion of foreign iron in order that the demand on the part of English iron smelters for oak charcoal might cause the production of English oak to be kept up, and thus prevent oak bark from becoming dear. (19) This instance may serve to remind us of the way in which an excessive demand for a thing may cause its sources of supply to be destroyed, and thus render scarce any joint products that it may have: for the demand for wood on the part of the ironmakers led to a relentless destruction of many forests in England. Again, an excessive demand for lamb was assigned as a cause of the prevailing scarcity of sheep some years ago; while some argued on the contrary that the better the price to be got for spring lamb sold to the rich, the more profitable would be the production of sheep, and the cheaper would mutton be for the people. The fact is that an increase of demand may have opposite effects according as it does or does not act so suddenly as to prevent producers from adapting their action to it.
Again, the development of railways and other means of communication for the benefit of one trade, as for instance wheat growing in some parts of America and silver mining in others, greatly lowers some of the chief expenses of production of nearly every other product of those districts. Again, the prices of soda, and bleaching materials and other products of industries, the chief raw material of which is salt, move up and down relatively to one another with almost every improvement in the various processes which are used in those industries; and every change in those prices affects the prices of many other goods, for the various products of the salt industries are more or less important factors in many branches of manufacture.
Again, cotton and cotton-seed oil are joint products, and the recent fall in the price of cotton is largely due to the improved manufacture and uses of cotton-seed oil: and further, as the history of the cotton famine shows, the price of cotton largely affects that of wool, linen and other things of its own class; while cotton-seed oil is ever opening up new rivalries with things of its own class. Again, many new uses have been found for straw in manufacture; and these inventions are giving value to straw that used to be burnt in the West of America, and tend to hinder the rise in the marginal cost of producing wheat. (20)
1. Compare III, III, section 6. It will be recollected that the things in a form ready for immediate use have been called goods of the first order, or consumers' goods; and that things used as factors of production of other goods have been called producers' goods, or goods of the second and higher orders or intermediate goods: also that it is difficult to say when goods are really finished; that many things are commonly treated as finished consumers' goods before they are really ready for consumption, e.g. flour. See II, iii, section I. The vagueness of the notion of instrumental goods, regarded as things the value of which is derived from that of their products, is indicated in Appendix E, section 3.
2. This is at any rate true under all ordinary conditions: there will be less extra charges for overtime; and the price of the labour of carpenters, bricklayers and others is likely rather to go down than to go up, and the same is true of brick and other building materials.
3. The broad account given in the text may suffice for most purposes; and the general reader should perhaps omit the remaining footnotes to this chapter.
It must be remembered that this Derived schedule has no validity except on the suppositions that we are isolating this one factor for separate study; that its own conditions of supply are disturbed; that there is at the time no independent disturbance affecting any other element in the problem; and that therefore in the case of each of the other factors of production the selling price may be taken to coincide always with the supply price.
In illustrating this by a diagram, it will be well, for the sake of shortness of wording, to divide the expenses of production of a commodity into the supply prices of two things of which it is made; let us then regard the supply price of a knife as the sum of the supply prices of its blade and handle, and neglect the expense of putting the two together. Let ss' be the supply curve for handles and SS' that for knives; so that M being any point on Ox, and MqQ being drawn vertically to cut ss'. in q and SS' in Q, Mq is the supply price for OM handles, qQ is the supply price for OM blades and MQ the supply price for OM knives. Let DD' the demand curve for knives cut SS' in A, and AaB be drawn vertically as in the figure. Then in equilibrium OB knives are sold at a price BA of which Ba goes for the handle and aA for the blade.
(In this illustration we may suppose that sufficient time is allowed to enable the forces which govern supply price to work themselves out fully; and we are at liberty therefore to make our supply curves inclined negatively. This change will not affect the argument; but on the whole it is best to take our typical instance with the supply curve inclined positively.)
Now let us suppose that we want to isolate for separate study the demand for knife handles. Accordingly we suppose that the demand for knives and the supply of blades conform to the laws indicated by their respective curves: also that the supply curve for handles still remains in force and represents the circumstances of normal supply for handles, although the supply of handles is temporarily disturbed. Let MQ cut DD' in P, then MP is the demand price for OM knives and Qq is the supply price for OM blades. Take a point p in MP such that Pp is equal to Qq, and therefore Mp is the excess of MP over Qq; then Mp is the demand price for OM handles. Let dd' be the locus of p obtained by giving M successive positions along Ox and finding the corresponding positions of p; then dd' is the derived demand curve for handles. Of course it passes through a. We may now neglect all the rest of the figure except the curves dd', ss'; and regard them as representing the relations of demand for and supply of handles, other things being equal, that is to say, in the absence of any disturbing cause which affects the law of supply of blades and the law of demand for knives. Ba is then the equilibrium price of handles, about which the market price oscillates, in the manner investigated in the preceding chapter, under the influence of demand and supply, of which the schedules are represented by dd' and ss' It has already been remarked that the ordinary demand and supply curves have no practical value except in the immediate neighbourhood of the point of equilibrium. And the same remark applies with even greater force to the equation of derived demand.
[Since Mp Mq = MP - MQ; therefore A being a point of stable equilibrium, the equilibrium at a also is stable. But this statement needs to be somewhat qualified if the supply curves are negatively inclined: see Appendix H.]
In the illustration that has just been worked out the unit of each of the factors remains unchanged whatever be the amount of the commodity produced; for one blade and one handle are always required for each knife; but when a change in the amount of the commodity produced occasions a change in the amount of each factor that is required for the production of a unit of the commodity, the demand and supply curves for the factor got by the above process are not expressed in terms of fixed units of the factor. They must be translated back into fixed units before they are available for general use. (See Mathematical Note XIV bis.)
4. We have to inquire under what conditions the ratio pM to aB will be the greatest, pM being the demand price for the factor in question corresponding to a supply reduced from OB to OM, that is reduced by the given amount BM. The second condition is that PM should be large; and since the elasticity of demand is measured by the ratio which BM bears to the excess of PM over AB, the greater PM is, the smaller, other things being equal, is the elasticity of demand.
5. The third condition is that when PM exceeds AB in a given ratio, pM shall be caused to exceed Ba in a large ratio: and other things being equal, that requires Ba to be but a small part of BA.
6. That is, if Qq had been smaller than it is, Pp would have been smaller and Mp would have been larger. See also Mathematical Note XV .
7. It is shown in Böhm Bawerk's excellent Grundzüge der Theorie des wirtschaftlichen Güterwerts (Jahrbuch für Natoonaiökonomie und Statistik, vol. XIII, p. 59) that if all but one of the factors of production of a commodity have available substitutes in unlimited supply, by which their own price is rigidly fixed, the derived demand price for the remaining factor will be the excess of the demand price for the finished product over the sum of the supply prices thus fixed for the remaining factors. This is an interesting special case of the law given in the text .
8. See Mathematical Note XVI.
9. See above, III, IV, sections 2, 4.
10. See III, v.
11. Thus, let a factor of production have three uses. Let d1d1' be the demand curve for it in its first use. From N any point on Oy draw Np1 horizontally to cut d1d1' in p1; then Np1 is the amount that is demanded for the first use at price ON . Produce Np1 to p2, and further on to P making p1p2 and p2P of such lengths as to represent the amounts of the factor demanded at price ON for the second and third uses respectively. As N moves along Oy let p2 trace out the curve d2d2' and let P trace out the curve DD'. Thus d2d2' would be the demand curve for the factor if it had only its first and second uses. DD' is its demand curve for all three uses. It is immaterial in what order we take the several uses. In the case represented, the demand for the second use begins at a lower price and that for the third use begins at a higher price than does the demand for the first use. (See Mathematical Note XVII.)
12. Professor Dewsnup (American Economic Review, Supplement 1914, p. 89) suggests that things should be described as joint products, when their "total costs of production by a single plant are less than the sum of the costs of their production by separate plants." This definition is less general than that reached at the end of this section; but it is convenient for some special uses.
13. If it is desired to isolate the relations of demand and supply for a joint product, the derived supply price is found in just the same way as the derived demand price for a factor of production was found in the parallel case of demand. Other things must be assumed to be equal (that is, the supply schedule for the whole process of production must be assumed to remain in force and so must the demand schedule for each of the joint products except that to be isolated). The derived supply price is then found by the rule that it must equal the excess of the supply price for the whole process of production over the sum of the demand prices of all the other joint products; the prices being taken throughout with reference to corresponding amounts.
We must again illustrate by a simple example in which it is assumed that the relative amounts of the two joint products are unalterable. Let SS' be the supply curve for bullocks which yield meat and leather in fixed quantities; dd' the demand curve for their carcases, that is, for the meat derived from them. M being any point on Ox draw Mp vertically to cut dd' in p, and produce it to P so that pP represents the demand price for OM hides. Then MP is the demand price for OM bullocks, and DD' the locus of P is the demand curve for bullocks: it may be called the total demand curve. Let DD' cut SS' in A; and draw AaB as in the figure. Then in equilibrium OB bullocks are produced and sold at the price BA of which Ba goes for the carcase and aA for the hide.
Let MP cut SS' in Q. From QM cut off Qq equal to Pp; then q is a point on the derived supply curve for carcases. For if we assume that the selling price of OM hides is always equal to the corresponding demand price Pp, it follows that since it costs QM to produce each of OM bullocks there remains a price QM Pp, that is qM, to be borne by each of the OM carcases. Then ss' the locus of q, and yy' are the supply and demand curves for carcases. (See Mathematical Note XVIII.)
14. See Mathematical Note XIX.
15. A little more is said on this subject in the next chapter: it is discussed fully in the forthcoming work on Industry and Trade.
16. The latter phrase "competing commodities" is used by Prof. Fisher in his brilliant Mathematical Investigations in the Theory of Value and Prices, which throw much light on the subjects discussed in the present chapter.
17. Comp. Jevons, l. c. pp. 145-6. See also above, footnotes on pp. 100, 105.
18. The want which all the rivals tend to satisfy is met by a composite supply, the total supply at any price being the sum of the partial supplies at that price.
Thus, for instance, N being any point on Oy draw Nq1q2Q parallel to Ox such that Nq1' q1q2 and q2Q are respectively the amounts of the irst, second and third of those rivals which can be supplied at the price ON. Then NQ is the total composite supply at that price, and the locus of Q is the total supply curve of the means of satisfying the want in question. Of course the units of the several things which are rivals must be so taken that each of them satisfies the same amount of the want. In the case represented in the figure small quantities of the first rival can be put on the market at a price too low to call forth any supply of the other two, and small quantities of the second at a price too low to call forth any of the third. (See Mathematical Note XX.)
Continued rivalry is as a rule possible only when none of the rivals has its supply governed by the law of increasing return. The equilibrium is stable only when none of them is able to drive the others out; and this is the case when all of them conform to the law of diminishing return; because then if one did obtain a temporary advantage and its use increased, its supply price would rise, and then the others would begin to undersell it. But if one of them conformed to the law of increasing return, the rivalry would soon cease; for whenever it happened to gain a temporary advantage over its rivals its increased use would lower its supply price and therefore increase its saleits supply price would then be further lowered, and so on: thus its advantage over its rivals would be continually increased until it had driven them out of the field. It is true that there are apparent exceptions to this rule; and things which conform to the law of increasing return do sometimes seem to remain for a long time in the field as rivals: such is the case perhaps with different kinds of sewing machines and of electric lights. But in these cases the things do not really satisfy the same wants, they appeal to slightly different needs or tastes; there is still some difference of opinion as to their relative merits; or else perhaps some of them are patented or in some other way have become the monopoly of particular firms. In such cases custom and the force of advertising may keep many rivals in the field for a long time; particularly if the producers of those things which are really the best in proportion to their expenses of production are not able effectively to advertise and push their wares by travellers and other agencies.
19. Toynbee (Industrial Revolution, p. 80).
20. Again, since sheep and oxen compete for the use of land, leather and cloth compete in indirect demand for the use of a factor of production. But also in the upholsterer's shop they compete as supplying means for meeting the same want. There is thus a composite demand on the part of upholsterer and shoemaker for leather. and also for cloth when the upper part of a shoe is made of cloth: the shoe offers a joint demand for cloth and leather, they offering complementary supplies: and so on, in endless complications. See Mathematical Note XXI. The Austrian doctrine of "imputed value" has something in common with that of derived value given in this chapter. Whichever phrase be used, it is important that we should recognize the continuity between the old doctrine of value and the new; and that we should treat imputed or derived values merely as elements which take their place with many others in the broad problem of distribution and exchange. The new phrases merely give the means of applying to the ordinary affairs of life, some of that precision of expression which is the special property of mathematical language. Producers have alw.ays to consider how the demand for any raw material in which they are interested is dependent on the demand for the things in making which it is used, and how it is influenced by every change that affects them; and this is really a special case of the problem of ascertaining the efficient strength of any one of the forces, which contribute to a common result. In mathematical language this common result is called a function of the various forces: and the (marginal) contribution, which any of them is making to it, is represented by the (small) change in the result which would result from a (small) change in that force; that is by the differential coefficient of the result with regard to that force. In other words, the imputed value, or the derived value of a factor of production, if used for only one product, is the differential coefficient of that product with regard to that factor; and so on in successive complications, as indicated in Notes XIV-XXI of the Mathematical Appendix. (Some objections to parts of Prof. Wieser's doctrine of imputed values are well urged by Prof. Edgeworth, Economic Journal, Vol. v, pp. 279-85.)
Cost of Marketing, Insurance against Risk, Cost of Production
1. We may now return to the consideration of prime and supplementary costs, with special reference to the proper distribution of the latter between the joint products of a business.
It often happens that a thing made in one branch of a business is used as a raw material in another, and then the question of the relative profitableness of the two branches can be accurately ascertained only by an elaborate system of book-keeping by double entry; though in practice it is more common to rely on rough estimates made by an almost instinctive guess. Some of the best illustrations of this difficulty are found in agriculture, especially when the same farm combines permanent pasture and arable land worked on long rotation. (1)
Another difficult case is that of the shipowner who has to apportion the expenses of his ship between heavy goods and goods that are bulky but not heavy. He tries, as far as may be, to get a mixed cargo of both kinds; and an important element in the struggle for existence of rival ports is the disadvantage under which those ports lie which are able to offer a cargo only of bulky or only of heavy goods: while a port whose chief exports are weighty but not bulky, attracts to its neighbourhood industries which make for export goods that can be shipped from it at low freights. The Staffordshire Potteries, for example, owe part of their success to the low freights at which their goods are carried by ships sailing from the Mersey with iron and other heavy cargoes.
But there is free competition in the shipowning trade, and it has great powers of variation as regards the size and shape of ships, the routes which they take, and the whole method of trading; and thus in many ways the general principle can be applied, that the relative proportions of the joint products of a business should be so modified that the marginal expenses of production of either product should be equal to its marginal demand price. (2) Or, in other words, the amount of carrying power for each kind of cargo has a constant tendency to move towards equilibrium at a point at which the demand price for that amount in a normal state of trade is just sufficient to cover the expenses of providing it; these expenses being reckoned so as to include not only its (money) prime cost, but also all those general expenses of the business which are in the long run incurred on its account, whether directly or indirectly. (3)
In some branches of manufacture it is customary to make a first approximation to the total cost of producing any class of goods, by assuming that their share of the general expenses of the business is proportionate either to their prime cost, or to the special labour bill that is incurred in making them. Corrections can then be made to meet such cases as those of goods which require either more or less than an average share of space or light, or of the use of expensive machinery; and so on.
2. There are two elements of the general a business, the sharing of which between the different requires some special attention. They are the expense marketing and that of insurance against risk. Some kinds of goods are easily marketed; there is steady demand for them, and it is always safe to make them for stock. But for that very reason competition cuts their price "very fine," and does not allow a large margin above the direct cost of making them. Sometimes the tasks of making and selling them can be rendered almost automatic, so as to require very little to be charged on their account under the heads of the expenses of management and marketing. But in practice it is not uncommon to charge such goods with even less than the small share that would properly fall to them, and to use them as a means of obtaining and maintaining a business connection, that will facilitate the marketing of other classes of goods, the production of which cannot so well be reduced to routine; for as to these there is not so close a competition. Manufacturers, especially in trades connected with furniture and dress, and retailers in almost all trades, frequently find it best to use certain of their goods as a means of advertising others, and to charge the first with less and the second with more than their proportionate share of supplementary expenses. In the former class they put those goods which are so uniform in character and so largely consumed that nearly all purchasers know their value well, in the second those with regard to which purchasers think more of consulting their fancy than of buying at the lowest possible price.
All difficulties of this kind are much increased by that instability of supply price, which results whenever the tendency to increasing return is acting strongly. We have seen that in seeking the normal supply price in such cases we must select as representative a business which is managed with normal ability and so as to get its fair share of the economies, both internal and external, resulting from industrial organization: also that these economies, though they fluctuate with the fortunes of particular businesses, yet increase generally when the aggregate production increases. Now it is obvious that if a manufacturer makes a commodity the increased production of which would put largely increased internal economies within his reach, it is worth his while to sacrifice a great deal in order to push its sales in a new market. If he has a large capital, and the commodity is one in much demand, his expenditure for this purpose may be very great, even exceeding that which he devotes directly to the manufacture: and if, as is likely, he is pushing at the same time several other commodities, nothing more than a very rough guess can be made as to what share of this expenditure should be charged to the sales of each of them in the current year, and what share should be charged to the connection which he is endeavouring to build up for them in the future.
In fact when the production of a commodity conforms to the law of increasing return in such a way as to give a very great advantage to large producers, it is apt to fall almost entirely into the hands of a few large firms; and then the normal marginal supply price cannot be isolated on the plan just referred to, because that plan assumes the existence of a great many competitors with businesses of all sizes, some of them being young and some old, some in the ascending and some in the descending phase. The production of such a commodity really partakes in a great measure of the nature of a monopoly; and its price is likely to be so much influenced by the incidents of the campaign between rival producers, each struggling for an extension of territory, as scarcely to have a true normal level.
Economic progress is constantly offering new facilities for marketing goods at a distance: it not only lowers cost of carriage, but what is often more important, it enables producers and consumers in distant places to get in touch with one another. In spite of this, the advantages of the producer who lives on the spot are very great in many trades; they often enable him to hold his own against competitors at a distance whose methods of production are more economical. He can sell in his own neighbourhood as cheaply as they can, because though the cost of making is greater for his goods than for theirs, he escapes much of the cost which they incur for marketing. But time is on the side of the more economic methods of production; his distant competitors will gradually get a stronger footing in the place, unless he or some new man adopts their improved methods.
It remains to make a closer study of the relation in which insurance against the risks of a business stands to the supply price of any particular commodity produced in it.
3. The manufacturer and the trader commonly insure against injury by fire and loss at sea; and the premiums which they pay are among the general expenses, a share of which has to be added to the prime cost in order to determine the total cost of their goods. But no insurance can be effected against the great majority of business risks.
Even as regards losses by fire and sea, insurance companies have to allow for possible carelessness and fraud; and must therefore, independently of all allowances for their own expenses and profits, charge premiums considerably higher than the true equivalent of the risks run by the buildings or the ships of those who manage their affairs well. The injury done by fire or sea however is likely, if it occurs at all, to be so very great that it is generally worth while to pay this extra charge; partly for special trade reasons, but chiefly because the total utility of increasing wealth increases less than in proportion to its amount. But the greater part of business risks are so inseparably connected with the general management of the business that an insurance company which undertook them would really make itself responsible for the business: and in consequence every firm has to act as its own insurance office with regard to them. The charges to which it is put under this head are part of its general expenses, and a share of them has to be added to the prime cost of each of its products.
But here there are two difficulties. In some cases insurance against risk is apt to be left out of account altogether, in others it is apt to be counted twice over. Thus a large shipowner sometimes declines to insure his ships with the underwriters: and sets aside part at least of the premiums that he might have paid to them, to build up an insurance fund of his own. But he must still, when calculating the total cost of working a ship, add to its prime cost a charge on account of insurance. And he must do the same thing, in some form or other, with regard to those risks against which he could not buy an insurance policy on reasonable terms even if he wanted to. At times, for instance, some of his ships will be idle in port, or will earn only nominal freights: and to make his business remunerative in the long run he must, in some form or other, charge his successful voyages with an insurance premium to make up for his losses on those which are unsuccessful.
In general, however, he does this, not by making a formal entry in his accounts under a separate head, but by the simple plan of taking the average of successful and unsuccessful voyages together; and when that has once been done, insurance against these risks cannot be entered as a separate item in cost of production, without counting the same thing twice over. Having decided to run these risks himself, he is likely to spend a little more than the average of his competitors, in providing against their occurrence; and this extra expense enters in the ordinary way into his balance-sheet. It is really an insurance premium in another form; and therefore he must not count insurance against this part of the risk separately, for then he would be counting it twice over. (4)
When a manufacturer has taken the average of his sales of dress materials over a long time, and bases his future action on the results of his past experience, he has already allowed for the risk that the machinery will be depreciated by new inventions rendering it nearly obsolete, and for the risk that his goods will be depreciated by changes in fashion. If he were to allow separately for insurance against these risks, he would be counting the same thin twice over. (5)
4. Thus, though when we have counted up the average receipts of a risky trade, we must not make a separate full allowance for insurance against risk; though there may be something to be allowed as a charge on account of uncertainty. It is true that an adventurous occupation, such as gold mining, has special attractions for some people: the deterrent force of risks of loss in it is less than the attractive force of chances of great gain, even when the value of the latter estimated on the actuarial principle is much less than that of the former; and as Adam Smith pointed out, a risky trade, in which there is an element of romance, often becomes so overcrowded that the average earnings in it are lower than if there were no risks to be run. (6) But in the large majority of cases the influence of risk is in the opposite direction; a railway stock that is certain to pay four per cent. will sell for a higher price than one which is equally likely to pay one or seven per cent. or any intermediate amount.
Every trade then has its own peculiarities, but in most cases the evils of uncertainty count for something, though not very much: in some cases a slightly higher average price is required to induce a given outlay, if that average is the mean of widely divergent and uncertain results, than if the adventurer may reckon confidently on a return that differs but little from that average. To the average price therefore we must add a recompense for uncertainty, if that is unusually great; though if we added insurance against risk we should be counting the greater part of that twice over. (7)
5. This discussion of the risks of trade has again brought before us the fact that the value of a thing, though it tends to equal its normal (money) cost of production, does not coincide with it at any particular time, save by accident. Carey, observing this, suggested that we should speak of value in relation to (money) cost of reproduction instead of in relation to cost of production.
The suggestion has, however, no significance so far as normal values are concerned. For normal cost of production and normal cost of reproduction are convertible terms; and no real change is made by saying that the normal value of a thing tends to equal its normal (money) cost of reproduction instead of its normal (money) cost of production. The former phrase is less simple than the latter, but means the same thing.
And no valid argument for the change can be founded on the fact, which may be readily admitted, that there are some few cases in which the market value of a thing is nearer its cost of reproduction than the cost that was actually incurred in producing that particular thing. The present price of an iron ship for instance, made before the great recent improvements in the manufacture of iron, might diverge less from the cost of reproducing it, that is of producing another just like it by modern methods, than from that which was actually incurred in producing it. But the price of the old ship would be less than the cost of reproduction of the ship, because the art of designing ships has improved as fast as that of manufacturing iron; and moreover steel has displaced iron as the material of shipbuilding. It may still be urged that the price of the ship is equal to that of producing a ship, which would be equally serviceable, on a modern plan and by modern methods. But that would not be the same thing as saying that the value of the ship is equal to its cost of reproduction; and, as a matter of fact, when, as often happens, an unexpected scarcity of ships causes freights to increase very rapidly, those who are anxious to reap the harvest of profitable trade, will pay for a ship in sailing order a price much above that for which a shipbuilding firm would contract to produce another equally good and deliver it some time hence. Cost of reproduction influence on value, save when purchasers can wait for the production of new supplies.
Again, there is no connection between cost of reproduction and price in the cases of food in a beleaguered city, of quinine the supply of which has run short in a fever-stricken island, of a picture by Raphael, of a book that nobody cares to read, of an armour-clad ship of obsolete pattern, of fish when the market is glutted, of fish when the market is nearly empty, of a cracked bell, of a dress material that has gone out of fashion, or of a house in a deserted mining village.
The reader, unless already experienced in economic analysis, is recommended to omit the next seven chapters, and pass at once to Chapter XV, which contains a brief summary of this Book. It is true that the four chapters on marginal costs in relation to values, and especially Chapters VIII and IX, bear upon some difficulties which are latent in the phrase "the net product of labour"; and that this phrase is used in Book VI. But the broad explanation of it given there will suffice provisionally for most purposes; and the intricacies connected with it may be best appreciated at a somewhat advanced stage of economic studies.
1. There is scope for applications of mathematical or semi-mathematical analyses, such as are indicated in the last chapter, to some of the chief practical difficulties of book-keeping by double entry in different trades.
2. Compare VI, section 4.
3. Of course this does not apply to railway rates. For a railway company having little elasticity as to its methods of working, and often not much competition from outside, has no inducement to endeavour to adjust the charges which it makes for different kinds of traffic to their cost to itself. In fact though it may ascertain the prime cost in each case easily enough, it cannot determine accUrately what are the relative total costs of fast and slow traffic, of short and long distance traffic, of light and heavy traffic; nor again of extra traffic when its lines and its trains are crowded and when they are nearly empty.
4. Again, certain insurance companies in America take risks against fire in factories at very much less than the ordinary rates, on condition that some prescribed precautions are taken, such as providing automatic sprinklers and making the walls and floor solid. The expense incurred in these arrangements is really an insurance premium; and care must be taken not to count it twice over. A factory which undertakes its own risks against fire will have to add to the prime cost of its goods an allowance for insurance at a lower rate, if it is arranged on this plan, than if built in the ordinary way.
5. Again, when a farmer has calculated the expenses of raising any particular crop with reference to an average year, he must not count in addition insurance against the risk that the season may be bad, and the crop a failure: for in taking an average year, he has already set of the chances of exceptionally good and bad seasons against one another. When the earnings of a ferryman have been calculated on the average of a year, allowance has already been made for the risk that he may sometimes have to cross the stream with an empty boat.
6. Wealth of Nations, Book I, ch. x.
7. The evils resulting from the uncertainty involved in great business risks are well shown by von Thünen (Der isolierte Staat, II, I, p. 82).
1. This Chapter and the three following are given to a study of the marginal costs of products in relation to the values of those products on the one hand, and on the other hand to the values of the land, machinery, and other appliances used in making them. The study relates to normal conditions and long period results. This fact must ever be borne in mind. The market value of anything may be much above or much below the normal cost of production and the marginal costs of a particular producer at any time may stand in no close relation to marginal costs under normal conditions. (1)
It was indicated at the end of Chapter VI that no one part of the problem can be isolated from the rest. There are comparatively few things the demand for which is not greatly affected by the demand for other things to the usefulness of which they contribute; and it may even be said that the demand for the majority of articles of commerce is not direct but is derived from the demand for those commodities to the making of which they contribute, as materials or as implements. And again this demand, because it is so derived, is largely dependent on the supply of other things which will work with them in making those commodities. And again the supply of anything available for use in making any commodity is apt to be greatly influenced by the demand for that thing derived from its uses in making other commodities: and so on. These inter-relations can be and must be ignored in rapid and popular discussions on the business affairs of the world. But no study that makes any claim to thoroughness can escape from a close investigation of them. This requires many things to be borne in mind at the same time: and for that reason economics can never become a simple science. (2)
The contribution which this group of chapters aims at making covers little ground: but that ground is difficult and we shall need to work over it carefully, and from more than one point of view; for it is thickly strewn with pitfalls and stumbling blocks. It deals primarily with the earnings of land, machinery, and other material agents of production. Its main argument applies to the earnings of human beings; but they are influenced by some causes which do not Affect the earnings of material agents of production: and the matter in hand is sufficiently difficult without further complicating it by side issues.
2. Let us begin by recalling the action of the principle of substitution. In the modern world nearly all the means of production pass through the hands of employers and other business men, who specialize themselves in organizing the economic forces of the population. Each of them chooses in every case those factors of production which seem best for his purpose. And the sum of the prices which he pays for those factors which he uses is, as a rule, less than the sum of the prices which he would have to pay for any other set of factors which could be substituted for them: for, whenever it appears that this is not the case, he will, as a rule, set to work to substitute the less expensive arrangement or process. (3)
This statement is in close harmony with such common sayings of every-day life, as that "everything tends to find its own level," that "most men earn just about what they are worth," that "if one man can earn twice as much as another, that shows that his work is worth twice as much," that "machinery will displace manual labour whenever it can do the work cheaper." The principle does not indeed without hindrance. It may be restricted by custom or act law, by professional etiquette or trade-union regulation: it may be weakened by want of enterprise, or it may be softened by a generous unwillingness to part with old associates. But it never ceases to act, and it permeates all the economic adjustments of the modern world.
Thus there are some kinds of field work for which horsePower is clearly more suitable than steam-power, and vice versa. If we may now suppose that there have been no great recent improvements in horse or steam machinery, and that therefore the experience of the past has enabled farmers gradually to apply the law of substitution; then, on this supposition the application of steam-power will have been pushed just so far that any further use of it in the place of horse-power would bring no net advantage. There will however remain a margin on which they could be indifferently applied (as Jevons would have said); and on that margin the net efficiency of either in adding to the money value of the total product will be proportionate to the cost of applying it. (4)
Similarly, if there are two methods of obtaining the same result, one by skilled and the other by unskilled labour, that one will be adopted which is the more efficient in proportion to its cost. There will be a margin on which either will be indifferently applied. (5) On that line the efficiency of each will be in proportion to the price paid for it, account being taken of the special circumstances of different districts and of different workshops in the same district. In other words, the wages of skilled and unskilled labour will bear to one another the same ratio that their efficiencies do at the margin of indifference.
Again, there will be a rivalry between hand-power and machine-power similar to that between two different kinds of hand-power or two different kinds of machine-power. Thus hand-power has the advantage for some operations, as, for instance, for weeding out valuable crops that have an irregular growth; horse-power in its turn has a cleat advantage for weeding an ordinary turnip field; and the application of each of them will be pushed in each district till any further use of it would bring no net advantage there. On the margin of indifference between hand-power and horse-power their prices must be proportionate to their efficiency; and thus the influence of substitution will tend to establish a direct relation between the wages of labour and the price that has to be paid for horse-power.
3. As a rule many kinds of labour, of raw material, of machinery and other plant, and of business organization, both internal and external, go to the production of a commodity: and the advantages of economic freedom are never more strikingly manifest than when a business man endowed with genius is trying experiments, at his own risk, to see whether some new method, or combination of old methods, will be more efficient than the old. Every business man indeed, according to his energy and ability, is constantly endeavouring to obtain a notion of the relative efficiency of every agent of production that he employs; as well as of others that might possibly be substituted for some of them. He estimates as best he can how much net product (i.e. net addition to the value of his total product) will be caused by a certain extra use of any one agent; net that is after deducting for any extra expenses that may be indirectly caused by the change, and adding for any incidental savings. He endeavours to employ each agent up to that margin at which its net product would no longer exceed the price he would have to pay for it. He works generally by trained instinct rather than formal calculation; but his processes are substantially similar to those indicated in our study of derived demand; and, from another point of view, they may be described as those which might be reaped by a complex and refined system of book-keeping by double entry. (6)
We have already followed some simple estimates of this sort. We have noticed, for instance, how the proportion of hops and malt in ale can be varied, how the extra price which can be got for ale by increasing the quantity of hops in it is a representative of the causes which govern the demand price for hops. Assuming that no further trouble or expense of any kind is involved by this additional use of hops, and that the expediency of using this extra amount is doubtful, the extra value thus given to the ale is the marginal net product of the hops of which we are in search. In this case, as in most others, the net product is an improvement in quality or a general contribution to the value of the product; it is not a definite part of the produce which can be separated from the rest. But in exceptional instances that can be done. (7)
4. The notion of the marginal employment of any agent of production implies a possible tendency to diminishing return from its increased employment.
Excessive applications of any means to the attainment of any end are indeed sure to yield diminishing. returns in every branch of business; and, one may say, in all the affairs of life. We may take some additional examples of a principle that has already been illustrated. (8) In the manufacture of sewing machines some parts may well be made of cast iron; for others a common kind of steel will suffice; there are yet others for which a specially expensive steel-compound is needed; and all parts should be finished off more or less smoothly, so that the machine may work easily. Now if any one devoted a disproportionate care and expense to th selection of materials for the less important uses, it might truly be said that that expenditure was yielding a rapidly diminishing return; and that he would have done better to give some of it to making his machines work smoothly, or even to producing more machines: and the case might be even worse if he devoted an excessive expenditure to mere brilliancy of finish, and put low grade metal to work for which a higher grade was needed.
This consideration seems at first to simplify economic problems; but on the contrary it is a chief source of difficulty and confusion. For though there is some analogy between all these various tendencies to diminishing return, they yet are not identical. Thus the diminishing return which arises from an ill-proportioned application of the various agents of production into a particular task has little in common with that broad tendency to the pressure of a crowded and growing population on the means of subsistence. The great classical Law of Diminishing Return has its chief application, not to any one particular crop, but to all the chief food crops. It takes for granted that farmers raise, as a rule, those crops for which their land and other resources are best adapted, account being taken of the relative demands for the several crops; and that they distribute their resources appropriately between different routes. It does not attribute to them unlimited intelligence and wisdom, but it assumes that, taking one with another, they have shown a reasonable amount of care and discretion in the distribution of these resources. It refers to a country the whole land of which is already in the hands of active business men, who can supplement their own capital by loans from banks wherever they can show it is likely to be well applied; and asserts that an increase in the total amount of capital applied to agriculture in that country will yield diminishing returns of produce in general. This statement is akin to, but yet quite distinct from, the statement that if any farmer makes a bad distribution of his resources between different plans of cultivation, he will get a markedly diminishing return from those elements of expenditure which he has driven to excess.
For instance, in any given case, there is a certain proportion between the amounts which may with best advantage be spent on ploughing and harrowing, or manuring. There might be some differences of opinion on the matter, but only within narrow limits. An inexperienced person who ploughed many times over land, which was already in fairly good mechanical condition, while he gave it little or none of the manure which it was craving, would be generally condemned as having so over applied ploughing as to make it yield a rapidly diminishing return. But this result of the misapplication of resources has no very close connection with the tendency of agriculture in an old country to yield a diminishing return to a general increase of resources well applied in cultivation: and indeed exactly parallel cases can be found of a diminishing return to particular resources when applied in undue proportion, even in industries which yield an increasing return to increased applications of capital and labour when appropriately distributed. (9)
5. The part played by the net product at of production in the modern doctrine of Distribution is to be misunderstood. In particular many able writers have supposed that it represents the marginal use of a thing as governing the value of the whole. It is not so; the doctrine says we must go to the margin to study the action of those forces which govern the value of the whole: and that is a very different affair. Of course the withdrawal of (say) iron from any of its necessary uses would have just the same influence on its value as its withdrawal from its marginal uses; in the same way as the pressure in a boiler for cooking under high pressure would be affected by the escape of any other steam just as it would by the escape of the steam in one of the safety valves: but in fact the steam does not escape except through the safety valves. In like manner iron, or any other agent of production, is not (under ordinary circumstances) thrown out of use except at points at which its use yields no clear surplus of profit; that is, it is thrown out from its marginal uses only.
Again, the finger of an automatic weighing machine determines, in the sense of indicating, the weight sought for. So the escape of steam from a safety valve, governed by a spring representing a pressure of a hundred pounds to the square inch, determines the pressure of steam in the boiler, in the sense of indicating that it has reached a hundred pounds to the inch. The pressure is caused by the heat; the spring in the valve governs the pressure by yielding and letting out some of the steam when its amount is so great, at the existing heat, as to overbear the resistance of the spring.
Similarly, with regard to machinery and other appliances of production made by man, there is a margin through which additional supplies come in after overcoming the resistance of a spring, called "cost of production," For when the supply of those appliances is so small relatively to the demand that the earnings expected from new supplies are more than sufficient to yield normal interest (or profits, if earnings of management are reckoned in) on their cost of production, besides allowing for depreciation, etc., then the valve opens, and the new supplies come in. When the earnings are less than this, the valve remains shut: and as anyhow the existing supply is always in process of slow destruction by use and the lapse of time, the supply is always shrinking when the valve is closed. The valve is that part of the machinery by which the general relations of demand and supply govern value. But marginal uses do not govern value; because they, together with value, are themselves governed by those general relations.
6. Thus, so long as the resources of an individual producer are in the form of general purchasing power, he will push every investment up to the margin at which he no longer expects from it a higher net return than he could get by investing in some other material, or machine, or advertisement, or in the hire of some additional labour every investment will, as it were, be driven up to a valve which offers to it a resistance equal to its own expanding force. If he invests in material or in labour, that is soon embodied in some saleable product: the sale replenishes his fluid capital, and that again is invested up to the margin at which any further investment would yield a return so diminished as not to be profitable.
But if he invests in land, or in a durable building or machine, the return which he gets from his investment may vary widely from his expectation. It will be governed by the market for his products, which may change its character largely through new inventions, changes in fashion, etc., during the life of a machine, to say nothing of the perpetual life of land. The incomes which he thus may derive from investments in land and in machinery differ from his individual point of view mainly in the longer life of the land. But in regard to production in general, a dominant difference between the two lies in the fact that the supply of land is fixed (though in a new country, the supply of land utilized in man's service may be increased); while the supply of machines may be increased without limit. And this difference reacts on the individual producer. For if no great new invention renders his machines obsolete, while there is a steady demand for the things made by them, they will be constantly on sale at about their cost of production; and his machines will generally yield him normal profits on that cost of production, with deductions corresponding to their wear and tear.
Thus the rate of interest is a ratio: and the two things which it connects are both sums of money. So long as capital is "free," and the sum of money or general purchasing power over which it gives command is known, the net money income, expected to be derived from it, can be represented at once as bearing a given ratio (four or five or ten per cent) to that sum. But when the free capital has been invested in a particular thing, its money value cannot as a rule be ascertained except by capitalizing the net income which it will yield: and therefore the causes which govern it are likely to be akin in a greater or less degree to those which govern rents.
We are thus brought to the central doctrine of this part of economics, viz.: — "That which is rightly regarded as interest on 'free' or 'floating' capital, or on new investments of capital, is more properly treated as a sort of rent — a Quasi-rent — On old investments of capital. And there is no sharp line of division between floating capital and that which has been 'sunk' for a special branch of production, nor between new and old investments of capital; each group shades into the other gradually. And thus even the rent of land is seen, not as a thing by itself, but as the leading species of a large genus; though indeed it has peculiarities of its own which are of vital importance from the point of view of theory as well as of practice." (10)
1. Numerous objections have been urged against the important place assigned to marginal costs in modern analysis. But it will be found that most of them rely on arguments, in which statements referring to normal conditions and normal value are controverted by statements relating to abnormal or particular conditions.
2. The reader is referred to the footnote on p. 393 with special reference to the compressed mathematical version of the central problem of value which begins in Note XIV in the Mathematical Appendix and culminates in Note XXI.
3. Compare V, III, section 3; and V, IV, sections 3, 4; and Note XIV in the Mathematical Appendix.
4. This margin will vary with local circumstances, as well as with the habits, inclinations, and resources of individual farmers. The difficulty of applying steam machinery in small fields and on rugged ground is overcome more generally in those districts in which labour is scarce than in those in which it is plentiful; especially if, as is probable, coal is cheaper, and the feed of horses dearer in the former than the latter.
5. Skilled manual labour being generally used for special orders and for things of which not many are required of the same pattern; and unskilled labour aided by specialized machinery being used for others. The two methods are to be seen side by side on similar work in every large workshop: but the position of the line between them will vary a little from one workshop to another.
6. The changes, which he desires, may be such as could only be made on a large scale; as for instance the substitution of steam-power for hand-power in a certain factory; and in that case there would be a certain element of uncertainty and risk in the change. Such breaches of continuity are however inevitable both in production and consumption if we regard the action of single individuals. But as there is a continuous demand in a large market for hats and watches and wedding cakes, though no individual buys many of them (see III, III, section 5), so there will always be trades in which small businesses are most economically conducted without steam power, and larger businesses with; while businesses of intermediate size are on the margin. Again, even in large establishments in which steam is already in use, there will always be some things done by hand-power which are done by steam power elsewhere; and so on .
7. See p. 387, and Mathematical Note XVI. See also other illustrations in, VI, VII. A further illustration of the relation between the wages of the marginal shepherd, and the net product of his labour will be worked out in detail in VI, I, section 7 .
8. See V, IV, section 4; see also the note on von Thünen, below, p. 523.
9. See above IV, iii, section 8; and Carver, Distribution of Wealth, ch. ii, and above footnotes on pp. 319, 320. Mr J. A. Hobson is a vigorous and suggestive writer on the realistic and social sides of economics: but, as a critic of Ricardian doctrines, he is perhaps apt to underrate the difficulty of the problems which he discusses. He argues that if the marginal application of any agent of production be curtailed, that will so disorganize production that every other agent will be working to less effect than before; and that therefore the total resulting loss will include not only the true marginal product of that agent, but also a part of the products due to the other agents: but he appears to have overlooked the following points: — (1) There are forces constantly at work tending so to readjust the distribution of resources between their different uses, that any maladjustment will be arrested before it has gone far: and the argument does not profess to apply to exceptional cases of violent maladjustment. (2) When the adjustment is such as to give the best results, a slight change in the proportions in which they are applied diminishes the efficiency of that adjustment by a quantity which is very small relatively to that change in technical language it is of "the second order of smalls" — ; and it may therefore be neglected relatively to that change. (In pure mathematical phrase, efficiency being regarded as a function of the proportions of the agents; when the efficiency is at its maximum, its differential coefficient with regard to any one of these proportions is zero.) A grave error would therefore have been involved, if any allowance had been made for those elements which Mr Hobson asserts to have been overlooked. (3) In economics, as in physics, changes are generally continuous. Convulsive changes may indeed occur, but they must be dealt with separately: and an illustration drawn from a convulsive change can throw no true light on the processes of normal steady evolution. In the particular problem before us, this precaution is of special importance: for a violent check to the supply of any one agent of production, may easily render the work of all other agents practically useless; and therefore it may inflict a loss out of all proportion to the harm done by a small check to the supply of that agent when applied up to that margin, at which there was doubt whether the extra net product due to a small additional application of it would be remunerative. The study of changes in complex quantitative relations is often vitiated by a neglect of this consideration, to which Mr Hobson seems to be prone; as indeed is instanced by his remarks on a "marginal shepherd" in The Industrial System, p. i 10. See Professor Edgeworth's masterly analyses of the two instances mentioned in this note, Quarterly Journal of Economics, 1904, p. 167; and Scientia, 1910, pp. 95-100.
10. This statement is reproduced from the Preface to the first edition of the present volume.
General Principles, Continued
1. The incidents of the tenure of land are so complex: and so many practical issues connected with them have raised controversies on side issues of the problem of value, that it will be well to supplement our previous illustration from land. We may take another from an imaginary commodity so chosen that sharp outlines can be assigned to each stage of the problem, without inviting the objection that such sharp outlines are not found in the actual relations between landlord and tenant.
But before entering on this, we may prepare the way for using, as we go, illustrations drawn from the incidence of taxation to throw side-lights on the problem of value. For indeed a great part of economic science is occupied with the diffusion throughout the community of economic changes which primarily affect some particular branch of production or consumption; and there is scarcely any economic principle which cannot be aptly illustrated by a discussion of the shifting of the effects of some tax "forwards," i.e. towards the ultimate consumer, and away from the producer of raw material and implements of production; or else in the opposite direction, "backwards." But especially is this true of the class of problems now under discussion. (1)
It is a general principle that if a tax impinges on anything used by one set of persons in the production of goods or services to be disposed of to other persons, the tax tends to check production. This tends to shift a large part of the burden of the tax forwards on to consumers, and a small part backwards on to those who supply the requirements of this set of producers. Similarly, a tax on the consumption of anything is shifted in a greater or less degree backwards on to its producer.
For instance, an unexpected and heavy tax upon printing would strike hard upon those engaged in the trade, for if they attempted to raise prices much, demand would fall off quickly: but the blow would bear unevenly on various classes engaged in the trade. Since printing machines and compositors cannot easily find employment out of the trade, the prices of printing machines and wages of compositors would be kept low for some time. On the other hand, the buildings and steam engines, the porters, engineers, and clerks would not wait for their numbers to be adjusted by the slow process of natural decay to the diminished demand; some of them would be quickly at work in other trades, and very little of the burden would stay long on those of them who remained in the trade. A considerable part of the burden, again, would fall on subsidiary industries, such as those engaged in making paper and type; because the market for their products would be curtailed. Authors and publishers would also suffer a little; because they would be forced either to raise the price of books, with a consequent diminution of sales, or to see a greater proportion of their gross receipts swallowed up by costs. Finally, the total turnover of the booksellers would diminish, and they would suffer a little.
So far it has been assumed that the tax spreads its net very wide, and covers every place to which the printing industry in question could be easily transferred. But, if the tax were only local, the compositors would migrate beyond its reach; and the owners of printing houses might bear a larger and not a smaller proportionate share of the burden than those whose resources were more specialized but more mobile. If the local tax were uncompensated by any effect which tended to attract population, part of the burden would be thrown on local bakers, grocers, etc., whose sales would be diminished.
Next suppose the tax to be levied on printing presses instead of on printed matter. In that case, if the printers had no semi-obsolete presses which they were inclined to destroy or to leave idle, the tax would not strike marginal production: it would not immediately affect the output of printing, nor therefore its price. It would merely intercept some of the earnings of the presses on the way to the owners, and lower the quasi-rents of the presses. But it would not affect the rate of net profits which was needed to induce people to invest fluid capital in presses: and therefore, as the old presses wore out, the tax would add to marginal expenses, that is to expenses which the producer was free to incur or not as he liked, and which he was in doubt whether to incur. Therefore the supply of printing would be curtailed; its price would rise: and new presses would be introduced only up to the margin at which they would be able, in the judgment of printers generally, to pay the tax and yet yield normal profits on the outlay. When this stage had been reached the distribution of the burden of a tax upon presses would henceforth be nearly the same as that of a tax upon printing: excepting only that there would be more inducement to get a great deal of work out of each press. For instance more of the presses might be made to work double shifts; in spite of the fact that night work involves special expenses.
We now pass to apply these principles of shifting of taxes to our main illustration.
2. Let us suppose that a meteoric shower of a few thousand large stones harder than diamonds fell all in one place; so that they were all picked up at once, and no amount of search could find any more. These stones, able to cut every material, would revolutionize many branches of industry; and the owners of them would have a differential advantage in production, that would afford a large producer's surplus. This surplus would be governed wholly by the urgency and volume of the demand for their services on the one hand and the number of the stones on the other hand: it could not be affected by the cost of obtaining a further supply, because none could be had at any price. A cost of production might indeed influence their value indirectly: but it would be the cost of tools made of hard steel and other materials of which the supply can be increased to keep pace with demand. So long as any of the stones were habitually used by intelligent producers for work which could be done equally well by such tools, the value of a stone could not much exceed the cost of producing tools (allowance being made for wear and tear) equally efficient with it in these inferior uses.
The stones, being so hard as not to be affected by wear, would probably be kept in operation during all the working hours of the day. And if their services were very valuable, it might be worth while to keep people working overtime, or even in double or triple shifts, in order to extract the utmost service from them. But the more intensively they were applied, the less net return would be reaped from each additional service forced from them; thus illustrating the law that the intensive working not only of land, but of every other appliance of production is likely to yield a diminishing return if pressed far enough.
The total supply of stones is fixed. But of course any particular manufacturer might obtain almost as many as he liked to pay for: and in the long run he would expect his outlay on them to be returned with interest (or profits, if the remuneration for his own work were not reckoned separately), just in the same way as if he were buying machinery, the total stock of which could be increased indefinitely, so that its price conformed pretty closely to its cost of production.
But when he had once bought the stones, changes in the processes of production or of demand for the things made by their aid, might cause the income yielded by them to become twice as great or only half as great as he had expected. In the latter case it would resemble the income derived from a machine, which had not the latest improvements and could earn only half as much as a new machine of equal cost. The values of the stone and of the machine alike would be reached by capitalizing the income which they were capable of earning, and that income would be governed by the net value of the services rendered by them. The income earning power and therefore the value of each would be independent of its own costs of production, but would be governed by the general demand for its products in relation to the general supply of those products. But in the case of the machine that supply would be controlled by the cost of supply of new machines equally efficient with it; and in the case of the stone there would be no such limit, so long as all the stones in existence were employed on work that could not be done by anything else.
This argument may be put in another way. Since any one, who bought stones, would take them from other producers, his purchase would not materially affect the general relations of demand for the services of the stones to the supply of those services. It would not therefore affect the price of the stones; which would still be the capitalized value of the services which they rendered in those uses, in which the need for them was the least urgent: and to say that the purchaser expected normal interest on the price which represented the capitalized value of the services, would be a circular statement that the value of the services rendered by stones is governed by the value of those very services. (2)
Next let us suppose that the stones were not all found at once but were scattered over the surface of the earth on public ground, and that a laborious search might expect to be rewarded by finding one here and there. Then people would hunt for the stones only up to that point, or margin, at which the probable gain of so doing would in the long run just reward the outlay of labour and capital involved; and in the long run, the normal value of the stones would be such as to maintain equilibrium between demand and supply, the number of the stones gathered annually being in the long run just that for which the normal demand price was equal to the normal supply price.
Finally, let us bring the case of the stones into accord with that of the lighter machinery and other plant ordinarily used in manufacture, by supposing that the stones were brittle, and were soon destroyed; and that an inexhaustible store existed from which additional supplies could be obtained quickly and certainly at a nearly uniform cost. In this case the value of the stones would always correspond closely to that cost: variations in demand would have but little influence on their price, because even a slight change in price would quickly effect a great change in the stock of them in the market. In this case the income derived from a stone (allowance being made for wear-and-tear) would always adhere closely to interest on its cost of production.
3. This series of hypotheses stretches continuously from the one extreme in which the income derived from the stones is a rent in the strictest sense of the term, to the other extreme in which it is to be classed rather with interest on free or floating capital. In the first extreme case the stones cannot be worn out or destroyed, and no more can be found. They of course tend to be distributed among the various uses to which they are applicable in such a way that there is no use to which an increased supply of them could be applied, without taking them away from some other use in which they were rendering net services at least as valuable. These margins of application of the several uses are thus governed by the relation in which the fixed stock of stones stands to the aggregate of demands for them in different uses. And the margins being thus governed, the prices that will be paid for their use are indicated by the value of the services which they render at any one of those margins.
A uniform tax on them, collected from the user, will lower their net service in each use by the same amount: it will not affect their distribution between several uses; and it will fall wholly on the owner, after perhaps some little delay caused by a frictional resistance to readjustments.
At the opposite extreme of our chain of hypotheses, the stones perish so quickly, and are so quickly reproduced at about a uniform cost, that variations in the urgency and volume of the uses to which the stones can be put will be followed so promptly by changes in the stock of them available, that those services can never yield much more or much less than normal interest on the money cost of obtaining additional stones. In this case a business man, when making his estimates for the cost of any undertaking in which stones will be used, may enter interest (or if he is counting his own work in, profits), for the time during which those stones will be used (together with wear-and-tear), as part of the prime, special, or direct expenses of his undertaking. A tax on the stones under these conditions would fall entirely on any one who even a little while after the tax had come into force, gave out a contract for anything in making which the stones would be used.
Taking an intermediate hypothesis as to the length of life of the stones and the rapidity with which new supplies could be obtained; we find that the charges which the borrower of stones must expect to pay, and the revenue which the owner of the stones could reckon on deriving from them at any time, might temporarily diverge some way from interest (or profits) on their cost. For changes in the urgency and volume of the uses to which they could be applied, might have caused the value of the services rendered by them in their marginal uses to rise or fall a great deal, even though there had been no considerable change in the difficulty of obtaining them. And if this rise or fall, arising from variations in demand, and not from variations in the cost of the stones, is likely to be great during the period of any particular enterprise, or any particular problem of value that is under discussion; then for that discussion the income yielded by the stones is to be regarded as more nearly akin to a rent than to interest on the cost of producing the stones. A tax upon the stones in such a case would tend to diminish the rental which people would pay for their use, and therefore to diminish the inducements towards investing capital and effort in obtaining additional supplies. It would therefore check the supply, and compel those who needed the stones to pay gradually increasing rentals for their use, up to the point at which the rentals fully covered the costs of producing the stones. But the time needed for this readjustment might be long: and in the interval a great part of the tax would fall upon the owners of the stones.
If the life of the stones was long relatively to that process of production in which the stones were used which was under discussion, the stock of stones might be in excess of that needed to do all the work for which they were specially fitted. Some of them might be lying almost idle, and the owner of these stones might make up his estimate of the marginal price for which he was just willing to work without entering in that estimate interest on the value of the stones. That is to say, some costs which would have been classed as prime costs in relation to contracts, or other affairs, which lasted over a long period, would be classed as supplementary costs in relation to a particular affair which would last but a short time, and which came under consideration when business was slack.
It is of course just as essential in the long run that the price obtained should cover general or supplementary costs as that it should cover prime costs. An industry will be driven out of existence in the long run as certainly by failing to return even a moderate interest on capital invested in steam engines, as by failing to replace the price of the coal or the raw material used up from day to day: just as a man's work will be stopped as certainly by depriving him of food as by putting him in chains. But the man can go on working fairly well for a day without food; while if he is put in chains the check to his work comes at once. So an industry may, and often does, keep tolerably active during a whole year or even more, in which very little is earned beyond prime costs, and the fixed plant has "to work for nothing." But when the price falls so low that it does not pay for the out of pocket expenses during the yea r for wages and raw material, for coal and for lighting, etc., then the production is likely to come to a sharp stop.
This is the fundamental difference between those incomes yielded by agents of production which are to be regarded as rents or quasi-rents and those which (after allowing for the replacement of wear-and-tear and other destruction) may be regarded as interest (or profits) on current investments. The difference is fundamental, but it is only one of degree. Biology tends to show that the animal and vegetable kingdoms have a common origin. But yet there are fundamental differences between mammals and trees; while in a narrower sense the differences between an oak tree and an apple tree are fundamental; and so are in a still narrower sense those between an apple tree and a rose bush, though they are both classed as rosaceae. Thus our central doctrine is that interest on free capital and quasi-rent on an old investment of capital shade into one another gradually; even the rent of land being not a thing by itself, but the leading species of a large genus. (3)
4. Again, pure elements are seldom isolated from all others by nature either in the physical or moral world. Pure rent in the strict sense of the term is scarcely ever met with: nearly all income from land contains more or less important elements which are derived from efforts invested in building houses and sheds, in draining the land and so on. But economists have learnt to recognize diversity of nature in those composite things to which the names of rent, profits, wages etc. are given in popular language; they have learnt that there is an element of true rent in the composite product that is commonly called wages, an element of true earnings in what is commonly called rent and so on. They have learnt in short to follow the example of the chemist who seeks for the true properties of each element; and who is thus prepared to deal with the common oxygen or soda of commerce, though containing admixtures of other elements. (4)
They recognize that nearly all land in actual use contains an element of capital; that separate reasonings are required for those parts of its value which are, and those which are not, due to efforts of man invested in the land for the purposes of production; and that the results of these reasonings must be combined in dealing with any particular case of that income which commonly goes by the name "rent," but not all of which is rent in the narrower sense of the term. The manner in which the reasonings are to be combined depends on the nature of the problem. Sometimes the mere mechanical "composition of forces" suffices; more often allowance must be made for a quasi-chemical interaction of the various forces; while in nearly all problems of large scope and importance, regard must be had to biological conceptions of growth.
5. Finally a little may be said on a distinction that is sometimes made between "scarcity rents" and "differential rents." In a sense all rents are scarcity rents, and all rents are differential rents. But in some cases it is convenient to estimate the rent of a particular agent by comparing its yield to that of an inferior (perhaps a marginal) agent, when similarly worked with appropriate appliances. And in other cases it is best to go straight to the fundamental relations of demand to the scarcity or abundance of the means for the production of those commodities for making which the agent is serviceable.
Suppose for instance that all the meteoric stones in existence were equally hard and imperishable; and that they were in the hands of a single authority: further that this authority decided, not to make use of its monopolistic power to restrict production so as to raise the price of its services artificially, but to work each of the stones to the full extent it could be profitably worked (that is up to the margin of pressure so intensive that the resulting product could barely be marketed at a price which covered, with profits, its expenses without allowing anything for the use of the stone). Then the price of the services rendered by the stones would have been governed by the natural scarcity of the aggregate output of their services in relation to the demand for those services; and the aggregate surplus or rent would most easily be reckoned as the excess of this scarcity price over the aggregate expenses of working the stones. It would therefore generally be regarded as a scarcity rent. But on the other hand it could have been reckoned as the differential excess of the aggregate value of the net services of the stones over that which would have been reached if all their uses had been as unproductive as their marginal uses. And exactly the same would be true if the stones were in the hands of different producers, impelled by competition with one another to work each stone up to the margin at which its further use ceased to be profitable.
This last instance has been so chosen as to bring out the fact that the "differential" as well as the "scarcity" routes for estimating rent are independent of the existence of inferior agents of production: for the differential comparison in favour of the more advantageous uses of the stones can be made by reference to the marginal uses of good stones, as clearly as by reference to the use of inferior stones which are on the margin of not being worth using at all.
In this connection it may be noted that the opinion that the existence of inferior land, or other agents of production, tends to raise the rents of the better agents is not merely untrue. It is the reverse of the truth. For, if the bad land were to be flooded and rendered incapable of producing anything at all, the cultivation of other land would need to be more intensive; and therefore the price of the product would be higher, and rents generally would be higher, than if that land had been a poor contributor to the total stock of produce. (5)
1. The substance of this section is reproduced from answers to questions proposed by the Royal Commission on Local Taxation. See [C. 9528], 1899, pp. 112-26.
2. Such circular reasonings are sometimes nearly harmless: but they always tend to overlay and hide the real issues. And they are sometimes applied to illegitimate uses by company promoters; and by advocates of special interests, who desire to influence the course of legislation in their own favour. For instance a semi monopolistic business aggregation or trust is often "over-capitalized." To effect this a time is chosen, at which the branch of production with which it is concerned is abnormally prosperous: when perhaps some solid firms are earning fifty per cent. net on their capital in a single year, and thus making up for lean years past and to come in which their receipts will do little more than cover prime costs. Financiers connected with the flotation sometimes even arrange that the businesses to be offered to the public shall have a good many orders to fill at specially favourable prices: the loss falling on themselves, or on other companies which they control. The gains to be secured by semi-monopolistic selling, and possibly by some further economies in production are emphasized: and the stock of the trust is absorbed by the public. If ultimately objection to the conduct of the trust is raised, and especially to the strengthening of its semi-monopolistic position by a high tariff or any other public favour, the answer is given that the shareholders are receiving but a moderate return on their investments. Such cases are not uncommon in America. In this country a more moderate watering of the stock of some railways has been occasionally used indirectly as a defence of the shareholders against a lowering of rates, that threatens to reduce dividends on inflated capital below what would be a fair return on solid capital.
3. See above, p. 412.
4. Professor Fetter seems to ignore this lesson in an article on "The Passing of the Concept of Rent" in the Quarterly Journal of Economics, May 1901, p. 419; where he argues that "if only those things which owe nothing to labour are classed as land, and if it is then shown that there is no material thing in settled countries of which this can be said, it follows that everything must be classed as capital." Again he appears to have missed the true import of the doctrines which he assails, when he argues (ib. pp. 423-9) against "Extension as the fundamental attribute of land, and the basis of rent." The fact is that its extension (or rather the aggregate of "its space relations") is the chief, though not the only property ofland, which causes the income derived from it (in an old country) to contain a large element of true rent: and that the element of true rent, which exists in the income derived from land, or the "rent of land" in the popular use of the term, is in practice so much more important than any others that it has given a special character to the historical development of the Theory of Rent (see above, p. 147). If meteoric stones of absolute hardness, in high demand and incapable of increase, had played a more important part in the economic history of the world than land, then the elements of true rent which attracted the chief attention of students, would have been associated with the property of hardness; and this would have given a special tone and character to the development of the Theory of Rent. But neither extension nor hardness is a fundamental attribute of all things which yield a true rent. Professor Fetter seems also to have missed the point of the central doctrine as to rents, quasi-rents and interest, given above.
5. Compare Cassel, Das Recht auf den vollen Arbeitsertrag, p. 81.
The many misconceptions, that have appeared in the writings even of able economists, as to the nature of a quasi-rent, seem to arise from an inadequate attention to the differences between short periods and long in regard to value and costs. Thus it has been said that a quasi-rent is an "unnecessary profit," and that it is "no part of cost" Quasi-rent is correctly described as an unnecessary profit in regard to short periods, because no "special" or "prime" costs have to be incurred for the production of a machine that, by hypothesis, is already made and waiting for its work. But it is a necessary profit in regard to those other (supplementary) costs which must be incurred in the long run in addition to prime costs; and which in some industries, as for instance sub marine telegraphy, are very much more important than prime costs. It is no part of cost under any conditions: but the confident expectation of coming quasi-rents is a necessary condition for the investment of capital in machinery, and for the incurring of supplementary costs generally.
Again a quasi-rent has been described as a sort of "conjuncture" or "opportunity" profit; and, almost in the same breath, as no profit or interest at all, but only a rent. For the time being, it is a conjuncture or opportunity income: while in the long run it is expected to, and it generally does, yield a normal rate of interest (or if earnings of management are counted in, of profit) on the free capital, represented by a definite sum of money that was invested in producing it. By definition the rate of interest is a percentage; that is a relation between two numbers (see above, p. 412). A machine is not a number: its value may be a certain number of pounds or dollars: but that value is estimated, unless the machine be a new one, as the aggregate of its (discounted) earnings, or quasi-rents. If the machine is new, its makers have calculated that this aggregate will appear to probable purchasers as the equivalent of a price which will repay the makers for it: in that case therefore it is as a rule, both a cost price, and a price which represents an aggregate of (discounted) future incomes. But when the machine is old and partially obsolete in pattern, there is no close relation between its value and its cost of production: its value is then simply the aggregate of the discounted values of the future quasi-rents, which it is expected to earn.
Chapter 10, Marginal Costs in Relation to Agricultural Values
1. We now pass from general considerations to those relating to land; and we begin with those specially applicable to agricultural land in an old country.
Suppose, that a war, which was not expected to last long, were to cut off part of the food supplies of England. Englishmen would set themselves to raise heavier crops by such extra application of capital or labour as was likely to yield a speedy return; they would consider the results of artificial manures, of the use of clod-crushing machines, and so on; and the more favourable these results were, the less would be the rise in the price of produce in the coming year which they regarded as necessary to make it worth their while to incur additional outlay in these directions. But the war would have very little effect on their action as to those improvements which would not bear fruit till it was over. In any inquiry then as to the causes that will determine the prices of corn during a short period, that fertility which the soil derives from slowly made improvements has to be taken for granted as it then is, almost in the same way as if it had been made by nature. Thus, the income derived from these permanent improvements gives a surplus above the prime or special costs needed for raising extra produce. But it is not a true surplus, in the same sense that the rent proper is, i.e. it is not a surplus above the total costs of the produce: it is needed to cover the general expenses of the business.
To speak more exactly: — If the extra income derived from improvements that have been made in the land by its individual owner is so reckoned as not to include any benefit which would have been conferred on the land by the general progress of society independently of his efforts and sacrifices; then, as a rule, the whole of it is required to remunerate him for those efforts and sacrifices. He may have underestimated the gains which will result from them; but he is about equally likely to have made an overestimate. If he has estimated them rightly, his interest has urged him to make the investment as soon as it showed signs of being profitable: and in the absence of any special reason to the contrary we may suppose him to have done this. In the long run, then, the net returns to the investment of capital in the land, taking successful and unsuccessful returns together, do not afford more than an adequate motive to such investment. If poorer returns had been expected than those on which people actually based their calculations, fewer improvements would have been made.
That is to say: — for periods which are long in comparison with the time needed to make improvements of any kind, and bring them into full operation, the net incomes derived from them are but the price required to be paid for the efforts and sacrifices of those who make them: the expenses of making them thus directly enter into marginal expenses of production, and take a direct part in governing long-period supply price. But in short periods, that is, in periods short relatively to the time required to make and bring into full bearing improvements of the class in question, no such direct influence on supply price is exercised by the necessity that such improvements should in the long run yield net incomes sufficient to give normal profits on their cost. And therefore when we are dealing with such periods, these incomes may be regarded as quasi-rents which depend on the price of the produce. (1)
We may conclude then: — (1) The amount of produce raised, and therefore the position of the margin of cultivation (i.e. the margin of the profitable application of capital and labour to good and bad land alike) are both governed by the general conditions of demand and supply. They are governed on the one hand by demand; that is, by the numbers of the population who consume the produce, the intensity of their need for it, and their means of paying for it; and on the other hand by supply; that is, by the extent and fertility of the available land, and the numbers and resources of those ready to cultivate it. Thus cost of production, eagerness of demand, margin of production, and price of the produce mutually govern one another: and no circular reasoning is involved in speaking of any one as in part governed by the others. (2) That part of the produce which goes as rent is of course thrown on the market, and acts on prices, in just the same way as any other part. But the general conditions of demand and supply, or their relations to one another, are not affected by the division of the produce into the share of rent and the share needed to render the farmer's expenditure profitable. The amount of that rent is not a governing cause; but is itself governed by the fertility of land, the price of the produce, and the position of the margin: it is the excess of the value of the total returns which capital and labour applied to land do obtain, over those which they would have obtained under circumstances as unfavourable as those on the margin of cultivation. (3) If the cost of production were estimated for parts of the produce which do not come from the margin, a charge on account of rent would of course need to be entered in this estimate; and if this estimate were used in an account of the causes which govern the price of the produce; then the reasoning would be circular. For that, which is wholly an effect, would be reckoned up as part of the cause of those things of which it is an effect. (4) The cost of production of the marginal produce can be ascertained without reasoning in a circle. The cost of production of other parts of the produce cannot. The cost of production on the margin of the profitable application of capital and labour is that to which the price of the whole produce tends, under the control of the general conditions of demand and supply: it does not govern price, but it focusses the causes which do govern price.
2. It has sometimes been suggested that if all land were equally advantageous and all were occupied, the income derived from it would partake of the nature of a monopoly rent: but this seems to be an error. Of course the landowners might conceivably combine to stint production, whether their properties were of equal fertility or not; the raised prices which would thus be obtained for the produce would be monopoly prices; and the incomes of the owners would be monopoly revenues rather than rents. But, with a free market, the revenues from land would be rents, governed by the same causes and in the same way in a country where the land was all of equal advantage, as in those where good and bad land were intermingled. (2)
It is, indeed, true that if there were more than enough land, all of about the same fertility, to enable everyone to have as much of it as was needed to give full scope to the capital he was prepared to apply to it, then it could yield no rent. But that merely illustrates the old paradox that water, when abundant, has no market value: for though the services of some part of it are essential to support life, yet everyone can get without effort to that margin of satiety at which any further supplies would be of no service to him. When every cottager has a well from which he can draw as much water as he needs, with no more labour than is required at his neighbour's well, the water in the well has no market value. But let a drought set in, so that the shallow wells are exhausted, and even the deeper wells are threatened, then the owners of those wells can exact a charge for every bucket which they allow anyone to draw for his own use. The denser population becomes, the more numerous will be the occasions on which such charges can be made (it being supposed that no new wells are developed): and at last every owner of a well may find in it a permanent source of revenue.
In the same way the scarcity value of land in a new country gradually emerges. The early settler exercises no exclusive privilege, for he only does what anyone else is at liberty to do. He undergoes many hardships, if not personal dangers; and perhaps he runs some risks that the land may turn out badly, and that he may have to abandon his improvements. On the other hand, his venture may turn out well; the flow of population may trend his way, and the value of his land may soon give as large a surplus over the normal remuneration of his outlay on it as the fishermen's haul does when they come home with their boat full. But in this there is no surplus above the rewards needed for his venture. He has engaged in a risky business which was open to all, and his energy and good fortune have given him an exceptionally high reward: anyone else might have taken the same chance as he did. Thus the income which he expects the land to afford in the future enters into the calculations of the settler, and adds to the motives which determine his action when in doubt as to how far to carry his enterprise. He regards its "discounted value" (3) as profits on his capital, and as earnings of his own labour, in so far as his improvements are made with his own hands.
A settler often takes up land with the expectation that the produce which it affords while in his possession, will fall short of an adequate reward for his hardships, his labour and his expenditure. He looks for part of his reward to the value of the land itself, which he may perhaps after a while sell to some new-comer who has no turn for the life of a pioneer. Sometimes even, as the British farmer learns to his cost, the new settler regards his wheat almost as a by-product; the main product for which he works is a farm, the title-deeds to which he will earn by improving the land: he reckons that its value will steadily rise, not through his own efforts so much as through the growth of those comforts and resources, and of those markets in which to buy and in which to sell, that are the product of the growing public prosperity.
This may be put in another way. People are generally unwilling to face the hardships and isolation of pioneer agriculture, unless they can look forward with some confidence to much higher earnings, measured in terms of the necessaries of life, than they could get at home. Miners cannot be attracted to a rich mine, isolated from other conveniences and varied social opportunities of civilization, except by the promise of high wages: and those who superintend the investment of their own capital in such mines expect very high profits. For similar reasons pioneer farmers require high aggregate gains made up of receipts for the sale of their produce, together with the acquisition of valuable title-deeds, to remunerate them for their labour and endurance of hardships. And the land is peopled up to that margin at which it just yields gains adequate for this purpose, without leaving any surplus for rent, when no charge is made for the land. When a charge is made, immigration spreads only up to that margin, at which the gains will leave a surplus, of the nature of rent, to cover such charges, in addition to rewarding the pioneer's endurance.
3. With all this it is to be remembered that land is but a particular form of capital from the point of view of the individual producer. The question whether a farmer has carried his cultivation of a particular piece of land as far as he profitably can; and whether he should try to force more from it, or to take in another piece of land; is of the same kind as the question whether he should buy a new plough, or try to get a little more work out of his present stock of ploughs, using them sometimes when the soil is not in a very favourable condition, and feeding his horses a little more lavishly. He weighs the net product of a little more land against the other uses to which he could put the capital sum that he would have to expend in order to obtain it: and in like manner he weighs the net product, to be got by working his ploughs under unfavourable circumstances, against that got by increasing his stock of ploughs, and thus working under more favourable conditions. That part of his produce which he is in doubt whether to raise by extra use of his existing ploughs, or by introducing a new plough, may be said to be derived from a marginal use of the plough. It pays nothing net (i.e. nothing beyond a charge for actual wear-and-tear) towards the net income earned by the plough.
So again a manufacturer or trader, owning both land and buildings, regards the two as bearing similar relations to his business. Either will afford him aid and accommodation at first liberally; and afterwards with diminishing return, as he endeavours to force more and more from them: till at last he will doubt whether the overcrowding of his workshops or his storerooms is not so great a source of trouble, that it would answer his purpose to obtain more space. And when he comes to decide whether to obtain that space by taking in an extra piece of land or by building his factory a floor higher, he weighs the net income to be derived from further investments in the one against that to be derived from the other. That part of his production which he just forces out of his existing appliances (being in doubt whether it would not be better worth his while to increase those appliances than to work so intensively those which he has), does not contribute to the net income which those appliances yield him. This argument says nothing as to whether the appliances were made by man, or part of a stock given by nature; it applies to rents and quasi-rents alike.
But there is this difference from the point of view of society. If one person has possession of a farm, there is less land for others to have. His use of it is not in addition to, but in lieu of the use of a farm by other people: whereas if he invests in improvements of land or in buildings on it, he will not appreciably curtail the opportunities of others to invest capital in like improvements. Thus there is likeness amid unlikeness between land and appliances made by man. There is unlikeness because land in an old country is approximately (and in some senses absolutely) a permanent and fixed stock: while appliances made by man, whether improvements in land, or in buildings, or machinery, etc., are a flow capable of being increased or diminished according to variations in the effective demand for the products which they help in raising. So far there is unlikeness. But on the other hand there is likeness, in that, since some of them cannot be produced quickly, they are a practically fixed stock for short periods: and for those periods the incomes derived from them stand in the same relation to the value of the products raised by them, as do true rents. (4)
4. Let us apply these considerations to the supposition that a permanent tax is to be levied on "corn," in the sense in which it was used by the classical economists as short for all agricultural produce. It is obvious that the farmer would try to make the consumer pay some part at least of the tax. But any rise in the price charged to the consumer would check demand, and thus react on the farmer. In order to decide how much of this tax would be shifted on to the consumer, we must study the margin of profitable expenditure, whether that be the margin of a little expenditure applied to poor land and land far removed from good markets, or the margin of a large expenditure applied to rich land, and land near to dense industrial districts.
If only a little corn had been raised near the margin, a moderate fall in the net price received by the farmer would not cause a great check to the supply of corn. There would therefore be no great rise in the price paid for it by the consumer; and the consumer would bear very little of the tax. But the surplus value of the corn over its expenses of production would fall considerably. The farmer, if cultivating his own land, would bear the greater part of the tax. And, if he were renting the land, he could demand a great reduction of his rent.
If, on the other hand, a great deal of corn had been raised near the margin of cultivation, the tax would tend to cause a great shrinkage of production. The consequent rise of price would arrest that shrinkage, leaving the farmer in a position to cultivate nearly as intensively as before: and the landlord's rent would suffer but little. (5)
Thus, on the one hand, a tax which is so levied as to discourage the cultivation of land or the erection of farm buildings on it, tends to be shifted forward on to the consumers of the produce of land. But, on the other hand, a tax on that part of the (annual) value of land, which arises from its position, its extension, its yearly income of sunlight and heat and rain and air, cannot settle anywhere except on the landlord; a lessee being, of course, landlord for the time. This (annual) value of the land is commonly called its "original value" or its "inherent value"; but much of that value is the result of the action of men, though not of its individual holders. For instance, barren heath land may suddenly acquire a high value from the growth of an industrial population near it; though its owners have left it untouched as it was made by nature. It is, therefore, perhaps more correct to call this part of the annual value of land its "public value"; while that part which can be traced to the work and outlay of its individual holders may be called its "private value." The old terms "inherent value" and "original value" may however be retained for general use, with a note of caution as to their partial inaccuracy. And, using another term that has precedent in its favour, we may speak of this annual public value of the land as "true rent."
A tax on the public value of land does not greatly diminish the inducements to cultivate the land highly, nor to erect farm buildings on it. Such a tax therefore does not greatly diminish the supply of agricultural produce offered on the market, nor raise the price of produce; and it is not therefore shifted away from the owners of land.
This assumes that the true rent of land on which the tax is levied is assessed with reference to its general capabilities, and not to the special use which the owner makes of it: its net product is supposed to be that which could be got by a cultivator of normal ability and enterprise, turning it to good account to the best of his judgment. If an improved method of cultivation develops latent resources of the soil, so as to yield an increased return much in excess of what is required to remunerate the outlay with a good rate of profits; this excess of net return above normal profits belongs properly to true rent: and yet, if it is known, or even expected, that a very heavy special tax on true rent will be made to apply to this excess income, that expectation may deter the owner from making the improvement. (6)
5. A little has been said incidentally of the competition between different branches of industry for the same raw material or appliances for production. But now we have to consider the competition between various branches of agriculture for the same land. This case is simpler than that of urban land, because farming is a single business so far as the main crops are concerned; though the rearing of choice trees (including vines), flowers, vegetables etc. affords scope for various kinds of specialized business ability. The classical economists were therefore justified in provisionally supposing that all kinds of agricultural produce can be regarded as equivalent to certain quantities of corn; and that all the land will be used for agricultural purposes, with the exception of building sites which are a small and nearly fixed part of the whole. But when we concentrate our attention on any one product, as for instance, hops, it may seem that a new principle is introduced. That is however not the case. Let us look into this.
Hops are grown in varying rotations with other crops; and the farmer is often in doubt whether he shall grow hops or something else on one of his fields. Thus each crop strives against others for the possession of the land; and if any one crop shows signs of being more remunerative than before relatively to others, the cultivators will devote more of their land and resources to it. The change may be retarded by habit, or diffidence, or obstinacy, or limitations of the cultivator's knowledge; or by the terms of his lease. But it will still be true in the main that each cultivator — to recall once more the dominant principle of substitution — "taking account of his own means, will push the investment of capital in his business in each several direction until what appears in his judgment to be the margin of profitableness is reached; that is, until there seems to him no good reason for thinking that the gains resulting from any further investment in that particular direction would compensate him for his outlay."
Thus in equilibrium, oats and hops and every other crop will yield the same net return to that outlay of capital and labour, which the cultivator is only just induced to apply. For otherwise he would have miscalculated; he would have failed to get the maximum reward which his outlay can be made to yield: and it would still be open to him to increase his gains by redistributing his crops, by increasing or diminishing his cultivation of oats or some other crop. (7)
This brings us to consider taxation in reference to the competition of different crops for the use of the same land. Let us suppose that a tax is imposed on hops, wherever grown; it is not to be a mere local rate or tax. The farmer can evade a part of the pressure of the tax by lessening the intensity of his cultivation of the land which he plants with hops; and a yet further part by substituting another crop on land which he had proposed to devote to hops. He will have recourse to this second plan in so far as he considers that he would get a better result by growing another crop, and selling it free from the tax, than by growing hops and selling them in spite of the tax. In this case the surplus which he could obtain from the land by growing, say, oats upon it would come into his mind when deciding where to set the limit to his production of hops. But even here there would be no simple numerical relation between the surplus, or rent, which the land would yield under oats, and the marginal costs which the price of hops must cover. And a farmer whose land produced hops of exceptionally high quality, and which happened to be in good condition at the time for hops, would have no doubt at all that it was best to grow hops on the land; though in consequence of the tax he might decide to curtail a little his expenditure on it. (8)
Meanwhile the tendency towards a general restriction in the supply of hops would tend to raise their price. If the demand for them were very rigid, and hops of adequate quality could not easily be imported from beyond the range of this special tax, the price might rise by nearly the full amount of the tax. In that case the tendency would be checked, and very nearly as much hops would be grown as before the tax had been levied. And here, as in the case of a tax on printing, recently discussed, the effect of a local tax is in strong contrast to that of a general tax. For unless the local tax covered most of the ground in the country on which good hops could be grown, its effect would be to drive them beyond its boundary: very little revenue would be got from it, local farmers would suffer a good deal, and the public would pay a rather higher price for their hops.
6. The argument of the last section applies, so far as short periods are concerned, to the earning power of farmbuildings and to other quasi-rents. When existing farmbuildings, or other appliances which could be used in producing one commodity are diverted to producing another because the demand for that is such as to enable them to earn a higher income by producing it, then for the time the supply of the first will be less, and its price higher than if the appliances had not been able to earn a higher income by another use. Thus, when appliances are capable of being used in more than one branch of agriculture, the marginal cost in each branch will be affected by the extent to which these appliances are called off for work in other branches. Other agents of production will be pushed to more intensive uses in the first branch, in spite of a diminishing return; and the value of its product will rise, because only at a higher value will the price be in equilibrium. The increased earning power of the appliances due to the external demand will appear to be the cause of this increase in value: for it will cause a relative scarcity of the appliances in that branch of production, and therefore raise marginal costs. And from this statement it appears superficially to be a simple transition to the statement that the increased earning power of the appliances enter into those costs which govern value. But the transition is illegitimate. There will be no direct or numerical relation between the increase in the price of the first commodity and the income that the appliances can earn when they have been transferred to the second industry and adapted for service in it.
Similarly, if a tax be put on factories used in one industry, some of them will be diverted to other industries; and consequently the marginal costs and therefore the values of the products in those industries will fall; simultaneously with a temporary fall in net rental values of factories in all uses. But these falls will vary in amount, and there will be no numerical relation between the fall in the prices of the product and in these rents, or rather quasi-rents.
These principles are not applicable to mines, whether for short periods or for long. A royalty is not a rent, though often so called. For, except when mines, quarries, etc., are practically inexhaustible, the excess of their income over their direct outgoings has to be regarded, in part at least, as the price got by the sale of stored-up goods — stored up by nature indeed, but now treated as private property; and therefore the marginal supply price of minerals includes a royalty in addition to the marginal expenses of working the mine. Of course the owner desires to receive the royalty without undue delay; and the contract between him and the lessee often provides, partly for this reason, for the payment of a rent as well as a royalty. But the royalty itself on a ton of coal, when accurately adjusted, represents that diminution in the value of the mine, regarded as a source of wealth in the future, which is caused by taking the ton out of nature's storehouse. (9)
1. Of course the character and extent of the improvements depends partly on the conditions of land tenure, and the enterprise and ability and command over capital on the part of landlords and tenants which existed at the time and place in question. In this connection we shall find, when we come to study land tenure, that there are large allowances to be made for the special conditions of different places.
It may be noted, however, that rent proper is estimated on the understanding that the original properties of the soil are unimpaired. And when the income derived from improvements is regarded as a quasi-rent, it is to be understood that they are kept up in full efficiency: if they are being deteriorated, the equivalent of the injury done to them must be deducted from the income they are made to yield before we can arrive at that Net income which is to be regarded as their quasi rent.
That part of the income which is required to cover wear-and-tear bears some resemblance to a royalty, which does no more than cover the injury done to a mine by taking ore out of it.
2. Compare V, IX, section 5.
3. Compare III, V, section 3 and V, IV, section 2.
4. The relations between rent and profits engaged the attention of the economists of the last generation; among whom may be specially mentioned Senior and Mill, Hermann and Mangoldt. Senior seemed almost on the point of perceiving that the key of the difficulty was held by the element of time: but here as elsewhere he contented himself with suggestions; he did not work them out. He says (Political Economy, p. 1 29), "for all useful purposes the distinction of profits from rent ceases as soon as the capital from which a given revenue arises has become, whether by gift or by inheritance, the property of a person to whose abstinence and exertions it did not owe its creation." Again, Mill says, Political Economy, Book III, ch. v, §4, "Any difference in favour of certain producers or in favour of production in certain circumstances is the source of a gain, which though not called rent unless paid periodically by one person to another, is governed by laws entirely the same with it."
It has been well observed that a speculator, who, without manipulating prices by false intelligence or otherwise, anticipates the future correctly; and who makes his gains by shrewd purchases and sales on the Stock Exchange or in Produce Markets, generally renders a public service by pushing forward production where it is wanted, and repressing it where it is not: but that a speculator in land in an old country can render no such public service, because the stock of land is fixed. At the best he can prevent a site with great possibilities from being devoted to inferior uses in consequence of the haste, ignorance, or impecuniosity of those in control of it.
5. Of course the adjustments of rent to the true economic surplus from the land are in practice slow and irregular. These matters are discussed in VI, sections IX and X, and the incidence of a tax on grain under certain rather arbitrary assumptions is studied in some detail in Appendix K.
6. The exemption of vacant building land from taxes on its full value retards building. See Appendix G.
7. In so far as the farmer is producing raw material, or even human food, for market, his distribution of resources between different uses is a problem of business economy: in so far as he is producing for his own domestic consumption, it is, in part at least, a problem of domestic economy. Compare above V, iv, §4. It may be added that Note XIV in the Mathematical Appendix emphasizes the fact that that distribution of outlay between different enterprises, which will give a maximum aggregate return, is fixed by the same set of equations as that for the similar problem in domestic economy.
Mill (Principles, III, XVI, 2), when discussing "joint products," observed that all questions relating to the competition of crops for the possession of particular soils are complicated by the rotation of crops and similar causes; an intricate debit and credit account by double entry needs to be kept between the various members of the rotation. Practice and shrewd instinct enable the farmer to do this fairly well. The whole problem might be expressed in simple mathematical phrases. But they would be tedious, and perhaps unfruitful. They would therefore not be serviceable, so long as they remained abstract; though they belong to a class which may ultimately be of good use in the higher science of agriculture, when that has advanced far enough to fill in realistic details.
8. If for instance he reckoned that he could get a surplus of £30 above his expenses (other than rent) in spite of the tax by growing hops, and a surplus of only £20 above similar expenses by growing any other crop, it could not be trulv said that the rent which the field could be made to yield by growing other crops, "entered into" the marginal price of hops. But it is easier to interpret the classical doctrine that "Rent does not enter into cost of production" in a sense in which it is not true, and to scoff at it, than in the sense in which it was intended and is true. It seems best therefore to avoid the phrase.
The ordinary man is offended by the old phrase that rent does not enter into the price of oats; when he sees that an increase in the demand for land for other uses, manifests itself in a rise of the rental value of all land in the neighbourhood; leaves less land free for growing oats; consequently makes it worth while to force larger crops of oats out of the remaining oat-land, and thus raises the marginal expenses of oats and their price. A rise in rent does serve as a medium through which the growing scarcity of land available for hops and other produce obtrudes itself on his notice; and it is not worth while to try to force him to go behind these symptoms of the change in conditions to the truly operative causes. It is therefore inexpedient to say that the rent of land does not enter into their price. But it is worse than inexpedient to say that the rent of the land does enter into their price: that is false.
Jevons asks (Preface to Theory of Political Economy, p. liv): "If land which has been yielding £2 per acre rent, as pasture, be ploughed up and used for raising wheat, must not £2 per acre be debited against the expenses of production of wheat;" The answer is in the negative. For there is no connection between this particular sum of £2 and the expenses of production of that wheat which only just pays its way. What should be said is: "When land capable of being used for producing one commodity is used for producing another, the price of the first is raised bv the consequent limitation of its field of production. The price of the second will be the expenses of production (wages and profits) of that part of it which only just pays its way, that which is produced on the margin of profitable expenditure. And if for the purposes of any particular argument we take together the whole expenses of the production on that land, and divide these among the whole of the commodity produced; then the rent which we ought to count in is not that which the land would pay if used for producing the first commodity, but that which it does pay when used for producing the second."
9. See above, Book IV, chapter 3, note. Adam Smith is attacked by Ricardo for putting rent on the same footing with wages and profits as parts of (money) cost of production; and no doubt he does this sometimes. But yet he says elsewhere, "Rent it is to be observed enters into the composition of the price of commodities in a different way from wages and profit. High or low wages and profit are the causes of high or low price: high or low rent is the effect of it. It is because high or low wages and profit must be paid in order to bring a particular commodity to market that its price is high or low. But it is because its price is high or low a great deal more, or very little more, or no more than what is sufficient to pay those wages and profits, that it affords a high rent, or a low rent, or no rent at all." (Wealth of Nations, I, XI.) In this, as in many other instances, he anticipated in one part of his writings truths which in other parts he has seemed to deny.
Adam Smith discusses the "price at which coals can be sold for any considerable time"; and contends that "the most fertile mine regulates the price of coals at all other mines in the neighbourhood." His meaning is not clear; but he does not appear to be referring to any temporary underselling; and he seems to imply that the mines are leased at so much a year. Ricardo, following on apparently the same lines, comes to the opposite conclusion that it "is the least fertile mine which regulates price"; which is perhaps nearer the truth than Adam Smith's doctrine. But in fact when the charge for the use of a mine is mainly in the form of a royalty, neither proposition seems to be applicable. Ricardo was technically right (or at all events not definitely wrong) when he said that rent does not enter into the marginal cost of production of mineral produce. But he ought to have added that if a mine is not practically inexhaustible, the income derived from it is partly rent and partly royalty; and that though the rent does not, the minimum royalty does enter directly into the expenses incurred on behalf of every part of the produce, whether marginal or not.
The royalty is of course calculated in regard to those seams in the mine, which are neither exceptionally rich and easy of working, nor exceptionally poor and difficult. Some seams barely pay the expenses of working them; and some which run short, or have a bad fault, do not even nearlv pav the wages of the labour spent on them. The whole argument however implicitly assumes the conditions of an old country. Professor Taussig is probably right when, having in view the circumstances of a new country (Principles, II, p. 96), he "doubts whether any payment at all can be secured by the owner of the very poorest mine, assuming he has done nothing to develop it."
1. The last three chapters examined the relation in which cost of production stands to the income derived from the ownership of the "original powers" of land and other free gifts of nature, and also to that which is directly due to the investment of private capital. There is a third class, holding an intermediate position between these two, which consists of those incomes, or rather those parts of incomes which are the indirect result of the general progress of society, rather than the direct result of the investment of capital and labour by individuals for the sake of gain. This class has to be studied now, with special reference to the value of urban sites.
We have already noted that, though nature nearly always gives a less than proportionate return, when measured by the amount of the produce raised, to increasing applications of capital and labour in the cultivation of land; yet, on the other hand, if the more intensive cultivation is the result of the growth of a non-agricultural population in the neighbourhood, this very concourse of people is likely to raise the value of produce. We have seen how this influence opposes, and usually outweighs the action of the law of diminishing return when the produce is measured according to its value to the producer and not according to its amount; the cultivator gets good markets in which to supply his wants, as well as good markets in which to sell, he buys more cheaply while he sells more dearly, and the conveniences and enjoyments of social life are ever being brought more within his reach. (1)
Again, we have seen how the economies which result from a high industrial organization (2) often depend only to a small extent on the resources of individual firms. Those internal economies which each establishment has to arrange for itself are frequently very small as compared with those external economies which result from the general progress of the industrial environment; the situation of a business nearly always plays a great part in determining the extent to which it can avail itself of external economies; and the situation value which a site derives from the grow of a a rich and active population close to it, or from the opening up of railways and other good means of communication with existing markets, is the most striking of all the influences which changes in the industrial environment exert on cost of production.
If in any industry, whether agricultural or not, two producers have equal facilities in all respects, except that one has a more convenient situation than the other, and can buy or sell in the same markets with less cost of carriage, the differential advantage which his situation gives him is the aggregate of the excess charges for cost of carriage to which his rival is put. And we may suppose that other advantages of situation, such for instance as the near access to a labour market specially adapted to his trade, can be translated in like manner into money values. When this is done, and all are added together we have the money value of the advantages of situation which the first business has over the second: and this becomes its special situation value, if the second has no situation value and its site is reckoned merely at agricultural value. The extra income which can be earned on the more favoured site gives rise to what may be called a special situation rent: and the aggregate site value of any piece of building land is that which it would have if cleared of buildings and sold in a free market. The "annual site value" — to use a convenient, though not strictly correct form of speaking — is the income which that price would yield at the current rate of interest. It obviously exceeds the special situation value, merely by agricultural value; which is often an almost negligible quantity in comparison. (3)
2. It is obvious that the greater part of situation value is "public value." There are however exceptional cases, which call for notice. Sometimes the settlement of a whole town, or even district is planned on business principles, and carried out as an investment at the expense and risk of a single person or company. The movement may be partly due to philanthropic or religious motives, but its financial basis will in any case be found in the fact that the concourse of numbers is itself a cause of increased economic efficiency. Under ordinary circumstances the chief gains arising from this efficiency would accrue to those who are already in possession of the place: but the chief hopes of commercial success, by those who undertake to colonize a new district or build a new town, are usually founded on securing these gains for themselves.
When, for instance, Mr Salt and Mr Pullman determined to take their factories into the country and to found Saltaire and Pullman City, they foresaw that the land, which they could purchase at its value for agricultural purposes, would obtain the special situation value which town property derives from the immediate neighbourhood of a dense population. And similar considerations have influenced those, who, having fixed upon a site adapted by nature to become a favourite watering-place, have bought the land and spent large sums in developing its resources: they have been willing to wait long for any net income from their investment in the hope that ultimately their land would derive a high situation value from the concourse of people attracted to it. (4)
In all such cases the yearly income derived from the land (or at all events that part of it which is in excess of the agricultural rent) is for many purposes to be regarded as profits rather than rent. And this is equally true, whether the land is that on which the factory itself at Saltaire or Pullman City is built, or that which affords a high "ground-rent" as the site of a shop or store, whose situation will enable it to do a brisk trade with those who work in the factory. For in such cases great risks have to be run; and in all undertakings in which there are risks of great losses, there must also be hopes of great gains. The normal expenses of production of a commodity must include payment for the ventures required for producing it, sufficient to cause those who are on the margin of doubt whether to venture or not, to regard the probable net amount of their gains net, that is, after deducting the probable amount of their losses as compensating them for their trouble and their outlay. And that the gains resulting from such ventures are not much more than sufficient for this purpose is shown by the fact that they are not as yet very common. They are however likely to be more frequent in those industries which are in the hands of very powerful corporations. A large railway company, for instance, can found a Crewe or a New Swindon for manufacturing railway plant without running any great risk. (5)
Some what similar instances are those of a group of landowners who combine to make a railway, the net traffic receipts of which are not expected to pay any considerable interest on the capital invested in making it; but which will greatly raise the value of their land. In such cases part of the increase of their incomes as landowners ought to be regarded as profits on capital which they have invested in the improvement of their land: though the capital has gone towards making a railway instead of being applied directly to their own property.
Other cases of like nature are main drainage schemes, and other plans for improving the general condition of agricultural or town property, in so far as they are carried out by the landowners at their own expense, whether by private agreement or by the levying of special rates on themselves. Similar cases again are found in the investment of capital by a nation in building up its own social and political organization as well as in promoting the education of the people and in developing its sources of material wealth.
Thus that improvement of the environment, which adds to the value of land and of other free gifts of nature, is in a good many cases partly due to the deliberate investment of capital by the owners of the land for the purpose of raising its value; and therefore a portion of the consequent increase of income may be regarded as profits when we are considering long periods. But in many cases it is not so; and any increase in the net income derived from the free gifts of nature which was not brought about by, and did not supply the direct motive to, any special outlay on the part of the landowners, is to be regarded as rent for all purposes.
Cases somewhat analogous to these arise when the owner of a score or more of acres in the neighbourhood of a growing town "develops" them for building. He probably lays out the roads, decides where houses are to be continuous, and where detached; and prescribes the general style of architecture, and perhaps the minimum expenditure on each house; for the beauty of each adds to the general value of all. This collective value, thus created by him, is of the nature of public value; and it is dependent, for the greater part, on that dormant public value, which the site as a whole derived from the growth of a prosperous town in its neighbourhood. But yet that share of it which results from his forethought, constructive faculty and outlay, is to be regarded as the reward of business enterprise, rather than as the appropriation of public value by a private person.
These exceptional cases must be reckoned with. But the general rule holds that the amount and character of the building put upon each plot of land is, in the main (subject to the local building bylaws), that from which the most profitable results are anticipated, with little or no reference to its reaction on the situation value of the neighbourhood. In other words the site value of the plot is governed by causes which are mostly beyond the control of him who determines what buildings shall be put on it: and he adjusts his expenditure on it to his estimates of the income to be derived from various descriptions of buildings on it.
3. The owner of building land sometimes builds on it himself: sometimes he sells it outright: very often he lets it at a fixed ground-rent for ninety-nine years, after which the land and the buildings on it (which by covenant must be kept in good repair) revert to his successor in title. Let us consider what governs the value at which he can sell the land and the ground-rent at which he can let it.
The capitalized value of any plot of land is the actuarial "discounted" value of all the net incomes which it is likely to afford, allowance being made on the one hand for all incidental expenses, including those of collecting the rents, and on the other for its mineral wealth, its capabilities of development for any kind of business, and its advantages, material, social and aesthetic, for the purposes of residence. The money equivalent of that social status and those other personal gratifications which the ownership of land affords, does not appear in the returns of the money income derived from it, but does enter into its capital money value. (6)
Next let us consider what governs the "ground-rent" which the owner can obtain for a plot which he lets on, say, a ninety-nine years' building lease. The present discounted value of all the fixed money payments under that lease tends to be equal to the present capital value of the land; after deducting, firstly, for the obligation to return the land with the buildings on it to the successor in title of the present owner at the end of the lease, and secondly for the possible inconvenience of any restrictions on the use of the land contained in the lease. In consequence of these deductions the ground-rent would be rather less than the "annual site value" of the land, if that site value were expected to remain fixed throughout. But in fact the site value is expected to rise in consequence of the growth of population, and other causes: and therefore the ground-rent is generally a little above the annual site value at the beginning of the lease, and much below it towards the end. (7)
Among the estimated outgoings on account of any building, which have to be deducted from its estimated gross yield before deciding what is the value of the privilege of erecting it on any given plot of land, are the taxes (central and local) which may be expected to be levied on the property, and to be paid by the owner of the property. But this raises difficult side-issues, which are postponed to Appendix G.
4. Let us revert to the fact that the law of diminishing return applies to the use of land for the purposes of living and working on it in all trades. (8) Of course in the trade of building, as in agriculture, it is possible to apply capital too thinly. Just as a homesteader may find that he can raise more produce by cultivating only a half of the 160 acres allotted to him than by spreading his labour over the whole, so even when ground has scarcely any value, a very low house may be dear in proportion to its accommodation. But, as in agriculture, there is a certain application of capital and labour to the acre which gives the highest return, and further applications after this give a less return, so it is in building. The amount of capital per acre which gives the maximum return varies in agriculture with the nature of the crops, with the state of the arts of production, and with the character of the markets to be supplied; and similarly in building, the capital per square foot which would give the maximum return, if the site had no scarcity value, varies with the purpose for which the building is wanted. But when the site has a scarcity value, it is worth while to go on applying capital beyond this maximum rather than pay the extra cost of land required for extending the site. In places where the value of land is high, each square foot is made to yield perhaps twice the accommodation, at more than twice the cost, that it would be made to give, if used for similar purposes where the value of land is low.
We may apply the phrase the margin of building to that accommodation which it is only just worth while to get from a given site, and which would not be got from it if land were less scarce. To fix the ideas, we may suppose this accommodation to be given by the top floor of the building. (9)
By erecting this floor, instead of spreading the building over more ground, a saving in the cost of land is effected, which just compensates for the extra expense and inconvenience of the plan. The accommodation given by this floor, when allowance has been made for its incidental disadvantages, is only just enough to be worth what it costs without allowing anything for the rent of land; and the expenses of production of the things raised on this floor, if it is part of a factory, are just covered by their price; there is no surplus for the rent of land. The expenses of production of manufactures may then be reckoned as those of the goods which are made on the margin of building, so as to pay no rent for land. That is to say the rent of the land does not enter into that set of expenses at the margin at which the action of the forces of demand and supply in governing value may be most clearly seen.
Suppose, for instance, that a person is planning a hotel or a factory; and considering how much land to take for the purpose. If land is cheap he will take much of it; if it is dear he will take less and build high. Suppose him to calculate the expenses of building and working his establishment with frontages of 100 and 110 feet respectively, in ways equally convenient on the whole to himself, his customers and employees, and therefore equally profitable to himself. Let him find that the difference between the two plans, after capitalizing future expenditure, shows an advantage of £500 in favour of the larger area; he will then be inclined to take the larger if the land is to be got at less than £50 per foot of frontage, but not otherwise; and £50 will be the marginal value of land to him. He might have reached this result by calculating the increased value of the business that could be done with the same outlay in other respects on the larger site as compared with the smaller, or again by building on less expensive ground instead of in a more favourable situation. But, by whatever route he makes his calculation, its character is similar to that by which he decides whether it is worth his while to buy business plant of any other kind: and he regards the net income (allowance being made for depreciation) which he expects to get from either investment as standing in the same general relation to his business; and if the advantages of the situation are such, that all the land available on it can find employments of different kinds in each of which its marginal use is represented by a capital value of £50 per foot of frontage, then that will be the current value of the land.
5. This assumes that the competition for land for various uses will cause building in each locality and for each use to be carried up to that margin, at which it is no longer profitable to apply any more capital to the same site. As the demand for residential and business accommodation in a district increases, it becomes worth while to pay a higher and higher price for land, in order to avoid the expense and inconvenience of forcing more accommodation from the same ground area.
For instance, if the value of land in, say, Leeds rises because of the increased competition for it by shops, ware. then a woollen manufacturer finding houses, iron works, etc., his expenses of production increased, may move to another town or into the country; and thus leave the land on which he used to work to be built over with shops and warehouses, for which a town situation is more valuable than it is for factories. For he may think that the saving in the cost of land that he will make by moving into the country, together with other advantages of the change, will more than counterbalance its disadvantages. In a discussion as to whether it was worth while to do so, the rental value of the site of his factory would be reckoned among the expenses of production of his cloth; and rightly.
But we have to go behind that fact. The general relations of demand and supply cause production to be carried up to a margin at which the expenses of production (nothing being entered for rent) are so high that people are willing to pay a high value for additional land in order to avoid the inconvenience and expense of crowding their work on to a narrow site. These causes govern site value; and site value is therefore not properly regarded as governing marginal costs.
Thus the industrial demand for land is in all respects parallel to the agricultural. The expenses of production of oats are increased by the fact that land, which could yield good crops of oats, is in great demand for growing other crops that enable it to yield a higher rent: and in the same way the printing-presses, which may be seen at work in London some sixty feet above the ground, could afford to do their work a little cheaper if the demand for ground for other uses did not push the margin of building up so high. Again a hop-grower may find that on account of the high rent which he pays for his land, the price of his hops will not cover their expenses of production where he is, and he may abandon hop-growing, or seek other land for it; while the land that he leaves may perhaps be let to a market-gardener. After a while the demand for land in the neighbourhood may again become so great that the aggregate price which the market-gardener obtains for his produce will not pay its expenses of production, including rent; and so he in his turn makes room for, say, a building company.
In each case the rising demand for land alters the margin to which it is profitable to carry the intensive use of land: the costs at this margin indicate the action of those fundamental causes which govern the value of the land. And at the same time they are themselves those costs to which the general conditions of demand and supply compel value to conform: and therefore it is right for our purpose to go straight to them; though any such inquiry would be irrelevant to the Purposes of a private balance sheet.
6. The demand for exceptionally valuable urban land comes from traders of various kinds, wholesale and retail, more than from manufacturers; and it may be worth while to say something here as to the very interesting features of demand that are peculiar to their case.
If two factories in the same branch of trade have equal outputs they are sure to have nearly equal floor space. But there is no close relation between the size of trading establishments and their turn-overs. Plenty of space is for them a matter of convenience and a source of extra profit. It is not physically indispensable; but the larger their space, the greater the stock which they can keep on hand, and the greater the advantage to which they can display specimens of it; and especially is this the case in trades that are subject to changes of taste and fashion. In such trades the dealers exert themselves to collect within a comparatively small space representatives of all the best ideas that are in vogue, and still more of those that are likely soon to be so; and the higher the rental values of their sites the more prompt they must be in getting rid, even at a loss, of such things as are a little behind the time and do not improve the general character of their stocks. If the locality is one in which customers are more likely to be tempted by a well-chosen stock than by low prices, the traders will charge prices that give a high rate of profit on a comparatively small turn-over: but, if not, they will charge low prices and try to force a large business in proportion to their capital and the size of their premises; just as in some neighbourhoods the market-gardener finds it best to gather his peas young when they are full of flavour, and in others to let them grow till they weigh heavily in the scales. Whichever plan the traders follow, there will be some conveniences which they are in doubt whether it is worth while to offer to the public; since they calculate that the extra sales gained by such conveniences are only just remunerative, and do not contribute any surplus towards rent. The goods which they sell in consequence of these conveniences, are goods into whose expenses of marketing rent does not enter any more than it does into those of the peas which the market-gardener only just finds it worth his while to produce.
Prices are low in some very highly-rented shops, because their doors are passed by great numbers of people who cannot afford to pay high prices for the gratification of their fancy; and the shopkeeper knows that he must sell cheaply, or not sell at all. He has to be content with a low rate of profit each time he turns over his capital. But, as the wants of his customers are simple, he need not keep a large stock of goods; and he can turn over his capital many times a year. So his annual net profits are very great, and he is willing to pay a very high rent for the situation in which they can be earned. On the other hand, prices are very high in some of the quiet streets in the fashionable parts of London and in many villages; because in the one case customers must be attracted by a very choice stock, which can only be sold slowly; and in the other the aggregate turn-over is very small indeed. In neither place can the trader make profits that will enable him to pay as high a rent as those of some cheap but bustling shops in the East end of London.
It is however true that, if without any increase in traffic such as brings extra custom, a situation becomes more valuable for purposes other than shopkeeping; then only those shopkeepers will be able to pay their way who can manage to secure a large custom relatively to the prices which they charge and the class of business which they do. There will therefore be a smaller supply of shopkeepers in all trades for which the demand has not increased: and those who remain, will be able to charge a higher price than before, without offering any greater conveniences and attractions to their customers. The rise of ground values in the district will thus be an indication of a scarcity of space which, other things being equal, will raise the prices of retail goods; just in the same way as the rise of agricultural rents in any district will indicate a scarcity of land which will raise the marginal expenses of production, and therefore the price of any particular crop.
7. The rent of a house (or other building) is a composite rent, of which one part belongs to the site and the other to the buildings themselves. The relations between these two are rather intricate, and may be deferred to Appendix G. A few words may however be said here as to composite rents in general. At starting there may appear to be some contradiction in the statement that a thing is yielding at the same time two rents: for its rent is in some sense a residual income after deducting the expenses of working it; and there cannot be two residues in regard to the same process of working and the same resulting revenue. But when the thing is composite each of its parts may be capable of being so worked as to yield a surplus of revenue over the expenses of working it. The corresponding rents can always be distinguished analytically, and sometimes they can be separated commercially. (10)
For instance, the rent of a flour-mill worked by water includes the rent of the site on which it is built, and the rent of the water power which it uses. Suppose that it is contemplated to build a mill in a place where there is a limited water power which could be applied equally well on any one of many sites; then the rent of the water power together with the site selected for it is the sum of two rents; which are respectively the equivalent of the differential advantages which possession of the site gives for production of any kind, and which the ownership of the water power gives for working a mill on any of the sites. And these two rents, whether they happen to be owned by the same person or not, can be clearly distinguished and separately estimated both in theory and in practice.
But this cannot be done if there are no other sites on which a mill can be built: and in that case, should the water power and the site belong to different persons, there is nothing but "higgling and bargaining" to settle how much of the excess of the value of the two together over that which the site has for other purposes shall go to the owner of the latter. And even if there were other sites at which the water power could be applied, but not with equal efficiency, there would still be no means of deciding how the owners of the site and the water power should share the excess of the producer's surplus which they got by acting together, over the sum of that which the site would yield for some other purpose, and of that which the water power would yield if applied elsewhere. The mill would probably not be put up till an agreement had been made for the supply of water power for a term of years: but at the end of that term similar difficulties would arise as to the division of the aggregate producer's surplus afforded by the water power and the site with the mill on it.
Difficulties of this kind are continually arising with regard to attempts by partial monopolists, such as railway, gas, water and electrical companies, to raise their charges on the consumer who has adapted his business arrangements to make use of their services, and perhaps laid down at his own expense a costly plant for the purpose. For instance, at Pittsburgh when manufacturers had just put up furnaces to be worked by natural gas instead of coal, the price of the gas was suddenly doubled. And the history of mines affords many instances of difficulties of this kind with neighbouring landowners as to rights of way, etc., and with the owners of neighbouring cottages, railways and docks. (11)
1. See IV, III, section 6.
2. See IV, X-XIII.
3. If we suppose that two farms, which sell in the same market, return severally to equal applications of capital and labour amounts of produce, the first of which exceeds the second by the extra cost of carrying its produce to market, then the rent of the two farms will be the same. (The capital and labour applied to the two farms are here supposed to be reduced to the same money measure, or which comes to the same thing, the two farms are supposed to have equally good access to markets in which to buy.) Again, if we suppose that two mineral springs A and B supplying exactly the same water are capable of being worked each to an unlimited extent at a constant money cost of production; this cost being, sav twopence a bottle at A whatever the amount produced by it, and twopence half penny at B; then those places to which the cost of carriage per bottle from B is a half-penny less than from A, will be the neutral zone for their competition. (If the cost of carriage be proportional to the distance, this neutral zone is a hyperbola of which A and B are foci.) A can undersell B for all places on A's side of it, and vice versa; and each of them will be able to derive a monopoly rent from the sale of its produce within its own area. This is a type of a great many fanciful, but not uninstructive, problems which readily suggest themselves. Compare von Thünen's brilliant researches in Der isolierte Staat.
4. Cases of this kind are of course most frequent in new countries. But they are not very rare in old countries: Saltburn is a conspicuous instance; awhile a more recent instance of exceptional interest is furnished by Letchworth Garden City.
5. Governments have great facilities for carrying out schemes of this kind, especially in the matter of choosing new sites for garrison towns, arsenals, and establishments for the manufacture of the materials of war. In comparisons of the expenses of production by Government and by private firms, the sites of the Government works are often reckoned only at their agricultural value. But such a plan is misleading. A private firm has either to pay heavy annual charges on account of its site, or to run very heavy risks if it tries to make a town for itself. And therefore in order to prove that Government management is for general purposes as efficient and economical as private management, a full charge ought to be made in the balance-sheets of Government factories for the town-value of their sites. In those exceptional branches of production for which a Government can found a manufacturing town without incurring the risks that a private firm would incur in a similar case, that point of advantage may fairly be reckoned as an argument for Governments undertaking those particular businesses.
6. The value of agricultural land is commonly expressed as a certain number of times the current money rental, or in other words a certain "number of years' purchase" of that rental: and other things being equal it will be the higher, the more important these direct gratifications are, as well as the greater the chance that they and the money income afforded by the land will rise. The number of years' purchase would be increased also by an expected fall either in the future normal rate of interest or in the purchasing power of money.
The discounted value of a very distant rise in the value of land is much less than is commonly supposed. For instance, if we take interest at five per cent (and higher rates prevailed during the Middle Ages), £1 invested at compound interest would amount to about £17,000 in 200 years, and £40,000,000,000 in 500 years. Therefore an expenditure by the State of £1 in securing to itself the reversion of a rise in the value of land which came into operation now for the first time would have been a bad investment, unless the value of that rise now exceeded £17,000, if the payment was made 200 years ago; if 500 years ago to £40,000,000,000. This assumes that it would have been possible to invest a sum of this dimension at five per cent: which of course it would not.
7. A few site values have fallen in districts which have been deserted by fashion or trade. But on the other hand annual site values have risen to be many times as great as the ground rents in the case of land which was leased when it had no special situation value, but has since become a chief centre of fashion, or of trade: and all the more if the lease was granted in the first half of the eighteenth century, when gold was scarce and the incomes of all classes of the people, measured in money, were very low The present discounted value of the return of property to the ground landlord a hundred years hence, which will then be worth £1000, is less perhaps than is commonly supposed; though the error is not so great as in the case of anticipations ranging over many hundred years, which were discussed in a recent note: if interest be taken at three per cent. it is about £50; if at five per cent, as was the rule three or four generations ago, it is but £8.
8. See IV, III, section 7.
9. Houses built in flats are often provided with a lift which is run at the expense of the owner of the house, and in such cases, at all events in America, the top floor sometimes lets for a higher rent than any other. If the site is very valuable and the law does not limit the height of his house in the interest of his neighbours, he may build very high: but at last he will reach the margin of building. At last he will find that the extra expenses for foundations and thick walls, and for his lift, together with some resulting depreciation of the lower floors, make him stand to lose more than he gains by adding one more floor; the extra accommodation which it only just answers his purpose to supply is then to be regarded as at the margin of building, even though the gross rent be greater for the higher floors than for the lower.
But in England bylaws restrain an individual from building so high as to deprive his near neighbours of air and light. In the course of time those who build high will be forced to have a good deal of free space about their buildings; and this will render very high buildings unprofitable.
10. It will be borne in mind that if a house is not appropriate to its site, its aggregate rent will not exceed its site rent by the full building rent which the house would command on an appropriate site. Similar limitations apply to most composite rents.
11. The relations between the interests of different classes of workers in the same business and in the same trade, have some affinity to the subject of composite rents. See below VI, VIII, sections 9, 10.
1. We may now continue the study begun in chapters III and V; and examine some difficulties connected with the relations of demand and supply as regards commodities the production of which tends to increasing return.
We have noted that this tendency seldom shows itself immediately on an increase of demand. To take an example, the first effect of a sudden fashion for watch-shaped aneroids would be a temporary rise of price, in spite of the fact that they contain no material of which there is but a scanty stock. For highly paid labour, that had no special training for the work, would have to be drawn in from other trades; a good deal of effort would be wasted, and for a time the real and the money cost of production would be increased.
But yet, if the fashion lasted a considerable time, then even independently of any new invention, the cost of making aneroids would fall gradually. For specialized skill in abundance would be trained, and properly graduated to the various work to be done. With a large use of the method of interchangeable parts, specialized machinery would do better and more cheaply much of the work that is now done by hand; and thus a continued increase in the annual output of watch-shaped aneroids would lower their price very much.
Here there is to be noted an important difference between demand and supply. A fall in the price, at which a commodity is offered, acts on demand always in one direction. The amount of the commodity demanded may increase much or little according as the demand is elastic or inelastic: and a long or short time may be required for developing the new and extended uses of the commodity, which are rendered possible by the fall in price. (1) But at all events if exceptional cases in which a thing is driven out of fashion by a fall in its price be neglected — the influence of price on demand is similar in character for all commodities: and, further, those demands which show high elasticity in the long run, show a high elasticity almost at once; so that, subject to a few exceptions, we may speak of the demand for a commodity as being of high or low elasticity without specifying how far we are looking ahead.
But there are no such simple rules with regard to supply. An increase in the price offered by purchasers does indeed always increase supply: and thus it is true that, if we have regard to short periods only, and especially to the transactions of a dealer's market, there is an "elasticity of supply" which corresponds closely to elasticity of demand. That is to say, a given rise in price will cause a great or a small increase in the offers which sellers accept, according as they have large or small reserves in the background, and as they have formed low or high estimates of the level of prices at the next market: and this rule applies nearly in the same way to things which in the long run have a tendency to diminishing return as to those which have a tendency to increasing return. In fact if the large plant needed in a branch of manufacture is fully occupied, and cannot be rapidly increased, an increase in the price offered for its products may have no perceptible effect in increasing the output for some considerable time: while a similar increase in the demand for a hand-made commodity might call forth quickly a great increase in supply, though in the long run its supply conformed to that of constant return or even of diminishing return.
In the more fundamental questions which relate to long periods, the matter is even more complex. For the ultimate output corresponding to an unconditional demand at even current prices would be theoretically infinite; and therefore the elasticity of supply of a commodity which conforms to the law of Increasing Return, or even to that of Constant Return, is theoretically infinite for long periods. (2)
2. The next point to be observed is that this tendency to a fall in the price of a commodity as a result of a gradual development of the industry by which it is made, is quite a different thing from the tendency to the rapid introduction of new economies by an individual firm that is increasing its business.
We have seen how every step in the advance of an able and enterprising manufacturer makes the succeeding step easier and more rapid; so that his progress upwards is likely to continue so long as he has fairly good fortune, and retains his full energy and elasticity and his liking for hard work. But these cannot last for ever: and as soon as they decay, his business is likely to be destroyed through the action of some of those very causes which enabled it to rise; unless indeed he can pass it over into hands as strong as his used to be. Thus the rise and fall of individual firms may be frequent, while a great industry is going through one long oscillation, or even moving steadily forwards; as the leaves of a tree (to repeat an earlier illustration) grow to maturity, reach equilibrium, and decay many times, while the tree is steadily growing upwards year by year. (3)
The causes which govern the facilities for production at the command of a single firm, thus conform to quite different laws from those which control the whole output of an industry. And the contrast is perhaps heightened, when we take the difficulties of marketing into account. For instance manufactures, which are adapted to special tastes, are likely to be on a small scale; and they are generally of such a character that the machinery and modes of organization already developed in other trades, could be easily adapted to them; so that a great increase in their scale of production would be sure to introduce vast economies at once. But these are the very industries in which each firm is likely to be confined more or less to its own particular market: and, if it is so confined, any hasty increase in its production is likely to lower the demand price in that market out of all proportion to the increased economies that it will gain; even though its production is but small relatively to the broad market for which in a more general sense it may be said to produce.
In fact, when trade is slack, a producer will often try to sell some of his surplus goods outside of his own particular market at prices that do little more than cover their prime costs: while within that market he still tries to sell at prices that nearly cover supplementary costs; and a great part of these are the returns expected on capital invested in building up the external organization of his business. (4)
Again supplementary costs are, as a rule, larger relatively to prime costs for things that obey the law of increasing return than for other things; (5) because their production needs the investment of a large capital in material appliances and in building up trade connections. This increases the intensity of those fears of spoiling his own peculiar market, or incurring odium from other producers for spoiling the common market; which we have already learnt to regard as controlling the short-period supply price of goods, when the appliances of production are not fully employed.
We cannot then regard the conditions of supply by an individual producer as typical of those which govern the general supply in a market. We must take account of the fact that very few firms have a long-continued life of active progress, and of the fact that the relations between the individual producer and his special market differ in important respects from those between the whole body of producers and the general market. (6)
3. Thus the history of the individual firm cannot be made into the history of an industry any more than the history of an individual man can be made into the history of mankind. And yet the history of mankind is the outcome of the history of individuals; and the aggregate production for a general market is the outcome of the motives which induce individual producers to expand or contract their production. It is just here that our device of a representative firm comes to our aid. We imagine to ourselves at any time a firm that has its fair share of those internal and external economies, which appertain to the aggregate scale of production in the industry to which it belongs. We recognize that the size of such a firm, while partly dependent on changes in technique and in the costs of transport, is governed, other things being equal, by the general expansion of the industry. We regard the manager of it as reckoning up whether it would be worth his while to add a certain new line to his undertakings; whether he should introduce a certain new machine and so on. We regard him as treating the output which would result from that change more or less as a unit, and weighing in his mind the cost against the gain. (7)
This then is the marginal cost on which we fix our eyes. We do not expect it to fall immediately in consequence of a sudden increase of demand. On the contrary we expect the short-period supply price to increase with increasing output. But we also expect a gradual increase in demand to increase gradually the size and the efficiency of this representative firm; and to increase the economies both internal and external which are at its disposal.
That is to say, when making lists of supply prices (supply schedules) for long periods in these industries, we set down a diminished supply price against an increased amount of the flow of the goods; meaning thereby that a flow of that increased amount will in the course of time be supplied profitably at that lower price, to meet a fairly steady corresponding demand. We exclude from view any economies that may result from substantive new inventions; but we include those which may be expected to arise naturally out of adaptations of existing ideas; and we look towards a position of balance or equilibrium between the forces of progress and decay, which would be attained if the conditions under view were supposed to act uniformly for a long time. But such notions must be taken broadly. The attempt to make them precise over-reaches our strength. If we include in our account nearly all the conditions of real life, the problem is too heavy to be handled; if we select a few, then long-drawn-out and subtle reasonings with regard to them become scientific toys rather than engines for practical work.
The theory of stable equilibrium of normal demand and supply helps indeed to give definiteness to our ideas; and in its elementary stages it does not diverge from the actual facts of life, so far as to prevent its giving a fairly trustworthy picture of the chief methods of action of the strongest and most persistent group of economic forces. But when pushed to its more remote and intricate logical consequences, it slips away from the conditions of real life. In fact we are here verging on the high theme of economic progress; and here therefore it is especially needful to remember that economic problems are imperfectly presented when they are treated as problems of statical equilibrium, and not of organic growth. For though the statical treatment alone can give us definiteness and precision of thought, and is therefore a necessary introduction to a more philosophic treatment of society as an organism; it is yet only an introduction.
The Statical theory of equilibrium is only an introduction to economic studies; and it is barely even an introduction to the study of the progress and development of industries which show a tendency to increasing return. Its limitations are so constantly overlooked, especially by those who approach it from an abstract point of view, that there is a danger in throwing it into definite form at all. But, with this caution, the risk may be taken; and a short study of the subject is given in Appendix H.
1. See above III, IV, section 5.
2. Strictly speaking, the amount produced and the price at which it can be sold, are functions one of another, account being taken of the length of time allowed for the evolution of appropriate plant and organization for production on a large scale. But in real life, the cost of production per unit is deduced from the amount expected to be produced, and not vice versa. Economists commonly follow this practice; and they follow also the practice of business life in inverting this order with regard to demand. That is, they consider the increase of sales that will follow from a given reduction of price, more frequently than the diminution of price which will be required to effect a given increase of sales.
3. See IV, IX-XIII; and especially XI, section 5.
4. This may be expressed by saying that when we are considering an individual producer, we must couple his supply curve not with the general demand curve for his commodity in a wide market, but with the particular demand curve of his own special market. And this particular demand curve will generally be very steep; perhaps as steep as his own supply curve is likely to be, even when an increased output will give him an important increase of internal economies.
5. Of course this rule is not universal. It may be noted, for instance, that the net loss of an omnibus, that is short of passengers throughout its trip, and loses a fourpenny fare, is nearer fourpence than threepence, though the omnibus trade conforms perhaps to the law of constant return. Again, if it were not for the fear of spoiling his market, the Regent Street shoemaker, whose goods are made by hand, but whose expenses of marketing are very heavy, would be tempted to go further below his normal price in order to avoid losing a special order, than a shoe manu facturer who uses much expensive machinery and avails himself generally of the economies of production on a large scale. There are other difficulties connected with the supplementary costs of joint products, e.g. the practice ofselling some goods at near prime cost, for the purpose of advertisement (see above V, VII, section 2). But these need not be specially considered here.
6. Abstract reasonings as to the effects of the economies in production, which an individual firm gets from an increase of its output are apt to be misleading, not only in detail, but even in their general effect. This is nearly the same as saying that in such case the conditions governing supply should be represented in their totality. They are often vitiated by difficulties which lie rather below the surface, and are especially troublesome in attempts to express the equilibrium conditions of trade by mathematical formula. Some, among whom Cournot himself is to be counted, have before them what is in effect the supply schedule of an individual firm; representing that an increase in its output gives it command over so great internal economies as much to diminish its expenses of production; and they follow their mathematics boldly, but apparently without noticing that their premises lead inevitably to the conclusion that, whatever firm first gets a good start will obtain a monopoly of the whole business of its trade in its district. While others avoiding this horn of the dilemma, maintain that there is no equilibrium at all for commodities which obey the law of increasing return; and some again have called in question the validity of any supply schedule which represents prices diminishing as the amount produced increases. See Mathematical Note XIV, where reference is made to this discussion.
The remedy for such difficulties as these is to be sought in treating each important concrete case very much as an independent problem, under the guidance of staple general reasonings. Attempts so to enlarge the direct applications of general propositions as to enable them to supply adequate solutions of all difficulties, would make them so cumbrous as to be of little service for their main work. The "principles" of economics must aim at affording guidance to an entry on problems of life, without making claim to be a substitute for independent study and thought.
7. See above V, V, section 6.
1. In earlier chapters of this Book, and especially in chapter XII, we have considered gradual changes in the adjustment of demand and supply. But any great and lasting change in fashion; any substantive new invention; any diminution of population by war or pestilence; or the development or dwindling away of a source of supply of the commodity in question, or of a raw material used in it, or of another commodity which is a rival and possible substitute for it: — such a change as any of these may cause the prices set against any given annual (or daily) consumption and production of the commodity to cease to be its normal demand and supply prices for that volume of consumption and production; or, in other words, they may render it necessary to make out a new demand schedule or a new supply schedule, or both of them. We proceed to study the problems thus suggested.
An increase of normal demand for a commodity involves an increase in the price at which each several amount can find purchasers; or, which is the same thing, an increase of the quantity which can find purchasers at any price. This increase of demand may be caused by the commodity's coming more into fashion, by the opening out of a new use for it or of new markets for it, by the permanent falling off in the supply of some commodity for which it can be used as a substitute, by a permanent increase in the wealth and general purchasing power of the community, and so on. Changes in the opposite direction will cause a falling off in demand and a sinking of the demand prices. Similarly an increase of normal supply means an increase of the amounts that can be supplied at each several price, and a diminution of the price at which each separate amount can be supplied. (1) This change may be caused by the opening up of a new source of supply, whether by improved means of transport or in any other way, by an advance in the arts of production, such as the invention of a new process or of new machinery, or again, by the granting of a bounty on production. Conversely, a diminution of normal supply (or a raising of the supply schedule) may be caused by the closing up of a new source of supply or by the imposition of a tax.
2. We have, then, to regard the effects of an increase of normal demand from three points of view, according as the commodity in question obeys the law of constant or of diminishing or of increasing return: that is, its supply price is practically constant for all amounts, or increases or diminishes with an increase in the amount produced.
In the first case an increase of demand simply increases the amount produced without altering its price; for the normal price of a commodity which obeys the law of constant return is determined absolutely by its expenses of production: demand has no influence in the matter beyond this, that the thing will not be produced at all unless there is some demand for it at this fixed price.
If the commodity obeys the law of diminishing return an increase of demand for it raises its price and causes more of it to be produced; but not so much more as if it obeyed the law of constant return.
On the other hand, if the commodity obeys the law of increasing return, an increase of demand causes much more of it to be produced, — more than if the commodity obeyed the law of constant return, — and at the same time lowers its price. If, for instance, a thousand things of a certain kind have been produced and sold weekly at a price of 10s., while the supply price for two thousand weekly would be only 9s., a small rate of increase in normal demand may gradually cause this to become the normal price; since we are considering periods long enough for the full normal action of the causes that determine supply to work itself out. The converse holds in each case should normal demand fall off instead of increasing. (2)
The argument of this section has been thought by some writers to lend support to the claim that a Protective duty on manufactured imports in general increases the home market for those imports; and, by calling into play the Law of Increasing Return, ultimately lowers their price to the home consumer. Such a result may indeed ultimately be reached by a wisely chosen system of "Protection to nascent industries" in a new country; where manufactures, like young children, have a power of rapid growth. But even there the policy is apt to be wrenched from its proper uses, to the enrichment of particular interests: for those industries which can send the greatest number of votes to the poll, are those which are already on so large a scale, that a further increase would bring very few new economies. And of course the industries in a country so long familiar with machinery as England is, have generally passed the stage at which they can derive much real help from such Protection: while Protection to any one industry nearly always tends to narrow the markets, especially the foreign markets, for other industries. These few remarks show that the question is complex: they do not pretend to reach further than that.
3. We have seen that an increase in normal demand, while leading in every case to an increased production, will in some cases raise and in others lower prices. But now we are to see that increased facilities for supply (causing the supply schedule to be lowered) will always lower the normal price at the same time that it leads to an increase in the amount produced. For so long as the normal demand remains unchanged an increased supply can be sold only at a diminished price; but the fall of price consequent on a given increase of supply will be much greater in some cases than in others. It will be small if the commodity obeys the law of diminishing return; because then the difficulties attendant on an increased production will tend to counteract the new facilities of supply. On the other hand, if the commodity obeys the law of increasing return, the increased production will bring with it increased facilities, which will co-operate with those arising from the change in the general conditions of supply; and the two together will enable a great increase in production and consequent fall in price to be attained before the fall of the supply price is overtaken by the fall of the demand price. If it happens that the demand is very elastic, then a small increase in the facilities of normal supply, such as a new invention, a new application of machinery, the opening up of new and cheaper sources of supply, the taking off a tax or granting a bounty, may cause an enormous increase of production and fall of price. (3)
If we take account of the circumstances of composite and joint supply and demand discussed in chapter VI, we have suggested to us an almost endless variety of problems which can be worked out by the methods adopted in these two chapters.
4. We may now consider the effects which a change in the conditions of supply may exert on consumers' surplus or rent. For brevity of language a tax may be taken as representative of those changes which may cause a general increase, and a bounty as representative of those which may cause a general diminution in the normal supply price for each several amount of the commodity.
Firstly, if the commodity is one, the production of which obeys the law of constant return, so that the supply price is the same for all amounts of the commodity, consumers' surplus will be diminished by more than the increased payments to the producer; and therefore, in the special case of a tax, by more than the gross receipts of the State. For on that part of the consumption of the commodity, which is maintained, the consumer loses what the State receives: and on that part of the consumption which is destroyed by the rise in price, the consumers' surplus is destroyed; and of course there is no payment for it to the producer or to the State. (4) Conversely, the gain of consumers' surplus caused by a bounty on a commodity that obeys the law of constant return, is less than the bounty itself. For on that part of the consumption which existed before the bounty, consumers' surplus is increased by just the amount of the bounty; while on the new consumption that is caused by the bounty, the gain of the consumers' surplus is less than the bounty. (5)
If however the commodity obeys the law of diminishing return; a tax by raising its price, and diminishing its consumption, will lower its expenses of production other than the tax: and the result will be to raise the supply price by something less than the full amount of the tax. In this case the gross receipts from the tax may be greater than the resulting loss of consumers' surplus, and they will be greater if the law of diminishing return acts so sharply that a small diminution of consumption causes a great falling-off in the expenses of production other than the tax. (6)
On the other hand, a bounty on a commodity which obeys the law of diminishing return will lead to increased production, and will extend the margin of cultivation to places and conditions in which the expenses of production, exclusive of the bounty, are greater than before. Thus it will lower the price to the consumer and increase consumers' surplus less than if it were given for the production of a commodity which obeyed the law of constant return. In that case the increase of consumers' surplus was seen to be less than the direct cost of the bounty to the State; and therefore in this case it is much less. (7)
By similar reasoning it may be shown that a tax on a commodity which obeys the law of increasing return is more injurious to the consumer than if levied on one which obeys the law of constant return. For it lessens the demand and therefore the output. It thus probably increases the expenses of manufacture somewhat: sends up the price by more than the amount of the tax; and finally diminishes consumers' surplus by much more than the total payments which it brings in to the exchequer. (8) On the other hand, a bounty on such a commodity causes so great a fall in its price to the consumer, that the consequent increase of consumers' surplus may exceed the total payments made by the State to the producers; and certainly will do so in case the law of increasing return acts at all sharply. (9)
These results are suggestive of some principles of taxation which require careful attention in any study of financial policy; when it will be necessary to take account of the expenses of collecting a tax and of administering a bounty, and of the many indirect effects, some economic and some moral, which a tax or a bounty is likely to produce. But these partial results are well adapted for our immediate purpose of examining a little more closely than we have done hitherto the general doctrine that a position of (stable) equilibrium of demand and supply is a position also of maximum satisfaction: and there is one abstract and trenchant form of that doctrine which has had much vogue, especially since the time of Bastiat's Economic Harmonies, and which falls within the narrow range of the present discussion.
5. There is indeed one interpretation of the doctrine according to which every position of equilibrium of demand and supply may fairly be regarded as a position of maximum satisfaction. (10) For it is true that so long as the demand price is in excess of the supply price, exchanges can be effected at prices which give a surplus of satisfaction to buyer or to seller or to both. The marginal utility of what he receives is greater than that of what he gives up, to at least one of the two parties; while the other, if he does not gain by the exchange, yet does not lose by it. So far then every step in the exchange increases the aggregate satisfaction of the two parties. But when equilibrium has been reached, demand price being now equal to supply price, there is no room for any such surplus: the marginal utility of what each receives no longer exceeds that of what he gives up in exchange: and when the production increases beyond the equilibrium amount, the demand price being now less than the supply price, no terms can be arranged which will be acceptable to the buyer, and will not involve a loss to the seller.
It is true then that a position of equilibrium of demand and supply is a position of maximum satisfaction in this limited sense. that the aggregate satisfaction of the two parties concerned increases until that position is reached; and that any production beyond the equilibrium amount could not be permanently maintained so long as buyers and sellers acted freely as individuals, each in his own interest.
But occasionally it is stated, and very often it is implied, that a position of equilibrium of demand and supply is one of maximum aggregate satisfaction in the full sense of the term: that is, that an increase of production beyond the equilibrium level would directly (i.e. independently of the difficulties of arranging for it, and of any indirect evils it might cause) diminish the aggregate satisfaction of both parties. The doctrine so interpreted is not universally true.
In the first place it assumes that all differences in wealth between the different parties concerned may be neglected, and that the satisfaction which is rated at a shilling by any one of them, may be taken as equal to one that is rated at a shilling by any other. Now it is obvious that, if the producers were as a class very much poorer than the consumers, the aggregate satisfaction might be increased by a stinting of supply when it would cause a great rise in demand price (i.e. when the demand is inelastic); and that if the consumers were as a class much poorer than the producers, the aggregate satisfaction might be increased by extending the production beyond the equilibrium amount and selling the commodity at a loss. (11)
This point however may well be left for future consideration. It is in fact only a special case of the broad proposition that the aggregate satisfaction can prima facie be increased by the distribution, whether voluntarily or compulsorily, of some of the property of the rich among the poor; and it is reasonable that the bearings of this proposition should be set aside during the first stages of an inquiry into existing economic conditions. This assumption therefore may be properly made, provided only it is not allowed to slip out of sight.
But in the second place the doctrine of maximum satisfaction assumes that every fall in the price which producers receive for the commodity, involves a corresponding loss to them; and this is not true of a fall in price which results from improvements in industrial organization. When a commodity obeys the law of increasing return, an increase in its production beyond equilibrium point may cause the supply price to fall much; and though the demand price for the increased amount may be reduced even more, so that the production would result in some loss to the producers, yet this loss may be very much less than that money value of the gain to purchasers which is represented by the increase of consumers' surplus.
In the case then of commodities with regard to which the law of increasing return acts at all sharply, or in other words, for which the normal supply price diminishes rapidly as the amount produced increases, the direct expense of a bounty sufficient to call forth a greatly increased supply at a much lower price, would be much less than the consequent increase of consumers' surplus. And if a general agreement could be obtained among consumers, terms might be arranged which would make such action amply remunerative to the producers, at the same time that they left a large balance of advantage to the consumers. (12)
6. One simple plan would be the levying of a tax by the community on their own incomes, or on the production of goods which obey the law of diminishing return, and devoting the tax to a bounty on the production of those goods with regard to which the law of increasing return acts sharply. But before deciding on such a course they would have to take account of considerations, which are not within the scope of the general theory now before us, but are yet of great practical importance. They would have to reckon up the direct and indirect costs of collecting a tax and administering a bounty; the difficulty of securing that the burdens of the tax and the benefits of the bounty were equitably distributed; the openings for fraud and corruption; and the danger that in the trade which had got a bounty and in other trades which hoped to get one, people would divert their energies from managing their own businesses to managing those persons who control the bounties.
Besides these semi-ethical questions there will arise others of a strictly economic nature, relating to the effects which any particular tax or bounty may exert on the interests of landlords, urban or agricultural, who own land adapted for the production of the commodity in question. These are questions which must not be overlooked; but they differ so much in their detail that they cannot fitly be discussed here. (13)
7. Enough has been said to indicate the character of the second great limitation which has to be introduced into the doctrine that the maximum satisfaction is generally to be attained by encouraging each individual to spend his own resources in that way which suits him best. It is clear that if he spends his income in such a way as to increase the demand for the services of the poor and to increase their incomes, he adds something more to the total happiness than if he adds an equal amount to the incomes of the rich, because the happiness which an additional shilling brings to a poor man is much greater than that which it brings to a rich one; and that he does good by buying things the production of which raises, in preference to things the production of which lowers the character of those who make them. (14) But further, even if we assume that a shilling's worth of happiness is of equal importance to whomsoever it comes, and that every shilling's worth of consumers' surplus is of equal importance from whatever commodity it is derived, we have to admit that the manner in which a person spends his income is a matter of direct economic concern to the community. For in so far as he spends it on things which obey the law of diminishing return, he makes those things more difficult to be obtained by his neighbours, and thus lowers the real purchasing power of their incomes; while in so far as he spends it on things which obey the law of increasing return, he makes those things more easy of attainment to others, and thus increases the real purchasing power of their incomes.
Again, it is commonly argued that an equal ad valorem tax levied on all economic commodities (material and immaterial). or which is the same thing a tax on expenditure, is prima facie the best tax; because it does not divert the expenditure of individuals out of its natural channels: we have now seen that this argument is invalid. But ignoring for the time the fact that the direct economic effect of a tax or a bounty never constitutes the whole, and very often not even the chief part of the considerations which have to be weighed before deciding to adopt it, we have found: — firstly, that a tax on expenditure generally causes a greater destruction of consumers, surplus than one levied exclusively on commodities as to which there is but little room for the economies of production on a large scale, and which obey the law of diminishing return; and secondly, that it might even be for the advantage of the community that the government should levy taxes on commodities which obey the law of diminishing return, and devote part of the proceeds to bounties on commodities which obey the law of increasing return.
These conclusions, it will be observed, do not by themselves afford a valid ground for government interference. But they show that much remains to be done, by a careful collection of the statistics of demand and supply, and a scientific interpretation of their results, in order to discover what are the limits of the work that society can with advantage do towards turning the economic actions of individuals into those channels in which they will add the most to the sum total of happiness. (15)
1. A rise or fall of the demand or supply prices involves of course a rise or fall of the demand or supply curve.
If the change is gradual, the supply curve will assume in succession a series of positions, each of which is a little below the preceding one; and in this way we might have represented the effects of that gradual improvement of industrial organization which arises from an increase in the scale of production, and which we have represented by assigning to it an influence upon the supply price for long-period curves. In an ingenious paper privately printed by Sir H. Cunynghame, a suggestion is made, which seems to come in effect to proposing that a long-period supply curve should be regarded as in some manner representing a series of short-period curves; each of these curves would assume throughout its whole length that development of industrial organization which properly belongs to the scale of production represented by the distance from Oy of the point in which that curve cuts the long period supply curve (compare Appendix H, § 3) and similarly with regard to demand.
2. Diagrams are of especial aid in enabling us to comprehend clearly the problems of this chapter.
The three figures 24, 25, 26 represent the three cases of constant, diminishing and increasing return respectively. The return in the last case is a diminishing one in the earlier stages of the increase of production, but an increasing one in those subsequent to the attainment of the original position of equilibrium, i.e. for amounts of the commodity greater than OH. In each case SS' is the supply curve, DD' the old position of the demand curve, and dd' its position after there has been increase of normal demand. In each case A and a are the old and new positions of equilibrium respectively, AH and ah are the old and new normal or equilibrium prices, and OH and Oh the old and new equilibrium amounts. Oh is in every case greater than OH, but in fig. 25 it is only a little greater, while in fig. 26 it is much greater. (This analysis may be carried further on the plan adopted later on in discussing the similar but more important problem of the effects of changes in the conditions of normal supply.) In fig. 24 ah is equal to AH, in fig. 25 it is greater, in fig. 26 it is less.
The effect of a falling off of normal demand can be traced with the same diagrams, dd' being now regarded as the old and DD' as the new position of this demand curve; ah being the old equilibrium price, and AH the new one.
3. All this can be most clearly seen by the aid of diagrams, and indeed there are some parts of the problem which cannot be satisfactorily treated without their aid. The three figures 27, 28, 29 represent the three cases of constant and diminishing and increasing returns, respectively. In each case DD' is the demand curve, SS' the old position, and ss' the new position of the supply curve. A is the old, and a the new position of stable equilibrium. Oh is greater than OH, and ah is less than AH in every case: but the changes are small in fig. 28 and great in fig. 29. Of course the demand curve must lie below the old supply curve to the right of A, otherwise A would be a point not of stable, but of unstable equilibrium.
1. It has never been supposed that the monopolist in seeking his own advantage is naturally guided in that course which is most conducive to the wellbeing of society regarded as a whole, he himself being reckoned as of no more importance than any other member of it. The doctrine of Maximum Satisfaction has never been applied to the demand for and supply of monopolized commodities. But there is much to be learnt from a study of the relations in which the interests of the monopolist stand to those of the rest of society, and of the general conditions under which it might be possible to make arrangements more beneficial to society as a whole than those which he would adopt if he consulted only his own interests: and with this end in view we are now to seek for a scheme for comparing the relative quantities of the benefits which may accrue to the public and to the monopolist from the adoption of different courses of action by him. In a later volume a study will be made of the Protean shapes of modern trade combinations and monopolies, some of the most important of which, as for example "Trusts," are of very recent growth. At present we consider only those general causes determining monopoly values, that can be traced with more or less distinctness in every case in which a single person or association of persons has the power of fixing either the amount of a commodity that is offered for sale or the price at which it is offered.
2. The prima facie interest of the owner of a monopoly is clearly to adjust the supply to the demand, not in such a way that the price at which he can sell his commodity shall just cover its expenses of production, but in such a way as to afford him the greatest possible total net revenue.
But here we meet with a difficulty as to the meaning of the term Net revenue. For the supply price of a freely-produced commodity includes normal profits; the whole of which, or at all events what remains of them after deducting interest on the capital employed and insurance against loss, is often classed indiscriminately as net revenue. And when a man manages his own business, he often does not distinguish carefully that portion of his profits, which really is his own earnings of management, from any exceptional gains arising from the fact that the business is to some extent of the nature of a monopoly.
This difficulty however is in a great measure avoided in the case of a public company; where all, or nearly all, the expenses of management are entered in the ledger as definite sums, and are subtracted from the total receipts of the company before its net income is declared.
The net income divided among the shareholders includes interest on the capital invested and insurance against risk of failure, but little or no earnings of management; so that the amount by which the dividends are in excess of what may fairly be allowed as interest and insurance, is the Monopoly Revenue which we are seeking.
Since then it is much easier to specify exactly the amount of this net revenue when a monopoly is owned by a public company than when it is owned by an individual or private firm, let us take as a typical instance the case of a gas company that has the monopoly of the supply of gas to a town. For the sake of simplicity the company may be supposed to have already invested the whole of its own capital in fixed plant, and to borrow any more capital, that it may want to extend its business, on debentures at a fixed rate of interest.
3. The demand schedule for gas remains the same as it would be if gas were a freely-produced commodity; it specifies the price per thousand feet at which consumers in the town will among them use any given number of feet. But the supply schedule must represent the normal expenses of production of each several amount supplied; and these include interest on all its capital, whether belonging to its shareholders or borrowed on debentures, at a fixed normal rate; they include also the salaries of its directors, and permanent officials, adjusted (more or less accurately) to the work required of them, and therefore increasing with an increase in the output of gas. A monopoly revenue schedule may then be constructed thus: — Having set against each several amount of the commodity its demand price, and its supply price estimated on the plan just described, subtract each supply price from the corresponding demand price and set the residue in the monopoly revenue column against the corresponding amount of the commodity.
Thus for instance if a thousand million feet could be sold annually at a price of 3s. per thousand feet, and the supply price for this amount were 2s. 9d. per thousand feet, the monopoly revenue schedule would show 3d. against this amount; indicating an aggregate net revenue when this amount was sold, of three million pence, or £12,500. The aim of the company, having regard only to their own immediate dividends, will be to fix the price of their gas at such a level as to make this aggregate net revenue the largest possible. (1)
4. Now suppose that a change takes place in the conditions of supply; some new expense has to be incurred, or some old expense can be avoided; or perhaps a new tax is imposed on the undertaking or a bounty is awarded to it.
First let this increase or diminution of the expenses be a fixed sum, bearing on the undertaking as one undivided whole and not varying with the amount of the commodity produced. Then, whatever be the price charged and the amount of the commodity sold, the monopoly revenue will be increased or diminished, as the case may be, by this sum; and therefore that selling price which afforded the maximum monopoly revenue before the change will afford it afterwards; the change therefore will not offer to the monopolist any inducement to alter his course of action. Suppose for instance that the maximum monopoly revenue is got when twelve hundred million cubic feet are sold annually; and that this is done when the price is fixed at 30d. per thousand feet: suppose that the expenses of production for this amount are at the rate of 26d., leaving a monopoly revenue at the rate of four pence per thousand feet, that is £20,000 in all. This is its maximum value: if the company fixed the price higher at, say, 31d. and sold only eleven hundred million feet, they would perhaps get a monopoly revenue at the rate of 4.2 pence per thousand feet, that is £19,250 in all; while in order to sell thirteen hundred millions they would have to lower their price to, say, 28d. and would get a monopoly revenue at the rate of perhaps 3.6d. per thousand feet, that is £19,500 in all. Thus by fixing the price at 30d. they get £750 more than by fixing it at 31d., and £500 more than by fixing it at 28d. Now let a tax of £10,000 a year be levied on the gas company as a fixed sum independent of the amount they sell. Their monopoly revenue will become £10,000 if they charge 30d., £9,250 if they charge 31d., and £9,500 if they charge 28d. They will therefore continue to charge 30d.
The same is true of a tax or a bounty proportioned not to the gross receipts of the undertaking, but to its monopoly revenue. For suppose next that a tax is levied, not of one fixed sum, but a certain percentage, say 50 per cent of the monopoly revenue. The company will then retain a monopoly revenue of £10,000 if they charge 30d., of £9,625 if they charge 31d., and of £9,750 if they charge 28d. They will therefore still charge 30d. (2)
On the other hand a tax proportional to the amount produced gives an inducement to the monopolist to lessen his output and raise his price. For by so doing he diminishes his expenses. And the excess of total receipts over total outlay may therefore be now increased by a diminution of output; though before the imposition of the tax it would have been lessened. Further, if before the imposition of the tax the net revenue was only a little greater than that which would have been afforded by much smaller sales, then the monopolist would gain by reducing his production very greatly; and hence in such cases as this, the change is likely to cause a very great diminution of production and rise of price. The opposite effects will be caused by a change which diminishes the expense of working the monopoly by a sum that varies directly with the amount produced under it.
In the last example, for instance, a tax of 2d. on each thousand feet sold would have reduced the monopoly revenue to £10,083 if the company charged 31d. per thousand feet and therefore sold eleven hundred millions; to £10,000 if they charged 30d. and therefore sold twelve hundred millions, and to £8,666 if they charged 28d. and therefore sold thirteen hundred million feet. Therefore the tax would induce the company to raise the price to something higher than 30d.; they would perhaps go to 31d., perhaps somewhat higher; for the figures before us do not show exactly how far it would be their interest to go.
On the other hand, if there were a bounty of 2d. on the sale of each thousand feet, the monopoly revenue would rise to £28,416 if they charged 31d., to £30,000 if they charged 30d., and to £30,333 if they charged 28d.: it would therefore cause them to lower the price. And of course the same result would follow from an improvement in the method of making gas, which lowered its cost of production to the monopolist company by 2d. per 1000 feet. (3)
5. The monopolist would lose all his monopoly revenue if he produced for sale an amount so great that its supply price, as here defined, was equal to its demand price: the amount which gives the maximum monopoly revenue is always considerably less than that. It may therefore appear as though the amount produced under a monopoly is always less and its price to the consumer always higher than if there were no monopoly. But this is not the case.
For when the production is all in the hands of one person or company, the total expenses involved are generally less than would have to be incurred if the same aggregate production were distributed among a multitude of comparatively small rival producers. They would have to struggle with one another for the attention of consumers, and would necessarily spend in the aggregate a great deal more on advertising in all its various forms than a single firm would; and they would be less able to avail themselves of the many various economies which result from production on a large scale. In particular they could not afford to spend as much on improving methods of production and the machinery used in it, as a single large firm which knew that it was certain itself to reap the whole benefit of any advance it made.
This argument does indeed assume the single firm to be managed with ability and enterprise, and to have an unlimited command of capital an assumption which cannot always be fairly made. But where it can be made, we may generally conclude that the supply schedule for the commodity, if not monopolized, would show higher supply prices than those of our monopoly supply schedule; and therefore the equilibrium amount of the commodity produced under free competition would be less than that for which the demand price is equal to the monopoly supply price. (4)
One of the most interesting and difficult applications of the theory of monopolies is to the question whether the public interest is best served by the allotment of a distinct basin to each great railway, and excluding competition there. For the proposal it is urged that a railway can afford to carry two million passengers, or tons of goods, cheaper than one million: and that a division of the public demand between two lines will prevent either of them from offering a cheap service. It must be admitted that, other things being equal, the "monopoly revenue price" fixed by a railway will be lowered by every increase in the demand for its services, and vice versa. But, human nature being what it is, experience has shown that the breaking of a monopoly by the opening out of a competing line accelerates, rather than retards the discovery by the older line that it can afford to carry traffic at lower rates. There still remains the suggestion that after a while the railways will combine and charge the public with the expense wasted on duplicating the services. But this again only opens out new matters of controversy. The theory of monopolies starts rather than solves practical issues such as these: and we must defer their study. (5)
6. So far we have supposed the owner of a monopoly to fix the price of his commodity with exclusive reference to the immediate net revenue which he can derive from it. But, in fact, even if he does not concern himself with the interests of the consumers, he is likely to reflect that the demand for a thing depends in a great measure on people's familiarity with it: and that if be can increase his sales by taking a price a little below that which would afford him the maximum net revenue, the increased use of his commodity will before long recoup him for his present loss. The lower the price of gas, the more likely people are to have it laid on to their houses; and when once it is there, they are likely to go on making some use of it, even though a rival, such as electricity or mineral oil, may be competing closely with it. The case is stronger when a railway company has a practical monopoly of the transport of persons and goods to a sea-port, or to a suburban district which is as yet but partly built over; the railway company may then find it worth while, as a matter of business, to levy charges much below those which would afford the maximum net revenue, in order to get merchants into the habit of using the port, to encourage the inhabitants of the port to develop their docks and warehouses; or to assist speculative builders in the new suburb to build houses cheaply and to fill them quickly with tenants, thus giving to the suburb an air of early prosperity which goes far towards insuring its permanent success. This sacrifice by a monopolist of part of his present gains in order to develop future business differs in extent rather than kind from the sacrifices which a young firm commonly makes in order to establish a connection.
In such cases as these a railway company though not pretending to any philanthropic motives, yet finds its own interests so closely connected with those of the purchasers of its services, that it gains by making some temporary sacrifice of net revenue with the purpose of increasing consumers' surplus. And an even closer connection between the interests of the producers and the consumers is found when the landowners of any district combine to make a branch railway through it, without much hope that the traffic will afford the current rate of interest on the capital which they invest — that is, without much hope that the monopoly revenue of the railway, as we have defined it, will be other than a negative quantity — but expecting that the railway will add so much to the value of their property as to make their venture on the whole a profitable one. And when a municipality undertakes the supply of gas or water, or facilities for transport by improved roads, by new bridges, or by tramways, the question always arises whether the scale of charges should be high, so as to afford a good net revenue and relieve the pressure on the rates; or should be low, so as to increase consumers' surplus.
7. It is clear then that some study is wanted of calculations by which a monopolist should govern his actions, on the supposition that he regards an increase of consumers' surplus as equally desirable to him, if not with an equal increase of his own monopoly revenue, yet with an increase, say, one-half or one-quarter as great.
If the consumers, surplus which arises from the sale of the commodity at any price, is added to the monopoly revenue derived from it, the sum of the two is the money measure of the net benefits accruing from the sale of the commodity to producers and consumers together, or as we may say the total benefit of its sale. And if the monopolist regards a gain to the consumers as of equal importance with an equal gain to himself, his aim will be to produce just that amount of the commodity which will make this total benefit a maximum. (6)
But it will seldom happen that the monopolist can and will treat £1 of consumers' surplus as equally desirable with £1 of monopoly revenue. Even a government which considers its own interests coincident with those of the people has to take account of the fact that, if it abandons one source of revenue, it must in general fall back on others which have their own disadvantages. For they will necessarily involve friction and expense in collection, together with some injury to the public, of the kind which we have described as a loss of consumers' surplus: and they can never be adjusted with perfect fairness, especially when account is taken of the unequal shares that different members of the community will get of the benefits for the sake of which it is proposed that the government should forego some of its revenue.
Suppose then that the monopolist makes a compromise, and reckons £1 of consumers' surplus as equivalent to say 10s. of monopoly revenue. Let him calculate the monopoly revenue to be got from selling his commodity at any given price, and to it let him add one half the corresponding consumers' surplus: the sum of the two may be called the compromise benefit; and his aim will be to fix on that price which will make the compromise benefit as large as possible. (7)
The following general results are capable of exact proof; but on a little consideration they will appear so manifestly true as hardly to require proof. Firstly, the amount which the monopolist will offer for sale will be greater (and the price at which he will sell it will be less) if he is to any extent desirous to promote the interests of consumers than if his sole aim is to obtain the greatest possible monopoly revenue; and secondly, the amount produced will be greater (and the selling price will be less) the greater be the desire of the monopolist to promote the interests of consumers; i.e. the larger be the percentage of its actual value at which he counts in consumers' surplus with his own revenue. (8)
8. Not many years ago it was commonly argued that: "An English ruler, who looks upon himself as the minister of the race he rules, is bound to take care that he impresses their energies in no work that is not worth the labour that is spent upon it, or — to translate the sentiment into plainer language — that he engages in nothing that will not produce an income sufficient to defray the interest on its cost." (9) Such phrases as this may sometimes have meant little more than that a benefit which consumers were not willing to purchase at a high price and on a large scale, was likely to exist for the greater part only in the specious counsels of those who had some personal interest in the proposed undertakings; but probably they more often indicated a tendency to under-estimate the magnitude of that interest which consumers have in a low price, and which we call consumers' surplus. (10)
One of the chief elements of success in private business is the faculty of weighing the advantages and disadvantages of any proposed course, and of assigning to them their true relative importance. He who by practice and genius has acquired the power of attributing to each factor its right quantity, is already well on the way to fortune; and the increase in the efficiency of our productive forces is in a great measure due to the large number of able minds who are devoting themselves ceaselessly to acquiring these business instincts. But unfortunately the advantages thus weighed against one another are nearly all regarded from one point of view, that of the producer; and there are not many who concern themselves to weigh against one another the relative quantities of the interests which the consumers and the producers have in different courses of action. For indeed the requisite facts come within the direct experience of only a very few persons, and even in the case of those few, only to a very limited extent and in a very imperfect way. Moreover when a great administrator has acquired those instincts with regard to public interests which able business men have with regard to their own affairs, he is not very likely to be able to carry his plans with a free hand. At all events in a democratic country no great public undertaking is secure of being sustained on consistent lines of policy, unless its advantages can be made clear, not only to the few who have direct experience of high public affairs, but also to the many who have no such experience and have to form their judgment on the materials set before them by others.
Judgments of this kind must always be inferior to those which an able business man forms, by the aid of instincts based on long experience with regard to his own business. But they may be made much more trustworthy than they are at present, if they can be based on statistical measures of the relative quantities of the benefits and the injuries which different courses of public action are likely to cause to the several classes of the community. Much of the failure and much of the injustice, in which the economic policies of governments have resulted, have been due to the want of statistical measurement. A few people who have been strongly interested on one side have raised their voices loudly, persistently and all together; while little has been heard from the great mass of people whose interests have lain in the opposite direction; for, even if their attention has been fairly called to the matter, few have cared to exert themselves much for a cause in which no one of them has more than a small stake. The few therefore get their way, although if statistical measures of the interests involved were available, it might prove that the aggregate of the interests of the few was only a tenth or a hundredth part of the aggregate of the interests of the silent many.
No doubt statistics can be easily misinterpreted; and are often very misleading when first applied to new problems. But many of the worst fallacies involved in the misapplications of statistics are definite and can be definitely exposed, till at last no one ventures to repeat them even when addressing an uninstructed audience: and on the whole arguments which can be reduced to statistical forms, though still in a backward condition, are making more sure and more rapid advances than any others towards obtaining the general acceptance of all who have studied the subjects to which they refer. The rapid growth of collective interests, and the increasing tendency towards collective action in economic affairs, make it every day more important that we should know what quantitative measures of public interests are most needed and what statistics are required for them, and that we should set ourselves to obtain these statistics.
It is perhaps not unreasonable to hope that as time goes on, the statistics of consumption will be so organized as to afford demand schedules sufficiently trustworthy, to show in diagrams that will appeal to the eye, the quantities of consumers, surplus that will result from different courses of public and private action. By the study of these pictures the mind may be gradually trained to get juster notions of the relative magnitudes of the interests which the community has in various schemes of public and private enterprise; and sounder doctrines may replace those traditions of an earlier generation, which had perhaps a wholesome influence in their time; but which damped social enthusiasm by throwing suspicion on all projects for undertakings by the public on its own behalf which would not show a balance of direct pecuniary profit.
The practical bearings of many of the abstract reasonings in which we have recently been engaged will not be fully apparent till we approach the end of this treatise. But there seemed to be advantages in introducing them thus early, partly because of their close connection with the main theory of equilibrium of demand and supply, and partly because they throw side lights on the character and the purposes of that investigation of the causes which determine distribution on which we are about to enter.
9. So far it has been assumed that the monopolist can buy and sell freely. But in fact monopolistic combinations in one branch of industry foster the growth of monopolistic combinations in those which have occasion to buy from or sell to it: and the conflicts and alliances between such associations play a role of ever increasing importance in modern economics. Abstract reasoning of a general character has little to say on the subject. If two absolute monopolies are complementary, so that neither can turn its products to any good account, without the other's aid, there is no means of determining where the price of the ultimate product will be fixed. Thus if we supposed, following Cournot's lead, that copper and zinc were each of them useless except when combined to make brass: and if we supposed that one man, A, owned all the available sources of supply of copper; while another, B, owned all those of zinc; there would then be no means of determining beforehand what amount of brass would be produced, nor therefore the price at which it could be sold. Each would try to get the better of the other in bargaining; and though the issue of the contest would greatly affect the purchasers, they would not be able to influence it. (11)
Under the conditions supposed, A could not count on reaping the whole, nor even any share at all of the benefit, from increased sales, that would be got by lowering the price of copper in a market in which the price of zinc was fixed by natural causes rather than strategical higgling and bargaining. For, if he reduced his price, B might take the action as a sign of commercial weakness, and raise the price of zinc; thus causing A to lose both on price and on amount sold. Each would therefore be tempted to bluff the other; and consumers might find that less brass was put on the market, and that therefore a higher price could be exacted for it, than if a single monopolist owned the whole supplies both of copper and of zinc: for he might see his way to gaining in the long run by a low price which stimulated consumption. But neither A nor B could reckon on the effects of his own action, unless the two came together and agreed on a common policy: that is unless they made a partial, and perhaps temporary fusion of their monopolies. On this ground, and because monopolies are likely to disturb allied industries it may reasonably be urged that the public interest generally requires that complementary monopolies should be held in a single hand.
But there are other considerations of perhaps greater importance on the other side. For in real life there are scarcely any monopolies as absolute and permanent as that just discussed. On the contrary there is in the modern world an ever increasing tendency towards the substitution of new things and new methods for old, which are not being developed progressively in the interests of consumers; and the direct or indirect competition thus brought to bear is likely to weaken the position of one of the complementary monopolies more than the other. For instance if there be only one factory for spinning and only one for weaving in a small isolated country, it may be for the time to the public interest that the two should be in the same hands. But the monopoly so established will be much harder to shake than would either half of it separately. For a new venturer might push his way into the spinning business and compete with the old spinning mill for the custom of the old weaving sheds.
Consider again a through route, partly by rail and partly by sea, between two great centres of industry. If competition on either half of the route were permanently impossible, it would probably be to the public interest that the ships and the railway line should be in the same hands. But as things are, no such general statement can be made. Under some conditions it is more to the public interest that they should be in one hand; under others, and those perhaps the conditions that occur the more frequently, it is in the long run to the public interest that they should remain in different hands.
Similarly the prima facie arguments in favour of the fusion of monopolistic cartels, or other associations, in complementary branches of industry, though often plausible and even strong, will generally be found on closer examination to be treacherous. They point to the removal of prominent social and industrial discords; but at the probable expense of larger and more enduring discords in the future. (12)
1. Thus DD' being the demand curve, and SS' the curve corresponding to the supply schedule described in the text, let MP2P1 be drawn vertically from any point M in Ox, cutting SS' in P2 and DD' in P1; and from it cut off MP3 = call P2P1, then the locus of P3 will be our third curve, QQ', which we may the monopoly revenue Curve. The supply price for a small quantity of gas will of course be very high; and in the neighbourhood of Oy the supply curve will be above the demand curve, and therefore the net revenue curve will be below Ox. It will cut Ox in K and again in H, points which are vertically under B and A, the two points of interaction of the demand and supply curves. The maxi mum monopoly revenue will then be obtained by finding a point q3 on QQ' such that Lq3 being drawn perpendicular to Ox, OL x Lq3 is a maximum. Lq3 being produced to cut SS' in q2 and DD' in q1, the company, if desiring to obtain the greatest immediate monopoly revenue, will fix the price per thousand feet at Lq1, and consequently will sell OL thousand feet; the expenses of pro duction will be Lq2 per thousand feet, and the aggregate net revenue will be OL x q2q1, or which is the same thing OL x Lq3.
The dotted lines in the diagram are known to mathematicians as rectangular hyperbolas; but we may call them constant revenue curves: for they are such that if from a point on any one of them lines be drawn perpendicular to Ox and Oy respectively (the one representing revenue per thousand feet and the other representing the number of thousand feet sold), then the product of these will be a constant quantity for every point on one and the same curve. This product is of course a smaller quantity for the inner curves, those nearer Ox and Oy, than it is for the outer curves. And consequently since P3 is on a smaller constant revenue curve than q3 is, OM x MP 3 is less than OL x Lq2. It will be noticed that q3 is the point in which QQ' touches one of these curves. That is, q3 is on a larger constant revenue curve than is any other point on QQ'; and therefore OL x Lq3 is greater than OM x MP3, not only in the position given to M in the figure, but also in any position that M can take along Ox. That is to say, q3 has been correctly determined as the point on QQ' corresponding to the maximum total monopoly revenue. And thus we get the rule: — If through that point in which QQ' touches one of a series of constant revenue curves, a line be drawn vertically to cut the demand curve, then the distance of that point of intersection from Ox will be the price at which the commodity should be offered for sale in order that it may afford the maximum monopoly revenue. See Note XXII in the Mathematical Appendix.
2. If to the expenses of working a monopoly there be added (by a tax or otherwise) a lump sum independent of the amount produced, the result will be to cause every point on the monopoly revenue curve to move downwards to a point on a constant revenue curve representing a constant revenue smaller by a fixed amount than that on which it lies. Therefore the maximum revenue point on the new monopoly revenue curve lies vertically below that on the old: that is, the selling price and the amount produced remain unchanged, and conversely with regard to a fixed bounty or other fixed diminution of aggregate working expenses. As to the effects of a tax proportional to monopoly revenue, see Note XXIII in the Mathematical Appendix.
It should however be noticed that if a tax or other new additional expense exceeds the maximum monopoly revenue, it will prevent the monopoly from being worked at all; it will convert the price which had afforded the maximum monopoly revenue into the price which would reduce to a minimum the loss that would result from continuing to work the monopoly.
3. In the text it is supposed that the tax or bounty is directly proportional to the sales: but the argument, when closely examined, will be found to involve no further assumption than that the aggregate tax or bounty increases with every increase in that amount: the argument does not really require that it should increase in exact proportion to that amount.
Much instruction is to be got by drawing diagrams to represent various conditions of demand and of (monopoly) supplv, with the resultant shapes of the monopoly revenue curve. A careful study of the shapes thus obtained will give more assistance than any elaborate course of reasoning in the endeavour to realize the multiform action of economic forces in relation to monopolies. A tracing may be made on thin paper of the constant revenue curves in one of the diagrams; and this, when laid over a monopoly revenue curve, will indicate at once the point, or points, of maximum revenue. For it will be found, not only when the demand and supply curves cut one another more than once, but also when they do not, there will often be, as in fig. 35, several points on a monopoly revenue curve at which it touches a constant revenue curve. Each of these points will show a true maximum monopoly revenue; but one of them will generally stand out pre-eminently as being on a larger constant revenue curve than any of the others and therefore indicating a larger monopoly revenue than they.
1. The present chapter contains no new matter: it is a mere summary of the results of Book V. The second half of it may be of service to anyone who has omitted the later chapters: for it may indicate, though it cannot explain, their general drift.
In Book V we have studied the theory of the mutual relations of demand and supply in their most general form; taking as little account as possible of the special incidents of particular applications of the theory, and leaving over for the following Book the study of the bearings of the general theory on the special features of the several agents of production, Labour, Capital, and Land.
The difficulties of the problem depend chiefly on variations in the area of space, and the period of time over which the market in question extends; the influence of time being more fundamental than that of space.
Even in a market of very short period, such as that of a provincial corn-exchange on market-day, the "higgling and bargaining" might probably oscillate about a mean position, which would have some sort of a right to be called the equilibrium price: but the action of dealers in offering one price or refusing another would depend little, if at all, on calculations with regard to cost of production. They would look chiefly at present demand on the one hand, and on the other at the stocks of the commodity already available. It is true that they would pay some attention to such movements of production in the near future as might throw their shadow before; but in the case of perishable goods they would look only a very little way beyond the immediate present. Cost of production has for instance no perceptible influence on the day 's bargaining in a fish-market.
In a rigidly stationary state in which supply could be perfectly adjusted to demand in every particular, the normal expenses of production, the marginal expenses, and the average expenses (rent being counted in) would be one and the same thing, for long periods and for short. But, as it is, the language both of professed writers on economics and of men of business shows much elasticity in the use of the term Normal when applied to the causes that determine value. And one fairly well marked division needs study.
On the one side of this division are long periods, in which the normal action of economic forces has time to work itself out more fully; in which therefore a temporary scarcity of skilled labour, or of any other of the agents of production, can be remedied; and in which those economies that normally result from an increase in the scale of production — normally, that is without the aid of any substantive new invention — have time to develop themselves. The expenses of a representative firm, managed with normal ability and having normal access to the internal and external economies of production on a large scale, may be taken as a standard for estimating normal expenses of production: and when the period under survey is long enough to enable the investment of capital in building up a new business to complete itself and to bear full fruits; then the marginal supply price is that, the expectation of which in the long run just suffices to induce capitalists to invest their material capital, and workers of all grades to invest their personal capital in the trade.
On the other side of the line of division are periods of time long enough to enable producers to adapt their production to changes in demand, in so far as that can be done with the existing provision of specialized skill, specialized capital, and industrial organization; but not long enough to enable them to make any important changes in the supplies of these factors of production. For such periods the stock of material and personal appliances of production has to be taken in a great measure for granted; and the marginal increment of supply is determined by estimates of producers as to the amount of production it is worth their while to get out of those appliances. If trade is brisk all energies are strained to their utmost, overtime is worked, and then the limit to production is given by want of power rather than by want of will to go further or faster. But if trade is slack every producer has to make up his mind how near to prime cost it is worth his while to take fresh orders. And here there is no definite law, the chief operative force is the fear of spoiling the market; and that acts in different ways and with different strengths on different individuals and different industrial groups. For the chief motive of all open combinations and of all informal silent and "customary" understandings whether among employers or employed is the need for preventing individuals from spoiling the common market by action that may bring them immediate gains, but at the cost of a greater aggregate loss to the trade.
2. We next turned aside to consider the relations of demand and supply with reference to things that need to be combined together for the purposes of satisfying a joint demand; of which the most important instance is that of the specialized material capital, and the specialized personal skill that must work together in any trade. For there is no direct demand on the part of consumers for either alone, but only for the two conjointly; the demand for either separately is a derived demand, which rises, other things being equal, with every increase in the demand for the common products, and with every diminution in the supply price of the joint factors of production. In like manner commodities of which there is a joint supply, such as gas and coke, or beef and hides, can each of them have only a derived supply price, governed by the expenses of the whole process of production on the one hand, and on the other by the demand for the remaining joint products.
The composite demand for a thing, resulting from its being used for several different purposes, and the composite supply of a thing, that has several sources of production, present no great difficulty; for the several amounts demanded for the different purposes, or supplied from different sources, can be added together, on the same plan as was adopted in Book III, for combining the demands of the rich, the middle classes and the poor for the same commodity.
Next we made some study of the division of the supplementary costs of a business, — and especially those connected with building up a trade connection, with marketing, and with insurance — among the various products of that business.
3. Returning to those central difficulties of the equilibrium of normal demand and supply which are connected with the element of time, we investigated more fully the relation between the value of an appliance for production and that of the things produced by it.
When different producers have different advantages for producing a thing, its price must be sufficient to cover the expenses of production of those producers who have no special and exceptional facilities; for if not they will withhold or diminish their production, and the scarcity of the amount supplied, relatively to the demand, will raise the price. When the market is in equilibrium, and the thing is being sold at a price which covers these expenses, there remains a surplus beyond their expenses for those who have the assistance of any exceptional advantages. If these advantages arise from the command over free gifts of nature, the surplus is called a producer's surplus or producer's rent: there is a surplus in any case, and if the owner of a free gift of nature lends it out to another, he can generally get for its use a money income equivalent to this surplus.
The price of the produce is equal to the cost of production of that part of it, which is raised on the margin, that is under such unfavourable conditions as to yield no rent. The cost of this part can be reckoned up without reasoning in a circle; and the cost of other parts cannot.
If land which had been used for growing hops, is found capable of yielding a higher rent as market-garden land, the area under hops will undoubtedly be diminished; and this will raise their marginal cost of production and therefore their price. The rent which land will yield for one kind of produce, calls attention to the fact that a demand for the land for that kind of produce increases the difficulties of supply of other kinds; though it does not directly enter into those expenses. And similar arguments apply to the relation between the site values of urban land and the costs of things made on it.
Thus when we are taking a broad view of normal value, when we are investigating the causes which determine normal value "in the long run," when we are tracing the "ultimate" effects of economic causes; then the income that is derived from capital in these forms enters into the payments by which the expenses of production of the commodity in question have to be covered; and estimates as to the probable amount of that income directly control the action of the producers, who are on the margin of doubt as to whether to increase the means of production or not. But, on the other hand, when we are considering the causes which determine normal prices for a period which is short relatively to that required for largely increasing the supply of those appliances for production; then their influence on value is chiefly indirect and more or less similar to that exerted by the free gifts of nature. The shorter the period which we are considering, and the slower the process of production of those appliances, the less part will variations in the income derived from them play in checking or increasing the supply of the commodity produced by them, and in raising or lowering its supply price.
4 This leads to the consideration of some difficulties of a technical character connected with the marginal expenses of production of a commodity that obeys the law of increasing return. The difficulties arise from the temptation to represent supply price as dependent on the amount produced, without allowing for the length of time that is necessarily occupied by each individual business in extending its internal, and still more its external organization; and in consequence they have been most conspicuous in mathematical and semi-mathematical discussions of the theory of value. For when changes of supply price and amount produced are regarded as dependent exclusively on one another without any reference to gradual growth, it appears reasonable to argue that the marginal supply price for each individual producer is the addition to his aggregate expenses of production made by producing his last element; that this marginal price is likely in many cases to be diminished by an increase in his output much more than the demand price in the general market would be by the same cause.
The statical theory of equilibrium is therefore not wholly applicable to commodities which obey the law of increasing return. It should however be noted that in many industries each producer has a special market in which he is well known, and which he cannot extend quickly; and that therefore, though it might be physically possible for him to increase his output rapidly, he would run the risk of forcing down very much the demand price in his special market, or else of being driven to sell his surplus production outside on less favourable terms. And though there are industries in which each producer has access to the whole of a large market, yet in these there remain but few internal economies to be got by an increase of output, when the existing plant is already well occupied. No doubt there are industries as to which neither of these statements is true: they are in a transitional state, and it must be conceded that the statical theory of equilibrium of normal demand and supply cannot be profitably applied to them. But such cases are not numerous; and with regard to the great bulk of manufacturing industries, the connection between supply price and amount shows a fundamentally different character for short periods and for long.
For short periods, the difficulties of adjusting the internal and external organization of a business to rapid changes in output are so great that the supply price must generally be taken to rise with an increase, and to fall with a diminution in the amount produced.
But in long periods both the internal and the external economies of production on a large scale have time to develop themselves. The marginal supply price is not the expenses of production of any particular bale of goods: but it is the whole expenses (including insurance, and gross earnings of management) of a marginal increment in the aggregate process of production and marketing.
5. Some study of the effects of a tax, regarded as a special case of a change in the general conditions of demand and supply suggests that, when proper allowance is made for the interests of consumers, there is on abstract grounds rather less prima facie cause than the earlier economists supposed, for the general doctrine of so-called "Maximum Satisfaction"; i.e. for the doctrine that the free pursuit by each individual of his own immediate interest, will lead producers to turn their capital and labour, and consumers to turn their expenditure into such courses as are most conducive to the general interests. We have nothing to do at this stage of our inquiry, limited as it is to analysis of the most general character, with the important question how far, human nature being constituted as it is at present, collective action is likely to be inferior to individualistic action in energy and elasticity, in inventiveness and directness of purpose; and whether it is not therefore likely to waste through practical inefficiency more than it could save by taking account of all the interests affected by any course of action. But even without taking account of the evils arising from the unequal distribution of wealth, there is prima facie reason for believing that the aggregate satisfaction, so far from being already a maximum, could be much increased by collective action in promoting the production and consumption of things in regard to which the law of increasing return acts with especial force.
This position is confirmed by the study of the theory of monopolies. It is the immediate interest of the monopolist so to adjust the production and sale of his wares as to obtain for himself the maximum net revenue, and the course which he thus adopts is unlikely to be that which affords the aggregate maximum satisfaction. The divergence between individual and collective interests is prima facie less important with regard to those things which obey the law of diminishing return, than with regard to those which obey the law of increasing return: but, in the case of the latter, there is strong prima facie reason for believing that it might often be to the interest of the community directly or indirectly to intervene, because a largely increased production would add much more to consumers' surplus than to the aggregate expenses of production of the goods. More exact notions on the relations of demand and supply, particularly when expressed in the form of diagrams, may help us to see what statistics should be collected, and how they should be applied in the attempt to estimate the relative magnitudes of various conflicting economic interests, public and private.
Ricardo's theory of cost of production in relation to value occupies so important a place in the history of economics that any misunderstanding as to its real character must necessarily be very mischievous; and unfortunately it is so expressed as almost to invite misunderstanding. In consequence there is a widely spread belief that it has needed to be reconstructed by the present generation of economists. Cause is shown in Appendix I for not accepting this opinion; and for holding on the contrary that the foundations of the theory as they were left by Ricardo remain intact; that much has been added to them, and that very much has been built upon them, but that little has been taken from them. It is there argued that he knew that demand played an essential part in governing value, but that he regarded its action as less obscure than that of cost of production, and therefore passed it lightly over in the notes which he made for the use of his friends, and himself; for he never essayed to write a formal treatise: also that he regarded cost of production as dependent — not as Marx asserted him to have done on the mere quantity of labour used up in production, but — on the quality as well as quantity of that labour; together with the amount of stored up capital needed to aid labour, and the length of time during which such aid was invoked.